Chapter 09

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

9-1

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.
9-2

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.

9-3

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

9-4

Typical Activities
Planning
Production plan

Production
Bill of materials
Requisitions

Cost Accounting
Standard costs
Overhead allocation

9-5

Exhibit 9.3
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.
All inventory items should be accounted for
Used in production
Scrap
Returned to inventory
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

Open purchase orders

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 tickets

Check proper authorizations

Examine review of cost reports
9-11

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

9-12

Physical Inventory
Observation
Auditors are required to make, or observe, some
physical counts of the inventory and apply
appropriate tests of intervening transactions.
Usually make test counts at a time other than yearend.
test roll-forward or roll-back

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 or team number and dates

Instructions for descriptions and counts
Noting obsolete or damaged items
Tag controlcompilation of counts
Shutting down production
Controlling inventory movement including
shipping and receiving
Supervisory approval
Making changes and corrections
9-15

Exhibit 9.8
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,

liquids in storage tanks)

Measuring volume, ensuring composition of content/Climb the

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, competitors, or industry
averages

Verify REASONABLENESS of ending inventory

Days Sales in Inventory
Inventory Turnover

9-21

Fraud Red Flags

Uncontrolled access to inventory
Many high-dollar items with market value (i.e. salable on
eBay?)
Unexspected 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.

9-22