McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 09 Production Cycle
Learning Objectives
1. Describe the production cycle, including typical
source documents and controls.
2. Give examples of tests of controls for auditing the
controls over conversion of materials and labor in
a production process.
3. Identify and describe considerations involved in
the observation of physical inventory and tests of
inventory pricing and compilation.
4. Describe some common errors and frauds in the
accounting for production costs and related cost
of goods sold, and design some audit and design
some audit and investigation procedures for
detecting these errors and frauds.
9-2
Importance of Inventory
• Major component of current assets on the
balance sheet.
• Errors effect both the balance sheets and net
income.
• Valuation is usually very subjective.
– Potential obsolescence
– Goods have not been sold, so marketability may be
uncertain.
9-3
Inherent Risks in Production
Cycle
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Complexity (e.g. dollar value LIFO)
Susceptibility to theft
Movement of inventory
Lower-of-Cost-or-Market valuation
Effects on gross profits
9-4
Typical Activities
• Planning
– Production plan
• Production
– Bill of materials
– Requisitions
• Cost Accounting
– Standard costs
– Overhead allocation
9-5
Production Cycle:
Control Considerations
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Production runs are authorized.
Raw Materials should be counted, and inspected
As production is undertaken, materials and labor quantities should be summarized.
All inventory items should be accounted for
– Used in production
– Scrap
– Returned to inventory
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Use of TRANSFER tickets
Count/inspect the items and compare quantities
The cost accounting department reviews
– Quantity of raw materials to materials requisition
– Quantity of direct labor to time sheets and labor distribution report
– Cost accounting applies overhead costs to production using OVERHEAD TICKETS
– Cost summary
9-6
Production Cycle: Control Procedures
• Physical Controls
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Production Order and Materials Requisition.
Physical inventories reconciled to perpetual inventory records.
Restrict access to inventories
Transfer Tickets
• Separation of Duties
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Authorization
Recording
Custody
Reconciliation
• Performance Reviews
– Scrap reports
– Variance analysis
9-7
Management Reports
• Sales Forecasts
• Inventory reports
– Items on hand
• Open purchase orders
• Production plans and reports
9-8
Test of Controls
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Observe separation of duties
Vouch costs to labor and material reports
 Time tickets
 Receiving reports
 Transfer tickers
Check proper authorizations
Examine review of cost reports
Substantive Procedures
• Observation of inventory count
• Tests of pricing and compilation
• Analytical procedures
 Excessive inventory
 Slow moving inventory
9-9
Physical Inventory Observation
• “…it will always be necessary for the auditor to make, or
observe, some physical counts of the inventory and apply
appropriate tests of intervening transactions" (AU 331.12).
• Usually make test counts at a time other than year-end.
– test roll-forward or roll-back
• Review client instructions
• Stop flow of goods
• Make TEST COUNTS
– From INVENTORY LISTING
– From WAREHOUSE FLOOR
– Record some counts in working papers
9-10
Client Count Instructions
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Names and dates
Instructions for descriptions and counts
Noting obsolete or worn items
Tag control—compilation of counts
Shutting down production
Controlling inventory movement including
shipping and receiving
• Supervisory approval
• Making changes and corrections
9-11
Physical Inventory
Observation
• Listen to instructions provided to count teams
• Understand the use of control tags, count sheets, scanners,
or RFID
• Be wary of "hollow squares" and "empty boxes”
• Tour shipping and receiving areas
• Watch for OBSOLETE and SLOW-MOVING inventory
• CONFIRM inventory on CONSIGNMENT and at other
locations
• Consider the use of SPECIALISTS
• Confirm inventory in transit.
9-12
Inventory Count and
Measurement Challenges
Examples
Challenges/ Special procedures.
Lumber
Problem identifying quality or grade. /Employ a specialist
Piles of sugar, coal, scrap steel
Geometric computations, aerial photos./ Employ a specialist
Items weighed on scales
Accuracy of scales./Examine certification.
Bulk materials (oil, grain,
liquids in storage tanks)
Measuring volume, ensuring composition of content/Climb the
tanks Dip measuring rods. Sample for assay or chemical
analysis.
Diamonds, jewelry
Identification and quality determination problems/ Hire a
specialist.
Pulp wood
Quantity measurement estimation/Examine aerial photos.
Livestock
Movement not controllable/Use chutes to control animals.
9-13
Pricing and Compilation Tests
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Valuation (Price Tests)
– VENDOR INVOICES
– COST FLOW ASSUMPTION (FIFO, LIFO, average, specific identification)
– LOWER OF COST OR MARKET for inventory
Check Extensions and Footings.
Agree to G/L
Purchase Cutoffs
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Verify CUT-OFFs for purchases and sales
– Examine Receiving Reports and Vendor Sales Invoices occurring around year-end.
– Examine bills of lading and sales invoices
– Agree to inclusion/exclusion from inventory
9-14
Analytic Procedures
• Verify REASONABLENESS of COGS
– Gross Profit Margin
– Compare to prior year, industry averages
• Verify REASONABLENESS of ending inventory
– Days Sales in Inventory
– Inventory Turnover
9-15
Fraud Red Flags
• Uncontrolled access to inventory
• Many high-dollar items with market value (i.e. salable on
eBay?)
• Unpredictable counts during inventory
• Large differences between counts and inventory records.
• Inventory shows signs of damage, obsolescence or excess
quantities.
• Unusual interplant transfers during physical inventory or at yearend.
• Reluctance of client to move merchandise to allow inspection of
additional items located behind.
9-16