What is a transaction?
A transaction is an entire agreement between a buyer and a seller to exchange goods, services, or financial assets. But in business accounting, this simple definition can get complicated. A transaction will be posted sooner or later, depending on whether the business uses accrual (or accrual) accounting rather than cash accounting.
- The accrual accounting method requires that a transaction be recorded when it occurs, regardless of when money is received or expenses are paid.
- The cash accounting method records a transaction only when money is received or expenses are paid. This may require a letter of intent or a memorandum of understanding.
Businesses with gross income greater than $ 5 million a year use accrual (or accrual) accounting, while most small businesses use the cash method of accounting.
Understanding the transaction
A sales transaction between a buyer and a seller is relatively straightforward. Person A pays person B in exchange for a product or service. When the terms are agreed, the transaction is complete.
Transactions can be more complex in the accounting world, as companies can make a deal today that won’t close until a future date. Or they may have income or expenses that are known but not yet due. Third-party transactions can also complicate the process.
The fact that a company records income and expense transactions using the accrual method of accounting or the cash method of accounting affects the financial and tax reports of the company.
- Accrual (or accrual) accounting recognizes a transaction immediately after it is finalized, regardless of when the payment is received or paid.
- Cash accounting records a transaction only when money is received or paid.
- Most small businesses use cash accounting, while businesses with gross income greater than $ 5 million a year use accrual (or accrual) accounting.
Using accrual accounting
When accrual (or accrual) accounting is used, a business records revenue by completing a service or delivering goods. If inventory is required when accounting for a business’s revenue, and the business has gross revenue greater than $ 5 million per year, the business typically uses the accrual method to account for sales and purchases.
Accrual accounting examples
For example, a business that sells merchandise to a customer on store credit in October immediately posts the transaction as an item in accounts receivable. Even if the customer does not make a cash payment for the merchandise until December or pay in installments, the transaction is recorded as October income.
If a customer buys something on credit, it will be recorded immediately as a transaction if the accrual accounting method is used.
The same happens with the goods or services that the company buys. Business expenses are recorded when the products or services are received. Supplies purchased on credit in April are recorded as April expenses, even if the company does not make a cash payment for the supplies until May.
Use of cash accounting
Most small businesses, especially sole proprietorships and partnerships, use the cash method of accounting. Income is recorded when customers receive cash, checks, or credit card payments.
Cash accounting examples
For example, a business sells $ 10,000 worth of widgets to a customer in March. The customer pays the invoice in April. The company recognizes the sale only after the cash is received in April.
Meanwhile, expenses are recorded only when a payment is made. For example, a business may buy $ 500 worth of office supplies in May and pay for it in June. The company recognizes the purchase when it pays the invoice in June.
For tax reasons, the cash basis of accounting is available only if a business has less than $ 5 million in annual sales. The cash basis is easier than the accrual basis to record transactions because complex accounting transactions such as accruals and deferrals are not necessary. Its downside is that business profits can vary enormously from month to month, at least on paper.