Auditing the Production Cycle

Transactions

Production cycle relates to production activities or transactions of converting raw material into finished. The transactions includes:

1.The use of raw material costs

2.The use of direct labor costs

3.The use of factory overhead costs

Common terms:

•Raw material & direct labor = prime costs

•Direct labor & FOC = conversion costs

Accounts BalancesRelated accounts balances:

1. Raw material inventory

2. Salary and wages

3. All accounts include as factory overhead costs.

4. WIP (Work in Process) WIP – Raw Materials WIP – Direct Labor Costs WIP – Factory Overhead Costs

5. WIP – Inventory

6. Finished Goods Inventory

7. Cost of Goods Sold

Interfaces TransactionsThe production cycle interfaces with:

1. Expenditures cycle – on preparing raw material and FOC.

2. HRM & payroll cycle – on preparing human resources for production.

3. Investing cycle – on providing facilities for production.

4. Revenue cycle – on providing information of customer demand or order.

Audit ObjectivesTesting the fairness of management assertion relates to production cycle, they are:

1.The usage of raw material costs

2.The usage of labor costs

3.The usage of FOC

4.The WIP inventory

5.The finished goods inventory

6.The cost of goods sold

Audit Objectives in DetailAssertion Category

Transaction Class Audit Objective

Account Balance Audit Objectives

Existence or occurrence

Recorded manufacturing transactions represent materials, labor, and overhead transferred to production and the movement of completed production to finished goods during the current period.

Inventories included in the balance sheet physically exist.Cost of goods sold represents the cost of goods shipped (sold) during the period.

Completeness All manufacturing transactions that occurred during the period have been recorded.

Inventories include all materials, products, and supplies on hand at the balance sheet date. Cost of goods sold includes the effects of all sales transactions during the period.

Assertion Category

Transaction Class Audit Objective

Account Balance Audit Objectives

Rights and obligations

The entity has rights to the inventories resulting from recorded manufacturing transactions.

The reporting entity has legal title to the inventories at the balance sheet date.

Valuation or allocation

Manufacturing transactions are correctly journalized, summarized, and posted.

Inventories are properly stated at the lower of cost or market.Cost of goods sold is based on the consistent application of an acceptable cost flow method or methods.

Audit Objectives in Detail

Audit Objectives in DetailAssertion Category

Transaction Class Audit Objective

Account Balance Audit Objectives

Presentation and disclosure

The details of manufacturing transactions support their presentation in the financial statements including their classification and disclosure.

Inventories and cost of goods sold are properly identified and classified in the financial statements.Disclosures pertaining to basis of valuation and the pledging or assignment of inventories are adequate.

Inherent Risks1. The volume of purchases, manufacturing, and

sales transactions that affects these accounts is generally high, increasing the opportunities for misstatements to occur.

2. Contentious issues surrounding the identification, measurement, and allocation of inventory-able costs such as indirect materials, labor, and manufacturing overhead, joint product costs, and the disposition of cost variances, accounting for scarp, and other accounting issues.

Inherent Risks

3. The wide diversity of inventory items sometimes requires the use of special procedures to determine inventory quantities and estimation of quantities by experts.

4. Inventories are often stored at multiple sites, adding to the difficulties associated with maintaining physical controls over theft and damages, and properly accounting for goods in transit between sites.

Inherent Risks

5. The wide diversity of inventory items may present special problems in determining their quantity and market value.

6. Inventories are vulnerable to spoilage, obsolescence, and other factors such as general economic conditions that may affect demand and salability, and thus the proper valuation of the inventories.

7. Inventory may be sold subject to right of return and repurchase agreements.

Analytical ProceduresAnalytical procedures useful to test the potential misstatement. The following are the alternatives of ratio analysis:Inventory turn days

Avg. inventory payable : cost of goods sold x 365

Audit significantPrior experience in inventory turn days combined

with knowledge of cost of sales can be useful in estimating current inventory levels. A lengthening of the period may indicate existence problems, or lower of cost or market problems.

Analytical ProceduresInventory growth to cost of sales growths

((inventory n : Inventory n-1) – 1) : ((cost of sales n : cost of sales n-2) – 1

Audit significantRatio larger than 1.0 indicate that inventories are

growing faster than sales. Large ratios may indicate possible inventory obsolescence problems.Finished goods produced to raw material used

Finished goods quantities : raw material quantitiesAudit significant Useful in estimating the efficiency of the manufacturing

process. May be helpful in evaluating the reasonableness of production costs.

Analytical ProceduresFinished goods produced to direct labor

Finished goods quantities : direct labor hoursAudit significantUseful in estimating the efficiency of the manufacturing

process. May be helpful in evaluating the reasonableness of production costs

Product defects per millionNumber of product defects as a percent of each million

produced.Audit significantUseful in estimating the effectiveness of the manufacturing

process. May be helpful in evaluating the reasonableness of production costs and warranty expenses.

Common Documents and Records1. Production order. Form indicating the quantity and

kind of goods to be manufactured. An order may pertain to a job order or a continuous process.

2. Material requirements report. Listing of raw materials and parts needed to fill a production order.

3. Material issue slip. Written authorization from a production department for stores to release materials for use on an approved production order.

4. Time ticket. Record of time worked by an employee on a specific job.

Common Documents and Records

5. Move ticket. Notice authorizing the physical movement of work in process between production departments, and between work in process and finished goods.

