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Investors and lenders rely on financial accounting to obtain critical information about businesses’ financial solvency and the risks they face. The most important benefit of financial accounting and the benefit the Financial Accounting Standards Board (FASB) most emphasizes is access to information.
The average lender or investor does not have ongoing inside access to the day-to-day operations of a company. Instead, they rely on financial accounting to provide accurate and readily comparable information.
Key Takeaways:
- Financial accounting is crucial for investors and lenders to assess the solvency of businesses.
- Financial accounting provides transparency and access to information concerning the operations of a company.
- With standardized accounting practices according to GAAP, investors can compare the financial statements and performance of companies with those of their industry peers.
Understanding the Benefits of Financial Accounting
Financial accounting allows outside actors to observe the profitability and value of a business. An investor can see which companies have consistently performed well, paid dividends, and appear to have positive margins. A lender can review the financial accounts to assess liquidity, cash flow, leverage, and overall solvency.
Consistent Schedule of Final Accounts
The three main external financial statements—the income statement, balance sheet, and cash flow statement—are issued on a routine schedule, typically every quarter. This means investors and lenders have access to information on a consistent and dependable basis not just when the company is doing well or when it looks the most solvent.
Plurality of Uses
Financial accounting information is used in a variety of ways by different market actors. Information is not generally tailored to any one specific group, though investors and lenders are clearly the most important stakeholders for a business. After all, company capital primarily comes from these two sources.
Flexible usage is maintained through a set of standards, or common rules, known as the generally accepted accounting principles (GAAP) in the United States and the International Financial Reporting Standards (IFRS) in the rest of the world.
In the United States, the U.S. Securities and Exchange Commission (SEC) has the authority to set accounting standards under GAAP, which it has further delegated to the FASB. Accountants and corporate managers adopt these standards uniformly. This makes it relatively easy for an investor or lender to compare a company’s performance across time and against its competitors.
Financial Accounting, Financial Statements, and Financial Reporting
Financial accounting is one component of a larger business accounting field, which is different from managerial accounting. Financial accounting is performed for the benefit of outside parties. The financial statements are only one portion of financial reporting.
Generally, only three or four issues are considered financial statements. The fourth is sometimes identified as the statement of stockholders’ equity. In addition to the financial statements, financial reporting includes the company’s annual report to the SEC and its annual report to stockholders. Financial reporting also includes any proxy statements or additional reports created outside of the routine framework of the financial statements.
Transparency and the Financial Accounting Standards Board
The FASB was created in 1973 and is recognized by the SEC as the designated accounting standard setter for publicly traded companies. The SEC’s stated goal is to encourage transparency and improve the fairness of investment and lending contracts among publicly traded companies.
Privately held companies do not have to comply with GAAP and the SEC, but transparency is aided by the training and standard procedures of public accountants and lender expectations.
Why Is Financial Accounting Important for Investors and Lenders?
Financial accounting provides critical transparency and standardized information that helps investors and lenders assess a company’s financial health. By examining financial statements they can evaluate a business’s profitability, liquidity, and solvency, which are key factors in making informed investment or lending decisions.
How Does Financial Accounting Differ From Managerial Accounting?
Financial accounting focuses on providing financial information to external parties like investors, lenders, and regulatory agencies, following standardized principles such as GAAP or IFRS. Managerial accounting, on the other hand, is designed for internal decision-making and helps managers assess operational efficiency, plan budgets, and improve business strategies. Financial accounting emphasizes transparency and compatibility, while managerial accounting is more flexible and tailored to the company’s internal needs.
How Does Financial Accounting Contribute to Market Transparency?
Financial accounting promotes market transparency by ensuring companies follow standardized reporting practices, such as GAAP and IFRS. This standardization allows external stakeholders (investors, lenders, and regulators) to compare financial information across different companies and industries. By providing consistent, reliable data, financial accounting helps reduce information asymmetry, builds trust in financial markets, and allows stakeholders to make well-informed decisions based on accurate financial disclosures.
The Bottom Line
Financial accounting is essential for providing investors and lenders with the transparency and information they need to evaluate a company’s financial health and solvency. By adhering to standardized accounting principles like GAAP, businesses ensure that their financial statements are reliable and comparable across the industry.
This consistency allows stakeholders to assess profitability, cash flow, and leverage, allowing for informed investment and lending decisions. Financial accounting also supports broader financial reporting, contributing to overall transparency and fairness in financial markets, especially for publicly traded companies.