Question

Question 6 (This is multiple choice question 15-20 on page 466, but without the answers.) As a result of analytical procedures, the independent auditor determines that the gross profit percentage has declined from 30% in the preceding year to 20% in the current year. Required: Explain your thought process as you decide what to do.

Answer 1

Gross Profit Ratio refers to the percentage of gross profit to net sales. The basic format to find gross profit ratio is as follows:

Particulars	Amount	Particulars	Amount
To Opening Stock	xx	By Sales	xx
To Purchases	xx	By Closing Stock	xx
To Direct Expenses	xx
		By Gross Profit c/d (Balancing Figure)	xx
Totals	xxx	Totals	xxx

The formula to find Gross Profit Ratio is :-

(Gross Profit / Net Sales ) x 100

It has been told that as a result of analytical procedures, the independent auditor finds that the gross profit percentage has declined from 30% in the preceding year to 20% in the current year. There can be various reasons for the decline in gross profit percentage.

This can be clearly understood from the table above.

1. Opening Stock : Over valuation of opening stock would result in decreased gross profits.
2. Purchases : An unfavorable purchase volume or policy would result in overall purchase of more than what is required to be in line with optimal cost policy. Purchasing materials for an unreasonable price or purchasing higher volume of inputs than what is necessary for the current year are such examples.
3. Direct expenses : Expenses which are directly related to production fall under this category. Increased direct expenses would result in a decreased gross profit margin.
4. Sales : When there is an increase in cost of goods sold, there needs to be simultaneous increase in the selling price of the goods, if not, it would result is lower gross profit margin. Another possibility is the omission of certain sales which may happen during peak seasons of sale.
5. Closing Stock : While over valuation of opening stock can result in decreased gross profits, under valuation of closing stock can lead to the same situation. A review on the method of valuation of closing stock and if necessary performing the stock valuation again would help.