If you ask small business owners to identify the different accounting types, they’ll more than likely name the two accounting methods they use to operate their business: cash or accrual accounting.
They might not realize that these are just the primary accounting methods in one broader type of accounting – management accounting.
There are numerous other accounting types, each used for specialized purposes in business and government. Here’s a look at the different types of accounting and how some of them may impact your small business.
What is Accounting?
First, let’s try to understand what accounting means at a fundamental level. Accounting is essentially money management. It refers to any practice of measuring, recording, assessing, or evaluating financial accounts or transactions.
What are the Three Types of Accounting?
Management accounting is probably what you think of most often when you think of small business accounting. This type of accounting focuses on your business’s income and expenses and how you use the assets you have on hand.
Management accounting is typically used to generate reports about operations that can help you track and gauge your business success. Weekly, monthly, quarterly, or annual reports can help you see what’s working for you and where you need to make changes – in collecting receivables, setting prices, instituting operating efficiencies, doing payroll, or any number of other areas – that can make your small business stronger.
Also known as managerial accounting, this form of accounting is all about providing the business managers with all the information they need to make the right decisions.
Tax accounting is pretty much what it sounds like. It’s the accounting of business income, expenses, assets, and investments to pay taxes. Tax accounting is based on the code of the Internal Revenue Service and other taxing authorities.
A big part of tax accounting is recording allowable expenses to deduct from your reportable income to make your tax bill smaller. There are many commonly overlooked business deductions you can use to reduce your taxable income.
It requires a deep knowledge of constantly changing tax laws and a reliable recordkeeping system that provides you with timely and accurate information when you need it.
Financial accounting is targeted to entities outside your business. It’s necessary for large businesses, especially publicly traded companies. But it’s often important for small businesses, too. If you’ve ever applied for a small business loan, you know you need to provide certain financial data for the lender to consider. These financials show your business’s relative health and allow the loan underwriter to make a decision on your loan.
Financial accounting is also key to attracting partners or investors. When searching for either of these, you will likely need to open up certain parts of your books for inspection. Financial accounting offers you a clear method by which you can report your finances in the partnership or investment negotiations. You may also need financial reports for creditors when negotiating the terms for settling debts.
It’s essential that you accurately report your financial position, cash flows, and the results of your business. Not doing so can put you in legal jeopardy that could erode your business success.
Other Branches of Accounting
Those are the three main types of accounting, but there’s more. Here are five more important branches of accounting and their uses.
Internal auditing monitors systems and processes and corrects them to prevent inefficiencies, fraud, waste, information breaches, illegalities, and other problem-generating situations.
Internal auditors are generally interested in risk. They spotlight the company’s high-risk areas as they seek to reduce risk and create efficiencies that keep the company between the yellow lines. All businesses take risks, but effective risk management in business is key to success.
In a sense, small business owners do their own form of internal auditing when they analyze management and tax accounting reports. The savvy business owner will periodically look at these to make sure their business runs smoothly, complying with laws, and not engaging in risky practices.
Forensic accounting is usually associated with a lawsuit or investigation. Forensic accountants often plow through vast quantities of information in an attempt to reconstruct what may have gone wrong in an intricate transaction or series of transactions.
The evidence forensic accountants collect and the conclusions they reach may be presented in a court or arbitration proceeding. It may be used to identify fraud or negligence, calculate damages, value or dissolve a business, investigate money laundering, make insurance claims, or audit royalty payments.
Most small businesses hope to avoid the need for a forensic accountant. That’s another reason to stay on top of your finances and the laws that control them. However, forensic accounting may come in useful when, for example, a business needs to switch from a cash basis to an accrual basis method of accounting.
Since governments have unique needs, distinct from businesses, a different set of accounting standards have been developed to guide and control them.
Government accounting allows federal, state, and local governments to keep a tight rein on resources and funding. Small businesses that work with governments may encounter certain financial requirements necessary to transact business.
At its simplest, public accounting, as opposed to private accounting, refers to businesses that provide accounting help to other businesses. This assistance can come in the form of compiling financial statements, auditing books, preparing tax forms, handling tax audits, or offering any other accounting service that helps to make your business run well.
Cost accounting is about keeping track of all of the many costs that go into the production of goods and services for your business. This is sometimes considered a subcategory of management accounting.
Using cost accounting to analyze your business process can help you increase efficiency and decrease costs. The goals are cost control and cost reduction. If you can pinpoint where your costs go up the most in your production or delivery processes, you can best devise a solution to keep costs down.
What are the Two Accounting Methods?
There are two principal methods for management accounting: cash and accrual. Most small businesses opt for the cash method because of its simplicity. If you have inventory, though, you likely use the accrual method. Or you might also employ some hybrid of the two that help you best account for your business cash flow.
Cash accounting means keeping track of your finances according to when you pay or receive money directly. This means waiting to document a transaction until the money is exchanged. This method may help you to focus on your cash flow because it is concerned solely with the money you have immediately available.
The accrual accounting method is more complex than the cash method, but it also gives you a more accurate picture of your company’s finances. The accrual method is concerned not only with cash but with accounts payable and accounts receivable.
This means that you record transactions as soon as they are planned. If you make a sale or buy inventory, but cash involved in those transactions has not yet changed hands, you will still record it immediately. With this method, you know what revenue and expenses you expect before it directly impacts your cash flow.
Work with a Professional Accountant
This is a lot to keep track of. Accounting is an essential practice for any business, but you don’t have to do it on your own. What’s most important is accounting you can trust. If you’re going to be making decisions about your business’s future, you need your information to be reliable.
Effective and reliable accounting ensures that you save every possible dollar for reinvesting in your business. If you find that accounting matters are taking up too much of your valuable time, hiring a professional accountant can free you up focusing on what you do best – running your business.