What Is Financial Accounting and Why Is It Important?

Accounting is often called the language of business. Because businesses execute a wide variety of activities, from design to production to sales, they need a common language to measure how well they’re performing. Accounting translates those activities.

Every company relies on accounting, which is why a profession in the field is one of the steadiest that a business student can pursue. The number of jobs for accountants and auditors is expected to grow by 7% between 2020 and 2030, according to the U.S. Bureau of Labor Statistics (BLS), with about 135,000 openings each year, on average.

However, accounting is a diverse field, encompassing more than a dozen branches. Of all those branches, one of the most central is financial accounting. It’s the backbone of many other kinds of accounting, and individuals who earn advanced degrees in accounting can make an especially positive impact on a company’s success.

What Is Financial Accounting?

A financial accountant is like a financial storyteller. Financial accounting collects raw material — the numbers in a company’s books — and makes sense of it. It synthesizes numbers into narratives, known as financial statements. Those statements allow an observer to quickly assess the firm’s condition and performance. This information is used by both internal and external stakeholders, including investors, regulators and creditors.

Financial accounting is also a way of keeping score. When a company sets goals, the numbers help to determine whether it’s meeting those goals or falling short. Those numbers include key indicators, such as income, equity and cash on hand. Without financial accounting, a business may risk running into cash flow problems and even bankruptcy.

Job Description for a Financial Accountant

The job description for a financial accountant generally revolves around financial statements, but the work often includes several other responsibilities.

Preparing Financial Statements

Financial statements summarize various facets of a company’s finances, such as overall revenues, expenses and cash flow.

These statements can cover various time frames. They may portray a firm’s condition at one moment in time. They may add up transactions over a specified period or depict changes from one date to another.

Most commonly, statements cover a month, a quarter or a year. A financial accountant prepares them shortly after those periods end. Publicly traded companies must have their annual financial statements audited by a public accounting firm.

Maintaining Financial Records

The records maintained in a company’s accounting system form the raw material for financial statements. Sometimes, financial accountants set up the accounting system, but more often, they work with an existing system.

In that system, financial accountants make sure that every financial transaction is recorded. Accountants also ensure that each transaction gets filed into the correct account so that it can be retrieved when needed.

Assisting with Budgeting

To budget for the future, companies rely on past financial records. Past expenses can help businesses forecast what they will need to spend in the coming year. Past income can also help to determine whether the business is earning enough to cover expenses or whether it needs to budget for new products or services to bring in extra income.

Large disparities between actual versus budgeted amounts can serve as learning experiences for companies and may lead to changes in business strategy.

Tracking Cash Management

At any given time, a business has to have enough cash to pay invoices, taxes, payroll and loans. Financial accountants keep track of the cash in an organization’s bank accounts. They may also forecast whether enough cash will be available for specific future dates by tracking indicators like accounts payable and accounts receivable.

Internal Auditing

A company’s books are an interlocking network of accounts that are supposed to be balanced. Financial accountants monitor accounts for inconsistencies that require investigation and correction. In larger firms, financial accountants may periodically audit the books to ensure their integrity and to confirm that financial statements are accurate.

How Financial Accounting Works with Other Accounting Roles

Financial accounting primarily focuses on preparing and reporting financial statements, but businesses also rely on other forms of accounting. A financial accountant may work in conjunction with other accountants — both within and outside the organization — to provide them with information.

Managerial accounting analyzes data from financial accountants to help management understand internal operations.
Cost accounting studies production costs to determine whether a product is being sold at a profit and whether it can be manufactured more efficiently.
Tax accounting ensures that a company pays the right amount of taxes and meets tax deadlines. It uses the same data as financial statements, but often uses different rules to classify and analyze the data.
External auditing provides a quality check on financial accounting. A financial accountant may conduct internal audits, but for larger companies, regulators and lenders usually require an independent external audit to verify that statements are accurate and complete.

Helping Meet Legal Requirements and Accounting Standards

While maintaining records and preparing statements, financial accountants must follow certain laws and industry standards. Some key legal and regulatory requirements to be aware of include:

Cash vs. Accrual Accounting

The IRS requires most companies to choose between two methods of recording their transactions.

Cash accounting is the simpler method, particularly for small businesses that don’t sell or buy on credit. It records income at the time that a business receives cash, and it records an expense at the time a business pays a bill.

