Definition: An external transaction is an exchange of value between two entities that changes the accounting equation. In other words, an external transaction takes place between two entities or companies in which an account is changed. If one company transfers a product from one department to another inside the company, it would not be considered an external transaction. This is an internal transaction. External transactions must take place between two separate entities.
The most simplistic example of an external transaction is the purchase of equipment. Assume Corey’s manufacturing plant is expanding and he needs another CNC machine. Todd’s CNC Center, LLC is company down the road from Corey that builds machines. Corey purchases a new machine from Todd and records the purchase by debiting his fixed asset account and crediting the cash account. Todd does the opposite. He debits the receipt of cash and credits his revenues account for the sale.
As you can see, this business event took place between two different companies. That’s the first requirement. It also changed the accounting equation for both companies. Corey’s cash decreased and his fixed assets increased; where as, Todd’s cash and revenues increased. That’s the second requirement to be considered an external transaction.
What Does External Transactions Mean?
External transactions must change the accounting equation in order to exist. Activities like a company reaching a deal with the union and renewing the contract for an additional year doesn’t change the accounting equation. Thus, it isn’t considered an external transaction even though the contract is made between two entities. If, however, there were a monetary exchange, the activity would change the equation. For example, the company paid the union $100,000 in connection with reaching an agreement. This is an exchange of value between to parties that affects the equation.