Generally accepted accounting principles, or GAAP, provide the accounting standards that companies follow when recording financial transactions and financial reporting. Accountants apply GAAP with every financial transaction done by the company. Companies calculate their income using GAAP. Income provides investors with an understanding of the financial performance of the company.
GAAP requires companies to use accrual accounting when preparing their financial records. Accrual accounting requires companies to report financial activities as they occur. The company reports revenue when it performs the activity that generates the revenue. The company reports expenses when it performs the activity incurring the expense. Accrual accounting disregards the timing of any cash payments when calculating income. This allows the reporting of income to communicate the activities of the company rather than cash position.
The company reports gross profit on the multiple-step income statement created under GAAP. The multiple-step income statement includes several calculations of income reporting. The first income calculation is called gross profit. Gross profit equals the total sales less the cost of goods sold. Under GAAP, the total sales refer to money earned whether received or not. The cost of goods sold refers to the value of the inventory sold to the customer, even if the company has not paid for it yet. Gross profit does not consider any other expenses.
The next income calculation refers to operating income. Operating income uses the amount calculated for gross profit and subtracts any operating expenses incurred by the company. The operating expenses include selling expenses and administrative expenses that the company incurred, whether or not these expenses have been paid. The operating income communicates the revenue earned through the primary operation of the business.
The final income calculation performed is net income. Net income considers everything included in the operating income. In addition, net income also considers income earned and expenses incurred outside the realm of the primary business. The company considers the income and expenses whether cash has already exchanged hands or will in the future. Examples of income earned outside the realm of the primary business include rent earned on an unused warehouse or interest received for money lent to an internal employee. An example of an expense incurred outside the realm of the primary business includes interest paid.