Changes in Net Profit Margin and Gross Profit Margin - Essay Example

………………………………………………………………………….xxxxxx …………………………………………………………………….xxxxxx …………………………………………………………………………xxxxx ………………………………………………………………………..xxxxx @2013 Q1- Possible explanations for changes in net profit margin and gross profit margin Financial ratios are used in analyzing the performance of an entity and its trend over time. The net profit margin and gross profit margin are used in analyzing the profitability of an entity. The net profit margin and gross profit margins are used to evaluate the operating performance of a company (Pamela and Frank 2010). The net profit margin calculates the net profit as a percentage of sales. A high net profit margin indicates that a company converts its sales into profits fast. The net profit margin also considers costs associated with the sale of products. There are several factors which triggered a decrease in the net profit margins. They include: a. Inventories Even though, a company treats inventories as an asset in the balance sheet, the cost of sales are not reported until a sale is actually made. Therefore, it is possible to calculate the cost of sales in inventories. However, market fluctuations can reduce the value of inventories which in turn lead to devaluation of net profit margins. An economic slowdown leads to slow moving inventories and decreases company sales and causes a negative impact on net profit margins. b. Price changes Changes in price affect the number of units sold which in turn influences the profits. It is challenging to price items correctly especially in a perfect market. Therefore, the price point of a product is a primary factor responsible for decreasing net profit margin. A decrease in price may in turn cause a decrease in net profit margins. c. Variable costs Variable costs vary with the volume of units produced or sold and thus affect the net profit margin. Examples include the cost of raw materials, taxation and sales commission. An increase in variable costs reduces the net profit margins. d. Fixed costs Increase in the cost of overheads reduces the net profit margin of a company. Examples include rent, salaries and depreciation expenses. Even though, these costs do not change based on the volume or production and sales, they still influence the net profit margin. The gross profit margin is calculated as gross profit as a percentage of sales. According to Pamela and Frank (2010), an increase in gross profit margin from one period to another can be caused by one of the following factors: a) Increase in sales volume which in turn affect sales and the cost of sales b) Increase in sales price which affect sales revenue c) Reduction in the cost of production which affects cost of goods sold. Q2- Transactions or accounts that require additional audit effort The following are the transactions or accounts which require additional audit effort based on question one above: Revenues Operating expenses Inventories Cost of goods sold Q3- Additional Audit work In some situations, an auditor may perform additional procedures in order to determine the reliability of the underlying data (Spencer 2010). The auditor should get evidence from multiple sources depending on the risk of material misstatement and the quality and quantity of audit evidence required. Obtaining evidence from different sources or types increases the level of assurance. The additional audit procedures may include Computer-assisted audit techniques (CAATs) and substantive tests. CAATs help in identifying anomalies from the selected items. However, audit evidence may be gotten from items not selected since the auditor uses professional judgment. Substantive tests entail the activities performed by the auditor during the audit so as to obtain evidence regarding the completeness, validity and accuracy of the account balances and the underlying classes of transactions (Ray 2012). Therefore, evidence that the account balances and transactions are not complete is a sign that the financial statements are materially misstated. The substantive tests aim at gathering information about the financial statement assertions which include: existence, occurrence, valuation, rights and obligations completeness, presentation and disclosure. The substantive tests help in finding any errors and misstatements that might have occurred during documentation or that are within the accounts. Such tests include checking the trial balance created at the end of each cycle by the accountant, circularizing debtors to confirm receivable amounts that they owe the company and evaluating accuracy of the provision for bad debts by reviewing the company’s history. Substantive tests may also include tracing vouching and performing cut off tests on sales, cash receipts and sales returns. Documentation relating to a sample of the customer is examined including journal entries to ascertain the accuracy. There are two types of substantive tests; analytical procedures and tests of detail. Analytical review procedures make use of the significant accounting ratios in identifying areas of potential material misstatements in the financial statements (Spencer 2010). Apart from ratio analysis, there are other standards tools that can be used as analytical procedures such as trend analysis and reasonableness tests. The tests of detail touch on the account balances. Test of details are suitable when gathering evidence regarding certain assertions on account balances. Therefore, the auditor should use assertions in performing further audit procedures. Analytical review procedures are applied on a large number of transactions such as sales cost of sales and payroll. It the auditor finds out that internal controls are weak, he places more reliance on the test of details rather than analytical review procedures. Examples of tests of controls for sales include: ascertaining who accepts and approves credit sales, separation of duties such as filling out, recording of sales orders and shipping of goods, checking for documentation of cash receipts and depositing of cash, checking for appropriateness and authority to granting of discounts, sales returns and cash payments; and management authorization to determining whether bad debts should be written off or whether a customer’s account is uncollectable. For example, in the case of revenue, the gross profit margin and growth in revenue experienced by the company in one year can be examined. The organization’s maximum capacity for sales is to be examined as part of the analytical procedures on condition that all the resources have been fully utilized. Accounts receivables will also be looked into to ensure that they are not outgrowing sales. The auditor should identify and understand issues which prove difficult in the recognition of revenue. These issues are long-term contracts, potential for deferred or unearned revenue and bundled revenues. References Pamela P.D. and Frank J. F. 2010. The Basics of Finance: An Introduction to Financial Markets, Business Finance and Portfolio Management. Wiley Publishers. Spencer P, 2010. The internal Auditing Handbook. Wiley Publishers. Ray W.O, 2012. Wiley CPA Exam Review 2013, Auditing and Attestation. Wiley Publishers Read More