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CHAPTER 16

AUDIT THE PRODUCTION AND PERSONNEL
SERVICES CYCLE
Learning Check
16-1.

a.

The production cycle relates to the conversion of raw materials into finished goods,
and 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.

b.

The major transaction class within this cycle is manufacturing transactions.

c.

The production cycle interfaces with (1) the expenditure cycle through the purchase
of raw materials and incurrence of various overhead costs, (2) the personnel services
cycle through the incurrence of factory labor costs, and (3) the revenue cycle through the
sale of finished goods.

16-2. a.
The transaction class audit objectives for the production cycle are:
Occurrence. Recorded manufacturing transactions represent material, labor, and
overhead transferred to production and the movement to completed production to
finished goods during the current period (EO1). Recorded cost of sales represent the sale
of inventory during the year (EO2).
Completeness. All manufacturing transactions (C1) and cost of sales (C2) that occurred
during the period were recorded.
Accuracy. Manufacturing transactions (VA1) and cost of sales (VA2) are accurately
valued using GAAP and correctly journalized, summarized and posted.
Cutoff. All manufacturing transactions (EO1 and C1) and cost of sales (EO2 and C2)
have been recorded in the correct accounting period.
Classification. All manufacturing transactions (PD1) and cost of sales (PD2) have been
recorded in the proper accounts.
b. Several account balance audit objectives for the production cycle are:
Existence. Inventories included in the balance sheet physically exist (EO3).
Completeness. Inventories include all materials, products and supplies on hand at the
balance sheet date (C3).
Rights and Obligations. The reporting entity has legal title to recorded inventories at
the balance sheet date (RO1).
Valuation and Allocation. Inventories costing assumptions have been properly applied
(VA3) and inventories are properly stated at the lower of cost or market (VA4).
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16-3. a.

In a manufacturing company, inventories and cost of goods sold are usually
significant to the company's financial position and results of operations. Further, due
to the cost of observing inventory the auditor will normally allocate a significant
amount of overall materiality o the audit of inventory, without exceeding an amount
that the auditor believes will affect the analysis of a financial statement user.

b.

Several factors that affect inherent risk for assertions related to the production cycle
are:
 The volume of purchases, manufacturing, and sales transactions that affects these
accounts is generally high, increasing the opportunities for misstatements to
occur.
 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, the disposition of cost variances,
accounting for scrap, and other cost accounting issues.
 The wide diversity of inventory items sometimes requires the use of special
procedures to determine inventory quantities, such as geometric volume
measurements of stockpiles, aerial photography, and estimation of quantities by
experts.
 Inventories are often stored at multiple sites, adding to the difficulties associated
with maintaining physical controls over theft and damage, and properly accounting
for goods in transit between sites.
 The wide diversity of inventory items may present special problems in
determining their quality and market value.
 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.
 Inventories may be sold subject to right of return and repurchase agreements.

c.

Following are several examples of analytical procedures and a description of how
they might assist the auditor when auditing the production cycle.
Ratio
Inventory Turn Days

Formula
Avg. Inventory  Cost of Good
Sold x 365

Inventory Growth to Cost
of Sales Growth

((Inventory n Inventory n-1) – 1)
 ((Cost of Sales n  Cost of
Sales n-1) – 1)

Finished Goods
Produced to Raw
Material Used

Finished Goods Quantities 
Raw Material Quantities

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Audit Significance
Prior experience in inventory turn
days combined with knowledge of
cost of sales can be useful in
estimating current inventory levels. A
lengthening of the period may indicate
existence problems.
Ratios larger than 1.0 indicate that
inventories are growing faster than
sales. Large ratios may indicate
possible inventory obsolescence
problems.
Useful in estimating the efficiency of
the manufacturing process. May be
helpful in evaluating the
reasonableness of production costs.

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Ratio

16-4.

Formula

Audit Significance

Finished Goods
Produced to Direct
Labor

Finished Goods Quantities 
Direct Labor Hours

Product Defects per
Million

Number of Product Defects as
a Percent of Each Million
Produced

Useful in estimating the efficiency of
the manufacturing process. May be
helpful in evaluating the
reasonableness of production costs.
Useful in estimating the effectiveness
of the manufacturing process. May
be helpful in evaluating the
reasonableness of production costs
and warranty expenses.

a.

Control environment factors that may impact the production cycle include:
 The organizational structure should include an officer who has overall
responsibility for production, including authority over the production planning
and control department and each manufacturing department.
 The assignment of authority and responsibility should include timely
accountability for the use of the entity’s resources.
 Management's philosophy and operating style should include its approach to
taking and monitoring business risks related to production decisions and
inventory levels.
 The entity's human resource policies and practices pertaining to production
department employees can significantly impact the use of, and accountability for,
the factors of production.

b.

Unique elements of an entity's accounting information system that pertain to the
production cycle may include the use of control accounts and supporting records
such as product or master files, separate records for raw materials, work in process,
and finished goods inventories, job order and process cost systems, and standard cost
systems.

16-5. The documents and records are summarized in the following table:

Function
Initiating production:
o Planning and controlling production.
Production of Inventory:
o Issuing raw materials.
o Processing goods in production.
o Transferring completed work to finished
goods.
o Protecting inventories.
Recording manufacturing and inventory
transactions:
o Determining and recording
manufacturing costs.

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Documents and Records
Production orders
Material requirements reports
Materials issue slips or requisitions
Time tickets
Inventory move tickets




Daily production reports
Completed production report
Standard cost master file
Raw material inventory master file
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o Maintaining correctness of inventory
balances.


Work in process inventory master file
Finished goods inventory master file

16-6. Controls that are important in determining and recording manufacturing costs are:
 Computer checks on the agreement of entries for the allocation of manufacturing costs to
work in process with data on materials and labor usage in daily production activity
reports.
 Computer checks on the agreement of entries for the transfer of work in process to
finished goods with data in completed production reports.
16-7. Controls important in protecting inventories include:
 Storage of raw materials and finished goods inventories in locked storerooms with
access restricted to authorized individuals.
 Surveillance of production areas by supervisory and plant security employees.
 Tagging goods in production.
 Using prenumbered move tickets to control the transfer of work in process through the
plant.
 Controls relating to the correctness of inventory balances include:
 Periodic independent counts of inventory on hand and comparison with recorded
quantities per the perpetual inventory records.
 Periodic independent checks on the agreement of the dollar carrying amounts for the raw
materials, work in process, and finished goods inventory master files with their
respective general ledger control accounts.
 Periodic inspections of inventory condition and management review of inventory
activity reports for the purpose of determining the need for adjustments to reduce
inventory carrying values to market when required.
16-8.

a.

Factors that should be considered by an auditor in specifying the acceptable level of
detection risk for assertions pertaining to merchandise inventory include the relevant
transaction class inherent and control risk assessments for the purchases and sales
transactions that affect the merchandise inventory account, as well as inherent and
control risk factors associated directly with the merchandise inventory balance.

b.

Factors that should be considered by an auditor in specifying the acceptable level of
detection risk for assertions pertaining to manufactured finished goods inventory
include relevant inherent and control risk assessments for the manufacturing and
sales transactions that affect the finished goods inventory account, as well as inherent
and control risk factors associated directly with the manufactured finished goods
inventory balance.

