Dealing with gross margin analysis, academic often provide the following guidances for analyst / auditor in the approach on how to analyse:
- compare gross margin of a subject company to competitors within the industry
- compare gross margin of a subject company to prior period
- compare gross margin of a subject company to our expectations (i.e. increase in fuel costs would likely result in the decrease in the subject company's gross margin)
The above analysis is fundamental and provide insight for analyst / auditor of the subject Company. We, Accounting & Auditing blog, propose the auditor to critically review the component of gross margin and the movement within each key compoent, to reflect the gross margin of the Company factually and within reasonable expectation of a financial statement user.
Gross margin represents the difference between sales revenue and cost of goods sold. Sales revenue represents the revenue the Company generated after transferring the significant risk and rewards/ title of the goods. Cost of goods sold include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead.
Management may have incentive to change the classification of its cost component, such that the gross margin appears to be favorable. For instance, management of a manufacturing may decide to include freight inward as selling and distribution costs, while in fact, freight inwards is the cost incurred in bringing in raw materials for its production purpose. By excluding freight inward from being a component of cost of goods sold, the gross margin will appear to be higher.
As the auditor, it is recommended to review through the cost of goods sold component of our audit client, to critically review the reasonableness of the cost of goods solds. The analysis need to be supplemented by our understanding of the business and discussion with management. Engaging different client personnel from different departments/ operations assist in developing our understanding of the business better.
Gross margin analysis should not be limited to comparing to prior period, comparing to industry norm, as this is not sufficient to understand a business better. We, as the auditor, has the responsibility to re-assess what we have done in the past and critically review the existing account against the changing business environment to make sure that the financial statment reflect the financial affair of the audit client reasonably within the current business context.
- compare gross margin of a subject company to competitors within the industry
- compare gross margin of a subject company to prior period
- compare gross margin of a subject company to our expectations (i.e. increase in fuel costs would likely result in the decrease in the subject company's gross margin)
The above analysis is fundamental and provide insight for analyst / auditor of the subject Company. We, Accounting & Auditing blog, propose the auditor to critically review the component of gross margin and the movement within each key compoent, to reflect the gross margin of the Company factually and within reasonable expectation of a financial statement user.
Gross margin represents the difference between sales revenue and cost of goods sold. Sales revenue represents the revenue the Company generated after transferring the significant risk and rewards/ title of the goods. Cost of goods sold include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead.
Management may have incentive to change the classification of its cost component, such that the gross margin appears to be favorable. For instance, management of a manufacturing may decide to include freight inward as selling and distribution costs, while in fact, freight inwards is the cost incurred in bringing in raw materials for its production purpose. By excluding freight inward from being a component of cost of goods sold, the gross margin will appear to be higher.
As the auditor, it is recommended to review through the cost of goods sold component of our audit client, to critically review the reasonableness of the cost of goods solds. The analysis need to be supplemented by our understanding of the business and discussion with management. Engaging different client personnel from different departments/ operations assist in developing our understanding of the business better.
Gross margin analysis should not be limited to comparing to prior period, comparing to industry norm, as this is not sufficient to understand a business better. We, as the auditor, has the responsibility to re-assess what we have done in the past and critically review the existing account against the changing business environment to make sure that the financial statment reflect the financial affair of the audit client reasonably within the current business context.
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