Li Chen has calculated profitability ratios using data extracted from his client
ID: 2582951 • Letter: L
Question
Li Chen has calculated profitability ratios using data extracted from his client's pre-audit trial balance. He also has the values for the same ratios for the preceding two years (using audited figures).
Ratio
2016
2015
2014
Gross profit margin
0.45
0.35
0.40
Profit margin
0.09
0.15
0.20
Li is a little confused because the profit margin shows declining profitability, but the gross profit margin has improved in the current year and is higher in 2016 than in the previous two years.
Required
A) Make list of possible explanations for the pattern observed in the gross profit and profit margin
B) Which of your explanation suggest addittional audit work should be planned ? for each explain the accountas and /or transactions that would need special attentions in the audit?
Ratio
2016
2015
2014
Gross profit margin
0.45
0.35
0.40
Profit margin
0.09
0.15
0.20
Explanation / Answer
A) List of possible explanations for increasing gross profit margin and declining profit margin :- 1) Understated Cost of Good Sold 2) Factory Expenses are treated as operating Expenses 3) Overstated closing inventory 4) Understated Purchases cost 5) Overstated Sales B) Additional audit work need special audit 1) Understated Cost of Good Sold Auditor should verify classification of expenses,verify supplier invoices to purchases account,vouch other expenses with proper invoices and documentation and vouch cost of good sold with sales invoice. 2) Factory Expenses are treated as operating Expenses Auditor should verify classification of expenses direct expenses and indirect expenses. 3) Overstated closing inventory Identifying and valuing obsolete and damaged closing inventory, Verify inventory quantity and cost records 4) Understated Purchases cost Verify Creditors with payment invoice, Verify Inventory Movement,Vouch the receipt with payments made. 5) Overstated Sales Verify inventory movements to match sales, Increased advertisement expenses reduced the profit margin , Vouch the sales receipts with accounts receivables and check bad debts . 6) Overcharged Non- Cash Expenses Verify any excess amount of depreciation charged in the current year and is that consistent with the past years or not. Vouch the depreciation with the Assets purchased in the current year.
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