1. Chapter 9 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
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Importance of Inventory
9-2
Importance of Inventory
Major component of current assets on the balance sheet.
Significant effect on net income.
Valuation is usually very subjective.
Potential obsolescence
Goods have not been sold, so marketability may be uncertain.

3. Inherent Risks in Production Cycle
9-3
Inherent Risks in Production Cycle
Complexity (e.g. dollar value LIFO)
Susceptibility to theft
Lower-of-Cost-or-Market valuation
Effects on gross profits

4. Typical Activities Planning Production Cost Accounting Production plan
9-4
Typical Activities
Planning
Production plan
Production
Bill of materials
Requisitions
Cost Accounting
Standard costs
Overhead allocation

5. Exhibit 9.2
Production Cycle
9-5

6. Production Cycle: Control Considerations
9-6
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.

7. Production Cycle: Control Considerations
9-7
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

8. Production Cycle: Control Procedures
9-8
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. Management Reports Sales Forecasts Inventory reports
9-9
Management Reports
Sales Forecasts
Inventory reports
Items on hand
Production plans and reports

10. Test of Controls Observe separation of duties
9-10
Test of Controls
Observe separation of duties
Vouch costs to labor and material reports
Time tickets
Receiving reports
Transfer tickers
Check proper authorizations
Examine review of cost reports

11. Substantive Procedures
9-11
Substantive Procedures
Observation of inventory count
Tests of pricing and compilation
Analytical procedures

12. Physical Inventory Observation
9-12
Physical Inventory Observation
“…it will always be necessary for the auditor to make, or observe, some physical counts of the inventory and apply appropriate tests of intervening transactions" (AU ).
May make test counts at a time other than year-end.
test roll-forward.

13. Physical Inventory Observation
9-13
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

14. Client Count Instructions
9-14
Client Count Instructions
Names and dates
Instructions for descriptions and counts
Noting obsolete or worn items
Tag control—compilation of counts
Shutting down production
Controlling movement
Supervisory approval
Making changes and corrections

15. Exhibit 9.7
Inventory Count Sheet
9-15

16. Physical Inventory Observation
9-16
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.

17. Inventory Count and Measurement Challenges
9-17
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.

18. Pricing and Compilation Tests
9-18
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

19. Purchase Cutoffs Verify CUT-OFFs for purchases and sales
9-19
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

20. Analytic Procedures Verify REASONABLENESS of COGS
9-20
Analytic Procedures
Verify REASONABLENESS of COGS
Gross Profit Margin
Compare to prior year, industry averages
Verify REASONABLENESS of ending inventory
Days Sales in Inventory
Inventory Turnover

21. Fraud Detection Procedures
9-21
Fraud Detection Procedures
Focus on high-dollar items.
Unpredictable counts.
Be skeptical of large differences.
Be alert for signs of damage, obsolescence or excess quantities.
Ensure interplant transfers are kept to a minimum.