What Is Financial Accounting and Why Is It Important?

Accounting is the language of business. It’s a system for measuring, recording, and conveying information about business results in a standardized way.

As with spoken languages, there are many types of accounting. Financial accounting is just one branch of accounting, used primarily to report information to parties outside of the company, such as external stakeholders. 

It’s important to become familiar with financial accounting because it’s the most encompassing type of accounting – it’s often referred to as the “official” language of business in the U.S. Other branches of accounting include managerial, tax, and nonprofit accounting.

Why Use Financial Accounting?

The primary objective of financial accounting is to provide business performance information that's useful to readers outside of the company, such as investors and lenders. The process begins by recording activity using double-entry bookkeeping and culminates with the preparation of financial statements – the balance sheet, income statement, cash flow statement, statement of equity, and the notes to the financial statements. 

In order to accurately and reliably deliver on this objective, financial accounting adheres to Generally Accepted Accounting Principles (GAAP), a massive set of rules and guidelines on how to value, record, and report financial activity that's published in the U.S. by the Financial Accounting Standards Board (FASB). This standardization helps ensure that financial statements are consistently comparable from one organization to the next. 

How Financial Accounting Works

A walk through most accounting departments will show financial accounting in practice. Here’s a simplified step-by-step introduction to how it works. 

1. Record activity. 

Every business transaction is recorded in a set of physical or electronic books using the double-entry method of accounting, which is based on the principal that every transaction has a credit side and a debit side. So, each transaction is entered into the books in at least two accounts. In a balanced book, the total amounts of debits and credits are equal. This method helps detect errors.

2. Comply with GAAP. 

Most companies use the accrual method of accounting, which recognizes revenue when earned and expenses when incurred. For each type of transaction, GAAP guides the bookkeeper in determining which accounts to use and how to value the transaction. The seven types of accounts are: assets, liabilities, equity, revenue, gains, expenses, and losses.

3. Compile financial statements.

All transactions for a period are summarized and reported in financial statements. Classification, report formats, and other conventions are applied to ensure that each of the financial statements meets GAAP requirements and can be trusted by external readers.

4. Issue reporting package. 

While each of the financial statements fulfills a particular information need, they're most insightful when read together.

The five financial statements include the balance sheet, which shows a company’s financial position, the income statement, which shows profitability, the cash flow statement, which highlights the cash coming into and going out, the statement of equity, which presents a company’s ownership details, and the notes to the financial statements, which provides context and supplemental information.

Although the main purpose of financial accounting centers on objectively and accurately communicating financial results to external stakeholders, it’s also the primary source of financial data for internal users. For example, business managers analyze the accounting data compiled in the financial statements – and the statements themselves – to inform decision-making. This financial data often serves as the foundation for managerial accounting as well.

Following Financial Accounting Regulations 

In the U.S. there are several standard-setting bodies that contribute to GAAP, aiming to create independent guidelines that lead to relevant, reliable, and non-biased financial reports. The FASB, which is not a government body, works together with state boards of accountancy, the American Institute of CPAs (AICPA), and the Securities & Exchange Commission (SEC), among others, to issue accounting codes, interpretations, and implementation guidelines. 

In addition, there is a sizable network of FASB subcommittees that continually challenge, refine, and update accounting codes. Accountants, especially Certified Public Accountants (CPAs), keep up with the constant evolution of GAAP through required continuing education and professional organizations.

International companies follow International Financial Reporting Standards (IFRS), which is similar to GAAP in many ways but not all. IFRS is issued by the International Accounting Standards Board (IASB). The FASB and IASB have several initiatives to help bring the standards closer together.

Other Types of Accounting

There are many other well-known types of accounting not included in in the scope of financial accounting. These specialized types have different objectives, users, and specific guidelines other than, or in addition to, GAAP.

For example, tax accounting often comes to mind when thinking about “accounting,” although it is an extremely specific subset. Tax accounting concentrates on preparing tax returns and ensuring that a company pays the correct amount of taxes based on its circumstances, adhering to the Internal Revenue Service’s tax codes. Often, tax accounting has a second objective of developing strategies to minimize the amount of taxes legally owed, increasing a company’s profitability. 

Managerial accounting focuses on helping business managers make decisions for their company. Because its intended audience is internal to the company, managerial accounting does not need to adhere strictly to GAAP and instead is often tailored to the unique needs of a company’s internal decision makers. Examples of managerial accounting include budgets, margin analysis, key performance indicators, and future-oriented reporting.

Nonprofit, government, construction, pension, cost, and forensic accounting are other branches of accounting. 

Does My Company Need Financial Accounting?

Most likely yes – at least to some degree. At the broadest level, all public companies must use GAAP-compliant financial accounting to be listed on exchanges. The SEC has additional reporting requirements but defers to FASB standards for the underlying accounting data. 

Private companies are not technically required to be GAAP-compliant, but doing so can still prove useful. As a practical matter, most lenders will request GAAP-compliant financial statements as part of loan applications. In addition, companies looking for investor capital will likely be required to show current financial statements and/or forecasts so potential investors can perform their due diligence – an example of how financial accounting and managerial accounting often go hand-in-hand.

The primary objective of financial accounting is to provide business performance information that's useful to readers outside of the company, such as investors and lenders.

The Takeaway

Accounting is a broad discipline with several different branches. Financial accounting has the widest base of users and is used by most companies – public, private, start-up, and established. It's an important way for internal and external audiences to objectively track financial results and make decisions. GAAP compliance is an essential part of keeping financial accounting practices standardized, thereby increasing its reliability and comparability across organizations – like how language forms a structured method of communication.

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