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

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Learning Objectives1. 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.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.

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Importance of Inventory

• Major component of current assets on the balance sheet.

• Errors effect both the balance sheets and net income.income.

• Valuation is usually very subjective.– Potential obsolescence– Goods have not been sold, so marketability may be

uncertain.

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Inherent Risks in Production Cycle

• Complexity (e.g. dollar value LIFO)• Susceptibility to theft• Movement of inventory• Movement of inventory• Lower-of-Cost-or-Market valuation• Effects on gross profits

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Typical Activities

• Planning– Production plan

• Production– Bill of materials– Bill of materials– Requisitions

• Cost Accounting– Standard costs– Overhead allocation

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Exhibit 9.3Production Cycle

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Production Cycle: Control Considerations

• Production runs are authorized.• Raw Materials should be counted, and

inspected• As production is undertaken, materials and • 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

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Production Cycle: Control Considerations

• Use of TRANSFER tickets• Count/inspect the items and compare quantities• The cost accounting department reviews• 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

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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• Separation of Duties– Authorization– Recording– Custody– Reconciliation

• Performance Reviews– Scrap reports– Variance analysis

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Management Reports

• Sales Forecasts• Inventory reports

– Items on hand– Items on hand

• Open purchase orders• Production plans and reports

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Test of Controls

• Observe separation of duties• Vouch costs to labor and material reports

– Time tickets– Time tickets– Receiving reports– Transfer tickets

• Check proper authorizations• Examine review of cost reports

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Substantive Procedures

• Observation of inventory count• Tests of pricing and compilation• Analytical procedures

– Excessive inventory– Slow moving inventory

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Physical Inventory Observation

• Auditors are required to make, or observe, some physical counts of the inventory and apply appropriate tests of intervening transactions.appropriate tests of intervening transactions.

• Usually make test counts at a time other than year-end. – test roll-forward or roll-back

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Physical Inventory Observation

• Review client instructions• Stop flow of goods• Make TEST COUNTS• Make TEST COUNTS

– From INVENTORY LISTING– From WAREHOUSE FLOOR– Record some counts in working papers

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Client Count Instructions• Names or team number and dates• Instructions for descriptions and counts• Noting obsolete or damaged items• Tag control—compilation of counts• Tag control—compilation of counts• Shutting down production• Controlling inventory movement including

shipping and receiving• Supervisory approval• Making changes and corrections

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Exhibit 9.8Inventory Count Sheet

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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”• 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.

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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

Inventory Count and Measurement Challenges

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.

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Pricing and Compilation Tests

• Valuation (Price Tests) – VENDOR INVOICES– COST FLOW ASSUMPTION (FIFO, LIFO,

average, specific identification)average, specific identification)– LOWER OF COST OR MARKET for

inventory • Check Extensions and Footings. • Agree to G/L

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Purchase Cutoffs

• Verify CUT-OFFs for purchases and sales– Examine Receiving Reports and Vendor Sales

Invoices occurring around year-end.Invoices occurring around year-end.– Examine bills of lading and sales invoices– Agree to inclusion/exclusion from inventory

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Analytic Procedures

• Verify REASONABLENESS of COGS– Gross Profit Margin– Compare to prior year, competitors, or industry

averagesaverages

• Verify REASONABLENESS of ending inventory– Days Sales in Inventory – Inventory Turnover

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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 • 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.

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