So I'm in the elementary stages of my first business class. Here's one of my homework questions that's got me stumped. "Velu pays interest to himself on a loan he made to the business three years ago." I have to decide whether this is a transaction or not. My guess is it's not because he's paying it to himself and there needs to be two parties for a transaction to take place. But it could be argued that a business is a separate entity and there is indeed two parties.

This is a transaction. The business is paying the interest on the load to the person.

I lean toward your counterargument; view the biz as a separate entity, and that argues that there has indeed been a transaction.

First, if the business is organized as an LLC or corporation, then under state law (and by extension, for most business purposes), it's certainly a separate legal entity; hence two parties, and thus a "transaction" has occurred (by your stated criterion).

If OTOH the business is in sole prop form, I'd still argue for viewing it as an entity distinct from its owner, for most purposes. For one thing, an owner can't accurately determine the true economic "return" he or she derives from the biz without making an allowance for the opportunity cost of the capital tied up in the business. Having the company pay interest on loans made to the company is one way of making this allowance explicit.

(In this latter scenario it's true that you won't have a "transaction" for tax purposes, in the sense that the sole prop won't deduct interest paid to himself. Still, for accounting purposes, there was a physical transfer of money, and hence there's still a transaction to book, even if it's only Debit Draws, Credit Cash.)

Extending that last thought about sole props, I'd guess it's the case that most accountants would argue that even a sole prop should maintain a set of books (for a variety of reasons) that's separate and distinct from the owner's personal balance sheet and records. If so, this payment of "interest" certainly generates a transaction to be recorded, whether the debit is to Interest Expense, or to Draws.

My $0.02

While I agree with everything ArcSine said - that does have more to do with how this will get recorded. That is, is this interest or is it a draw? It would depend on circumstances, and you don't know the circumstances.

And there is an accounting concept called "business entity," (creatively enough) that says business and owner are separate. Yeah, for someone working out of their home and only barely keeping enough records to suit the IRS, they might not be separated. But this is what GAAP says.

However, we can actually make this very simple. If a check was written out of the business's account to pay the owner, then a transaction absolutely happened without question. And you absolutely would be crediting cash (if you were using a double-entry system). The cash came out - so a transaction happened.

What we call the transaction or how exactly we record it is an entirely different issue. But if the cash came out of the account, it has to be recorded somehow.

You could argue it over some general definition of the term, etc. but when we're dealing with money issues (accounting/finance), then we assume that's the definition we're using.