When people think of accounting, they immediately associate it with financial accounting. One of the reasons behind it is that these terms have been synonymous. However, accounting defines a wide range of processes or functions within a company. On the other hand, financial accounting is a part of those processes. In essence, it is a branch of the overall area that is accounting.
Two of the most well-known branches of accounting include financial and cost accounting. The latter is highly regarded for helping companies make various decisions. Usually, these decisions relate to costs, pricing, production, resources, etc. Within that branch, accountants have several tools that can enhance decision-making. However, these decisions occur within the company, although they may impact external stakeholders.
Financial accounting, in contrast, is usually regarded as a branch that helps provide information. Due to the emphasis on cost accounting for decision-making, some people may disregard the former branch. However, financial accounting is highly crucial in helping companies in decision-making. On top of that, it can also be significantly critical for external stakeholders for decisions. However, one must understand financial accounting in itself first.
What is Financial Accounting?
Financial accounting is the branch of accounting that involves processing financial transactions. In that context, it involves recording, summarizing, analyzing, and reporting those transactions. For a company, financial accounting is essential in providing information to external stakeholders. While cost accounting can offer sufficient information internally, it is not usually available externally. Therefore, companies use financial accounting to communicate with external users.
Financial accounting concerns the preparation of financial statements, which is its primary objective. They include the balance sheet, income statement, cash flow statement, and statement of changes in equity. Apart from these, companies also prepare notes to the financial statements. These notes are crucial in supporting the information presented in the primary financial statements. However, the process behind the presentation is more complex.
When companies prepare financial statements, they require information to put into them. This information comes from the financial accounting systems in place. Usually, companies use accounting software that takes care of the process. In the past, the process used to be manual. Nonetheless, in both scenarios, the initiating factor was a business transaction. When a company entered into a transaction, it recorded it in financial accounting.
Financial accounting also refers to the supporting processes behind financial statements. These usually include the books of prime entry, general ledger, and trial balance. For most companies, a financial transaction starts from the books of prime entry. From there, it reaches the general ledger, usually summarized. Once it goes through the general ledger, companies calculate the balance for that account. This balance then ends up on the trial balance.
Overall, financial accounting involves the recording and processing of financial information. It is an essential part of communicating with external stakeholders. In some cases, it is mandatory for companies to prepare financial statements. For that, they must use financial accounting to support the information. Once prepared, these financial statements can be a crucial part of decisions for external stakeholders.
How can financial accounting help in decision-making?
Financial accounting is a crucial part of a company’s communication with external stakeholders. As mentioned, for internal purposes, companies usually rely on cost accounting. However, for stakeholders, financial accounting and statements are the only sources of information. Stakeholders use this information to decide about their relationship with a company.
However, most people may wonder how financial accounting helps in decision-making. The answer to that question is not as straightforward, though. Usually, the advantages of financial accounting in making decisions depend on the type of stakeholder. Nonetheless, the ways how financial accounting helps in decision-making include the following.
Investors and shareholders
One of the primary users of financial statements includes investors and shareholders. These are parties that provide equity finance to a company. In exchange, they require profits and better results from the underlying company. Usually, the objectives of each investor or shareholder may differ. Based on that, their decisions may also vary. Nonetheless, financial accounting can help them with those decisions.
For investors and shareholders, the primary measure when making decisions is financial performance. Usually, this information comes from the income statement. This statement reports the profits or losses a company makes. The higher these profits are, the more preferable the investment is. On the other hand, losses provide an adverse view of the company’s operations.
Apart from financial performance, investors also focus on the financial position and cash flows. This info comes from the balance sheet and cash flow statement, respectively. However, these factors are not as crucial as profits and losses. Nonetheless, investors decide based on how many assets a company has or its liabilities. Cash flows are also crucial to decision-making, although not as critical for these stakeholders.
Another stakeholder interested in financial information is a company’s creditors. These are parties to whom a company owes money. Therefore, they have an interest in the company’s operations due to their stake in the company. Unlike investors and shareholders, creditors provide a company with debt finance. In exchange for this finance, they require the company to pay regular interest. However, some creditors may also have other objectives.
For creditors, the primary areas of focus are debt and cash flows. While they also focus on profits, usually, they get guaranteed income. Therefore, they may not concentrate on that aspect. However, it may be crucial to do so when companies experience consecutive losses. When considering loans, creditors usually focus on cash flows. This way, they check if the company can make regular interest payments on time.
With debt finance, creditors ensure a company does not have significant leverage. While contributing to those companies can provide higher interests, they can also be riskier. Creditors may also consider whether a company has enough resources to provide security. In some cases, these resources can be crucial in guaranteeing returns from the company. These are the factors that creditors consider when deciding on their relationship with a company.
Stakeholders, investors, and creditors are the primary parties that use financial accounting in decision-making. However, other stakeholders may also require this information to decide about their connection with a company. These may include external and internal stakeholders. For example, customers, employees, management, the government, and other parties may use financial accounting for decisions.
For customers, the primary deciding factor is whether a company can provide future products or services. Employees, in contrast, may use financial accounting information to know about their employer. Some employees may also check this information to understand their situation within the company. The management of a company also falls within the same category. For the government, the primary concern would be the taxes paid by a company.
The information provided in the financial statements can be highly crucial for companies. Whether financial position or performance, companies must ensure the best results. Stakeholders use this information for decision-making. Therefore, the company’s operations play a significant role in how those stakeholders react. Whether internal or external, this information can be critical. Financial accounting helps provide this information to those stakeholders.
Financial accounting relates to recording and presenting financial transactions. This process can provide crucial information for decision-making. However, those decisions may differ based on the stakeholder that uses them. The primary parties concerned with financial accounting are investors and creditors. However, other stakeholders may also use this information for decision-making purposes.