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16-9. Several ratios and their formulas that may be used in applying analytical procedures to
inventory balances are:
Ratio
Inventory Turn Days

Formula
Avg. Inventory  Cost of Good
Sold x 365

Inventory Growth to Cost
of Sales Growth

((Inventory n Inventory n-1) – 1)
 ((Cost of Sales n  Cost of
Sales n-1) – 1)

Finished Goods
Produced to Raw
Material Used

Finished Goods Quantities 
Raw Material Quantities

Finished Goods
Produced to Direct
Labor

Finished Goods Quantities 
Direct Labor Hours

Product Defects per
Million

Number of Product Defects as
a Percent of Each Million
Produced

16-10. a.

b.

Audit Significance
Prior experience in inventory turn
days combined with knowledge
of cost of sales can be useful in
estimating current inventory
levels. A lengthening of the
period may indicate existence
problems.
Ratios larger than 1.0 indicate
that inventories are growing
faster than sales. Large ratios
may indicate possible inventory
obsolescence problems.
Useful in estimating the
efficiency of the manufacturing
process. May be helpful in
evaluating the reasonableness of
production costs.
Useful in estimating the
efficiency of the manufacturing
process. May be helpful in
evaluating the reasonableness of
production costs.
Useful in estimating the
effectiveness of the
manufacturing process. May be
helpful in evaluating the
reasonableness of production
costs and warranty expenses.

Five tests of details of balances that may be applied to inventories are:
 Observe client's physical inventory count.
 Test clerical accuracy of inventory listings.
 Test inventory pricing.
 Confirm inventories at locations outside the entity.
 Examine consignment agreements and contracts.
1.

The observation of inventories is required whenever inventories are material
to a company's financial statements and it is practicable and reasonable to
make the observation.

2.

The timing of an inventory observation depends on the client's inventory
system and the effectiveness of internal controls. In a periodic inventory
system, the observation of the inventory should occur at or near the balance
sheet date. In a perpetual inventory system with well-kept records,
observation may occur during or after the end of the period under audit.

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3.

In evaluating the client's inventory taking plans, the auditor should determine
that the plan includes all of the following:
 Names of employees responsible for supervising the inventory taking.
 Date of the counts.
 Locations to be counted.
 Detailed instructions on how the counts are to be made.
 Use and control of prenumbered inventory tags and summary
(compilation) sheets.
 Provisions for handling the receipt, shipment, and movement of goods
during the counts if such activity is unavoidable.
 Segregation or identification of goods not owned.

4. In observing inventories, the auditor should
 Scrutinize the care with which client employees are following the
inventory plan.
 See that all merchandise is tagged and no items are double tagged.
 Determine that prenumbered inventory tags and compilation sheets are
properly controlled.
 Make some test counts and trace quantities to compilation sheets.
 Be alerts for empty containers and hollow squares (empty spaces) that
may exist when goods are stacked in solid formations.
 Watch for damaged and obsolete inventory items.
 Appraise the general condition of the inventory.
 Identify the last receiving and shipping documents used and determine
that goods received during the count are properly segregated.
 Inquire about the existence of slow-moving inventory items.
16-11. a.

In testing inventory pricing for purchased inventories, the auditor should (1) vouch
costs to representative vendor invoices and (2) verify both cost and market when the
lower of cost or market method is used. In testing inventory pricing for manufactured
inventories, the auditor should review the methods used in costing the inventories for
propriety and the accuracy and consistency of application. For example, when
standard costs are used, the auditor should test the calculation of the standards,
compare the calculations with engineering specifications, determine that the
standards are current, and evaluate whether the standards approximate actual costs
by examining the variance accounts.

b.

Confirmations may be used in the audit of inventories to obtain evidence about the
existence of inventories stored in public warehouses or with other outside custodians
such as consignees.

16-12. a.

When the auditor is testing net realizable value the auditor needs to determine if the
client will be able to sell inventory on hand at year-end in the normal operating cycle
and not suffer a loss (break-even) in the process. The auditor is testing the client’s

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estimates of future outcomes – the value of future sales. This is particularly
problematic with inventory that is considered obsolete.
b.

16-13. a.
b.

16-14. a.

b.

When auditing the net realizable value of inventory the auditor will want to
understand management’s process for estimating any allowance for obsolete
inventory. The auditor will need to understand how long it takes the client to turn its
inventory and evaluate recent history (the last several inventory turn cycles) for
evidence of the client’s ability to turn its inventory and break even. The auditor will
also want to review sales prices after year-end to the extent possible.
The personnel services cycle involves the events and activities that pertain to
executive and employee compensation.
This cycle interfaces with two other cycles: (1) the paying of the payroll and payroll
taxes involves cash disbursements in the expenditure cycle; (2) the distribution of
factory labor costs to work in process pertains to the production cycle.
Gross earnings of personnel are generally the largest operating expense in
merchandising (after costs of goods sold) and service companies. They also are a
major component in costing work in process. Employee fraud is a major inherent risk
that the auditor should consider.
The auditor's usual strategy is to use a lower assessed level of control risk approach
in auditing payroll transactions because:
 The audit risk is primarily in the processing of payroll transactions.
 Most companies have extensive internal controls for the routine nature of payroll
transactions.
 Year-end payroll liability balances are often immaterial.

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16-15. The audit objectives for payroll transactions and related assertions are:
Specific Audit Objectives
Transaction Objectives
Occurrence. Recorded employee compensation, benefits and payroll tax expenses
relate to compensation for services rendered during the year (EO1).
Completeness. Recorded employee compensation, benefits and tax expenses include
all such expenses incurred for personnel services during the year (C1).
Accuracy. Employee compensation, benefits and payroll tax expenses are accurately
computed and recorded (VA1).
Cutoff. Employee compensation, benefits and payroll tax expenses have been recorded
in the correct accounting period (EO1 and C1).
Classification. Employee compensation, benefits and payroll tax expenses are properly
identified and classified in the income statement (PD1).
Balance Objectives
Existence. Employee compensation, benefits and payroll tax liabilities represent
amounts owed at the balance sheet date (EO2).
Completeness. Employee compensation, benefits and payroll tax liabilities include all
such amounts owed at the balance sheet date (C2).
Rights and Obligations. Employee compensation, benefits and payroll tax liabilities
are obligations of the reporting entity (RO1).
Valuation and Allocation. Employee compensation, benefits and payroll tax liabilities
are accurately computed and recorded (VA2).
Disclosure Objectives
Occurrence and Rights and Obligations. Disclosed employee compensation and
benefits transactions and balance have occurred and pertain to the entity (PD3).
Completeness. All employee compensation and benefits disclosures that should have
been included in the financial statements have been included (PD4).
Understandability. All employee compensation and benefits information is
appropriately presented and information in disclosures is understandable to users (PD5).
Accuracy and Valuation. All employee compensation and benefits information is
disclosed accurately and at appropriate amounts (PD6).

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16-8

16-16. Following are several examples of analytical procedures and a description of how they
might assist the auditor when auditing the production cycle.
Ratio
Average payroll cost
per employee
classification

Formula
Total payroll costs for an
employee group divided by
the number of employees in
the group

Revenue per
employee

Total Revenue  number of
full time equivalent
employees.

