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. Thus, if there are $3 million of revenues and $2.5 million of expenses, as derived from individual transactions, then profits should be $500,000.
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 the following:
- Dividends paid out
- Stock sales
- Stock repurchases
Thus, if owner's equity is $5 million at the end of an accounting period and there was $4.5 million in owner's 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.