How To Find Mistakes In The Income Statement

Introduction

This tutorial will guide you through the process of identifying mistakes in a company's income statement. By analyzing revenue and expenses line by line, you will learn common areas where accounting errors or misstatements frequently occur. Understanding these concepts is crucial for anyone involved in finance, accounting, or auditing.

Step 1: Analyze Revenue

• Start with the gross unit revenue line. Look for significant fluctuations throughout the year.
  • Example: If revenue changes drastically each month, it may indicate a misstatement.
• Check for inappropriate revenue items:
  • Interest income should not appear in operating revenue unless the company is a financial institution.
  • If you see interest income listed here for a manufacturing company, note it as a mistake.

Step 2: Examine Cost of Goods Sold (COGS)

• Identify the components of COGS and ensure they align with revenue trends:
  • For a food manufacturing company, analyze food inventory costs and packaging costs.
• Use formulas to compare COGS with revenue:
  • For example, calculate packaging COGS as a percentage of revenue.
  • If you notice a sudden spike (e.g., a $35,000 packaging expense in February), investigate the cause.
• Ensure delivery costs:
  • Delivery in costs should be recorded. If they are zero, it could indicate a problem.
  • Delivery out costs should not be included in COGS; they belong in operating expenditures.

Step 3: Review Operating Expenditures

• Break down operating expenses into categories:
  • For payroll expenses, check for consistency. Sudden spikes (e.g., a $25,000 salary entry) may indicate that bonuses should have been accrued over several months.
• Evaluate whether direct labor costs (like chef salaries) are recorded in the right section:
  • Ensure salaries related to production are included in COGS rather than operating expenses.
• Confirm that fixed costs, such as industrial kitchen rent, are categorized correctly:
  • Rent for production facilities should be included in COGS, not operating expenses.

Step 4: Assess Non-Operating Expenses

• Analyze depreciation and interest expenses:
  • Look for consistency in depreciation amounts. A significant spike (e.g., $10,000 in one month) requires further investigation.
• Review income taxes:
  • If income tax entries are irregular (e.g., zero for several months followed by a sudden $5,000 entry), question whether the tax should have been accrued over the period.

Conclusion

Identifying mistakes in an income statement involves a detailed review of revenue and expenses. Key areas to focus on include ensuring that revenue items are appropriate, COGS aligns with production-related costs, and operating expenditures are correctly categorized. By following these steps, you can enhance your financial analysis skills and ensure accurate financial reporting. Consider applying these techniques to real income statements to practice your skills further.