GAAP (Generally Accepted Accounting Principles) is a collection of commonly followed accounting rules and standards for financial reporting. The acronym is pronounced “gap.”
Companies are responsible for providing reports on their cash flows, profit making operations and overall financial conditions. There are three major financial statements required under GAAP: the income statement, the balance sheet and the cash flow statement.
The income statement recaps the revenue earned by a company during the reporting period, along with any corresponding expenses. This includes revenue from operating and non-operating activities, allowing investors and lenders to evaluate profitability. It’s sometimes referred to as the profit and loss statement.
A company’s balance sheet summarises assets and sets them equal to liabilities and shareholder’s equity. These three categories highlight what a company owns and how it finances its operations. The balance sheet is an open snapshot of a company at a specific point in time.
GAAP also requires a cash flow statement, which acts as a record of cash as it enters and leaves the company. Investors and lenders can see how effectively a company maintains liquidity, makes investments and collects on its receivables. The cash flow statement is crucial, because the income statement and balance sheet are constructed using the accrual basis of accounting, which largely ignores real cash flow.
The practice of GAAP is meant to ensure a minimum level of consistency in a company’s financial statements, which makes it easier for investors to analyse and extract useful information. GAAP also facilitates the cross comparison of financial information across different companies.