Reasons for Fluctuations in Gross Profit GP Ratio, In the preparation and finalization of Financial Statements, GP analysis plays a very important role. Here, we will analyze the reasons for fluctuations and how to observe them. Before we proceed further, let us understand the basic meaning of the term.
Reasons for Fluctuations in Gross Profit GP Ratio
Gross Profit on Sales
Gross profit simply means income accrued over and above the cost of goods sold. While assessing the gross profit, we give importance to the variable costs only. Cost of Materials, labor and other variable expenditure is considered here. For example: An organization sold goods amounting to Rs. 1 crore, there were no opening and closing stocks, The Cost of Goods Sold is Rs. 60 Lakhs. Then the Gross profit of the organization is 40%.
Gross profit percentage can be determined by
Importance of Gross profit:
- Profit is the prime objective of doing Business.
- Bankers while providing loans pay attention towards the earning capacity of the organization i.e. Gross Profit.
- Various Institutions while rating organization consider gross profit ratio.
- It determines the efficiency of organization.
- It determines whether the organization will be able to meet all its liabilities within the given period of time.
- It is a means to employees to determine whether they will receive Bonus, incentives and other benefits in future.
Thus, it becomes necessary to determine what the factors that can influence the gross profit are.
Reasons which increase gross profit:
1] Understating Opening Stock:
Organization sometimes understate the opening stock purposefully, this will result in reduction on debit side resulting in increase in the amount of Gross Profit. Auditors should check the opening stock value from the previous year’s audit report. Auditor should check that inventory is valued at net realizable value or cost whichever is lower.
2] REDUCTION IN PROVISION OF EXPENSES CONSIDERED IN TRADING ACCOUNT:
Organization may not make full provision of expenditure that is likely to occur. Thus reducing expenditure from trading account would lead to increase in the gross profit.
Auditor should determine whether provisions are appropriate by checking previous year provisions and current year recent developments.
3] CONSIDERING GOODS LYING AT THIRD PARTY PLACE AS SALES:
Goods lying at third party places should not be considered as sales. These goods might be at an agent’s place which are not sold and may be returned back. Goods sent to third party may be for use and are in nature of being returned back. Organization in order to increase profit and sales may consider goods lying at third party as sales and may after some time say years may take the goods back by passing entry of sales return.
4] IMPROPER EXPENSES ALLOCATION
Organization may allocate expenses according to their needs.
Example: Purchase of Raw material may be recorded as some other expenses and instead of debiting in trading a/c., they may debit it in profit and loss a/c. Leading to increase in gross profit and decrease in net profit.
Auditor should vouch the bills properly and should check whether the expenses are recorded in appropriate heads.
5] OVERVALUING CLOSING STOCK
Organizations may in order to increase profit overvalue the Closing stock. Sometimes even the basis of valuation may be changed as compared to opening stock. Even sometimes organization may overstate inventory than it actually exists.
Auditor should design his Substantive procedures such that he is able to determine these frauds.
Reasons Which Decreases Gross Profit
1] OVERSTATING OPENING STOCK:
Overvaluation of opening stock will increase debit side of trading account which will lead to increase in expenditure and thus gross profit would be lowered.
2] EXCESSIVE PROVISIONS MADE
Organization may make excessive provisions for expenditure which are not required.
An analysis of overall trading expenditure needs to be carried out by Auditor
3] RECORDING EXPENDITURE IN INCORRECT HEADS:
False fully diverting P & L expenses to trading account, recording expenditure which are not incurred and are not likely to be incurred in the year. Auditor must check whether there exists appropriate evidence in regards to this expenditure. Expenses incurred in cash should be checked in entirety. Sampling should not be applied.
4] UNDER VALUATION OF CLOSING STOCK
Organizations may under value closing stock resulting in reduction of credit side of trading account leading to overall reduced gross profit ratio. Organization may not consider FG stock in entirety. Auditor should check these items in detail. Physical Verification should be carried out.
5] INCREASED PURCHASES OF RAW MATERIAL,INCREASED FREIGHT INWARD,REDUCED SALES, INCREASED SALES RETURN ETC MAY LEAD TO REDUCTION IN GROSS PROFIT.