Total payroll costs as
a percentage of
revenues
Payroll tax expense
as a percent of gross
payroll
Compare payroll
expenses (salaries
and wages,
commissions,
bonuses, employee
benefits, etc) with
prior year balances
or budgets

Total payroll expenses  total
revenues

Compare current
year payroll liability
with prior year payroll
liability
Compute ratio of
payroll tax expense
to total payroll
expenses
Employee benefits
expenses as a
percent of gross
payroll

Current year payroll tax
liability  prior year payroll tax
liability adjusted for growth in
payroll volume
Payroll tax expense  total
payroll expense

Reasonableness test for payroll
liability if the ratio is significantly
different from 1.0

Total benefits expenses 
gross payroll

Reasonableness test of benefits
expenses. This is often compared
with industry statistics.

Total payroll tax expenses 
gross payroll
Current year payroll expenses
 prior year payroll expenses

Audit Significance
Reasonableness test of gross payroll
for a group of employees. Many
companies have more than one class
of employee, and it is important to
evaluate the reasonableness of
payroll based on employee class.
This may be a measure of productivity
per full time equivalent employee.
This is particularly important in
services industries and would be
compared with industry statistics.
Reasonableness test of payroll costs.
This is often compared with industry
statistics.
Reasonableness test of payroll taxes.
This can often be compared with
standard tax rates.
Reasonableness test for payroll
expenses if the ratio is significantly
different from 1.0

Reasonableness test for payroll tax
expense based on prior year ratio of
payroll tax expense to total payroll.

16-17. The control environment is as relevant to the personnel services cycle as it is to any cycle.
The elements of human resources associated with hiring practices and the care with which
controls are established over putting new employees on the payroll is essential to good
control.
Management should actively assess the risks associated with errors and fraud and design
appropriate controls to reduce these risks consider the cost-benefit tradeoff when
implementing controls.

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Finally, management should monitor the system of internal controls, perhaps as a
responsibility of the internal audit function. Management needs to review the results control
failures that result in errors or fraud in the personnel services function and take actions to
correct exiting problems.
16-18. The functions in processing payroll transactions are:
 Initiating payroll transactions including (a) hiring employees and (b) authorizing payroll
changes.
 Receiving services including preparing attendance and timekeeping data.
 Recording payroll including (a) preparing and (b) recording the payroll.
 Paying the payroll including (a) paying the payroll and protecting unclaimed wages, and
(b) filing payroll tax returns.
16-19. a.

b.

16-20. a.

b.

The responsibilities of the personnel department include: (1) hiring employees, (2)
preparing personnel authorization forms for new hires, (3) authorizing payroll
changes and terminations, and (4) maintaining employee personnel files.
The control procedures in preparing attendance and timekeeping data include (1)
using time clocks to record hours worked, (2) supervising clock card punching, (3)
supporting time clock hours with time tickets, (4) approving time worked in writing
by a supervisor, and (5) reconciling time tickets and clock cards.
Tests of controls for terminated employees involve making inquiries and observing
the processes for removing personnel from the payroll. Many companies create a
report of terminated employees that is reviewed in personnel. The auditor might
substantively for subsequent payment of terminated employees using generalized
audit software and selecting a sample of termination notices and scanning subsequent
payroll registers to determine that the terminated employees did not continue to
receive pay checks.
In witnessing the distribution of payroll checks, the auditor observes that:
 Segregation of duties exists between the preparation and payment of the payroll.
 Each employee receives only one check.
 Each employee is identified by a badge or employee ID card.
 There is proper control and disposition of unclaimed checks.

16-21. The following table provides example controls and tests of controls for each assertion (and
transaction level audit objective) related to the personnel services cycle. Examples
emphasize programmed control procedures where appropriate. Student should note that
tests of controls should also emphasize testing computer general controls, observing
exception reports, and testing manual follow-up of items that appear on exception reports.

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16-10

Personnel Services
Assertion (Audit Objective)
Existence and Occurrence
(Occurrence)

Completeness
(Completeness)
Existence and Occurrence /
Completeness (Cutoff)
Valuation and Allocation
(Accuracy)
Presentation and Disclosure
(Classification)
Rights and Obligations

16-22. a.
b.

16-23. a.

Control
Only a few key employees in
personnel can add a new employee to
the master payroll file.
Computer reports all changes to the
personnel data master file.
Management in personnel reviews
report of all master file changes.
Batch total of hours worked prepared
by payroll department and verified
by the computer.
Manual controls check payroll cutoff
and accrue payroll when pay periods
do not coincide with month end.
Computer limit test on the number of
hours worked and the amount of each
payroll check.
Computer compares account
classification for hours worked with
account classification on time cards.
N/A

Test of Controls
Observe the process for changing the
master payroll file, review the accuracy of
reports of changes to the master file, and
reperform control.

Use CAATs to test the control by
submitting data that should be rejected by
the control.
Observe the process testing payroll cutoff
and accruing payroll costs, and reperform
control.
Use CAATs to test the control by
submitting data that should be rejected by
the control.
Use CAATs to test the control by
submitting data that should be rejected by
the control.
N/A

The likely acceptable level of detection risk for payroll balances is moderate or high
because moderate or low assessments of control risk are usually possible.
When moderate or high detection risk levels are acceptable, substantive tests may be
limited to applying analytical procedures and limited tests of details. If unexpected
fluctuations are found, more extensive tests of details will be required.
To obtain evidence about the reasonableness of management's accrued payroll
liabilities, the auditor should review management's calculations or make independent
calculations, compare the accruals with amounts shown on payroll tax returns, and
examine subsequent payments where applicable.

b.

Officers' compensation is audit sensitive because it must be separately disclosed in
10-K reports filed with the SEC, and because officers may be able to override
controls and receive salaries, bonuses, stock options, and other forms of
compensation in excess of authorized

c.

When auditing pension expenses, the auditor should also evaluate the reasonableness
of the key actuarial estimates such as the discount rate that is used to determine the
projected benefit obligation and the long-term rate of return assumption used for the
expected return on plan assets. The discount rate should be in line with current
annuity purchase rates for high-quality fixed income investments. The long-term
rate of return assumption should reflect the actual and anticipated returns for the
plan’s assets.

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2005, John Wiley and Sons, Inc.

16-11

d.

With respect to accounting for stock option expense, most companies structure their
stock option plans to meet the requirements of APB No. 25, so that they may use the
intrinsic value approach and report no compensation expense associated with the use
of stock options. Stock appreciation rights, however, require the recognition of
compensation expense, regardless of whether the right is exercised during the period.
FASB No. 123 requires these companies to disclose pro forma net income and
earnings per share as if the fair value approach were used. As a result the auditor
must audit the valuation model used to determine the fair value of the stock options.
When evaluating fair presentation in the financial statements, the auditor evaluates
assumptions that include the risk-free rate, the expected life of the option, the
expected volatility of the stock price, and expected dividends.

Comprehensive Questions
16-24. (Estimated Time: 30 minutes)
a.
The following table includes the calculations for part a. (Note the calculations use
ending balances rather than average balances. Also note that AP turn days is calculated by
using Accounts Payable ÷ Purchases x 365.)

b.

