Business transactions are a crucial aspect of every business. Without it, a business may not know its position at a particular period of time. This article will give you a formal definition of a business transaction, its different types, and examples of typical business transactions.
1. What is a business transaction?
In accounting, a business transaction (also known as a financial transaction) is an event that must be measurable in terms of money and impacts the business’s financial position. It can also be defined as any monetary activity that occurs in a business. All business transactions must be accompanied by a source document.
For instance, if you run a merchandising business and sell goods to a customer for $1000 cash, you can measure this event in terms of money and impact to your business’s financial position. So it’s a valid business transaction. Similarly, suppose you pay $500 in cash to your salesman as his pay. In that case, this event is also a transaction because it has a monetary value of $500, making a financial impact on your business. Only those events that can be measured in monetary terms are included in the business’ accounting records.
There are numerous events related to a business to which we can’t reliably assign a monetary value. Such events can’t be called business transactions or financial transactions. For example, when a company CEO delivers a motivational speech to the employees, though this event may be of great benefit to the business, we can’t assign a monetary value to it. So it isn’t a business transaction and can’t become a part of accounting records.
Each business transaction must be recorded by making a journal entry by the bookkeeper or accountant. Since each transaction impacts the business’s financial position, the bookkeeper or accountant must make sure that a responsible person has authorized it.
See also: Bookkeeping For Entrepreneurs Best Practices.
One or more source documents must support a valid business transaction before being recorded to the journal. Typical examples of source documents are sales invoices, purchase invoices, cash receipts, payment vouchers, statement of accounts, bills of exchange, promissory notes. Basically, any other document containing the basic transaction details can be presented as proof of valid transaction.
2. Characteristics of a business transaction
A business transaction can be an exchange transaction (which involves physical value exchange such as purchase, payment, etc.) or a non-exchange transaction (which does not involve physical exchange, such as fire loss, flood loss, internal production, depreciation, etc.). A business transaction can be as simple as a cash purchase or as complex as a long-term service contract. However, a business transaction must include the following characteristics:
- The transaction must be for a certain sum of money
- The transaction occurs between two parties
- The transaction is on behalf of the business entity
- The transaction isn’t for any individual person’s purpose
- The transaction must be supported by authorized legitimate documents (sales invoice, official receipt, disbursement voucher, remittance advice, etc.)
- The transaction must have a two-fold effect on the elements of accounting.
3. Main types of business transactions
In accounting, there are two ways to classify business transactions: cash and credit transactions or internal and external transactions.
Cash and credit transactions
Cash transaction: In a cash transaction, the payment was paid or received in cash at the time the transaction occurred. For example, suppose you purchase a new shirt from a store and pay at checkout, a cash transaction happens between you and the store. Even if you made the payment with a credit card, as long as it was a payment in-full at the time of purchase, it is still considered a cash transaction because the payment is made when the transaction occurs. In the modern business world today, cash transactions are not limited to currency notes for making or receiving payments. All transactions made using debit or credit issued by financial institutions are also categorized as cash transactions.
Credit transaction: A transaction is classified as a credit transaction when the payment is made after a set period of time, also called the credit period. In other words, the payment is received or paid at a future date. For example, when you purchase a couch from a furniture store, the store allows you to pay within the next 30 days instead of paying at the time of the transaction. Though cash isn’t involved at the time of sale, you will need to pay to the couch after a set period of 30 days. In the business world today, goods are mostly purchased and sold on credit.
Internal and external transactions
Internal transaction: When there is no external party involved in a business transaction, it’s classified as an internal transaction. Even though there is no value exchange with a third party, a monetary event has taken place that impacts the business’s accounting. An internal transaction can be in the form of depreciation on a fixed asset or loss of assets. The internal transaction is also known as a non-exchange transaction.
External Transaction: An external transaction is sometimes called an exchange transaction. This transaction occurs when two or more parties are involved in the transaction. These are daily occurring transactions such as purchasing goods, paying rent or utilities, or paying employees. Normally, a large portion of business transactions consists of external transactions.
4. Examples of business transactions
Let’s take a look at some common business transactions:
- Sales of goods and services (either for cash or credit);
- Purchasing of goods and materials (either in cash or credit);
- Purchasing services (such as equipment repair, advertising, printing costs);
- Investment of cash on other assets by the business owners;
- Borrowing of cash for business purposes from other entities;
- Withdrawal of cash or other assets, and distribution of dividends;
- Paying wages and salaries;
- Accounting for and paying tax;
- Collection of receivables from customers and other entities;
- Payment of payables to the supplier or other entities;
- Consumption or expiration of assets (e.g., the use of office supplies, the expiration of insurance, expiration of rent, depreciation of equipment, etc.);
- Movements of cash in the bank account (which usually arise from the transactions above).
It’s important to understand your company’s role in a transaction. It affects everything from how you provide services to your customers to marketing, pricing, and more. Understanding thoroughly about these types of business transactions helps you make more informed decisions about the business.
In most cases, companies have to work with multiple types of business transactions, and they need to keep track of them with numerous paperwork like invoices, receipts, and expense reports. If this sounds familiar to you, then you can consider digitizing your paper receipts and getting them into action.
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