MODERN AUDITING 7th Edition

MODERN AUDITING 7th Edition
William C. Boynton California Polytechnic State University at San Luis Obispo Raymond N. Johnson Portland State University Walter G. Kell University of Michigan Developed by: Gregory K. Lowry, MBA, CPA Saint Paul’s College John Wiley & Sons, Inc.

CHAPTER 16 AUDITING THE PRODUCTION AND PERSONNEL SERVICES CYCLES
Planning the Audit of the Production Cycle Control Activities — Manufacturing Transactions Substantive Tests of Inventory Balances Value-Added Services in the Production Cycle

Planning the Audit of the Personnel Services Cycle Control Activities — Payroll Transactions Substantive Tests of Payroll Balances Value-Added Services in the Personnel Services Cycle

Planning the Audit of the Production Cycle
The production cycle relates to the conversion of raw materials into finished goods. This cycle includes production planning and control of the types and quantities of goods to be manufactured, the inventory levels to be maintained, and the transactions and events pertaining to the manufacturing process. Transactions in this cycle begin at the point where raw materials are requisitioned for production, and end with the transfer of the manufactured product to finished goods. The transactions in this cycle are called manufacturing transactions.

The production cycle interfaces with the following 3 other cycles: 1. the expenditure cycle in purchasing raw materials and incurring various overhead costs, 2. the personnel services cycle in incurring factory labor costs, and 3. the revenue cycle in selling finished goods.

Selected Specific Audit Objectives for the Production Cycle Figure 16-2

Understanding the business and industry assists the auditor in designing an effective and efficient audit program. When auditing a manufacturing company, the auditor will usually want to understand the capital intensiveness of the manufacturing process, as well as the mix of raw materials and labor that are needed in the manufacturing process. Because of the importance of inventory to fair presentation for most manufacturers, wholesalers, and retailers, the auditor may use analytical procedures to identify problem areas.

Materiality Figure 16-3 illustrates the importance of inventory to manufacturers and retailers. For these entities, inventory is material and the audit of inventory is critical to reaching an opinion on the overall fair presentation in the financial statements. The primary consideration in evaluating the allocation of materiality is the determination of the magnitude of misstatement that will influence the decisions of a reasonable financial statement user. A secondary consideration is the relationship to the cost of detecting errors.

Summary of Selected Industry Statistics Figure 16-3

Inherent Risk The inherent risk of misstatement in the financial statements arising from inventory transactions for the hotel chain or the school district is relatively low, as inventory is not a material part of the entity’s core process. With a manufacturer, wholesaler, or retailer, however, inventory may be assessed at or near the maximum for the following reasons: 1. The volume of purchases, manufacturing, and sales transactions that affects these accounts is generally high, increasing the opportunities for misstatements to occur.

2. There are often contentious issues surrounding the identification, measurement, and allocation of inventoriable costs such as indirect materials, labor, and manufacturing overhead, joint product costs, and the disposition of cost variances, accounting for scrap, and other cost accounting issues. 3. The wide diversity of inventory items sometimes requires the use of special procedures to determine inventory quantities, such as geometric volume of stockpiles, aerial photography, and estimation of quantities by experts.

4. Inventories are often stored at multiple sites, adding to the difficulties associated with maintaining physical controls over theft and damages, and properly accounting for goods in transit between sites. 5. The wide diversity of inventory items may present special problems in determining their quality and market value. 6. Inventories are vulnerable to spoilage, obsolescence, and other factors such as general economic conditions that may affect demand and salability, and thus the proper valuation of the inventories. 7. Inventory may be sold subject to right of return and repurchase agreements.

Analytical Procedures Analytical procedures are cost effective and they may alert the auditor to potential misstatements. If the financial presented for audit show a trend of increased profit margin combined with an increase in the number of inventory turn days, inventory may be overstated. This will alert the auditor to pay careful attention to the existence and valuation of inventory. The auditor might also be alert to cutoff problems that might have resulted in overstating inventory.

