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Chapter 09 Production Cycle

Learning Objectives
1. 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. 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.

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


Inherent Risks in Production Cycle

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


Typical Activities
Production plan

Bill of materials Requisitions

Cost Accounting
Standard costs Overhead allocation


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. All inventory items should be accounted for Used in production Scrap Returned to inventory
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


Production Cycle: Control Procedures

Physical Controls
Production Order and Materials Requisition. Physical inventories reconciled to perpetual inventory records. Restrict access to inventories Transfer Tickets Authorization Recording Custody Reconciliation

Separation of Duties

Performance Reviews
Scrap reports Variance analysis


Management Reports
Sales Forecasts Inventory reports
Items on hand

Open purchase orders Production plans and reports


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

Substantive Procedures
Observation of inventory count Tests of pricing and compilation Analytical procedures Excessive inventory Slow moving inventory


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 331.12). Usually make test counts at a time other than year-end. test roll-forward or roll-back
Review client instructions Stop flow of goods
From INVENTORY LISTING From WAREHOUSE FLOOR Record some counts in working papers


Client Count Instructions

Names and dates Instructions for descriptions and counts Noting obsolete or worn items Tag controlcompilation of counts Shutting down production Controlling inventory movement including shipping and receiving Supervisory approval Making changes and corrections

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.


Inventory Count and Measurement Challenges

Examples Lumber Piles of sugar, coal, scrap steel Items weighed on scales Bulk materials (oil, grain, liquids in storage tanks) Diamonds, jewelry Pulp wood Challenges/ Special procedures. Problem identifying quality or grade. /Employ a specialist Geometric computations, aerial photos./ Employ a specialist Accuracy of scales./Examine certification. Measuring volume, ensuring composition of content/Climb the tanks Dip measuring rods. Sample for assay or chemical analysis. Identification and quality determination problems/ Hire a specialist. Quantity measurement estimation/Examine aerial photos.


Movement not controllable/Use chutes to control animals.


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

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


Analytic Procedures
Gross Profit Margin Compare to prior year, industry averages

Verify REASONABLENESS of ending inventory

Days Sales in Inventory Inventory Turnover


Fraud Red Flags

Uncontrolled access to inventory Many high-dollar items with market value (i.e. salable on eBay?) Unpredictable counts during inventory Large differences between counts and inventory records. Inventory shows signs of damage, obsolescence or excess quantities. Unusual interplant transfers during physical inventory or at yearend. Reluctance of client to move merchandise to allow inspection of additional items located behind.