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Chapter 9

Chapter 9. Production and Payroll 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. Learning Objectives.

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Chapter 9

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  1. Chapter 9 Production and Payroll 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

  2. Learning Objectives • Describe the production cycle, including typical source documents and controls. • Identify and describe considerations involved in the observation of physical inventory and tests of inventory pricing and compilation. • Describe some common errors and frauds and design some audit and investigation procedures for detecting them. • Describe some common errors and frauds in payroll, and design some audit and investigation procedures for detecting them.

  3. Production and Payroll (Conversion) Cycle • Concerned with the production/manufacture of the organization's inventory.

  4. 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.

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

  6. Exhibit 9.1

  7. Substantive Procedures • Observation of inventory count • Tests of pricing and compilation • Analytical procedures

  8. 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. Physical Inventory Observation • Review client instructions • Stop flow of goods • Make TEST COUNTS • From INVENTORY LISTING, • From WAREHOUSE FLOOR • Record all counts in working papers

  10. Physical Inventory Observation • Control tags or count sheets • 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.

  11. 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

  12. Purchase Cutoffs • Verify CUT-OFFs for purchases • Examine Receiving Reports and Vendor Sales Invoices occurring around year-end.

  13. 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

  14. 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.

  15. Payroll • Often processed by service bureaus • Balance sheet accounts usually small. • Rely on tests of controls/substantive tests of transactions.

  16. Inherent Risks in the Payroll Subcycle • Ghost employees • Overpaying for time or production • Incorrect accounting (classification)

  17. Payroll Subcycle: Control Activities • Physical Controls • Payroll Checks and signature plates kept in a secure location • Payroll Checks distributed by a person not involved in processing or recording payroll • Payroll Checks distributed to individuals with proper identification • Unclaimed Payroll Checks stored in a secure location • Segregation of Duties • The Personnel Department and the Hiring/Employing Department AUTHORIZE payroll transactions and payroll-related changes. • Payroll is RECORDED by the Payroll Department and General Accounting • The Cash Disbursements Department/Treasurer has CUSTODY of the Payroll Checks • Performance Reviews • Payroll transaction data compared to prior-year data or budgeted/expected data. • Review of Payroll Register for reasonableness • Reconcile the Payroll bank account

  18. Exhibit 9.7

  19. Payroll Subcycle: Management Reports and Files • Personnel files • Payroll register • Labor cost analysis • Clearing accounts • Government and tax reports • Year-to-date earnings records

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