Analytical Procedures Commonly Used to Audit the Production Cycle Figure 16-4

Control Activities — Manufacturing Transactions
The control activities component of internal controls consists of 4 categories of activities: 1. segregation of duties, general controls, and application controls, 2. information processing controls that include proper authorization, 3. physical controls, and 4. performance reviews and accountability.

Common Documents and Records Following are some of the common documents, records, and computer files used in processing manufacturing transactions: 1. Production order. Form indicating the quantity and kind of goods to be manufactured. An order may pertain to a job order or a continuous process. 2. Material requirements report. Listing of raw materials and parts needed to fill a production order. 3. Materials issue slip. Written authorization from a production department for stores to release materials of use on an approved production order.

4. Time ticket. Record of time worked by an employee on a specific job. 5. Move ticket. Notice authorizing the physical movement of work in process between production departments, and between work in process and finished goods. 6. Daily production activity report. Report showing raw materials and labor used during the day. 7. Completed production report. Report showing that work has been completed on a production order.

8. Inventory subsidiary ledgers or master files (perpetual inventory records). Records maintained separately for raw materials, work in process, and finished goods. Contain information on units and costs added to and deducted from the respective inventory accounts, and units on hand and associated costs comprising the inventory balances at a point in time. 9. Standard cost master file. A computer file containing standard costs. 10. Raw materials master file. A computer file with the quantities of raw materials inventory on hand.

11. Work-in-process inventory master file. A computer file containing the sum of actual work-in-process costs. The file is used to prepare the daily production report. 12. Finished goods inventory master file. A computer file that contains the sum total of production costs. It may be used as a perpetual inventory for finished goods.

Functions and Related Controls Executing and recording manufacturing transactions and safeguarding inventories involve the following manufacturing functions: 1. Initiating production: a. Planning and controlling production. b. Issuing raw materials. 2. Movement of goods: a. Processing goods in production. b. Transferring completed work to finished goods. c. Protecting inventories.

3. Recording manufacturing and inventory transactions: a. Determining and recording manufacturing costs. b. Maintaining correctness of inventory balances.

Obtaining an Understanding and Assessing Control Risk In obtaining and documenting an understanding of portions of internal control components relevant to manufacturing transactions, the auditor uses the same procedures as for other transaction classes. This includes reviewing any prior experience with the client, making inquiries of management and other production personnel, inspecting production documents and records, and observing production activities and conditions. It may also include the use of internal control questionnaires, flowcharts, and narrative memoranda.

Substantive Tests of Inventory Balances
Determining Detection Risk for Tests of Details In keeping with the audit risk model described and applied in previous chapters, the auditor’s specification of acceptable levels of detection risk for tests of details for inventory assertions will reflect an inverse relationship with relevant inherent risk, control risk, and analytical procedures risk assessments pertaining to those assertions.

Relevant control risk assessments vary based on the transaction classes that affect the particular inventory account as shown in the following tabulation:

Designing Substantive Tests Possible substantive tests of inventory balance assertions and the specific account balance audit objectives to which relate are shown in Figure Evidence from some of the tests applicable to merchandise inventory and to manufactured finished goods inventories also relates to objectives for the corresponding cost of goods sold accounts due to the reciprocal relationship of these accounts.

Initial Procedures An essential initial procedures involves obtaining an understanding of the entity’s business and industry to set the context for the evaluation of analytical procedures and tests of details. In tracing beginning inventory balances to prior year working papers, the auditor should make certain that any audit adjustments agreed upon in the prior year did, in fact, get recorded.

Analytical Procedures A review of industry experience and trends may be essential in developing expectations to be used in evaluating analytical data for the client. A review of relationships of inventory balances to recent purchasing, production, and sales activities should also aid the auditor in understanding changes in inventory levels. Because of the reciprocal relationship between inventories and cost of goods sold, these procedures may provide evidence useful in determining the fairness of management’s assertions pertaining to both accounts.

Test of Details of Transactions These tests involve the procedures of vouching and tracing to obtain evidence about the processing of individual transactions that affect inventory balances. Special consideration is given to determining the propriety of the cutoff of inventory transactions at the end of the accounting period.

