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 .
 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.
 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
 9-4

Typical Activities
• Planning
– Production plan
• Production
– Bill of materials
– Requisitions
• Cost Accounting
– Standard costs
– Overhead allocation
 9-5
Exhibit 9.2
Production Cycle
 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.
 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
 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
 9-9

Management Reports
• Sales Forecasts
• Inventory reports
– Items on hand
• Production plans and reports
 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
 9-11

Substantive Procedures

• Observation of inventory count

• Tests of pricing and compilation
• Analytical procedures
 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 331.12).
• May make test counts at a time other than year-end.
– test roll-forward.
 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
 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
 9-15
Exhibit 9.7
Inventory Count Sheet
 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.
 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, Measuring volume, ensuring composition of content/Climb the
liquids in storage tanks) 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.
 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
 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
 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
 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.