1. Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Auditing & Assurance Services, 6e

2. 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

3. 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

4. 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

5. 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

6. Typical Activities Planning –Production plan Production –Bill of materials –Requisitions Cost Accounting –Standard costs –Overhead allocation 9-6

7. Exhibit 9.3 Production Cycle 9-7

8. 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

9. 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

10. 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

11. Management Reports Sales Forecasts Inventory reports –Items on hand Open purchase orders Production plans and reports 9-11

12. 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

13. Substantive Procedures Observation of inventory count Tests of pricing and compilation Analytical procedures –Excessive inventory –Slow moving inventory 9-13

14. 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 year- end. –test roll-forward or roll-back 9-14

15. 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

16. 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

17. Exhibit 9.8 Inventory Count Sheet 9-17

18. 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

19. ExamplesChallenges/ Special procedures. LumberProblem identifying quality or grade. /Employ a specialist Piles of sugar, coal, scrap steelGeometric computations, aerial photos./ Employ a specialist Items weighed on scalesAccuracy 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, jewelryIdentification and quality determination problems/ Hire a specialist. Pulp woodQuantity measurement estimation/Examine aerial photos. LivestockMovement not controllable/Use chutes to control animals. Inventory Count and Measurement Challenges 9-19

20. 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

21. 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

22. 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

23. 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 year- end. Reluctance of client to move merchandise to allow inspection of additional items located behind. 9-23