An auditor is performing analytical procedures during the planning stage. The auditor notes that the company's gross margin has increased significantly while sales volume has remained flat. Which of the following is a plausible explanation for this relationship?

Answer options:

The company has overstated purchases.

The company has overstated ending inventory.

The company has recorded unearned revenue as revenue.

The company has paid higher prices for raw materials.

How to approach this question

Use the COGS formula. Impact on Margin = Sales - COGS. If Margin is up, COGS must be down (assuming sales flat). How do you lower COGS? Increase Ending Inventory.

Full Answer

B.The company has overstated ending inventory.✓ Correct

The company has overstated ending inventory.

An overstatement of ending inventory reduces Cost of Goods Sold (COGS). Since Gross Margin = Sales - COGS, a reduction in COGS leads to an increase in Gross Margin. This is a common fraud scheme.

Common mistakes

Getting the direction of the relationship wrong (thinking higher costs = higher margin).

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