The trends show an increase in inventory turn days, a decrease in accounts payable
turn days, and a steady gross margin. The gross operating cycle is constant due to
the improvement in accounts receivable turn days. The net operating cycle does not
show the same level of improvement as gross operating cycle due to the decrease in
payable turn days.

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16-12

c.

If tolerable misstatement is $45,000 this translates to an expectation range of plus or
mine 9 days based on the following calculation.
$45,000 ÷ $1,859,000 *365 = 8.8 days which rounds to 9 days.

d.

The increase in inventory turn days indicates that inventory may be overstated. A
further risk may be associated with unrecorded liabilities. The combination may
result in an overstatement of net income.

16-25. (Estimated Time – 30 minutes)

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16-13

Unaudited
Audited
Audited
20X4
20X3
20X2
$
12,005,336 $
10,291,333 $
8,892,133

Sales
Cost of Raw Materials Used
Direct Labor Cost
Cost of Payroll Taxes and Benefits
Indirect Costs

$
$
$
$
$

3,923,336
1,696,081
580,060
1,088,885
7,288,362

$
$
$
$
$

3,173,333
1,364,314
439,309
1,094,930
6,071,886

$
$
$
$
$

2,800,000
1,190,000
383,180
962,100
5,335,280

Beginning Inventory
Ending Inventory

$
$

330,587
470,016

$
$

274,764
330,587

$
$

156,577
274,764

Capacity
Units Produced
Units Sold
Beginning Inventory
Ending Inventory
Direct Labor Hours
Number of Manufacturing Employees
Labor Cost including benefits

$

Tons of Raw Material Used
Tons of Ending Raw Materials Inventory
a. Calcualtions
Cost of Goods Sold
Gross Profit Margin
Inventory Turn Days
Number of Units per Ton of Raw Mat'l
Number of Units per Direct Labor Hr.
Cost per ton of materials
Cost per direct labor hour
Payroll taxes and benefits as a% o
direct labor cost
Cost per unit of inventory

b.

10,000,000
8,780,800
8,750,000
415,000
445,800

10,000,000
7,840,000
7,775,000
350,000
415,000

10,000,000
7,000,000
6,850,000
200,000
350,000

92,429
46

76,863
38

70,000
35

2,276,140

$

7,473
21

$

$
$

$

1,803,623

$

6,222
18

5,600
16

7,148,933 $
40.5%
24.0
1175
95
525.00 $
24.63 $

6,016,063 $
41.5%
20.1
1260
102
510.00 $
23.47 $

34.2%

32.2%

1.054

$

0.797

1,573,180

5,217,093
41.3%
19.2
1250
100
500.00
22.47
32.2%

$

0.785

Analytical procedures indicate that ending inventory appears to be overstated due to
pricing problems in the valuation of inventory. Manufacturing productivity appears
to have decreased due to the decreases in the number of units produced per ton of
raw materials and decreases in the number of units produced per direct labor hour.
Further, the cost of raw materials increased during the years, as did payroll cost (both
the cost per direct labor hour and the cost of benefits).

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2005, John Wiley and Sons, Inc.

16-14

Increases in gross profit margin are inconsistent with this underlying information
related to the cost of production. The dramatic increase in inventory turn days, and
the cost per unit of inventory are consistent with the fact that inventory appears to be
overvalued, probably as a result of problems with the valuation of inventory (or
possibly the existence of inventory). Audit tests need to focus carefully on the cost
build-up for ending inventory, and the allocation of cost between ending inventory
and cost of sales.
16-26. (Estimated time - 30 minutes)
Ingredients Inventory
a. Weaknesses
b. Recommended Improvements
Failure to delegate authority for
If feasible a separate receiving department
receiving material.
should be established. At least specific
employees should be given responsibility for
receiving merchandise.
Receivers are currently accepting
whatever is delivered and simply
taking some sort of count or tally.
Ingredients inventory is stored in the
production area.
Apparently a periodic inventory
system is being employed.
No mention is made of adjustment
and reconciliation of book to
physical inventory, including
appropriate cut-off procedures.
There appears to be a lack of
accountability for inventory
throughout the production process.

Receivers should be given a copy of purchase
orders with complete descriptions except
quantities. These copies should be used instead of tallies.
Ingredients inventory should be placed in a
protected storage area which has controlled
access.
A perpetual system should be installed if
possible.
All differences between physical and book
inventory should be re-viewed and investigated
when deemed appropriate.
Ingredients inventory items should only be
released from stores upon written requisition.
Appropriate documentation should follow the
production process.

2. Maintenance Materials and Supplies Inventory
a. Weaknesses
b. Recommended Improvements
Access to inventory is unrestricted
The room should be locked and a clerk present
at various times during the first two at all times when the room is open.
shifts and during the entire third
Requisitions should be required for all
shift and on Saturday.
withdrawals of materials and supplies.
A periodic inventory system
A perpetual system should be used if possible.
appears to be in effect.
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16-15

No indication is given of book to
physical inventory adjustments.
16-27. (Estimated time - 25 minutes)
a. Substantive Test
1.

Observe client's inventory
taking

2.

Verify accuracy of schedules
and perpetual records and
agreement with inventory
balances
Consider evidence from sales
and purchases cutoff tests
Observe client's

3.
4.
5.

Confirm inventories in public
warehouses

6.

Observe client's inventory
taking

7.

Test inventory pricing

8.

Observe client's inventory
taking

9.

Inquire of management
regarding ownership
Compare statement presentation
with GAAP

10.

Book to physical inventory adjustments should
be made and investigated when appropriate.
b. Financial Statement
c. Type of Evidence
Assertions
All except rights and
Physical, oral
obligations and presentation and
disclosure
Valuation or allocation
Mathematical

Existence or occurrence and
completeness
All except rights and
obligations and presentation and
disclosure
Existence or occurrence,
completeness, and rights and
obligations
All except rights and
obligations and presentation and
disclosure
Valuation or allocation

Documentary
Physical, oral
Confirmation
Physical, oral
Documentary,
mathematical
Physical, oral

All except rights and
obligations and presentation and
disclosure
Rights and obligations, and
Oral
presentation and disclosure
Presentation and disclosure
Documentary

16-28. (Estimated time - 25 minutes)
a.
During an audit of a manufacturing company the CPA reviews the cost system for the
following purposes:
 To determine that costs are properly allocated to current and future periods and
hence that cost figures used in arriving at balance sheet and income statement
amounts are supported by the accounting records.

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16-16


b.

To obtain assurance that the cost system, as an integral part of the system of
internal control, provides proper accounting control over costs incurred and
related inventories.
To ascertain, as a service to management, that the cost system is economical and
effectively provides information for reducing or controlling costs and for
determining the cost and profitability of products, and other related data
necessary for informed managerial decisions.