Test of Details of Balances The observation of inventories has been a generally accepted auditing procedure for more than 50 years. This procedure is required whenever inventories are material to a company’s financial statements and it is practicable and reasonable. In performing this auditing procedure, the client has responsibility for the taking of the inventory. SAS 1 (AU ), Receivables and Inventories, states that from this substantive test, the auditor obtains direct knowledge of the effectiveness of the client’s inventory taking and the measure of reliance that may be placed on management’s assertions as to the quantities and physical condition of the inventories.

Timing and Extent of the Test The timing of an inventory observation depends on the client’s inventory system and the effectiveness of internal controls. In a periodic inventory system, quantities are determined by a physical count, and all counts are made as of a specific date. The date should be at or near the balance sheet date. In a perpetual inventory system with effective internal controls, physical counts may be taken and compared with inventory records at interim dates.

Inventory-Taking Plans The taking of a physical inventory by a client is normally done according to a plan or a list of instructions. The client’s instructions should include such matters as the: 1. Names of employees responsible for supervising the inventory taking 2. Date of the counts 3. Locations to be counted 4. Detailed instructions on how the counts are to be made

5. Use and control of prenumbered inventory tags and summary sheets 6. Provisions for handling the receipt, shipment, and movement of goods during the counts if such activity is unavoidable 7. Segregation or identification of goods not owned

Performing the Test In observing inventories, the auditor should: 1. Scrutinize the care with which client employees are following the inventory plan 2. See that all merchandise is tagged and no items are double tagged 3. Determine that prenumbered inventory tags and compilation sheets are properly controlled 4. Make some test counts and trace quantities to compilation sheets

5. Be alert for empty containers and hollow squares (empty spaces) that may exist when goods are stacked in solid formations 6. Watch for damaged and obsolete inventory items 7. Appraise the general condition of the inventory 8. Identify the last receiving and shipping documents used and determine that goods received during the count are properly segregated 9. Inquire about the existence of slow-moving inventory items.

When inventories are material and the auditor does not observe the inventory at or near the year-end, AU states that: 1. Tests of the accounting records alone will not be sufficient as to quantities. 2. It will always be necessary for the auditor to make, or observe, some physical counts of the inventory and to apply appropriate tests of intervening transactions.

Inventories Determined by Statistical Sampling When statistical sampling methods are used by the client, AU indicates the auditor must ascertain that: 1. the sampling plan has statistical validity, 2. it has been properly applied, and 3. the results in terms of precision and reliability are reasonable in the circumstances.

Applicability to Assertions Like the confirmation of accounts receivable, the observation of the client’s inventory taking applies to many assertions. This test is the primary source of evidence that the inventory exists. In addition, this test relates to the following assertions:

Confirm Inventories at Locations Outside the Entity When client inventories are stored in public warehouses or with other outside custodians, the auditor should obtain evidence as to the existence of the inventory by direct communication with the custodian. This type of evidence is deemed sufficient except when the amounts involved represent a significant proportion of current or total assets.

When this is the case, AU states the auditor should apply one or more of the following procedures: 1. Test the owner’s procedures for investigating the warehouseman and evaluating the warehouseman’s performance. 2. Obtain and independent accountant’s report on the warehouseman’s control procedures relevant to custody of goods and, if applicable, pledging of receipts, or apply alternative procedures at the warehouse to gain reasonable assurance that information received from the warehouseman is reliable.

3. Observe physical counts of the goods, if practicable and reasonable. 4. If warehouse receipts have been pledged as collateral, confirm with lenders pertinent details of the pledged receipts (on a test basis, if appropriate).

Test of Details of Balances: Accounting Estimates When auditing inventory, the auditor must determine whether it is appropriate to write down the value of inventory below cost because the inventory is obsolete or slow-moving, and whether conditions would cause the client to sell inventory at such a price that it would experience a loss on its sale.

