Question

For the current year audit, Blue Cow’s draft Trading Account shows the following figures: Sales $100,000 Cost of Sales 69,000 Gross Profit $31,000 Basic analytical procedures therefore show a GP% of 31% this year which is higher than the normal range of 24% - 26%. You intend to enquire of management as to the reasons for the current year increase, before undertaking further audit work to investigate potential misstatements.

Required: a) Identify one possible explanation that you would accept from management that would satisfy you that the above GP% increase was not due to potential misstatements.

b) Assume that management has no satisfactory explanations and that further audit investigation reveals Cost of Sales is misstated due to potential misstatements in the closing inventory figure:

i) Calculate by how much closing inventory may be overstated.

ii) State and explain whether you consider this to be a material misstatement.

iii) Identify which two audit assertions you would focus on and explain how these relate to investigating the suspected overstatement of closing inventory

Answer 1

Sales = $100,000

Cost of sales = $69,000

Gross Profit = $31,000

Gross Profit % = Gross Profit/Sales * 100

= $31,000 / $100,000 * 100

= 31%

Normal range of Gross Profit % = 24 to 26%

Ans.A. Since Gross Profit % = Gross Profit/Sales, so same can increase if Gross profit has risen as compared to sales. Further, Gross Profit = Sales – Cost of sales. So, Gross Profit can increase in either of the two situations –

1. That the Sales has increased as a result of price increase or volume increase.

2. That the cost of sales has reduced as a result of lower cost of raw materials.

So, in above cases, the GP% can rise without any misstatements on part of management.

Ans.B. If cost of sales is likely to be misstated, so for getting higher Gross Profit, lower cost of sales would be stated. Cost of sales = Opening inventory + Purchases – Closing inventory

i. Since normal range of Gross Profit = 24 to 26%, taking it is 24%, the Gross Profit normally would be 24% * $100,000 = $24,000

Now, if this difference ($31,000 - $24,000 = $7,000) is entirely on account of cost of sales misstated, so it means cost of sales is stated less by $7,000. Further, within cost of sales, if this misstatement is on account of closing inventory, so the closing inventory would have been overstated by $7,000 (as per the formula for Cost of sales above).

Thus, the closing inventory would be overstated by $7,000 maximum.

ii. A material misstatement is misstatement which is large enough to create an impact on reported financials. This misstatement will be considered material misstatement since it affects the Gross Profit % by approx 7 % points.

iii. The audit assertions that will be focused on in this case to identify any potential overstatement of inventory will be:

a. Accuracy and valuation: This assertion states that all the figures presented are accurate and valuations are as per extant accounting rules and regulations. So, for inventory, this assertion would make sure that inventory figure is accurate and inventory is value as per accounting rule of lower of cost or market value.

b. Existence: This assertion states that the assets, liabilities stated actually exist. So, in case of inventory, this assertion would state that inventory as stated in financial statements actually exists in the Company.