Every business encounters and accounts for a plethora of transactions while undertaking its operations. Any business event which impacts the finances of the business would constitute a transaction. Business transactions can be categorized into several types. Categorization helps determine the accounting treatment to be given to each transaction.
This article looks at meaning of and differences between two different types of transactions based on the parties involved – internal transaction and external transaction.
Definitions and meanings
Internal transaction:
An internal transaction is a business transaction which does not involve any outside organisation or third party. An internal transaction does not involve two parties.
These transactions are generally triggered by and are concerned with internal functions of a business. For example, conversion of raw material of one department to work in progress of another department is internal consumption of stock and is an example of an internal transaction.
Some internal transactions are also triggered by passage of time such charge of depreciation in the books, amortization of prepaid expenses etc.
External transaction:
An external transaction is a business transaction which takes place between the business and an outside third party. An external transaction therefore involves two or more parties.
External transactions involve exchange of resources between the business and outside third parties. For example, purchase or sale of goods from a third party in exchange of cash/credit, payment for supply of utilities to a third party.
An event including 2 parties must have a monetary impact on the company’s accounts to qualify as an external transaction. For example, a settlement reached with a trade union although involves 2 parties does not qualify as an external transaction as it does not have impact on the accounts. On the other hand a payment of compensation to employees under this settlement would qualify as an external transaction as it affects the accounts of the business.
Difference between internal transaction and external transaction:
The main difference between internal transaction and external transaction has been explained by the following points:
1. Meaning
- An internal transaction is a business transaction which is not undertaken with any external third party.
- An external transaction is a business transaction which is undertaken with one or more external third parties.
2. Exchange of resources
- Internal transaction is a result of internal functions of a business and may not involve exchange of resources. If it involves exchange of resources it would be between internal departments of an organisation.
- External transaction is an exchange of resources between the organisation and one or more external third parties.
3. Impact on cash flow
- As internal transactions are concerned with inter-departmental transactions or as a result of internal functions of the business, they generally do not have an impact on the cash flow of the business.
- External transactions involve exchange of resources with third parties and thus often impact the cash flow of the business.
4. Number of parties
- Internal transaction only involves one party – the organisation itself.
- External transactions involve 2 or more parties – the organisation and one or more third parties.
5. Trigger
- Internal transactions are triggered by internal functions of a business or by simple passage of time.
- External transactions are triggered by business activity between the organisation and outside third parties.
6. Examples
- Internal transactions include internal stock transfers from one department to another, charge of depreciation, amortization of prepaid expenses etc.
- External transactions include third party purchase or sale of goods, incurring of expenses etc.
Internal transaction versus external transaction – tabular comparison
A tabular comparison of internal transaction and external transaction is given below:
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| Meaning | ||||
| Business transaction which occurs without involving an external third party | Business transaction that occurs with the involvement of one or more external third parties | |||
| Exchange of resources | ||||
| None or within the organisation | Between the organisation and external third party/parties | |||
| Impact on cash flow | ||||
| Generally no impact | In most cases, there is an impact on the cash flow | |||
| Number of parties | ||||
| Single – only the organisation | Multiple – the organisation and one or more external parties | |||
| Trigger | ||||
| Internal functions or passage of time | Business dealings involving external exchange of resources | |||
| Examples | ||||
| Internal inventory transfer, depreciation, amortization, recording looses, charging of prepaid expenses | Purchase and sale of goods with outside third parties | |||
Conclusion – internal transaction vs external transaction:
While both internal and external transactions have a monetary impact on the finances of the company, true exchange of values occurs in external transactions as it involves exchange of resources between parties. Internal transactions do impact the financial statements however they rarely result in exchange of values and are more in the nature of shift of values from one part of the business to another part.