The audit procedures to be applied to determine that cost standards and related
variance accounts applicable to materials are acceptable and have not distorted the
financial statements would include the following:
 Review the internal control structure to estimate the amount of testing necessary.
 Test check the arithmetic of the standard cost cards.
 Determine that the data on the standard cost cards are reasonably current. Out-ofdate standards may result in abnormal variances.
 Ascertain the accuracy of the specifications on the standard cost cards by
comparison with engineering specifications or other independent sources.
Determine that the procedure for establishing standard material yields gives
consideration to spoilage, scrap loss and
by-products of the process.
 Determine that, in establishing standard material prices, consideration was given
to the following factors: normal quality, normal quantity, normal sources, and
delivery by normal carrier. The treatment in the accounts of discounts, whether
excluded or included in the standard costs, should be investigated for
consistency.
 The accounting system for recording standard costs should be reviewed for
reasonableness, and test checks should be applied to determine that the system is
functioning effectively. Source documents (vendors' invoices, requisitions,
production reports, and other internally generated accounting evidence) should
be examined and related to the transactions flowing through the cost system. In
this connection reference would be made to the standard cost cards to determine
that standard cost data flowing through the accounting system are being
accurately compiled.
 Review the material price variance and material usage variance accounts for
over-all reasonableness. The variance accounts should also be reviewed for
excessive variations in the month to month charges, and satisfactory explanations
should be obtained where necessary.
 The impact of the variances on the financial statements should be considered. If
the variances are of amounts so substantial that placing them in the income
statement would distort current operating results and inventory valuations, then
consideration should be given to allocating them on a pro rata basis to cost of
goods sold and inventories.

16-29. (Estimated time - 25 minutes)
Inventory

How General-Purpose Computer

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2005, John Wiley and Sons, Inc.

16-17

Substantive Tests

Software Package and Copy of
Inventory File Data Might Be Helpful
Observe the physical count,
Determining which items are to be test counted by
making and recording test counts making a random sample of a representative
where applicable.
number of items from the inventory file as of the
data of the physical count.
Test the mathematical accuracy of Mathematically computing the dollar value of each
the inventory compilation
inventory item counted by multiplying the quantity
(summary).
on hand by the cost per unit and verifying the
addition of the extended dollar values.
Compare the auditor's test counts Arranging test counts in a file format identical to
to the inventory records.
the inventory file and matching the records
Compare physical count data to
Comparing the total extended values of all items
inventory records.
counted and the extended values of each inventory
item counted to the inventory
Test the pricing of the inventory
Preparing a file in a format identical to the
by obtaining a list of costs per
inventory file and matching the files.
item from buyers, vendors, or
other sources.
Examine purchases and sales
Listing a sample of items on the inventory file for
cutoffs.
which the date of last purchase and date of the last
sale are on or immediately prior to the date of the
physical count.
Ascertain the propriety of items
Listing items located in public warehouses.
of inventory located in public
warehouses.
16-30. (Estimated time - 30 minutes)
The substantive auditing procedures Brown may consider performing include the following:
Using the perpetual inventory file:
 Recalculate the beginning and ending balances (prices x quantities), foot, and print out a
report to be used to reconcile the totals with the general ledger (or agree beginning
balance with the prior year's working papers).
 Calculate the quantity balances as of the physical inventory date for comparison to the
physical inventory file. (Alternatively, update the physical inventory file for purchases
and sales from January 6 to January 31, 20x2, for comparison to the perpetual inventory
at January 31, 20x2.)
 Select and print out a sample of items received and shipped for the periods (a) before
and after January 5 and 31, 20x2, for cut-off testing, (b) between January 5 and January
31, 20x2, for vouching or analytical procedures, and (c) prior to January 5, 20x2, for test
of details or analytical procedures.
 Compare quantities sold during the year to quantities on hand at year end. Print out a
report of items for which turnover is less than expected. (Alternatively, calculate the
number of days' sales in inventory for selected items.)
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Select items noted as possibly unsalable or obsolete during the physical inventory
observation and print out information about purchases and sales for further
consideration.
Recalculate the prices used to value the year-end FIFO inventory by matching prices and
quantities to the most recent purchases.
Select a sample of items for comparison to current sales prices.
Identify and print out unusual transactions. (These are transactions other than purchases
or
sales for the year, or physical inventory adjustments as of January 5, 20x2.)
Recalculate the ending inventory (or selected items) by taking the beginning balances
plus purchases, less sales, (quantities and/or amounts) and print out the differences.
Recalculate the cost of sales for selected items sold during the year.

Using the physical inventory and test count files:
 Account for all inventory tag numbers used and print out a report of missing or duplicate
numbers for follow-up.
 Search for tag numbers noted during the physical inventory observation as being voided
or not used.
 Compare the physical inventory file to the file of test counts and print out a report of
differences for auditor follow-up.
 Combine the quantities for each item appearing on more than one inventory tag number
for comparison to the perpetual file.
 Compare the quantities on the file to the calculated quantity balances on the perpetual
inventory file as of January 5, 20x2. (Alternatively, compare the physical inventory file
updated to year end to the perpetual inventory file.)
 Calculate the quantities and dollar amounts of the book-to-physical adjustments for each
item and the total adjustment. Print out a report to reconcile the total adjustment to the
adjustment recorded in the general ledger before year end.
 Using the calculated book-to-physical adjustments for each item, compare the quantities
and dollar amounts of each adjustment to the perpetual inventory file as of January 5,
20x2, and print out a report of differences for follow-up.

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16-19

16-31. (25 Minutes)
SUTTER COMPANY
PPS SAMPLE – INVENTORY
DECEMBER 31, 20X1
OBJECTIVE:
POPULATION AND
SAMPLING UNIT:
SAMPLE SIZE:

SAMPLE SELECTION:

EXECUTION OF
SAMPLING PLAN:
EVALUATION OF
SAMPLE RESULTS:
1
2
3
4
5

1
2
3
4
5

W/P REF: ______
PREPARED BY: ________DATE______________
REVIEWED BY: ________DATE______________

TO OBTAIN EVIDENCE THAT THE BOOK VALUE OF INVENTORY AT DECEMBER 31, 20X1 IS NOT
MATERIALLY MISSTATED.
POPULATION IS THE DOLLAR BALANCE OF INVENTORY; LOGICAL SAMPLING UNIT = LINE ITEM ON
INVENTORY LISTING.
BOOK VALUE OF POPULATION
2,960,000 (BV)
RISK OF INCORRECT ACCEPTANCE
5 % RF= 3.00
TOLERABLE MISSTATEMENT
200,000 (TM)
ANTICIPATED MISSTATEMENT
50,000 (AM) RF= 1.60
SAMPLE SIZE = n = (BV * RF)/(TM - (AM * EP))
74 (n)
SAMPLING INTERVAL = BV/n
40,000 (SI)
RANDOM START
34,189
LOGICAL SAMPLING UNITS SELECTED LISTED
————————
ON W/P
AUDIT PROCEDURES APPLIED LISTED ON W/P
————————
BOON AND AUDIT VALUES FOR SAMPLE ITEMS WITH MISSTATEMENTS LISTED BELOW
PROJECTED MISSTATEMENT
PROJECTED
BOOK
AUDIT
TAINTING
SAMPLING
MISSTATEMENT
VALUE
VALUE
% (TP) =
INTERVAL
(TP * SI) OR
(BV)
(AV)
((BV - AV)/BV)
(SI)
(BV - AV)
15,700
12,500
20.00
40,000
8,000
56,000
50,400
NA
NA
5,600
23,000
22,040
5.00
40,000
2,000

94,900
85,000
TOTAL
ALLOWANCE FOR SAMPLING RISK:
BASIC PRECISION = RF * SI
INCREMENTAL ALLOWANCE:
RANKED
INCREMENTAL CHANGE IN
PROJECTED
RELIABILITY FACTOR
MISSTATEMENTS
MINUS ONE
8,000
0.75
2,000
0.55
0
0.46
0
0.40
0
0.36
TOTAL
ASR = BP + IA
UPPER MISSTATEMENT LIMIT:
UML = PM + ASR

15,600
120,000
INCREMENTAL
ALLOWANCE FOR
SAMPLING RISK
6,000
1,100
0
0
0
7,100
127,100

(PM)
(BP)

(IA)
(ASR)

(UML <=
TM)
CONCLUSION: Because the UML of $142,700 is less than the tolerable misstatement of $200,000, the sample results support the conclusion that the book
value is not materially misstated.

