1. Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Brad MacDonald SIAST © 2003 McGraw-Hill Ryerson Limited

2. Copyright © 2003 McGraw-Hill Ryerson Limited Chapte r 11 2 Production and Payroll Cycle

3. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 3 Learning Objective 1 Describe the production cycle, including typical source documents and controls.

4. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 4 Production Cycle: Typical Activities The production cycle includes transactions that flow through the following business activities: –production planning, inventory planning and management –producing goods and services –cost accounting and cost of goods sold administration

5. Production Cycle Start Here Production planning Cost accounting Determine cost of goods sold Produce goods and services Inventory planning 5Chapter 11 Copyright © 2003 McGraw-Hill Ryerson Limited

6. Chapter 11 6 Production Cycle: Typical Activities –Authorization - Production authorization based on sales forecasts interacts with production orders, bills of materials, materials requisitions. –Custody - Physical custody of materials, equipment and labour, and cost accounting requisitions. –Recordkeeping (cost accounting) - Determination of cost-per-unit, standard costs, and variances. –Periodic Reconciliation - Reconciliation of physical assets and liabilities to amounts recorded in the company accounts.

7. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 7 Audit Evidence in Management Reports and Files Production accounting systems produce timely reports to supervise and control production. These can be used as supporting evidence for assertions: –Sales Forecast - Provides the basis for management planning. –Production Plans and Reports -Plan for the amount and timing of production, based on sales forecast. –Amortization Schedule - Detailed schedule of depreciation on fixed assets, prepared by cost accounting.

8. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 8 Learning Objective 2 Give examples of detail test of controls procedures for auditing the controls over conversion of materials and labour in a production process.

9. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 9 Control Risk Assessment Control risk assessment governs the nature, timing, and extent of substantive audit procedures that will be applied in the audit of the account balances in the production cycle. –Accounts include inventories (raw materials, work in process, finished goods) cost of goods sold amortization (expense and accumulated)

10. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 10 Control Risk Assessment General Control Considerations –Proper segregation of responsibilities for authorization, custody, recording and reconciliation Custody of inventories in hands of persons who do not authorize or account for production Cost accounting performed by persons who do not authorize production or have custody of production assets

11. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 11 Control Risk Assessment General Control Considerations –Controls should produce evidence to allow for for detail control checking procedures. –Complex computer systems may be used to manage production and materials flow. –Information about the production cycle control structure often is gathered initially by completing an internal control questionnaire. (ICQ). An ICQ for general controls is in Appendix 11A-1.

12. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 12 Detail Test Controls Audit Procedures Tests of controls should address all of the control objectives. –Tests include identification of population and expression of the action to be taken. Note dual direction of testing for completeness and validity requires selection of sample from appropriate population. –See Exhibit 11-3.

13. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 13 Control Risk Assessment The purpose of testing controls is to determine nature, extent, and timing of substantive procedures. –Good controls – low control risk Smaller sample sizes, earlier timing for substantive tests. –Poor controls – high control risk Larger samples, more work at year end.

14. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 14 Learning Objective 3 Describe some common errors, irregularities, and frauds in the accounting for production costs and related cost of goods sold, and design some audit and investigation procedures for detecting them.

15. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 15 Substantive Procedures Audit procedures to gather direct evidence on account balances are called substantive procedures. –recalculation, observation, confirmation, enquiry, vouching, tracing, scanning, analytical review –Dual purpose procedures – gain substantive purpose evidence and control purpose evidence with the same test.

16. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 16 Specific examples of test of controls and substantive procedures are in the form of casettes (mini-case studies). –Each casette has the following parts: Audit Casettes: Substantive Audit Procedures Method Paper Trail Amount Audit ObjectiveControl Test of Controls Audit of Balance Audit Approach

17. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 17 Audit Casettes: Substantive Audit Procedures 11.1: Unbundled Before Its Time: –Production “sold” as finished goods before actual unit completion caused understated inventory, overstated cost of goods sold. 11.2: When in Doubt, Defer! –SoCom Corporation deferred costs under the heading of work in process, military claims, and R&D test equipment, thus overstating asses, understating cost of goods sold, and overstating income. Disclosure of the auditor’s fees was manipulated and understated.

18. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 18 Learning Objective 4 Describe the payroll cycle, including typical source documents and controls.

19. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 19 Part II: Payroll Cycle: Typical Activities Personnel management and the payroll accounting cycle include transactions that affect the wage and salary accounts and a number of related accounts: –Personnel and Labour Relations: Hiring and firing. –Supervision: Approval of work time. –Timekeeping and cost accounting: Payroll preparation and cost accounting. –Payroll Accounting: Cheque preparation and related payroll reports. –Payroll Distribution: Actual custody and distribution to employees.

20. Payroll Cycle Start Here Personnel hiring / firing Payroll accounting Cash disbursement Supervision, attendance, and work Compensation determination Payroll distribution Copyright © 2003 McGraw-Hill Ryerson Limited 20 Chapter 11

21. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 21 Part II: Payroll Cycle: Typical Activities –Authorization: Personnel department, supervision, timekeeping, and cost accounting. –Custody - Possession of payroll cheques, payroll distribution, supervision, and timekeeping documents. –Recordkeeping - Payroll accounting prepares checks and related tax reports. –Periodic Reconciliation - Payroll records and reports should be reconciled.

22. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 22 Audit Evidence in Management Reports and Files Payroll systems produce numerous reports that can be used as supporting evidence for assertions. –Personnel Files - Detailed individual employees files (existence). –Timekeeping Records - Detailed records of hourly workers’ time. –Payroll Register - A special journal containing detailed pay information.

23. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 23 Audit Evidence in Management Reports and Files –Labour Cost Analysis - Labour cost information used for purposes such as reconciliation and distribution of labour rates. –Government and Tax Reports year-to-date earnings records employee T-4 reports

24. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 24 Learning Objective 5 Give examples of detail test of controls procedures for auditing the controls over payroll.

25. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 25 Control Risk Assessment The major risks in the payroll cycle are –paying fictitious employees –overpaying for time or production –incorrect accounting for costs and expenses.

26. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 26 General Control Considerations Proper segregation of responsibilities - for authorization, custody, recording, and reconciliation of payroll functions. Custody of payroll distribution by persons who do not authorize employees’ pay or prepare payroll cheques. Recordkeeping is performed by payroll and cost accounting personnel who do not make authorizations or distribute pay.

27. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 27 Computer-based Payroll –Various records and approval signatures may not exist. They may all embedded in computerized payroll systems. Internal Control Questionnaire –Information about payroll is often gathered initially by ICQ.

28. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 28 Detailed Test of Controls Tests of controls should address all of the control objectives. –Cut-off is important to revenue cycle. –Tests include identification of population and expression of the action to be taken. Note dual direction of testing for completeness and validity requires selection of sample from appropriate population. –See Exhibit 11-8.

29. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 29 Computerized Payroll Processing Payroll processing and payroll register preparation are usually the first computer applications a business implements. –Many off-the-shelf computer programs are available. –The files the auditor should expect to find include: reference files dynamic files

30. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 30 Control Risk Assessment The purpose of testing controls is to determine nature, extent, and timing of substantive procedures. –Good controls – low control risk: Smaller sample sizes, earlier timing for substantive tests. –Poor controls – high control risk: Larger samples, more work at year end.

31. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 31 Learning Objective 6 Describe some common errors, irregularities, and frauds in payroll, and design some audit and investigative procedures for detecting them.

32. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 32 Substantive Procedures Audit procedures to gather direct evidence on account balances are called substantive procedures. –recalculation, observation, confirmation, enquiry, vouching, tracing, scanning, analytical review –dual purpose procedures – gain substantive purpose and control purpose evidence with the same test.

33. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 33 Audit Casettes: Substantive Procedures 11.3 Time Card Forgeries: –False claims for work time caused the overpayment of wages. 11.4 The Well Padded Payroll: –Embezzlement with fictitious people on the payroll.

34. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 34 Just-In-Time Manufacturing (Appendix 11B) Underlying the JIT system is a continuous improvement philosophy of eliminating all non- value-added activities (waste) such as material movement, storage, rework, and waiting time. –In a typical JIT system all types of inventories, raw materials, work-in-process, and finished goods are minimized. –The ultimate measure of success with JIT occurs when manufacturing cycle efficiency ratio equals one.

35. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 11 35 The 10 JIT Principles Strive for linear production. Make it right the first time. (Rejects and scrap are waste.) Eliminate waste in rework. Dedicate work cells to product families. Form partnership with vendors. Reduce manufacturing lead time. Cut inventories to minimum. Synchronize production processes. User demand flows to control the shop. Reduce lot sizes and setup time.