What Is a Transaction? Definition & Meaning in Accounting

A financial transaction is an exchange between two parties. Learn the nuances of the term “transaction” in accounting in this quick guide.

Financial transactions are the basis of accounting. And yet. Depending on how you do accounting, the way they work is quite different.

The two main bookkeeping methods approach the term “transaction” in differing ways. The accrual accounting method and cash accounting method are the two modes we’ll explore.

Here’s What We’ll Cover:

What Is a Transaction? Definition

What Is a Third-Party Transaction

How Transactions Work in Accrual Basis Accounting

How Transactions Work in Cash Basis Accounting

Key Takeaways

What Is a Transaction? Definition

The meaning of the transaction is quite simple. It’s the monetary exchange between a buyer and a seller for a good or service.

The buyer gives money. The seller accepts the payment and delivers the service or product in kind.

What Is a Third-Party Transaction?

A third-party transaction complicates things slightly. Most financial transactions are between two parties. When an intermediary is added to the mix, it becomes a third-party transaction. The details of how the intermediary operates depends on the deal at hand.

For example, say that you are looking for business insurance. You can go to an insurance provider directly and pay them for the service. That would be a transaction in the traditional sense of the word.

Now consider going through an insurance broker. You’re using the broker to find you the best rates across a broad spectrum of insurance providers. The broker is your third-party intermediary in this transaction. They will receive a commission for the sale from the insurance provider. However, they are not directly affiliated with the insurance company or the customer. Therefore, it’s a third party transaction.

Other examples of third-party transactions:

• PayPal is an example of a third-party intermediary for online transactions
• Mortgage brokers are intermediaries for mortgage providers and homeowners

How Transactions Work in Accrual Basis Accounting

So the idea of transactions is simple on the surface. But how they are treated in your bookkeeping depends on the accounting system you subscribe to.

The accrual accounting method is when you record a transaction at the time of purchase. Once the deal is made between you and the customer, you record that money as income. That’s regardless of whether they have actually paid yet.

It’s the same for expenses. You record the business expense as done when the purchase is agreed upon. Not when the money actually leaves your account.

This follows the matching principle that revenue and expenses should match on your accounting ledger.

Example of accrual accounting in action:

Say you agree to sell a product to a customer in instalments from May to June. Using accrual accounting, you would mark the transaction for the full amount as accounts receivable as soon as the deal is made in May. It would therefore count as income in May, even though the balance isn’t settled until June.

How Transactions Work in Cash Basis Accounting

The cash accounting method works a little differently. It’s most popular with small businesses and freelancers.

The principle of cash accounting is to only record income when the money arrives in your business account. The same goes for expenses – you only record them when the money has left your account.

You get a snapshot of your day-to-day cash flow with this system, but it’s ultimately pretty inaccurate. Usually it shows you are more profitable than you are because you haven’t paid your bills yet. Accrual accounting is more accurate overall but more complex to manage and understand.

Cash accounting is far easier to manage in terms of your HMRC tax returns. However, only sole proprietorships and partnerships can use cash accounting legally. Limited companies have to use the accrual method for your accounting records.

Example of cash accounting in action:

You agree to provide a service for a customer. You sign a contract and send your bank details for the deposit in May. But the money doesn’t arrive until June. Using the cash system, you only record the payment as income once it is in your bank account.

Key Takeaways

Sales transactions are simply the exchange of money for goods and services. When you record the sale as income depends on which accounting method you follow.

For more quick accounting guides like this one, head to our resource hub.

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