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.

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.

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Inherent Risks in Production Cycle

• Complexity (e.g. dollar value LIFO)

• Susceptibility to theft

• Lower-of-Cost-or-Market valuation

• Effects on gross profits

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Typical Activities

• Planning– Production plan

• Production– Bill of materials– Requisitions

• Cost Accounting– Standard costs– Overhead allocation

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Exhibit 9.2Production Cycle

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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.

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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

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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

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Management Reports

• Sales Forecasts

• Inventory reports– Items on hand

• Production plans and reports

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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

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Substantive Procedures

• Observation of inventory count

• Tests of pricing and compilation

• Analytical procedures

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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.

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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

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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

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Exhibit 9.7Inventory Count Sheet

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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.

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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.

Inventory Count and Measurement Challenges

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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

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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

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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

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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.

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