When companies prepare income statements, they use the financial data contained in the accounting records. If the accountant recorded financial transactions incorrectly, the company will use inaccurate information when it creates the income statement. The company runs the risk of misstating the financial results. Common-size income statements restate each reported number as a percentage of total sales. These companies use the percentages reported on common-size income statements to estimate the amount of a potential misstatement.
Create common-size income statements for three years. Start with the most recent income statement. Assign total sales a value of 100 percent. Review the dollar amount of the first item reported on statement. Divide this amount by the total sales. This provides the percentage for the first item. Repeat this process for the remaining amounts reported on the income statement. Repeat this process for each year.
Compare net income percentage for each year. Identify the net income percentage for each of the three years. Identify any year with a large change in the net income percentage. This year may contain a financial misstatement.
Review each subtotal on the income statement for the year with the potential misstatement. These subtotals include gross profit, total operating expenses or income from operations. If any subtotal varies significantly from the percentages reported in other years, mark these sections for further review.
Review each financial item in the sections you marked. Large percentage changes represent potential misstatements.
Estimate the value of potential misstatements. Identify the percentage for the item you are reviewing. Identify the corresponding percentage on the next year’s income statement. Subtract to find the difference. Multiply this difference by the total sales. This represents the potential misstatement.
Remember that estimation is a tool. A tool provides you with a place to start looking at numbers and asking questions.
Do not assume that all large percentage changes represent misstatements. Economic, industry and business changes contribute to changes in the company’s work environment and the financial results reported. After identifying potential misstatements, investigate the actual financial transactions recorded to verify whether they were recorded correctly.