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While it may sound boring or esoteric, financial accounting plays a key role in allowing businesses to keep track of all their financial transactions.
Financial accounting is the process by which companies record and report the financial data that is part of their business operations.
It helps company managers, outside investors, and analysts gain a view of a company’s health and make informed decisions concerning its prospects for success.
Key Takeaways
- Financial accounting involves recording, summarizing, and reporting the stream of transactions and financial activity involving and resulting from business operations over a period of time.
- Governed by a standard set of accounting practices, financial accounting’s end product is a set of official company financial statements which includes the balance sheet and income statement.
- These financial statements are used by company managers, investors, analysts, lenders, and other stakeholders to make informed decisions relevant to the business of each.
Standards and Best Practices
There are accounting principles that companies must adhere to in their financial accounting.
Publicly traded companies in the United States must follow the generally accepted accounting principles (GAAP), a common set of standards and best practices that accountants use when they crunch their numbers and complete financial statements.
Companies outside the U.S. generally follow other international standards that vary by region and country.
But, regardless of which set of standards is followed, there are three main areas where financial accounting helps with decision-making:
- It provides investors and analysts with a baseline of analysis for (and comparison between) the financial health of corporations that issue securities.
- It helps creditors assess the solvency, liquidity, and creditworthiness of businesses.
- Along with managerial accounting, it helps businesses make decisions about how to allocate scarce resources.
Investing Decisions
Fundamental analysis depends heavily on the data that is recorded on a company’s financial statements, including the balance sheet, income statement, and cash flow statement.
Each of the financial statements for publicly traded companies is created and reported according to the financial accounting standards (GAAP) set forth by the Financial Accounting Standard Board (FASB) and submitted to the Securities and Exchange Commission (SEC).
Investors and analysts use the information from financial statements to make decisions about the valuation and creditworthiness of a company. It allows them to set price targets and determine if a stock’s price is fairly valued or not.
Without the information provided by financial accounting, investors would have less understanding of the historical, current, and prospective financial health and success potential of stock and bond issuers.
The requirements set forth by FASB create consistency in the timing and style of financial accounting, which means investors are less likely to be subject to accounting information that has been filtered based on a firm’s current condition.
Fast Fact
The Securities Exchange Act of 1934 gave the SEC the authority to establish financial accounting standards for publicly-held companies. In 1973, the SEC gave FASB the responsibility for setting financial accounting standards.
Lending Decisions
Financial accounting is also key for creditors, from banks to bondholders. Because financial statements outline all assets and short- and long-term debt, lenders can gain a good idea of a company’s creditworthiness.
A number of common accounting ratios that creditors rely on, such as the debt-to-equity (D/E) ratio and times interest earned ratio, are derived entirely from a company’s financial statements.
Even for privately-owned businesses that do not necessarily follow the requirements of FASB, no lending institution assumes the liability of a large business loan without critical information provided by the financial accounting process.
Ultimately, a lender really wants to know just how much risk is involved when lending a company money. This can be determined by reviewing the company’s financial accounting.
Once the level of risk is determined, the lender will also be able to outline exactly how much to lend and at what interest rates through the process of underwriting the loan.
Corporate Governance
Reliable accounting serves a practical function not only for outside investors and lenders but also for the internal management of a firm.
The objectives of financial accounting translate to several clear benefits for businesses, such as ensuring their ability to meet the legal and regulatory obligations outlined for (public) firms. Companies must be honest and transparent about their financial activities and the data reported must be accurate and regularly updated.
Beyond the regulatory and compliance hurdles, financial accounting helps companies optimize their day-to-day operations and identify the types of projects that could provide growth opportunities in the future.
It helps managers create budgets, understand public perception, track efficiency, analyze product performance, develop various short- and long-term business strategies, and more.
Why Is Financial Accounting Important?
It’s important because, when practiced according to official standards, it can decrease various types of risk (for a company, investors, lenders), provide insight into a company to stakeholders, ensure financial transparency, and enhance trust in public companies.
What Is the Primary Purpose of Financial Accounting?
It’s to accurately manage, record, and report financial data about a company so that its financial performance can be determined and analyzed.
What Financial Accounting Standards Do Private Companies Use?
They often use GAAP standards, just as public companies do. Aligning their financial accounting to GAAP standards gives private companies credibility and can increase how attractive they are to lenders and investors.
The Bottom Line
The data in financial accounting statements, including the balance sheet and income statement, can drive powerful and important decision-making.
Financial accounting is how management, investors, lenders, and other interested parties keep track of a company’s operations, its financial performance and health, and its prospects for success.
