Question

One business person says, “ Accounting income is a useless measurement because it is based on so many arbitrary decisions.” How would you respond to this person? Is he/she correct?

Answer 1

He is not correct and I would respond to the person in the following manner:

While it may sound boring or esoteric, financial accounting plays a key role that allows businesses to keep track of all their financial transactions. It is the process in which companies record and report the pieces of financial data that go in and out of its business operations that allow both company managers and outside investors and analysts to understand the company's health and make informed decisions.

KEY TAKEAWAYS

• Financial accounting involves recording, summarizing, and reporting the stream of transactions and economic activity resulting from business operations over a period of time.
• Governed by a standard set of practices, financial accounting's end product is a set of official company financial statements including the balance sheet and income statement.
• These financial statements are then used by company managers, investors, analysts, lenders, and other stakeholders to make informed decisions.

Standards and Best Practices

There are a series of accounting principles that companies must 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 and best practice that accountants follow when they crunch their numbers and complete financial statements.1

Companies outside the U.S. generally follow other international standards that vary by region and country. But, regardless of which set of standards is followed. there are three main areas where financial accounting helps with decision-making:

1. It provides investors with a baseline of analysis for—and comparison between—the financial health of securities-issuing corporations.
2. It helps creditors assess the solvency, liquidity, and creditworthiness of businesses.
3. Along with its cousin, managerial accounting, it helps businesses make decisions about how to allocate scarce resources.

Investing Decisions

Fundamental analysis depends heavily on the accounting data that is recorded on a company's financial statements, including the balance sheet, income statement, and cash flow statement.. Each 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) and submitted to the Securities and Exchange Commission (SEC).2

Investors and analysts use the information from financial statements to make decisions about the valuation and creditworthiness of a company, allowing them to set price targets and determine if a stock's price is fairly valued or not. Without the information provided by financial accounting, investors would have less understanding about the historical, current, and prospective 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.3 4

Lending Decisions

Financial accounting is also a key for creditors, from banks to bondholders. 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 entirely 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 really wants to know just how much risk is involved when lending a company money, which can be determined by reviewing the company's financial accounting. Once this level of risk is determined, the lender will also be able to outline exactly how much to lend and at what interest rates through the process of underwriting the loan.

Corporate Governance

Reliable accounting serves a practical function not only for outside investors and lenders but also for the internal workings of the firms themselves.

The most obvious benefit for businesses to refer to their financial accounting is to meet the legal and regulatory obligations outlined for (public) firms. Companies must be honest and transparent about their financial activities and the data reported must be accurate and regularly updated.

Beyond the regulatory and compliance hurdles financial accounting moreover helps companies optimize their day-to-day operations and identify the types of projects that could provide growth opportunities in the future. Financial accounting helps managers create budgets, understand public perception, track efficiency, analyze product performance, and develop short- and long-term strategies, among several other decisions aided by accounting figures.

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.