Accounting is the process of recording and tracking all financial transactions for either a company or an individual in a way that is easily understood by all stakeholders involved.
Accounting is important because it provides financial data and analysis which enables individuals, businesses, and governments to make informed decisions. It is also important for tax and legal purposes. Accounting provides information that is crucial for budgeting, financial forecasting, tax planning, and regulatory compliance for small to large businesses and government.
Most companies employ professionals to handle their accounting. While this is great, it is important to have an idea of the basic types of accounting and which one fits perfectly into your needs.
What is Accounting?
Accounting is the process of tracking income, expenses, assets, and liabilities which helps stakeholders to assess financial performance, identify opportunities, and mitigate risks. For a deeper understanding of accounting terminologies, refer to our guide on accounting terms for beginners.
Types of Accounting
People often think of “accounting” as just financial accounting. However, accounting includes various types, which we will explore in the following sections.
Financial Accounting
Financial accounting is the most popular type of accounting. Financial accounting involves recording, summarizing, and reporting transactions from business operations over a period of time. Details from financial accounting are usually presented as a financial statement which includes an income statement, balance sheet, statement of financial position, or cashflow statement.
The information obtained from financial accounting provides essential information about a company’s financial performance to investors, creditors, or regulators. Financial accounting is done under established principles like Generally Accepted Accounting Principles (GAAP) in the U.S and International Financial Reporting Standards (IFRS) which ensures transparency and consistency in financial reporting
Managerial Accounting
Managerial accounting or management accounting involves identifying, measuring, analyzing, interpreting, and communicating financial information to managers in an organization.
Managerial accounting differs from financial accounting in its target audience. Financial accounting focuses on communicating financial information to stakeholders and external bodies like potential investors or creditors. Managerial accounting focuses on communicating this financial information to the management and executives in a company to align with the business goals and decision-making internally.
The reports from managerial accounting are mainly used within the company and can be tailored to the specific needs of people at the management levels. It is not bound by principles like Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Managerial accounting reports are generally used to set goals and objectives and also monitor the company’s performance against these goals.
Cost Accounting
Cost accounting involves analyzing and reporting the cost of production involved in a company’s products and services. This detail is a form of managerial accounting and can only be accessed internally. Internal decision-makers,often guided by a cost accountant, use this report to determine which products and services will have the most ROI. Cost accounting enables companies to develop profitable pricing strategies. It also enables them to value inventories for financial statements and identify areas where costs can be minimized. Learn more about cost accounting basics.
Tax Accounting
Tax accounting deals with the preparation of tax payments and tax returns. Tax accounting is important to ensure compliance with tax laws and regulations. It also minimizes a taxpayer’s tax liabilities. The purpose of tax accounting is to determine how much a business or individual owes in taxes. Tax accounting is governed by the Internal Revenue Code, which is often referred to as the tax code.
Tax accounting includes various types of taxes, including personal income tax, corporate tax, payroll tax, sales tax, and property tax. Each category has its own regulations and reporting requirements.
Forensic Accounting
Forensic accounting is the branch of accounting that deals with the detection and prevention of financial crimes. Unlike financial accounting, which involves analyzing financial accuracy and compliance, forensic accounting searches for patterns and inconsistencies that may indicate fraud or other financial crimes.
Forensic accounting also involves investigating complex financial transactions, tracing the flow of funds, rebuilding financial records, and assessing damages. The findings of these operations are used in legal proceedings, where forensic accountants need to present their analysis, as expert witnesses.
Auditing
Auditing can be defined as the review of a company’s financial statement by an external third party to ensure that the financial records presented are accurate, reliable, and compliant with relevant standards. Experts who conduct this auditing are called auditors and their goal is to provide assurance to stakeholders like creditors, investors, or regulators that the financial information presented accurately represents the financial position of that company. Internal auditing focuses on evaluating internal controls and processes, while external auditing is performed by auditors from outside the company, focus on providing an unbiased assessment of the financial statements.
The audit process involves several key stages. First, auditors plan the audit, by understanding the company’s business operations and identifying potential areas of risk. Next, they collect audit evidence by inspecting documents, observing processes, and conducting interviews. Then they evaluate this evidence against established auditing standards to assess the fairness of the financial statements. Finally, auditors issue an audit report summarizing their findings and their opinions on the financial statements.