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2005, John Wiley and Sons, Inc.

142,700

16-20

16-32. (Estimate Time – 25 Minutes)
Young Computers, Inc
Internal Control Questionnaire - Payroll
Question















Yes

No

Are payroll changes (hires, separations, salary changes, overtime,
bonuses, promotions, etc.) properly authorized and approved?
Are discretionary payroll deductions and withholdings authorized in
writing by employees?
Are the employees who perform each of the following payroll functions
independent of the other functions?
o Personnel and approval of payroll changes.
o Preparation of payroll data.
o Approval of payroll.
o Signing of paychecks.
o Distribution of paychecks.
o Reconciliation of payroll account.
Are changes in standard data on which payroll is based (hires,
separations, salary changes, promotions, deduction and withholding
changes, etc.) promptly input to the system to process the payroll?
Is gross pay determined by using authorized salary rates and time and
attendance records?
Is there a suitable chart of accounts and/or established guidelines for
determining salary account distribution and for recording payroll
withholding liabilities?
Are clerical operations in payroll preparation verified?
Is payroll preparation and recording reviewed by supervisors or internal
audit personnel?
Are payrolls approved by a responsible official before payroll checks are
issued.
Are payrolls disbursed through an imprest account?
Is the payroll bank account reconciled monthly to the general ledger?
Are payroll bank reconciliations properly approved and differences
promptly followed up?
Is the custody and follow-up of unclaimed salary checks assigned to a
responsible official?
Are differences reported by employees followed up on a timely basis by
persons not involved in payroll preparation?
Are there procedures (e.g., tickler files) to assure proper and timely
payment of withholdings to appropriate bodies and to file required
information returns?
Are employee compensation records reconciled to control accounts?
Is access to personnel and payroll records, checks, forms, signature
plates, etc., limited?

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16-21

16-33. (Estimated time - 25 minutes)
a.
There are three basic shortcomings in the payroll procedures currently used at the
Galena plant:
 Actual payroll hours are not approved by production management.
 There is inadequate segregation of duties within the payroll department.
 Personnel department should not have access to payroll checks on a regular basis.
The following corrective action should be taken to improve the internal control of
payroll processing procedures:
 All incoming time cards should be signed by both the employee and supervisor.
 The payroll clerk who prepares the input for data processing should not do the
reconciliation but, rather, a second clerk should reconcile the payroll register to
the time cards.
 An employee of supervisory level should authorize voiding of computergenerated checks and the subsequent preparation of a manual replacement check.
 Replacement checks should be processed following good internal control
procedures.
 All payroll checks, including unsigned replacement checks, should then be given
to the accounting department rather than to the personnel department for storage
in a secure location until payday.
b.

Each of the three basic shortcomings mentioned above could lead to material errors
and irregularities. The inadequate segregation of duties within the payroll department
clearly is a material weakness. The payroll clerk is in a position to submit fictitious
input data and to conceal the irregularities by 'fudging" the reconciliations of the
payroll register.
Furthermore, the procedures over the voiding of computer-generated checks and
issuing of manual replacement checks could result in major irregularities that might
not be detected by others in the normal course of their duties.

16-34. (Estimated time - 25 minutes)
a. Misstatements
Hirings are made by
factory foreman on basis
of interview.

b. Recommended Improvements
A system of advice forms should be installed so that hirings,
terminations, rate changes, etc., are reported to the payroll
department in writing. Such forms should be approved by the
foreman's superior.
The background of
Before an applicant is hired, his or her background should be
applicants is not checked. investigated by contacting references to determine that he or
she is not dishonest and has no other undesirable personal
characteristics.
Rate adjustments are
Rate adjustments should be in writing and signed by both the
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16-22

a. Misstatements
made verbally by
foreman.

b. Recommended Improvements
foreman and a superior or personnel manager.

A supply of blank time
cards is kept near the
entrance.

The supply of blank time cards should be removed. At the
beginning of each week the payroll department should
provide each worker with a time card stamped with the
worker's name.
A time clock should be installed and the workers required to
punch in and out. A responsible employee should be
stationed at the time clock to determine that workers are not
punching the time cards of other workers who may be late or
absent, or who may have left work early.
The foreman should collect the time cards at the end of the
week, approve them, and turn them over to the payroll clerk.
All time cards should be accounted for and any missing
cards investigated.
The payroll clerks' work should be arranged so that they
check each other. Under the existing system of computing
the payroll, the clerk who does not do the original computing
should check the original work of the other clerk. As an
alternative, one clerk may make the original computations
for the full payroll and the other clerk do all the rechecking.
Payroll checks should be prenumbered to control their
issuance.
Employees should only be removed upon written notice
signed by the foreman and personnel manager.

Time worked is penciled
on the time card by each
worker.
Time cards are dropped
in a box at the end of the
week.
Payroll clerks divide the
cards alphabetically and
have full responsibility
for each section.
Payroll checks are
manually numbered.
Employees are
automatically removed
from the payroll when
they fail to turn in a time
card.
Payroll checks are signed
by the chief accountant.
The foreman distributes
the checks.
The foreman arranges
for the distribution
of unclaimed wages.
The payroll bank account

Checks should be signed by the treasurer.
The checks should be distributed by a paymaster or a
responsible person other than the foreman.
Unclaimed wages should be kept by the treasurer
or some other responsible personnel.
The payroll bank account should be independently
reconciled.

is reconciled by the chief
accountant.
16-35. (Estimated time - 25 minutes)
1.

a. Possible Misstatement
Fictitious payroll transactions may be

Solutions Manual to Modern Auditing: Copyright 

b. Possible Test of Controls
Examine authorizations.
2005, John Wiley and Sons, Inc.

16-23

a. Possible Misstatement
recorded.
Fictitious payroll transactions may be
recorded.
Actual payroll transactions may not be
authorized.
Payroll checks may be distributed to
unauthorized recipients.

b. Possible Test of Controls

5.

Payroll checks may be incorrect.

6.

Unclaimed wages may be stolen.

7.

Unauthorized changes may be made to
master files.
Actual payroll transactions may not be
authorized.
Fictitious time data may be processed.
Payroll tax returns may not be filed.

Examine evidence of internal
verifications; reperform verifications.
Observe storage area; inquire about
access.
Observe security over files; inquire about
access.
Examine authorizations and approvals.

2.
3.
4.

8.
9.
10.

Examine evidence of supporting
documentation.
Examine authorizations and approvals.
Witness distribution of checks.

