9-1 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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

9-2 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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 investigation procedures for detecting them.

9-3 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Production and Payroll (Conversion) Cycle Concerned with the production/manufacture of the organization's inventory.

9-4 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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.

9-5 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Inherent Risks in Production Cycle Complexity (e.g. dollar value LIFO) Susceptibility to theft Lower-of-Cost-or-Market valuation Effects on gross profits

9-6 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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.

9-7 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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

9-8 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Exhibit 9.1

9-9 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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

9-10 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Management Reports Sales Forecasts Inventory reports Production plans and reports

9-11 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Substantive Procedures Observation of inventory count Tests of pricing and compilation Analytical procedures

9-12 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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 ). May make test counts at a time other than year-end. –test roll-forward.

9-13 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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

9-14 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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.

9-15 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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

9-16 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Purchase Cutoffs Verify CUT-OFFs for purchases –Examine Receiving Reports and Vendor Sales Invoices occurring around year-end.

9-17 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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

9-18 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved. 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.