Governmental Accounting
Governmental accounting can be defined as the process of recording, analyzing, and reporting financial transactions that occur within the government. This includes federal, state, and local governments. Governmental accounting aims to hold public officials accountable for the management of public funds. It ensures that government expenditures align with approved budget allocations.
Government accounting follows the Generally Accepted Accounting Principles (GAAP) set by the Governmental Accounting Standard Boards (GASB) for state and local government, while the Federal Accounting Standards Advisory Board (FASAB) establishes accounting standards for the federal government. Expenditures are categorized into operational, capital, and debt service costs, ensuring transparency in how public money is utilized.
Nonprofit Accounting
Nonprofit accounting is a type of accounting used by charitable or nonprofit organizations
Unlike for-profit organizations, accounting for nonprofit organizations is focused on staying accountable to their donors and contributors. Instead of a balance sheet, nonprofits use a statement of financial position. The income statement is replaced by a statement of activities, which provides details of the changes in net assets over a period.
Since the revenue for nonprofit organizations comes from donations and charity, a core concept in nonprofit accounting is fund accounting. Fund accounting involves classifying funds and maintaining separate accounts based on their restrictions and purposes.
For instance, funds designated for specific programs or donor-restricted gifts are kept separate from unrestricted funds used for general operations. This ensures that donations are used as intended and that legal agreements are honored. The nonprofit accounting guidance in the US is provided by the Financial Accounting Standards Advisory Board. Here are some of the best nonprofit accounting software with specialized features for nonprofits.
Project Accounting
Project accounting is a specialized branch of accounting that involves tracking, monitoring, and analyzing all financial transactions related to a project, from start to finish. This type of accounting is used by project managers to understand the costs and revenue associated with a project. The aim of project accounting is usually to control various types of costs such as variable cost, fixed cost, direct, and indirect costs.
Project accounting works under the principles of tracking revenue and expenses tied to a project and comparing them to the forecasted budget. If there is a conflict between budgeted costs and actual cost, then either the project budget should be adjusted or the costs need to be controlled.
The role of a project accountant depends on the project being worked on. They monitor the financial progress of a project and also approve expenses while advising the project team on the implications of any expenses made.
Environmental Accounting
Environmental accounting also known as green accounting is a type of accounting that measures the environmental impact of business activities. It records metrics from resource utilization to greenhouse gas emissions.
Environmental accounting involves various methods and techniques. Physical accounting measures environmental impacts physically (like tons of waste or cubic meters of water), while monetary accounting assigns monetary values to these impacts. There is also a life cycle assessment, which analyzes the environmental impacts of a product or service from production to expiry.
This type of accounting is also important to demonstrate the environmental impact of a business to investors or acquirers.
Fiduciary Accounting
Fiduciary accounting is a type of accounting that records the financial transactions that occur in managing assets on behalf of another party. Fiduciary accounting aims to provide clear and detailed reports of financial activities to the beneficiary (owner of the property), the courts, and other interested individuals. It also ensures that the property/asset manager is acting in the best interests of the beneficiary.
Fiduciary accounting report includes the earnings or returns generated from the property, such as interests, dividends, or rental income. For example, when someone sets up a trust fund for their child’s education, they appoint a trustee, or a bank, to manage the trust fund. The bank/trustee becomes the fiduciary and has the legal obligation to manage the assets in the best interest of the beneficiaries.
The principles of fiduciary accounting vary from state to state and even country to country. Fiduciary accounting is a proactive approach to mitigating risks and ensuring smoother trust management. It also helps to assure beneficiaries that their assets are being managed well and are shielded from misuse.
How To Choose The Right Type Of Accounting
Consider the below factors to decide which type of accounting is right for you.
Business Size
The size of your business will greatly influence the type of accounting you will choose because different businesses have different needs and complexities.
Small businesses often have tight budgets so it is important to focus on core accounting needs, avoiding complex and expensive accounting solutions. They often handle their accounting needs with fewer resources and may not require specialized accounting types.
Small businesses will most likely need
- Financial Accounting for tracking income, expenses, and financial health.
- Managerial Accounting for making informed decisions about operations.
- Tax Accounting for compliance with tax regulations.
- Cost Accounting for tracking production costs if applicable.
