What is the Transaction Approach?

The transaction approach is the concept of deriving the financial results of a business by recording individual revenue, expense, and other purchase transactions. These transactions are then aggregated to see if a business has earned a profit or a loss. The transaction approach is a fundamental concept that underlies much of accounting.

Characteristics of the Transaction Approach

The key characteristics of the transaction approach are as follows:

Detailed recording. Every individual revenue, expense, asset purchase, liability incurrence, and equity transaction is separately recorded in the accounting system. This ensures a complete and detailed financial record of all business activities.
Chronological organization. Transactions are recorded in the order in which they occur, often first in journals and then posted to ledger accounts, maintaining a clear timeline of financial events.
Emphasis on source documents. Each transaction is supported by documentation such as invoices, receipts, contracts, or purchase orders, ensuring that financial records are verifiable and traceable.
Periodic summarization. At the end of accounting periods, individual transactions are summarized to prepare financial statements, such as the income statement and balance sheet.
Focus on actual events. The approach relies strictly on actual, realized events and measurable amounts, rather than estimates or projections, ensuring that financial reporting reflects factual activity.
Foundation for double-entry accounting. The transaction approach naturally supports double-entry bookkeeping, where every transaction affects at least two accounts, keeping the accounting equation (Assets = Liabilities + Equity) in balance.

Example of the Transaction Approach

A retailer engages in 20,000 individual sale transactions over the course of a year, compiling $3 million of revenues. It also processes 4,000 individual transactions from suppliers for the goods that it has sold, along with invoices for rent and utilities, which adds up to $2.5 million of expenses. Based on these individual transactions, profits should be $500,000.

The Difference Between the Transaction Approach and the Balance Sheet Approach

An alternative to the transaction approach is the balance sheet approach, under which net income or net loss is derived by determining the net change in owner's equity during an accounting period, not including transactions related to dividends paid out, stock sales, and stock repurchases. Thus, if owners’ equity is $5 million at the end of an accounting period and there was $4.5 million in owners’ equity at the beginning of the period, the $500,000 difference is profit.

Though companies use the transaction approach to derive results, auditors use the balance sheet approach to audit companies. Thus, auditors will review all balance sheet accounts in detail, and back into net profit or loss information from their review of the balance sheet. This is done to avoid auditing the massive number of transactions listed in the income statement.