In this guide, we will explore key steps for reviewing an income statement to ensure its accuracy and completeness. This involves tying the reported figures to external records and performing quick tests to identify potential errors. Let's dive deeper into the process.

One of the first steps when reviewing an income statement is to check whether the reported sales align with other records. For instance, in a retail environment, sales should match the cash register totals, also known as Z-totals, which are logged daily by most businesses. You’ll want to compare the Z-total logs or similar sales records to the reported sales on the income statement.

In other types of businesses, sales might be tracked separately from the accounting system, so you would need to cross-reference those records with the income statement. This process ensures that the reported sales figures are accurate and reliable.

Next, it’s essential to review the cost of goods sold (COGS) for any wholesaler, retailer, or manufacturing company. If COGS is missing from the income statement, that's a red flag.

To verify COGS, you’ll want to check whether it’s calculated correctly. The basic formula for COGS is:

Some businesses may provide a breakdown of this calculation on the income statement itself. If not, you should inquire about how COGS was computed to ensure accuracy.

Payroll is another significant area to review. You want to ensure that salaries are recorded at their gross amounts rather than just reflecting the net amounts paid to employees. A quick way to check this is by reviewing the federal forms 941, which are payroll tax returns submitted to the government.

These forms will show the gross payroll amounts for the year or quarter. Compare these figures with the payroll recorded on the income statement. If they don't match, there’s an issue with how payroll was recorded.

To review payroll taxes, use the same 941 forms. The total payroll tax amount includes both the employee and employer's contributions. The employer's portion should be recorded as an expense on the income statement. Divide the total payroll tax amount by two to see if the employer's portion is recorded correctly.

It's also important to review rent and utility expenses for reasonableness. For example, if a business occupies 5,000 square feet and the market rate is $30 per square foot annually, rent should be around $150,000. If the rent expense on the income statement is significantly different, there might be an error.

Similar tests can be performed for utilities, ensuring all bills are recorded correctly, regardless of whether they have been paid. If the company uses the accrual accounting method, expenses should be recorded when incurred, not when paid.

For C corporations, it’s crucial to check whether a provision for income taxes is included. Only C corporations pay their own taxes, so if you see income taxes on an S corporation, partnership, or LLC income statement, this indicates a mistake. In these cases, the income taxes of the owners should not be reflected in the company’s financials.

A valuable tool for analyzing income statements is comparing them to prior periods. For instance, you could compare month-to-month or year-to-date financials from the current year with those from the previous year. Look for large fluctuations in account balances and changes in the percentage of total sales or assets.

Significant changes may indicate an error or a fundamental change in the business. New accounts that appear on the income statement but didn’t exist in prior years should also be investigated. Consistency is common in most businesses, so new entries could signify an issue or a new development that needs to be discussed with the preparer of the financial statements.

By following these steps, you can gain valuable insights into the accuracy and completeness of an income statement. Whether verifying sales figures, reviewing COGS, or comparing current and prior periods, these techniques allow you to ensure that the financial statements are reliable and ready for deeper analysis.