Auditing &
Assurance
Services,
6e
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Chapter 09
Production Cycle
“There is one rule for industrialists and that is: Make the best
quality of goods possible at the lowest cost possible, paying the
highest wages possible.”—Henry Ford
9-2
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.
9-3
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.
9-4
Inherent Risks in Production
Cycle
•
•
•
•
•
Complexity (e.g. dollar value LIFO)
Susceptibility to theft
Movement of inventory
Lower-of-Cost-or-Market valuation
Effects on gross profits
9-5
Typical Activities
• Planning
– Production plan
• Production
– Bill of materials
– Requisitions
• Cost Accounting
– Standard costs
– Overhead allocation
9-6
Exhibit 9.3
Production Cycle
9-7
Production Cycle:
Control Considerations
• 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
9-8
Production Cycle:
Control Considerations
• 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
9-9
Production Cycle: Control Procedures
• Physical Controls
–
–
–
–
Production Order and Materials Requisition.
Physical inventories reconciled to perpetual inventory records.
Restrict access to inventories
Transfer Tickets
• Separation of Duties
–
–
–
–
Authorization
Recording
Custody
Reconciliation
• Performance Reviews
– Scrap reports
– Variance analysis
9-10
Management Reports
• Sales Forecasts
• Inventory reports
– Items on hand
• Open purchase orders
• Production plans and reports
9-11
Test of Controls
• Observe separation of duties
• Vouch costs to labor and material reports
– Time tickets
– Receiving reports
– Transfer tickets
• Check proper authorizations
• Examine review of cost reports
9-12
Substantive Procedures
• Observation of inventory count
• Tests of pricing and compilation
• Analytical procedures
– Excessive inventory
– Slow moving inventory
9-13
Physical Inventory
Observation
• Auditors are required to make, or observe, some
physical counts of the inventory and apply
appropriate tests of intervening transactions.
• Usually make test counts at a time other than yearend.
– test roll-forward or roll-back
9-14
Physical Inventory
Observation
• Review client instructions
• Stop flow of goods
• Make TEST COUNTS
– From INVENTORY LISTING
– From WAREHOUSE FLOOR
– Record some counts in working papers
9-15
Client Count Instructions
•
•
•
•
•
•
Names or team number and dates
Instructions for descriptions and counts
Noting obsolete or damaged items
Tag control—compilation of counts
Shutting down production
Controlling inventory movement including
shipping and receiving
• Supervisory approval
• Making changes and corrections
9-16
Exhibit 9.8
Inventory Count Sheet
9-17
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.
9-18
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.
9-19
Pricing and Compilation Tests
• 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
9-20
Purchase Cutoffs
• 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
9-21
Analytic Procedures
• Verify REASONABLENESS of COGS
– Gross Profit Margin
– Compare to prior year, competitors, or industry
averages
• Verify REASONABLENESS of ending inventory
– Days Sales in Inventory
– Inventory Turnover
9-22
Fraud Red Flags
• Uncontrolled access to inventory
• Many high-dollar items with market value (i.e. salable on
eBay?)
• Unexspected 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.
9-23