The auditor’s responsibility for quality is limited to that of a reasonably informed observer. The auditor obtains evidence of general condition of obsolescence by: 1. Observing the client’s inventory taking 2. Scanning perpetual inventory records for slow-moving items 3. Reviewing quality control production reports

In addition, the auditor will use hindsight to the extent possible and review the sale of inventory after year-end to determine the reasonableness of costs compared to subsequent sales prices. For example, the auditor will usually: 1. Compare the cost of inventory items with the entity’s current sales catalog and sales reports 2. Review inventory turnover after year-end 3. Consider whether a change in replacement costs is an indicator of changing market conditions 4. Make inquiries of the client about slow-moving and obsolete inventory and the realizable value of inventory through sales

Value-Added Services in the Production Cycle
When the auditor evaluates issues such as the net realizable value of inventory, he or she should consider the client’s business risks, and the risk of substitute products or competitors taking market share, and should share this knowledge and understanding with the client. Further, the auditor’s analytical procedures will address the effectiveness of the inventory management process. The auditor will normally evaluate an entity’s inventory turnover. Figure 16-3 points out the wide variation in inventory turnover for 3 different industries.

Planning the Audit of the Personnel Services Cycle
An entity’s personnel services cycle involves the events and activities that pertain to executive and employee compensation. The types of compensation include salaries, hourly and incentive (piecework) wages, commissions, bonuses, stock options, and employee benefits. The major class of transactions in this cycle is payroll transactions. The accounts affected by these transactions are shown in Figure 16-9.

Control Risk Assessment Considerations for Payroll Figure 16-9

Selected Specific Audit Objectives for the Personnel Services Cycle Figure 16-10

Using the Understanding of the Business and Industry to Develop Audit Strategy Personnel services may vary in importance to various manufacturers, wholesalers, and retailers. Some industries may vary widely on the labor intensiveness of the manufacturing process.

Before proceeding with the audit of personnel services, it is important for the auditor to understand: 1. The importance of personnel services to the overall entity. 2. The nature of compensation, as hourly compensation requires a different control system than salaried compensation. 3. The importance of various compensation packages such as bonuses, stock options and stock appreciation rights, and pension agreements.

Materiality For software companies and service firms such as banks, insurance companies, and professional firms, personnel services is a major expense. The growth of the service sector in the U.S. economy and the importance of human capital to the value of many technology and software companies makes the personnel services cycle a material audit area for many companies.

Inherent Risk The auditor is rarely concerned about the completeness assertion in the payroll cycle as most employees quickly follow up with their employers if they are not paid. However, payroll fraud (existence or occurrence) is a major concern for the auditor. Fraud may occur at 2 levels. Employees involved in preparing and paying the payroll may process data for fictitious employees and then divert the paychecks to their own use.

Alternatively, management may overtly misclassify or “pad” labor cost in government contract work to defraud the agency. Inherent risk may be high for the existence or occurrence, valuation or allocation, and presentation and disclosure assertions.

Analytical Procedures The auditor will normally perform analytical procedures early in the audit of the personnel services cycle because they are cost effective. Examples of analytical procedures that the auditor might use are presented in Figure Analytical procedures may be useful in identifying potential fraud such as when gross payroll per employee exceeds the auditor’s expectations.

Analytical Procedures Commonly Used to Audit the Personnel Services Cycle Figure 16-11

Control Activities — Payroll Transactions
Common Documents and Records The following documents and records are important in executing and recording payroll transactions: 1. Personnel authorization. Memo issued by personnel department indicating the hiring of an employee and each subsequent change in the employee’s status for payroll purposes. 2. Clock card. Form used by each employee to record hours worked daily during a pay period. It is used with time clocks that record the time on the card. This and the following form may be replaced in modern systems with an employee badge that is inserted into a terminal to cause an electronic record of the time to be made.

3. Time ticket. Form used to record time worked by an employee on specific jobs. Time worked is often machine imprinted. 4. Payroll Register. Report showing each employee’s name, gross earnings, payroll deductions, and net pay for a pay period. It provides the basis for paying employees and recording the payroll. 5. Imprest payroll bank account. Account to which a deposit equal to the total net payroll is made each pay period, and on which checks for salaries and wages for employees are drawn. 6. Payroll check. Order drawn on a bank to pay an employee. It is accomplished by a detachable memo indicating gross earnings and payroll deductions.