Accrual accounting is more complicated and has more rules to follow. Instead of waiting for cash to change hands, an accountant records income the moment the firm earns it, such as when the firm sends an invoice to a customer. Expenses get recorded as soon as the firm receives a bill, rather than later, when it pays the bill.

Because accrual accounting smooths out the sometimes haphazard timing of receiving cash, it can offer a more accurate picture of operations. That’s especially true for companies that operate extensively on credit.

However, if a business carries an inventory or earns more than $26 million in revenue, it doesn’t have a choice — the IRS mandates that it use accrual accounting.

Generally Accepted Accounting Principles

By law, U.S. public companies must use a set of standards called generally accepted accounting principles (GAAP).

A nonprofit organization called the Financial Accounting Standards Board (FASB) sets GAAP standards. The purpose of GAAP is to help ensure that financial statements provided to investors, creditors, regulators and others are accurate, consistent and reliable.

GAAP is guided by 10 key principles, such as:

Using the same standards each time a company prepares a statement
Reporting income and expenses in the time periods in which they were incurred
Disclosing all facts material to evaluating operations

International Standards

Outside the U.S., many countries require that public companies follow a parallel set of accounting standards called International Financial Reporting Standards (IFRS). While IFRS has some differences from GAAP, U.S. law allows foreign companies with U.S. operations to use IFRS for their financial reporting.

What Is the Primary Purpose of Financial Accounting?

The primary purpose of financial accounting is to paint a clear picture of a company’s operational performance over a specified period of time, as well as summarize its assets, liabilities and equity at a point in time. To compile this information, an accountant files financial records under categories and uses them to construct several kinds of financial statements.

Categories of Financial Data

Although financial records cover many different kinds of transactions, they fall into five broad categories:

Revenues cover the money that comes into a company from sales of products and services, as well as from other sources, such as interest or dividends.
Expenses are the costs of producing goods and services, consisting of everything from salaries and marketing to research and development.
Assets include the property that a company owns, both tangible (buildings, computer systems) and intangible (patents, trademarks).
Liabilities are debts, such as loans or lease obligations.
Equity represents the part of a company that shareholders actually own. It’s the difference between assets and liabilities, or what a company would be worth if its debts were paid off and its assets were liquidated.

Kinds of Financial Statements

A financial statement organizes data to present a picture of a company’s financial condition. However, no single statement tells the whole story. To construct a complete portrait, financial accounting entails the preparation of four major kinds of statements, with different time frames and different categories of data.

Balance Sheet

The most basic kind of financial statement is a balance sheet, also known as a statement of financial position or a statement of net worth. It shows a company’s overall value at a particular point in time.

Balance sheets follow a three-part formula. They portray assets, liabilities and equity. When liabilities and equity are added together, they must balance out assets — hence the term balance sheet.

Income Statement

Rather than covering a single point in time, an income statement provides information on a period of time, such as a quarter. It totals the revenues received in that period and subtracts the total expenses incurred.

The difference represents the profit or loss; this is why the statement is also called a profit and loss (P&L) statement.

Cash Flow Statement

A business needs to have cash on hand to pay its bills. However, accrual accounting can make cash management hard to follow, because it doesn’t record cash at the time it actually comes in and goes out.

A cash flow statement fills in the missing information. Over a period of time, it shows how much cash is being received and paid out in three areas:

Operations – A company’s core business activities
Investments – The money a company makes from buying and selling its investments, such as securities or fixed assets.
Financing – The money a company pays out in interest to lenders and dividends to shareholders or receives when taking out new loans or issuing new shares.

Shareholders’ Equity Statement

A shareholders’ equity statement displays how equity changes over time. It complements a balance sheet, which depicts equity at one moment in time.

A shareholders’ equity statement also provides additional detail about the components of equity:

Share capital is the money the company has raised by selling stock.
Net income is a company’s profit after expenses and deductions.
Dividends are the percentage of the company’s profits paid out to shareholders.
Retained earnings are the profits that the company keeps after paying dividends.