For medium-sized businesses, complexities grow as the business grows. They may also start to require more detailed audits and tax strategies.
Medium size businesses will most likely go for the following type of accounting
- Financial Accounting for investors, lenders, and regulators.
- Managerial Accounting for strategic planning and performance evaluation.
- Tax Accounting for complex tax planning and compliance.
- Cost Accounting for analyzing product profitability.
- Auditing might also be necessary to maintain credibility and attract investors.
Large businesses require sophisticated accounting processes. They are also required to adhere to various accounting standards and regulations.
Large businesses will need all accounting types for complex operations, investor relations, regulatory compliance, and risk management. They often employ specialized accountants for each area to ensure compliance and efficiency.
Industry
Industries with complex operations like manufacturing or construction will require cost accounting to analyze the cost of production and pricing strategies accurately. Service industries prioritize financial and managerial accounting for performance measurement and customer analysis.
Retail businesses focus on financial and managerial accounting for sales, inventory, and pricing decisions. Healthcare, construction, nonprofit, and government industries have their own specific accounting needs. Industries that experience rapid changes like technology will often adapt their accounting practices for quick adjustment and financial reporting.
Regulatory Requirements
Different industries have different regulatory bodies that require specific standards for accounting practice. For publicly traded companies, it is mandatory for them to comply with the Security and Exchange Commission (SEC) which demands that they follow the Generally Accepted Accounting Principles (GAAP) to ensure transparency. This means that they will adopt the type of accounting that aligns with the SEC guidelines.
Regulatory bodies like the Public Company Accounting Oversight Board (PCAOB) oversee the audits of public companies and enforce the standards that auditors must follow. Companies must choose accounting types that align with these regulations.
Businesses operating internationally will need to adopt accounting types that follow the IFRS developed by the International Accounting Standards Board (IASB). The IASB promotes transparency in cross-border financial reporting
Some industries like healthcare, insurance, or banking usually have extra regulatory requirements for revenue recognition and cost reporting.
Customizing Accounting Approaches for Specific Business Needs
Different businesses have different operational requirements. Custom accounting systems are designed to include the necessary features relevant to business operations. For example, a company that only works on a project basis may need a more suitable type of accounting like project accounting to track costs and revenue associated with each project.
Customizing accounting approaches will also depend on existing systems. For example, industries like healthcare have to consider existing compliance practices when deciding on custom accounting approaches. Schools and Construction-based businesses have specialized school accounting software and construction accounting software to incorporate the specific needs of these industries.
Scalability and flexibility are other factors to consider when customizing accounting approaches for business needs. Business accounting needs often expand as the business expands. This means that businesses should choose an accounting type that allows them to adapt easily to changing requirements. All these enable businesses to enhance their financial records and ensure they align with their specific accounting needs and regulations governing their industry.
Consulting with Accounting Professionals
Accounting professionals deeply understand accounting principles, industry-specific regulations, and the complexities surrounding different accounting types and will help you select the right type of accounting for your business.
Accounting professionals can evaluate your business size, industry, legal bindings and obligations, and financial goals. This assessment helps identify the core accounting needs. Accounting professionals ensure that your chosen accounting system aligns with all regulations, and tax requirements, saving you from penalties. Accounting professionals can also help weigh the costs and benefits of different accounting options
What Is the Difference Between Financial and Managerial Accounting?
Financial accounting provides a report on transactions of business operations over a period of time for external people like stakeholders, investors, creditors, and the IRS. Managerial accounting focuses on preparing financial reports to enable business managers to understand the financial position of their company.
Financial accounting focuses on past transactions and how it has impacted the company, while managerial accounting uses the details from past transactions for financial forecasting, decision-making, and budgeting.
While financial accounting provides a broad view of the company’s financial position, managerial accounting explains deeper about areas like profitability and other performance metrics. A cost benefit analysis helps companies to align their external financial reporting with internal decision-making to achieve the best possible outcome on their plan and goals.
The differences between financial accounting and managerial accounting are summarized in the table below.
| Aspect | Financial Accounting | Managerial Accounting |
|---|---|---|
| Purpose | Report transactions of business operations over a period | Prepare financial reports for internal managers |
| Audience | External stakeholders like investors, creditors, IRS | Internal management and executives |
| Focus | Past transactions and their impact | Past transactions for forecasting, decision-making, budgeting |
| Use of Information | Broad view of the company’s financial position | Detailed view on profitability and performance metrics |
| Depth of Analysis | High-level overview | In-depth analysis of specific areas |
Read about Financial Accounting Vs. Managerial accounting in detail.
