During the planning phase of an audit, the auditor performs analytical procedures on the client's draft financial statements. The auditor observes that the gross margin percentage has increased significantly while sales volume has declined. Which of the following is a plausible explanation that would require further investigation?

Answer options:

Cost of goods sold increased due to inflation.

Sales prices were decreased to stimulate demand.

Fictitious sales were recorded near year-end.

The company switched to LIFO during a period of rising prices.

How to approach this question

Analyze the ratio: Gross Margin = (Sales - COGS) / Sales. Look for a scenario that increases the numerator disproportionately.

Full Answer

C.Fictitious sales were recorded near year-end.✓ Correct

Fictitious sales were recorded near year-end.

If fictitious sales are recorded, they increase Revenue without a corresponding increase in Cost of Goods Sold (since no goods were actually shipped/sold). This causes the Gross Margin percentage to rise mathematically. The other options would generally cause the margin to decrease.

Common mistakes

Failing to do the math on how the ratio components move.

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