You’re probably thinking to yourself, “Accounting is accounting, right? How many different types of accounting can there be?”
Here’s a look at what accounting is, the different types of accounting, and why each type is essential in ensuring your business is profitable and growing.
What is accounting?
Accounting is the recording of an individual’s or an organization’s financial transactions. Just like statisticians record statistics during a sporting event, accountants record transactions during a business’s (or individual’s) day-to-day operations.
There are five different types of accounting transactions:
Every accounting transaction affects at least two of these accounts. Here are several examples:
- A customer pays cash for providing a product or service. This transaction increases both revenue and assets (cash).
- You make a monthly payment on a vehicle loan. This transaction decreases assets (cash), decreases liabilities (the loan balance gets smaller), and increases expenses (a portion of the payment is interest expense).
- As a business owner, you reward yourself with a bonus at the end of the year. This transaction decreases both assets (cash) and owners’ equity.
Why is accounting important for businesses?
At its most basic level, accounting helps monitor the health of your business.
After recording all transactions for a certain period, accounting reports can be created showing how much (or little!) profit your business has generated. You can then use these reports to make strategic decisions. For example:
Different Types of Accounting for Different Situations
There are different types of accounting depending on which report you’re trying to create or what you’re trying to accomplish. We will look at the five most common types of accounting, the role each can play in your business, and how each type can help your business identify inefficiencies and increase profitability.
1.) Financial Accounting - The Backbone of Business Transparency
Financial accounting is the process of creating the following three primary financial statements for use by people outside of your business, such as investors and lenders:
All other types of accounting are an outgrowth of financial accounting, which is why this type of accounting is often referred to as the foundation, or backbone, of accounting.
The financial accounting process starts with properly recording and classifying transactions in your business’s accounting system. These transactions are then used to create the aforementioned financial statements using Generally Accepted Accounting Principles or other financial reports, which will be detailed later in this article.
2.) Management Accounting - Strategic Decision Making
Management accounting is the process of creating financial reports to help people within your business make better management decisions. These reports focus on all aspects of your business, including revenue and expenses.
Here are some examples of financial management reports and how each report can be used:
Planning for the future: This report can be used to spot trends in the percentage of customers that pay on time and to update or revise your company’s customer credit policies.
Planning for the future: This report can help you identify vendors and suppliers who may give you favorable payment terms if you pay early and those who may be ok if you pay late. The goal is to hang on to your cash as long as possible and prioritize when to pay each of your bills.
Planning for the future: This report can help you decide when you have enough cash to add a new piece of machinery or create a new full-time employee position. It can also help ensure you have enough cash to pay your recurring monthly bills.
Planning for the future: This report can help you identify an area that is not trending in its supposed direction. For example, let’s say your net profit remains the same in 2022 and 2023. No cause for alarm, right? Well, maybe. What if your revenue significantly increased, but so did your salary and wage expenses? An increase in expenses could potentially hide an increase in revenue. Were you expecting an increase in salary and wage expenses?
3.) Cost Accounting - Optimizing Operational Efficiency
Cost accounting is the process of creating financial reports for use within your business that focus exclusively on costs and expenses. It tracks a business’s costs associated with making and providing its products and services and allocates them to specific products and services.
Example: You purchase a widget-making machine for $100,000 in 2023, anticipating that this machine will last for five years and make a total of 500,000 widgets. For each widget you sell in 2023, you would allocate a cost of 20 cents ($100,000 cost of the machine divided by 500,000 widgets).
4.) Tax Accounting - Legally Minimizing Your Tax Obligation
Tax accounting is the process of calculating, preparing, and filing a business’s income and expenses to taxing authorities. Many businesses spend a significant amount of time on this type of accounting to ensure they aren’t paying any more taxes than they are legally required to.
Keep in mind that the profit or loss you report on your income statement will often be different from the profit or loss you report on your tax return because of the following reasons:
Partner With Accounting Experts to Ensure Business Success
Your business may not have each of these different types of accounting by name, but the essence of each type can play a vital role in making sure your business is profitable and growing:
Partner with a 1-800Accountant small business accounting expert to help get the most out of each type of accounting in your business.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.