Financial accounting allows a business to keep track of all its financial transactions. It is the process in which the company records and reports all the financial data that go in and out of its business operations. The accounting data is recorded on a series of financial statements including the balance sheet, income statement, and cash flow statement.
There are a series of accounting principles companies adhere to in their financial accounting. The majority of publicly traded companies in the United States follow the generally accepted accounting principles (GAAP), a common set of standards accountants follow when they complete their financial statements. Companies outside the U.S. generally follow other international standards that vary by region and country.
There are three main areas where financial accounting helps decision-making:
- It provides investors with a baseline of analysis for—and comparison between—the financial health of securities-issuing corporations.
- It helps creditors assess the solvency, liquidity, and creditworthiness of businesses.
- Along with its cousin, managerial accounting, it helps businesses make decisions about how to allocate scarce resources.
Fundamental analysis depends heavily on a company's balance sheet, its statement of cash flows and its income statement. All of the financial statements for publicly traded companies are created and reported according to the financial accounting standards set forth by the Financial Accounting Standard Board (FASB).
Investors use the information from financial statements to make decisions about the valuation and creditworthiness of a company. Without the information provided by financial accounting, investors would have less understanding about the history and current financial health of stock and bond issuers. The requirements set forth by the FASB create consistency in the timing and style of financial accounts, which means investors are less likely to be subject to accounting information that has been filtered based on a firm's current condition.
Financial accounting is also a key for lenders. Because financial statements outline all its assets as well as the short- and long-term debt, lenders get a better sense of a company's creditworthiness.
A number of common accounting ratios creditors rely on, such as the debt-to-equity (D/E) ratio and times interest earned ratio, are derived from a company's financial statements. Even for privately-owned businesses that do not necessarily follow the requirements of the FASB, no lending institution assumes the liability of a large business loan without critical information provided by financial accounting techniques.
Ultimately, a lender wants to know just how much risk is involved by lending a company money, which can be determined by reviewing the company's financial accounting. Once this is determined, the lender will also be able to outline exactly how much to lend and at what interest rates.
Reliable accounting serves a practical function not only for investors and lenders but also for the firms themselves.
The most obvious benefit for businesses to complete their financial accounting is to meet the legal and regulatory obligations outlined for (public) companies. Companies must be honest about their financial activities and the data must be accurate and published regularly.
Beyond the regulatory and compliance hurdles financial accounting helps clear, financial accounting also helps managers create budgets, understand public perception, track efficiency, analyze product performance, and develop short- and long-term strategies.
The Bottom Line
Financial accounting is a way for businesses to keep track of their operations, but also to provide a snapshot of their financial health. By providing data through a variety of statements including the balance sheet and income statement, a company can give investors and lenders more power in their decision-making.