Definition and explanation
In accounting, the business transaction (also known as financial transaction) is an event that must be measurable in terms of money and that essentially impacts the financial position of the business. For example, you run a merchandising business and you sell some goods to a customer for $500 cash; it is an event that you can measure in terms of money and that impacts the financial position of your business so it is a valid business transaction. Similarly, you pay $400 cash to your salesman as his pay. This event is also a transaction because it has a monetary value of $400 and has a financial impact on your business. Only those events that can be measured in monetary terms are included in accounting records of the business.
There may be numerous events related to a business to which we cannot reliably assign a dollar value. Such conditions or events cannot be called business or financial transactions. For example, the CEO of a company delivers a motivational lecture to the employees. Undoubtedly, this event may be of great benefit for the company’s business but we cannot assign a monetary value to it so it is not a business transaction and therefore cannot become a part of accounting records.
Each transaction is recorded by making a journal entry by the bookkeeper or accountant. Since each transaction impacts financial position of the business, the bookkeeper or accountant must make sure that it has been authorized by a responsible person and is properly supported by one or more source documents before recording it in the journal. A source document is a document that provides basic information needed to record a transaction in the journal. Usual examples of source documents include sales invoices, purchase invoices, cash receipts, payment vouchers, statement of accounts, bills of exchange, promissory notes and any other document containing the basic transaction details which can be presented as a proof of valid transaction.
Characteristics of a business transaction
From above discussion, we can point out the following five important characteristics of a valid business transaction that every bookkeeper or accountant must take care of before entering the transaction in the journal.
- It is a monetary event.
- It affects financial position of the business.
- It belongs to business not to the owner or any other person managing the business.
- It is initiated by an authorized person.
- It is supported by a source document.
Types of business transactions
In accounting, the transactions may be classified as:
- cash transactions and credit transactions
- internal transactions and external transactions
(1) Cash and credit transactions
A transaction in which cash is paid or received immediately at the time when transaction occurs is known as cash transaction. For example, you sell some goods to Mr. John for $50 and Mr. John immediately pays $50 cash for the goods purchased. It is a cash transaction because you have immediately received cash for the goods sold to your customer. Similarly, you buy furniture for your business for $750. You immediately pay $750 cash to the supplier and get the possession of furniture. It is also a cash transaction.
In today’s modern business world, cash transactions are not limited to the use of currency notes or coins for making or receiving payments, all transactions made using debit or credit cards issued by financial institutions are also categorized as cash transactions.
In a credit transaction, the cash does not change the hands immediately at the time when transaction occurs. In other words, the cash is received or paid at a future date. For example, you buy some merchandise from your vendor for $1,000. Upon your request, your vendor agrees to receive the payment of $1,000 for goods sold to you next weak. You take the possession of the goods and transport them to your store. It is a credit transaction because you have not made the payment in cash immediately at the time of purchase of goods. Similarly, you sell some goods to Mr. Sam for $150. Mr. Sam requests you to receive the payment of $150 next month. You agree. Mr. Sam takes the goods to his home for use. This is also a credit transaction because you have not received the payment in cash at the time of sale of goods to Mr. Sam.
In today’s business world goods are mostly purchased and sold on credit.
(2) Internal and external transactions
Internal transactions (also known as non-exchange transactions) are those transactions in which no external parties are involved. These transactions do not involve in the exchange of values between two parties but the event constituting the transaction is measurable in monetary terms and impacts the financial position of the business. Examples of such transactions include recording depreciation of fixed assets and realizing the loss of assets caused by fire etc.
External transactions (also known as exchange transactions) are transactions in which a business exchanges value with external parties. Normally, all transactions other than internal transactions are external transactions. These are the usual transactions that a business performs on daily basis. Examples of external transactions include purchase of goods from suppliers, sale of goods to customers, purchase of fixed assets for business use, payment of rent to owner, payment of gas, electricity or water bills, payment of salary to employees etc. Normally, a large portion of transactions performed by any business consists of external transactions.