Importance of Financial Statements

Why do financial statements matter? They communicate important information to four key audiences:

Shareholders. As the owners of a company, shareholders want to know how the business is performing. If a financial report is disappointing, they may sell their stock in the business. In some cases, particularly at smaller companies, shareholders may ask questions or make suggestions to management — or press for new management.
Prospective investors. Prospective investors look at financial statements to assess whether a stock is worth buying and at what price. From the numbers, they calculate ratios like the price-earnings ratio: a stock price divided by the earnings per share. Because all public companies use GAAP accounting, investors can compare ratios from one company with another to evaluate which is a more promising investment.
Lenders. Before loaning money to a company, a bank reviews several years’ worth of the company’s financial statements. It looks for consistent revenues, earnings and cash flow so that it can feel confident that the company will be able to pay back the interest and principal.
Management. Financial statements tell a company’s managers how well the company is performing, what’s working and what’s not. If the company has made operational changes or introduced new products, financial statements help them understand whether the changes are succeeding.

A smiling financial accountant at a desk with financial charts and a laptop.

What Is the Difference Between Financial and Managerial Accounting?

In business, two of the most widely used forms of accounting are financial accounting and managerial accounting. They sound similar and use the same underlying records, but they have very different functions. In choosing which specialty to pursue, it helps to understand the difference between financial and managerial accounting.

Audience

Financial accounting: Information prepared by financial accountants can be used by both external parties — e.g. investors, lenders and regulators — and the company itself.
Managerial accounting: Information is strictly for internal use, to assist in making management decisions and planning strategies.

Governing Standards

Financial accounting: Statements must follow legal requirements, such as GAAP accounting.
Managerial accounting: Because analyses aren’t for public view, the standards governing them are more flexible. They can use different rules and procedures to provide different perspectives on operational questions.

Timing

Financial accounting: Statements follow a set schedule. They appear after the end of each accounting period, whether it’s a month, a quarter or a year.
Managerial accounting: Reports may be assembled at other times, whenever management needs financial information to aid in making decisions.

Focus

Financial Accounting: Statements focus on past performance, reporting on transactions that have already taken place.
Managerial accounting: Reports may include projections, such as the financial impacts of alternative courses of action.

Level of Detail

Financial accounting: Statements provide high-level summaries of the categories in a firm’s financial records.
Managerial accounting: Reports often offer more details on lower levels of operations, such as comparing the revenue and expenses from one product to another.

Career Opportunities

Financial accounting: Common jobs for experienced professionals include controller, who manages internal accounting, and financial analyst, who gives outside advice to both companies and investors.
Managerial accounting: Common jobs include data analytics manager; strategic planning director; and chief financial officer (CFO), who oversees a company’s complete financial picture.

How Do Financial and Managerial Accounting Work Together?

In practice, a company doesn’t choose between financial accounting and managerial accounting — it uses both. The two forms mesh to build optimal strategies for stability and growth.

When managerial accountants craft a strategic plan for future growth, they carefully examine past financial statements prepared by a financial accountant. The same holds true for preparing budgets or improving operations.

Conversely, when financial accountants assemble information for financial statements, they may consult with a managerial accountant to better understand why certain expenditures or investments were made.

The bottom line is that both financial accounting and managerial accounting are important to business success. A student who understands the key differences between them can pursue a career in either field.

Make an Impact on the World of Business

Reliable financial accounting is crucial for any business to prosper. That’s why there’s a steady demand for financial accountants. An advanced degree program like the University of Nevada, Reno’s online Master of Accountancy can prepare students to be certified as a CPA and help any company succeed.

The program combines accounting fundamentals with the latest developments in tax laws, financial analysis and reporting, while including real-world business experience through applied research. Explore how the University of Nevada, Reno can help open the door to a rewarding and impactful career in financial accounting.

Recommended Reading:

Accounting Curriculum: A Deep Dive Into MAcc Courses

Finance vs. Accounting: What Are the Differences?

How to Become an Accountant

Sources:

Business.com, “Everything You Need to Know About the Statement of Shareholder Equity”

Business.com, “Financial Accounting”

Chron, “What Are the Benefits of Financial Accounts to a Business?”

Indeed, “9 Types of Accounting and 5 Important Accountant Careers”

Indeed, “Financial Accounting vs. Managerial Accounting: 6 Differences”

Internal Revenue Service, Accounting Periods and Methods

Investopedia, “Cash Flow Statement”