7. Labor cost distribution summary. Report showing the account classifications for gross factory earnings for each pay period. 8. Payroll tax returns. Forms prescribed by tax authorities for filing with payments of taxes withheld from employees and employer’s payroll taxes for social security and federal and state unemployment. 9. Employee personnel file. Holds pertinent employment data for each employee and contains all personnel authorizations issued for the employee, job evaluations, and disciplinary actions, if any.

10. Personnel data master file. Computer file containing current data on employees needed for calculating payroll such as job classification, wage rate, and deductions. 11. Employee earnings master file. Computer file containing each employee’s gross earnings, payroll deductions, and net pay for the year to date by pay periods.

Functions and Related Controls The processing of payroll transactions involves the following payroll functions: 1. Initiating payroll transactions, including:  Hiring employees.  Authorizing payroll changes. 2. Receipt of services, including:  Preparing attendance and timekeeping data.

3. Recording payroll transactions, including:  Preparing and recording the payroll. 4. Paying payroll, including:  Paying the payroll and protecting unclaimed wages.  Filing payroll tax returns.

Obtaining an Understanding and Assessing Control Risk The procedures used to obtain and document the understanding of the internal control components for payroll transactions are the same as for the other major classes of transactions. The process of assessing control risk for payroll transactions begins with identifying potential misstatements and necessary controls.

In assessing control risk, the auditor realizes that misstatements in payroll may result from unintentional errors or fraud. Of particular concern is the risk of overstatement of payroll through the following: 1. Payments to fictitious employees 2. Payments to actual employees for hours not worked 3. Payments to actual employees at higher than authorized rates

2 tests of controls pertaining to control risk for the existence or occurrence assertion are: 1. the test for terminated employees and 2. witnessing a payroll distribution.

In witnessing the distribution of payroll checks, the auditor observes that: 1. Segregation of duties exists between the preparation and payment of the payroll 2. Each employee receives only one check 3. Each employee is identified by a badge or employee ID card 4. There is proper control and disposition of unclaimed checks

Substantive Tests of Payroll Balances
Determining Detection Risk Factors contributing to high inherent risk for existence or occurrence and valuation or allocation assertions related to payroll transactions have been noted earlier. However, evidence of effective controls over these risks in many cases permits low assessments of control risk, resulting in moderate or high acceptable levels of detection risk for most or all payroll assertions. Consequently, substantive tests of payroll balances are often limited to applying analytical procedures to the expense accounts and related accruals, and limited tests of details. If the analytical procedures reveal unexpected fluctuations, more extensive tests of details will be required.

Designing Substantive Tests Audit program considerations for accrued payroll liability balances are similar to those identified in Figure for accounts payable. However, the auditor does not confirm payroll liabilities. When no unexpected fluctuations are revealed by analytical procedures, the auditor has obtained evidence in support of audit objectives related to the existence or occurrence, completeness, and valuation or allocations assertions.

Text explanations of specific substantive tests for payroll balances are limited to the following procedures: 1. Recalculating accruals 2. Auditing employee benefits and pension plans 3. Auditing stock options and stock appreciation rights 4. Verifying officers’ compensation

Value-Added Services in the Personnel Services Cycle
Personnel management is a core process for many companies. The primary issue is how the auditor uses the knowledge obtained during the audit to provide value-added services to his or her client. When performing the audit, many CPAs monitor revenue per employee and evaluate performance relative to others in the industry. CPAs who understand the industry can often help clients identify opportunities that may exist in growing revenue per employee.

Value-Added Services in the Personnel Services Cycle
When auditing expenses and profitability, a CPA will often evaluate employee productivity statistics. CPAs are often skilled at developing means to hold responsibility centers accountable for their use of resources — in this case, the payroll resource. CPAs may assist clients by: 1. suggesting appropriate measures of employee productivity or by 2. Identifying steps that a client may take to improve employee productivity.

Copyright Copyright 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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