Chapter 9

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 ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objectives • Describe the production cycle, including typical source documents and controls. • Give examples of tests of controls for auditing the controls over conversion of materials and labor in a production process. • Identify and describe considerations involved in the observation of physical inventory and tests of inventory pricing and compilation. • Describe some common errors and frauds in the accounting for production costs and related cost of goods sold, and design some audit and investigation procedures for detecting them. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

3. Production and Payroll (Conversion) Cycle • Concerned with the production/manufacture of the organization's inventory. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

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. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

5. Inherent Risks in Production Cycle • Complexity (e.g. dollar value LIFO) • Susceptibility to theft • Lower-of-Cost-or-Market valuation • Effects on gross profits ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

6. Production Cycle: Typical Activities • Production runs are authorized. • Raw Materials should be counted, and inspected • As production is undertaken, materials and labor quantities should be summarized. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

7. Production Cycle: Typical Activities • Use Of TRANSFER TICKET • 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 ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

8. Exhibit 9.1 ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

9. Production Cycle: Control Procedures • Physical Controls • Production Order and Materials Requisition. • Physical inventories reconciled to perpetual inventory records. • Restrict access to inventories • Transfer Tickets • Segregation of Duties • Authorization • Recording • Custody • Reconciliation • Performance Reviews ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

10. Management Reports • Sales Forecasts • Inventory reports • Production plans and reports ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

11. Substantive Procedures • Observation of inventory count • Tests of pricing and compilation • Analytical procedures ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

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. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

13. 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 ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

14. 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. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

15. 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 ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

16. Purchase Cutoffs • Verify CUT-OFFs for purchases • Examine Receiving Reports and Vendor Sales Invoices occurring around year-end. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

17. 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 ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

18. 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. ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.