Observe time clock punching procedures.
Inquire of personnel responsible for filing;
examine tax returns.

16-36. (25 minutes)
a.

An important source of information for benchmarking performance in the personnel
services cycle is industry statistics. Often the best industry statistics can be obtained
from trade associations that represent an industry, which often report quite detailed
breakdowns of payroll costs for various industry sectors. Further, many larger
auditing firms develop their own information based on a nationwide or worldwide
database developed from a depth of clients in a particular industry.

b.
Evidence Obtained
During the Audit
Production Cycle
The auditor notes
significant increases in
overhead allocation rates
and observes under
utilization of capacity
The auditor notes a
significant amount of slow
moving inventory.
Personnel Services Cycle
The auditor vouches labor
costs on a test basis and

Audit Objective Satisfied
with the Evidence

Example of How Evidence
Would Support Value-added
Services

Valuation of inventory and
valuation of plant and
equipment (depreciation
rates).

The auditor develops strategies
for more effective utilization of
production facilities or
strategies to dispose of
nonproductive facilities.
The auditor develops strategies
to identify and liquidate slow
moving inventory to speed the
inventory turn cycle.

Valuation of inventory at
net realizable value.

Valuation assertion.

Solutions Manual to Modern Auditing: Copyright 

The auditor identified that
labor costs are increasing faster

2005, John Wiley and Sons, Inc.

16-24

compares labor costs
against industry standards

Solutions Manual to Modern Auditing: Copyright 

than expected for the industry.

2005, John Wiley and Sons, Inc.

16-25

Cases
16-37. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
16-38. (Estimated Time – 2 hours)
Phase I
This case allows the professor to explore the challenges of auditing privately held companies.
While privately held companies do not receive the attention of public companies, they represent a
significant portion of audits performed by CPAs. This case allows students to explore the control
environment issues associated with an owner-managed company with a domineering owner
manager. This case was developed based on an actual case that led to fraudulent financial reporting
in a privately held company.
Question 1: Control Environment Issues
The control environment at CTI is representative of that in a number of owner-managed businesses.
The following issues all represent control environment weaknesses.
o Jessica, the owner-manger, was increasing her intrusion into the company’s financial reporting
process.
o Jessica paid particular attention to accounting results, particularly in the last two quarters of the
year.
o Jessica regularly discussed accounting for particular transactions. Jessica was monitored the
year-end close on a daily basis, to discuss closing entries and their impact on earnings.
o Jessica would override policies and tell someone in account to change a sales invoice to offer a
particular price discount to a customer.
o Jessica would not accept explanations for draft financial statements that showed performance
falling below her expectations.
o Accounting was not a high priority in the company.
o Accounting was understaffed (not allowing for adequate segregation of duties) and everyone
worked long hours.
Question 2: Analytical Procedures
The table below shows an increase in inventory turn days, a decrease in accounts payable turn days,
and a steady gross margin. The gross operating cycle is constant due to the improvement in
accounts receivable turn days. The net operating cycle does not show the same level of
improvement as gross operating cycle due to the decrease in payable turn days. The increase in
inventory turn days indicates that inventory may be overstated. A further risk may be associated
with unrecorded liabilities. The combination may result in an overstatement of net income.

Solutions Manual to Modern Auditing: Copyright 

2005, John Wiley and Sons, Inc.

16-26

Question 3: Risk Assessment
a.

Many of the financial statement level risks that have a pervasive effect on the financial
statements also involve control environment issues. In particular:
o Jessica, the owner-manger, was increasing her intrusion into the company’s financial
reporting process.
o Jessica paid particular attention to accounting results, particularly in the last two quarters
of the year.
o Jessica regularly discussed accounting for particular transactions. Jessica was monitored
the year-end close on a daily basis, to discuss closing entries and their impact on
earnings.
o Jessica had a history of overriding accounting decisions.
o Jessica would not accept explanations for draft financial statements that showed
performance falling below her expectations.
o Accounting was not a high priority in the company.
o Accounting was understaffed (not allowing for adequate segregation of duties) and
everyone worked long hours.

b.

When it comes to incentives and pressures, Jessica put considerable pressure on the
accounting staff to achieve accounting results. In addition, the company had to met
particular debt covenants, and Jessica wanted particular year-end results to support
distribution of earnings to shareholders in a Subchatper S Corporation.
The person who had the opportunity to influence the outcome of the accounting system was
the CFO, Rob Kaiser. There were no controls over Rob’s activities in the financial reporting
process.

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2005, John Wiley and Sons, Inc.

16-27

Rob was under considerable pressure from Jessica to deliver expected results. Jessica’s
intrusion into the financial reporting process lessened only when reported results matched
the owner-manger’s expectations.
Question 4: Management Performance Reviews
Management performance reviews can be effective at identifying misstatements when senior
management encourages representational faithfulness in financial reporting. In these situations
management might review inventory levels or inventory pricing and identify accounting results that
are not consistent with actual experience. These controls do not work well, however, when
management is under considerable pressure to deliver desired results. Hence, management
performance reviews performed by Jessica and Rob would likely not be effective at identifying
financial statement misstatements.
Question 5: Internal Control Recommendations
A number of recommendations can be discussed in this letter, most of which will deal with the
control environment. Students could focus on any of the issues raised in question 1. Following is
an example letter.

Date
To the Board of Directors
Circuits Technology, Inc.
In planning and performing our audit of the financial statements of Circuits Technology, Inc. (CTI)
for the year ended December 31, 2002, we considered its internal control in order to determine our
audit procedures for the purpose of expressing an opinion on the financial statements and not to
provide assurance on internal control. However, we noted certain matter involving the internal
control and its operation that we consider to be reportable conditions under standards established by
the American Institute of Certified Public Accountants. Reportable conditions involve matters
coming to our attention related to significant deficiencies in the design or operation of internal
controls that, in our judgment, could adversely affect the organization’s ability to record, process,
summarize and report financial data consistent with the assertions of management in the financial
statements.
Control Environment
The control environment represents the tone set by management of an organization that influences
the control consciousness of its people. It is important because it represents the foundation for all
other components of internal control, providing discipline and structure. A weak control
environment will lessen the effectiveness of other control activities that may prevent or detect
misstatements on a timely basis.

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16-28

An important aspect of the control environment involves a commitment to competence and
investment in human resource polices that support a sound financial reporting system. In the past
we have noted financial statement misstatements that have resulted from the fact that the account
staff is stretched too thin. This lack of investment in account personnel has also led to a situation
where a good system of checks and balances and segregation of duties cannot be achieved. We
recommend that CTI consider the addition of an additional staff person in accounting during peak
periods to encourage better control activities.
A strong control environment also involves a management philosophy and operating style that
reinforces representational faithfulness in financial reporting. During our audit we noticed several
situations that are considered significant risk indicators including the daily involvement of the
owner-manager in accounting issues associated with the closing process. A sound control
environment delegates a higher degree of responsibility for financial reporting to the accounting
staff and it places a premium on financial reporting that fairly presents underlying results of
operations.
This report is intended solely for the information and use of the Board of Directors of Circuits
Technology, Inc., management and others within the organization and is not intended for any other
purposes. We thank you for the opportunity to continue to be of service to you.
Signature.
Part II.
Question 6. Results of Substantive Tests
a.

