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Key Takeaways
- A business transaction is an exchange of items of value between two or more parties. It is stated in terms of money and should be supported by business documents that specifies the details of the transaction.
- A financial statement item that results from a business transaction can be measured using two measurement bases: historical cost and current value. The historical cost is used in most cases since it is objective and can be easily verified.
- To recognize an item in the financial statements, it should meet the definition of a financial statement element such as an asset, liability, equity, income, and expense.
What is a Business Transaction?
A Business Transaction is an exchange between two or more parties and entities of rights or things of value.
The majority of the daily activities of your company would consist of business transactions that involve exchanging of values with other entities. Some examples of business transactions are:
- Selling of goods or services to customers for cash or on account
- Purchasing of goods and services from suppliers
- Acquiring financing from lenders and investors
- Purchase of fixed assets to be used for business operations
- Payment of wages or salaries to employees
A transaction can be considered a business transaction if it has all of the following characteristics:
- There must be an exchange of something of value.
- The transaction involves at least two parties.
- The transaction should be stated in terms of money.
- The transaction is supported by business documents.
Let’s tackle each characteristic below.
Exchange of Something of Value
When your company enters into a business transaction with another entity, both your company and the other party to the transaction will be giving up something of value to receive another of equal value from each other. Here are some scenarios to illustrate this characteristics:
- Sale of goods and services to customers. When your company sells a product or renders a service, it gives value by providing the needs of its customers. In return, your company receives cash payments from them.
- Purchase of raw materials from suppliers. Your company pays cash to its suppliers who give value by providing the raw materials needed by your company to manufacture its own products.
- Payment of bank loans. When your company needs additional funds to finance its expansion, it may take out a loan from a bank. In exchange for the use of the bank’s money, your company pays interest, in addition to the principal of the loan.
- Payment of wages to employees. Your company pays for the wages and salaries of its workers and employees in exchange for the services they provide for your company.
The above examples show the dual effects of business transactions where an asset for one party becomes a liability of the other party. A receivable of an entity is a payable of another entity. This concept of duality gave rise to the Double-entry Bookkeeping system of recording transactions.
Between two parties
A business transaction involves at least two parties or entities. There can be no transaction if there is only one party.
Will a transaction between a company and its owners qualify as a business transaction? An exchange of values between a company and its owners also qualifies as a business transaction because the Economic Entity Assumption states that the business enterprise or company is separate and distinct from its owners.
Stated in terms of money
The Monetary Unit Assumption establishes that all business transactions should be measured and recorded only in terms of a common unit of measurement which is money. In accounting, non-financial transactions are not considered business transactions because they are not quantifiable and measurable by money. However, non-financial transactions can be disclosed in a separate note to support and give context about the information presented in the financial reports.
Supported by business documents
Business source documents such as invoices, official receipts, bank statements, vouchers, and contracts support and capture the essential details of a business transaction. Accountants refer to these documents as the basis for recording financial transactions in the accounting books.
Recognizing Business Transactions
When you record a business transaction, it results in the recognition of an item in the financial statements. Recognition is the process of including in the financial statements an item that meets the definition of a financial statement element such as an asset, liability, equity, income, and expense.
Below are the definitions of each financial statement element as provided by the Conceptual Framework for Financial Reporting.
| Asset | A present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. |
| Liability | A present obligation of the entity to transfer an economic resource as a result of past events. |
| Equity | The residual interest in the assets of the entity after deducting all its liabilities. |
| Income | Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity. |
| Expense | Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity. |
Only items that meet the above definition of an asset, a liability or equity are recognized in the statement of financial position. Similarly, only items that meet the definition of income or expense are recognized in the income statement or statement of financial performance.
A financial statement element is recognized only if their recognition provides the users of your financial statements with information that is useful to them. Furthermore, when you don’t recognize an item that meets the definition of one of the elements, you could exclude useful information that could result in less complete financial statements.
In recognizing income, accrual accounting states that income is recognized only when earned, regardless of when your company receives cash. This means that even if there was no exchange of cash during a transaction, income is still recognized as earned at the point of sale when control of goods has been transferred to the buyer.
Likewise, expenses are recognized when incurred, regardless of when cash is paid by your company. An expense is considered as incurred when you received a service or good from the seller.
Expenses are also recognized in the same period that the related income it helped generate is recognized. This is in accordance with the matching principle where expenses incurred during the period is properly matched to the revenues earned on the same period.
