1.Factors which increase the gross profit :
- Undervaluation of opening stock; it may be either the effect of non-inclusion of certain items of stocks or that of valuation of the stock at a rate lower than that warranted by the basis of valuation adopted or miscalculation of the value of one or more items of stock. In such a case, the increase in the rate of gross profit would be preceded by a fall in the rate of gross profit in the previous year.
- Overvaluation of closing stock, either by the inclusion therein of fictitious items of stock or over-statement of values of some of them.
- Alteration of the basis of valuation of closing stock, e.g., where the opening stock was valued at cost or market rate whichever was lower, valuing the closing stock at the market price which is higher than cost.
- Increase in the values of some of the items included in the opening stock (which were valued at market rate which was lower than cost) above cost, on account of which the unsold stock of the these items at the close of the year is valued at cost.
- Under-statement of opening stock or over-statement of closing stock, due to adjustment of the amount of sales, when goods sold but not delivered are included in the closing stock or when goods were delivered and taken out of stock last year, but sales invoices are raised in the current year.
- Entry of fictitious purchases to boost up profits. If such a practice has been resorted to, it would have the effect of reducing the rate of gross profit in the ensuing year.
- Inclusion in the closing stock of goods returned awaiting despatch to supplier, the cost of which has been debited to them or goods returned by customers, the cost whereof has not been credited to parties.
- Inclusion in the closing stock of goods received for the sale on approval or on a consignment basis.
- Treatment of goods sent out for sale on consignment basis as regular sales.
- No provision or under-provision in the expenses accounts included in the Trading Account. For example, purchase may be understated, provision for outstanding wages or carriage inward may not have been made.
- Wrong allocations of expenses, e.g., carriage inwards either in whole or in part may be wrongly taken to the Profit and Loss Account
2. Factors which decrease the gross profit:
- Over valuation of the opening stock or undervaluation of closing stock either due to mistakes made in taking stock or in its valuation.
- Alteration of the basis of valuation of stock, e.g., closing stock having been valued at cost, which is below the market price, when the opening stock was valued at market price above cost.
- Inclusion in the year of the amount of goods purchased in the previous year, that were received and where taken in the same year.
- Reversal of the fictitious sale entries recorded in the previous year to boost up profit.
- Entry of sales returns twice or failure to account for purchase returns when the goods in question have been sent back.
- Excessive provisions have been made for wages or direct expenses.
- Failure to include in closing stock goods sent out for sale on approval or on a consignment basis.
- Omission to adjust the value of unused stock of consumables stores, such as fuel and packing material or inclusion in Trading Account expenses which should have been included in the Profit in the Loss Account.
- Failure to take credit for the amount of an insurance claim in respect of a consignment of goods lost in transit or destroyed by fire.
- Failure to account for goods sold or destroyed or given away as samples. From the aforementioned statement of factors affecting gross profit, it would be evident that it is affected by every failure to properly account for values receivable and payable at the time a benefit accrues or is given away. Such a position can arise in a multiplicity of situations, only some of which have been listed above.
The auditor must also take steps to verify that the amount of profit has not been overstated, e.g., by the inflation of sales or closing stock, by understatement of purchases and expenses or by omission to credit customers’s accounts with the value of goods returned by them, etc. The figure of profit can also be inflated by the failure to provide for losses and depreciation or reduction in their value, for instance, by not making adequate provisions for bad debts, for discounts payable on the recovery of book debts or for any fall that has taken place in the value investments or stock accounts would not disclose a true and fair state of affairs of the business. Likewise it should be verified that profits have not been understated. As per Part III of Schedule VI to the Companies Act, 1956 a provision which is in excess of the amount considered reasonable by directors must be treated as a reserve. In consequence, any provision for bad debts, depreciation, expenses or liabilities which is in excess of the sums considered reasonable will be treated as reserve.