If the results of the sample of 35 are representative of the population the project the an
estimated audit value of $ 839,179 based on the calculation below using ratio estimation.
216,295 ÷ 264,705 x 1,027,000 = 839,179.
This represents a potential overstatement of inventory of $187,821. In each instance, the
errors resulted not from errors in counting the quantity of inventory, but they resulted from
errors in pricing inventory.
In addition, payroll costs in the amount of $21,060 were capitalized as part of work in
process inventory when the project was complete and billed to the customer. In total
inventory was overstated, cost of goods sold was understated, and gross margin was
overstated by $208,881. This represents 20% of the book value of inventory and is material.

b.

At a minimum, the auditor should extend the sample for price testing inventory to determine
if the known misstatements are representative of the inventory as a whole. The pricing
errors are extensive and all in the same direction. Given the fraud risk indicators, it is likely
that misstatements are intentional with the intent of overstating inventory to achieve
budgeted results.

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The auditor might want to approach the accounting personnel, and the CFO, with the results and
determine the extent of their involvement with the pricing of inventory. If these pricing
errors and inappropriate capitalization of payroll costs rest solely with the CFO, the auditor
needs to question Rob Kaiser to determine the extent of misstatements in inventory and
other areas. Once presented with the audit evidence, the CFO might admit to his
involvement in financial statement misstatements. If the CFO does not admit to
involvement in the misstatements, the audit needs to be extended to determine the full extent
of the misstatements.
Finally, the auditor should consider the implication for other aspects of the audit. If
evidence suggests that prices and inventory values were changed to hit earnings targets, the
scope of other audit work should also be increased throughout the audit. The auditor might
want to suggest that management hire a forensic auditor to perform a fraud audit to
determine the extent of misstatements in the financial statements.
Question 7. Draft Management Letter Comments
Following is a draft of a management letter comment that should be discussed with the board of
directors. This comment is drafted based on the audit evidence alone.
During the audit we found evidence of overstatements of inventory by the Chief Financial
Officer in order to overstate gross margins with the purpose of achieving desired financial
results. In a sample of 35 items we found 17 items with pricing errors, all of which resulted
in the overpricing of the value of inventory. In addition, we found evidence of inappropriate
capitalization of payroll costs as part of work in process inventory. In total, we estimate
that inventory values presented for audit were overstated by almost $210,000 (or 20% of the
value of inventory). Due to the extensiveness of the misstatements, 17 out of 35 items
sampled, we recommend retesting the entire inventory for pricing errors.
If Rob Kaiser admits to his involvement in overstating inventory, this should also be discussed with
the board of directors. The auditor needs to recommend (1) changes in the control environment that
led to the fraudulent financial reporting and (2) replacement of the CFO.
Question 8. Discussion with First State Bank
The auditor cannot have any conversations with the bank about the potential fraud or financial
statement misstatements due to ethical rules on confidential client information. If CTI corrects the
financial statements, the First State Bank will get financial statements that present fairly in all
material respects.
If the corrected financial statements disclose violations of debt covenants, the client should
approach First State Bank about the potential violations of debt covenants and ask the Bank to
waive the violations. If the bank is unwilling to waive the debt covenant violations, the auditor
needs to consider whether long-term debt to the bank should be reclassified as current before
issuing an opinion on the financial statements.

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Professional Simulation
Payroll
Controls
Research
Situation

Inventory
Audit
Procedures

The suggested evaluation of the system of internal controls presented above is included in the
following table.
Assertion
Existence and
Occurrence

Adequacy of Controls
Controls are sufficient

A significant deficiency exits 

Recommend Improvements for Significant
Deficiencies
Time cards should be preprinted and/or prepunched
and prenumbered.
Foreman should approve (sign) all time cards and job
tickets.
Paychecks should not be distributed by foremen. They
should be mailed directly to the employee, or
distributed by the internal audit staff or by authorized
treasurer's office personnel not involved in preparing
or recording the payroll.

Completeness

Valuation and
Allocation

Controls are sufficient
A significant deficiency exits

Controls are sufficient
A significant deficiency exits

Operators should not be allowed to make data changes
at the console, the console log should be reviewed
regularly for operator interruptions and the
programming and operator functions should be
separated.
Implement programmed batch controls; e.g., hash
total of employee number and record count. The
payroll record count should be compared with the
number of timecards processed.
A limit test should be incorporated into the program to
halt the processing of any employee record whose
labor hours exceed 60; a listing of all exceptions
would be prepared for review to determine if the
hours were right or needed to be corrected.
A limit test should be incorporated into the program to
halt the processing of any employee's records
whenever the gross wages exceed $300 per week; a
listing of all exceptions would be prepared for review
to determine if the amounts were accurate or needed
to be corrected.

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Research
Situation

Payroll
Controls

Inventory
Audit
Procedures

The issues associated with the client’s use of statistical sampling to determine inventory quantities
is addressed in AU 331.11 which is stated below.
.11 In recent years, some companies have developed inventory controls or methods of determining
inventories, including statistical sampling, which are highly effective in determining inventory
quantities and which are sufficiently reliable to make unnecessary an annual physical count of
each item of inventory. In such circumstances, the independent auditor must satisfy himself that
the client's procedures or methods are sufficiently reliable to produce results substantially the
same as those which would be obtained by a count of all items each year. The auditor must be
present to observe such counts as he deems necessary and must satisfy himself as to the
effectiveness of the counting procedures used. If statistical sampling methods are used by the
client in the taking of the physical inventory, the auditor must be satisfied that the sampling plan
is reasonable and statistically valid, that it has been properly applied, and that the results are
reasonable in the circumstances. [Revised, June 1981, to reflect conforming changes necessary
due to the issuance of Statement on Auditing Standards No. 39.]
Inventory
Audit
Procedures
Situation

Payroll
Controls

Research

Audit procedure
A. Understand the key economic drivers that influence the entity’s cost of sales, gross margins and
the possibility of obsolete inventory.
B. On a test basis, trace data from purchases, manufacturing, completed production, and sales
records to inventory accounts.
C. Vouch the items on the final inventory listing to inventory tags, count sheets and test counts
taken during the inventory observation.
D. Trace test counts taken during the inventory observation to the final inventory listing.
E. Examine sales invoices after year-end and determine the net realizable value of inventory.
F. Confirm inventories at locations outside the entity.
G. Based on test of beginning inventory, production costs, and ending inventory, determine the
appropriateness of cost of goods sold.
H. Confirm agreements for assigning and pledging inventories.
I. Examine vendors paid invoices for purchased inventory prior to year-end.
J. Evaluate the completeness of presentation of disclosures to determine conformity with GAAP
by reference to a disclosure checklist.
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Determine the audit procedure that best addresses the following risks.
1.
2.
3.
4.
5.

Risk
Inventory that was counted and on hand at year-end
may not be included in the final inventory listing.
Inventory quantities may be correct, but inventory
may be incorrectly valued at FIFO.
Inventory that is said to be on hand in a public
warehouse may not exist.
Inventory may have to be sold at a loss in order to
move inventory.
All manufacturing costs may not be included in the
underlying accounting records supporting costs of
sales.

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(A) (B) (C) (D) (E) (F) (G) (H) (I) (J)

 

 

 

 

 

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