Measuring Business Transactions
Since business transactions are stated in terms of money, then a measurement basis is necessary at which you could determine the amount of the items that will be recorded. Measurement is the process that determines the monetary amounts at which a financial statement element is to be recognized.
As a guide, the Conceptual Framework for Financial Reporting has provided two measurement bases that can be used for financial statements in varying degrees and combinations. These two measurement bases are Historical Cost and Current Value.
Historical Cost
Historical Cost is the price of the transaction or the amount of exchange at the time an asset is acquired or a liability is assumed by your company during the business transaction.
For assets, the historical cost is the original acquisition cost, i.e. the amount incurred by your company in acquiring or creating the asset. Any other transaction costs to prepare the asset for its intended use such as installation costs are also included as part of the asset’s historical cost.
For example, let’s assume that your company acquires an equipment with a purchase price of $1,000. The amount to be reported in the statement of financial position will be $1,000 which is the cost indicated in the invoice. If your company incurred an additional installation cost amounting to $100 to prepare it for its intended use, then the equipment will be reported as $1,100 which includes the installation cost.
The historical cost of liabilities is the amount of proceeds or consideration received when the obligation was assumed minus any transaction costs. It can also be the expected amount to be paid to satisfy the liability.
For example, your company borrowed $2,000 and issued a non-interest bearing promissory note payable at the end of the year. The notes payable will be reported at its face amount of $2,000. If the promissory note is interest-bearing and the interest expense of $200 was deducted from its face amount in advance, then the notes payable will be reported at the discounted amount of $1,800, i.e. the face amount less the interest expense. Any transaction costs are also deducted from the amount of consideration received.
The historical cost is the measurement basis that you’ll be adopting in many financial statement items since it is objective and easily verifiable. Financial statement items are carried at historical cost without any subsequent change in value, except to the extent that its amount can be subsequently affected by any write-offs, payments, accrued interests, depreciation, or amortization.
Current Value
While historical cost is the measurement basis that is more commonly adopted because of its simplicity and cost-effectiveness, you may encounter cases that would demand another measurement basis due to the nature of the information that it could produce in the financial statements.
An alternative measurement basis that is provided by the Conceptual Framework for Financial Reporting is Current Value. This measurement basis includes fair value, value in use for assets, fulfillment value for liabilities, and current cost.
Measuring financial statement elements based on current values present amounts that are updated to reflect conditions at the measurement date. The update reflects changes in the estimated cash flows and other factors that affect the financial statement item since its previous measurement date.
The difference between historical cost and current value measurement bases is that the current value of the financial statement item is not derived from any price or costs related to the transaction. Instead, it could be based on market value, present value of cash flows or current cost of an equivalent item.
Fair Value
Fair Value is the price involved in a transaction between market participants. You can determine it by observing prices in an active market or using measurement techniques that considers factors such as estimated future cash flows, time value of money, inherent risk, and liquidity.
Fair value reflects the perspective and assumptions of market participants to which your company has access to.
Value In Use and Fulfilment Value
Value in Use is the present value of the cash flows or economic benefits that your company expects to receive from the use of an asset and from its ultimate disposal. Fulfilment Value, on the other hand, is the present value of the cash or economic resources that your company expects to to pay to settle the liability.
While fair value reflects the perspective of market participants, both value in use and fulfilment value reflect the assumptions of the company. However, in practice, there could be little difference between the assumptions used by both market participants and the company.
Current Cost
The Current Cost of an asset is the cost of an equivalent asset at the measurement date which comprises the amount your company would pay at the measurement date plus the transaction costs that would have been incurred at that date. For a liability, the current cost is the amount that your company would receive for an equivalent liability at measurement date minus the transaction costs that would be incurred at that date.
Current cost is similar to historical cost in the sense that it reflects the price in which the company would acquire the asset or incur the liability. The difference is that current cost reflects current conditions at measurement date while historical cost reflect the actual price when the transaction happened.
To conclude, the measurement basis that you’ll use must provide information that is useful to the people who will use and analyze your company’s financial statements. This information must be relevant to those users and must faithfully represent what it purports to represent.
Review Questions
- What are the 4 characteristics of a business transaction?
- What is the difference of historical cost and current value as measurement bases.
- What are the 4 measurement bases under current value?
- Why is historical cost the measurement basis adopted in most financial statement items?
- When should you recognize an item from a business transaction in the financial statements?
