Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Brad MacDonald SIAST © 2009 McGraw-Hill Ryerson Limited

Learning Objectives Chapter Overview Chapter 13 Production and Payroll Processes

Learning Objectives Chapter Overview Slide 3 1.Describe the key risks of misstatement in production and payroll processes. 2.Describe the production process, including typical transactions, source documents, controls and account balances. 3.Outline control tests for auditing control over conversion of materials and labour in the production process. 4.Describe the payroll process, including typical transactions, source documents, controls and account balances. Learning Objectives

Learning Objectives Chapter Overview Slide 4 5.Outline control tests for auditing control over the payroll process. Learning Objectives

Learning Objectives Chapter Overview Slide 5 Risk Assessment for Production and Payroll Processes Part I: Production Process: Typical Activities –Control Risk Assessment Part II: Payroll Process - Typical Activities –Control Risk Assessment Application Case and Analysis Chapter Overview

Learning Objectives Chapter Overview Learning objective Slide 6 Risk Assessment for Production and Payroll Processes Flexibility and judgement required for production accounting is a main source of risk in the production process. –Transactions include allocations from materials, overheads and labour to inventory, including work-in–process and finished goods, and to cost of goods sold. –All of the management assertions need to be considered.

Learning Objectives Chapter Overview Learning objective Slide 7 Risk Assessment for Production and Payroll Processes The main risk related to payroll relates to the ownership assertion. –The process involves cash payment to individuals and is vulnerable to fraud. –The auditor will seek to ensure that duties are well segregated.

Learning Objectives Chapter Overview Learning objective Slide 8 Production Process: Typical Activities The production cycle includes transactions that flow through the following business activities: –production planning, inventory planning and management, –producing goods and services, and –cost accounting and cost of goods sold administration.

Learning Objectives Chapter Overview Learning objective Slide 9 Production Most of the transactions in a production cycle are cost accounting allocations, unit cost determinations and standard cost calculations. –Think of the audit of inventory as two phases: verification of physical units and testing of unit costs.

Production Process Start Here Production planning Cost accounting Determine cost of goods sold Produce goods and services Inventory planning

Learning Objectives Chapter Overview Learning objective Slide 11 Production Process: Authorization Production planning starts with a sales forecast and interacts with inventory planning to create production orders. –Managers approve the plans and production orders. –The production order includes a bill of materials, which authorize the purchase and release of materials.

Learning Objectives Chapter Overview Learning objective Slide 12 Custody Supervisors and workers have physical custody of materials, equipment and labour while production work is performed. –They can also requisition materials, and direct labour. –Control over this type of moving inventory is more difficult than control over a closed warehouse of goods.

Learning Objectives Chapter Overview Learning objective Slide 13 Recordkeeping (Cost Accounting) When production is complete, production records including the production orders and materials and labour records are sent to the accounting department. –Effective separation of duties require that costs be determined from cost information independent of the production area. For example, material costs should come from the inventory custodian, labour costs from the payroll department.

Learning Objectives Chapter Overview Learning objective Slide 14 Periodic Reconciliation Reconciliation of physical assets and liabilities to amounts recorded in the company accounts should include a comparison of physical inventory to the recorded inventory.

Learning Objectives Chapter Overview Learning objective Slide 15 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.

Learning Objectives Chapter Overview Learning objective Slide 16 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 process. –Accounts include: inventories (raw materials, work in process, finished goods), cost of goods sold, and amortization (expense and accumulated).

Learning Objectives Chapter Overview Learning objective Slide 17 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.

Learning Objectives Chapter Overview Learning objective Slide 18 Control Risk Assessment General Control Considerations –Controls should produce evidence to allow 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 13A-1.

Learning Objectives Chapter Overview Learning objective Slide 19 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 13-3.

Learning Objectives Chapter Overview Learning objective Slide 20 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.

Learning Objectives Chapter Overview Learning objective Slide 21 Part II: Payroll Cycle: Typical Activities Personnel management and the payroll accounting process 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.

Payroll Process Start Here Personnel hiring / firing Payroll accounting Cash disbursement Supervision, attendance, and work Compensation determination Payroll distribution

Learning Objectives Chapter Overview Learning objective Slide 23 Payroll Process: Authorization A personnel department independent of other functions should have authority for hiring and terminating employees. –Should also approve pay rates and deductions from employees. Direct supervisors should approve the pay base data, such as hours, sick leave, etc.

Learning Objectives Chapter Overview Learning objective Slide 24 Custody Custody for the payroll process includes the possession of paycheques, cash, or electronic funds transfer codes. Access to other documents, such as time cards or time sheets is also considered custody.

Learning Objectives Chapter Overview Learning objective Slide 25 Recordkeeping The payroll accounting function should prepare the cheques and related tax reports. –Personnel should not also have authorization nor custody responsibility.

Learning Objectives Chapter Overview Learning objective Slide 26 Periodic Reconciliation Payroll bank accounts can be reconciled like any other bank account. In addition, payroll tax returns, and labour reports prepared for production provide other avenues for reconciliation

Learning Objectives Chapter Overview Learning objective Slide 27 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.

Learning Objectives Chapter Overview Learning objective Slide 28 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

Learning Objectives Chapter Overview Learning objective Slide 29 Control Risk Assessment The major risks in the payroll cycle are –paying fictitious employees, –overpaying for time or production, or –incorrect accounting for costs and expenses.

Learning Objectives Chapter Overview Learning objective Slide 30 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.

Learning Objectives Chapter Overview Learning objective Slide 31 Computer-Based Payroll With 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.

Learning Objectives Chapter Overview Learning objective Slide 32 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 13-7.

Learning Objectives Chapter Overview Learning objective Slide 33 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.

Learning Objectives Chapter Overview Learning objective Slide 34 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.

Learning Objectives Chapter Overview Learning objective Slide 35 Audit Casettes: Substantive Audit Procedures Specific examples of test of controls and substantive procedures are in the form of casettes (mini-case studies). –Each casette has the following parts: Method Paper Trail Amount Audit ObjectiveControl Test of Controls Audit of Balance Audit Approach

Learning Objectives Chapter Overview Learning objective Slide 36 Audit Casettes: Substantive Audit Procedures 13.1: Unbundled Before Its Time: –Production “sold” as finished goods before actual unit completion caused understated inventory, overstated cost of goods sold. 13.2: 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.

Learning Objectives Chapter Overview Learning objective Slide 37 Audit Casettes: Substantive Procedures 13.3 Ghosts on the Payroll –Embezzlement with fictitious people on the payroll.