How Do Tax Accounting and Financial Accounting Differ?
Tax accounting aims to reduce a company’s tax liability by applying tax laws and regulations to financial data. Tax accounting follows the tax code and regulations that are set by the Internal Revenue Service (IRS) and other applicable tax authorities. Tax accounting usually aims to help a company to reduce its taxable income.
On the other hand, financial accounting provides reports on a company’s business transactions, providing a clear picture of its financial position for investors, creditors, and other regulatory bodies. Financial accounting follows the Generally Accepted Accounting Principles (GAAP) and the golden rules of accounting to achieve accurate financial reports and maintain transparency.
The differences between tax accounting and financial accounting are summarized below.
| Aspect | Tax Accounting | Financial Accounting |
|---|---|---|
| Purpose | Reduce a company’s tax liability | Provide reports on business transactions |
| Regulations | Tax code and regulations set by IRS and other tax authorities | Generally Accepted Accounting Principles (GAAP) and golden rules of accounting |
| Primary Goal | Help a company reduce its taxable income | Achieve accurate financial reports and maintain transparency |
| Audience | Internal use for tax planning and compliance | External stakeholders like investors, creditors, regulatory bodies |
How To Choose Your Accounting Path
Education & Certification
Begin by analyzing your educational background and opportunities available to get required certifications. Different types of accounting require you to complete different numbers of credit hours to pass their exams.
You must research the educational requirements for different accounting specializations. For example, a forensic accountant will need a bachelor’s degree in accounting or a related field and additional certifications in fraud examination and investigation. This could be different for other types of accounting.
Career Outlook
Understand the job market and career opportunities in different accounting fields. Look out for opportunities for growth and stability available in the various accounting fields. This will help you to choose a path with promising career opportunities.
Personal Interest
Consider what your interests and strengths are when choosing your accounting path. It is important to align your career choice with your interests to increase job satisfaction and increase your chances of success in the accounting field.
Future of Accounting
Technology like cloud computing, artificial intelligence, automation, blockchain, and machine learning are improving the way things are done in the accounting sector.
AI will be integrated into the accounting sector to bring improved efficiency and accuracy in accounting processes. Accountants need to be updated on AI developments and be ready to maximize the potential of this technology.
AI can automate routine tasks, improve data analysis, and reduce human errors, especially in data entry, but it cannot replace the role of accountants in building trust with clients, navigating complex regulations, and providing strategic insights.
What Accounting Software is Popular for Small Businesses?
FreshBooks, QuickBooks and Xero are popular accounting software for small businesses including freelancers, consultants, and self-employed.
FreshBooks
FreshBooks enables freelancers and small service-based businesses to create invoices in minutes, calculate taxes, and manage expenses. FreshBooks is easy to use, making it accessible even for those without accounting experience. It also enables users to accept credit card payments and run accounting reports
Its key features include:
- Invoicing: FreshBooks enables users to generate professional invoices in just a few clicks, with multiple customization options.
- Expense Tracking: FreshBooks simplifies expense management by enabling users to import receipts and track expenses easily.
- Time Tracking: It includes project management features that enable users to track billable hours.
QuickBooks
QuickBooks is one of the most suitable accounting software for small to medium-sized businesses.
Its key features include:
- Invoicing and Payments: QuickBooks enables small and medium businesses to create and send custom online invoices anytime, anywhere from any device
- Financial Reporting: QuickBooks can be connected to your bank to automatically generate financial reports, save time, and reduce errors in financial reports
- Integration Capabilities: QuickBooks integrates well with various payment processors and other business applications
Xero
Xero is a comprehensive cloud-based accounting solution for larger businesses with more complex accounting needs. Its key features include:
- Multi-Currency Support: Xero excels in handling multiple currencies, making it suitable for businesses with international operations.
- Advanced Reporting: It offers detailed financial reporting capabilities, allowing users to customize reports and track specific KPIs.
- Unlimited Users: Unlike QuickBooks, Xero allows unlimited users on its plans, making it more cost-effective for larger teams.