The simplest definition of an accounting transaction is an event that occurs that has an impact on your business’ financial statements. This event is recorded in your business’ accounting records, and keeping track of the totality of these transactions allows you to analyze and predict your business’ financial health. (See also: “What is accounting and why do I need it?” for more on this.) Some examples of a transaction in accounting include making a sale to a customer, purchasing supplies for your business from a supplier, or borrowing money from a lender (such as taking out a loan from the bank).
The Accounting Equation
Every transaction in accounting is part of the accounting equation, which can be expressed as: assets = liabilities + owner’s equity. We’ll define these terms below, but for now you should know that any transaction that occurs within your business—whether it be a sale you’ve made to a customer or a loan you’ve taken out from the bank—must result in a balanced equation.
Let’s look at taking out a bank loan as an example: this transaction results in an increase to the amount of cash the business has (which is part of the business’ assets) on the left-hand side of the equation, while on the right-hand side of the equation, it also results in an increase, this time to loans payable (part of the business’ liabilities).
Now let’s look at each separate part of the accounting equation and define its different terms. First off, on the left-hand side we have assets. Assets can be defined as the resources controlled by your business which can lead to future financial gain (i.e., cash, equipment, vehicles, land, etc.). If something is owned or controlled by your company and will provide measurable future benefits, then it can be considered an asset. In this way, anyone who owes your company money (debtors) can be considered an asset: this is known as accounts receivable (“receivable” meaning “can or will be received”).
The first term on the right-hand side of the equation is owner’s equity, which is essentially the owner’s stake in the business. In the case of a legal corpoation, owner’s equity is called shareholders’ equity. When starting up a business, the owner will invest assets (capital) into the company with the goal of earning a profit.
Lastly, we have liabilities: these are debts owed to outside parties (such as a loan from the bank) which must be paid back in the future. Until they are paid back, these outside parties have a claim on the business’ assets equal to the amount of the liability.
At some point, you may want or need to withdraw assets from the company: this is referred to as drawings or owner’s draw, and is the opposite of investing capital in the business. This withdrawal results in a decrease in both the assets and the owner’s equity (and since the same amount is subtracted from either side of the accounting equation, it remains balanced). For more on this topic, see our support article “Recording Money the Company Owners Put Into and Take Out of the Business.”
Profits, Income and Expenses
We mentioned earlier that business owners invest capital into their company when starting up a business in order to earn a profit. A profit is the positive amount left over when subtracting expenses from income: profit = income – expenses. The profit being made by a for-profit organization is a good indicator of its financial performance. (Of course, there are also non-profit organizations, such as educational institutions and charities, where surplus revenues are used to advance the organization’s goals rather than pay owners and/or shareholders.)
Income in accounting can be defined as an event that results in money flowing into your business. Income is not the same as cash (which is a separate element of accounting), but rather is the event itself – making a sale, receiving interest, etc. – that leads to an increase in the business’ assets, as well as the owner’s equity. (Remember: both sides of the accounting equation mentioned above must remain balanced.)
Before moving on to define expenses, let’s look at accrued income. This is income that is owed to the business (income that is payable, which is where we get the term “accounts payable”). For example, let’s say you make a sale in September, but do not receive payment for the sale until December. This means that the sale was made on credit, and would be recorded in your accounting system on an accrual basis, where the income, as well as the fact that a debt is owed, is recorded from the time the sale is made in September until you receive payment in December. When this payment is received, the debt that was previously owed to you no longer exists, resulting in an increase in cash assets (from receiving the payment) and an equal decrease in debtor assets. Transactions recorded on a cash basis, on the other hand, mean that the income is recorded when you receive the payment in hand, and no debt is recorded.
Now that we’ve explored income and how it is recorded on an accrual or cash basis, let’s take a look at expenses. Expenses can be defined as events that result in money leaving, or flowing out of, your business (the opposite of income). The money may be flowing out of the business immediately, or at a later date, such as with the payment of a bill at the end of a payment term. Some common examples of expenses include wages paid to employees, insurance, and loan payments. Whereas an increase in income leads to an increase in owner’s equity, expenses and owner’s equity are conversely related, meaning that as expenses go up, owner’s equity goes down, and vice versa.
As with recording income, expenses may occur and be recorded on a cash basis (where the expense is paid right away), or on an accrual basis (where the expense will be paid at a later time). In terms of our accounting equation, expenses are added to liabilities: when the expense is paid off—whether it be a bill or a bank loan or some other expense—there will be a decrease on the assets side of the equation, as well as on the liabilities side, keeping the equation balanced. To learn more about entering expenses, bills, and bill payments in Kashoo, check out our support article.
And there you have it: the basics of accounting transactions! If you haven’t already, be sure to check out our last post, “What is accounting and why do I need it?” for a more general overview of why accounting is so important for your business. As always, feel free to send us any questions at firstname.lastname@example.org.