6. Daily production activity report. Report showing raw materials and labor used during the day.

7. Completed production report. Report showing that work has been completed on a production order.

8. Inventory subsidiary ledgers or master file (perpetual inventory records). Records maintained separately for raw materials, work in process, and finished goods.

9. Standard cost master file. A computer file contains standard costs.

Common Documents and Records

10. Raw materials inventory master file. A computer file with the quantities of raw materials inventory on hand.

11. Work-in-process inventory master file. A computer file contains the sum of actual work-in-process costs. The file is used to prepare the daily production report.

12. Finished goods inventory master file. A computer file that contains the sum total of production costs. It may be used as a perpetual inventory for finished goods.

Manufacturing Functions

1. Initiating Production: (a) planning and controlling production, (b) issuing raw materials.

2. Movement of goods: (a) processing goods in production, (b) transferring completed work to finished goods, (c) protecting inventories.

3. Recording manufacturing and inventory transactions: (a) determining and recording manufacturing costs, (b) maintaining correctness of inventory balances.

Control Risks

Initiating Production• Planning and controlling production, risk, Excessive

production may be ordered, control, Approval of production orders in production planning and control.

• Issuing raw materials, risk, unauthorized use of raw materials, control, Signed materials issue slips for approved production orders are required for all materials released to production, and/or Computer accounts for prenumbered materials issues slips and reconciles slips with recording in daily production reports.

Control Risks

Movement of Goods• Processing goods in production, risk, direct labor

hours may not be charged to production orders, control, computer compares production hours (or time tickets) to record direct labor hours on daily production reports, and/or Computer accounts for hours worked and hours charged to daily production reports.

• Transferring completed work to finished goods inventory, risk, finished goods personnel may claim goods were not received from production,

Control RisksMovement of Goods• control, Signature of finished goods warehouse

personnel on final move ticket on receipt of goods, and/or, computer accounts for inventory move tickets and reconciles with recording on completed production report

• Protecting inventories, risk, inventories may be stolen from the warehouse, control, Use of locked warehouse with access restricted to authorized personnel only, risk, WIP may be stolen or misrouted during production, control, use of plant surveillance personnel, control, Use of plant surveillance personnel,

Control RisksMovement of Goods

and/or, Signed inventory move tickets to control movement of goods through production department, with tickets reconciled to daily production reports and completed production reports.

Recording Manufacturing and Inventory TransactionsDetermining and recording manufacturing costs– Risk, manufacturing costs may be recorded in incorrect

amounts, control, use of chart of accounts; timely reporting of manufacturing cost data for management performance reviews including budget comparisons.

Control RisksRecording Manufacturing and Inventory Transactions

– Risk, direct manufacturing costs allocated to WIP may not be recorded or recorded at incorrect amounts, control, computer compares daily production report data with underlying source documents (inventory move tickets and time cards).

– Risk, inappropriate overhead rates or standard costs may be used, control, management approval of overhead rates and standard costs; timely reporting of manufacturing cost data for management performance reviews and investigation of variances.

– Risk, cost of completed production may not be transferred to completed goods or transferred in incorrect amounts.

Control RisksRecording Manufacturing and Inventory Transactions

control, Computer compares completed production report data with underlying source documents (inventory move tickets and time cards).

• Maintaining the correctness of inventory balances: – Risk, Recorded inventory quantities may not

agree with inventory-owned quantities on hand, control, periodic independent counts of inventories; comparison with records of amounts and ownership.

Control RisksRecording Manufacturing and Inventory Transactions

– Risk, inventory carrying values in subsidiary ledgers or master files may not agree with control accounts, control, Computer checks on agreement of subsidiary records and control accounts.

– Risk, inventories may be carried at amounts in excess of market values, control, periodic inspection of inventory condition; periodic inventory activity reports for management performance reviews.

– Risk, management of inventory may not be held accountably, resulting in a variety of misstatements in the financial statements, control, an appropriate level of management monitors the level of production, production costs, and the reasonableness of inventory levels relative to sales volume.

Substantive Tests of Inventory

Initial Procedures• Perform initial procedures on inventory balances and

records that will be subjected to further testing:– Trace beginning inventory balances to prior year’s

working papers.– Review activity in inventory accounts and

investigate entries that appear unusual in amount or source.

– Verify totals of perpetual records and other inventory schedules and their agreement with ending general ledger balances.

Substantive Tests of Inventory

Analytical Procedures• Perform analytical procedures:

– Review industry experience and trends.– Examine an analysis of inventory

turnover.– Review relationships of inventory

balances to recent purchasing, production, and sales activities.

– Compare inventory balances to anticipated sales volume.

Substantive Tests of InventoryTests of Details of Transactions• On a test basis, vouch entries in inventory accounts

to supporting documentation (e.g. vendor’s invoices, manufacturing cost records, completed production reports, and sales and sales returns records).

• On a test basis, trace data from purchases, manufacturing, completed production, and sales records to inventory accounts.

• Test cut-off of purchases and sales returns (receiving), movement of goods through manufacturing departments (routing), and sales (shipping).

Substantive Tests of Inventory

Test of Details of Balances• Observe client’s physical inventory count:

– Decide on timing and extent of test.– Evaluate adequacy of client’s inventory taking

plans.– Observe care taken in client’s counts and make

test counts.– Look for indications of slow-moving, damaged, or

obsolete inventory.– Account for all inventory tags and count sheets

used in physical count.

Substantive Tests of Inventory

Test of Details of Balances• Test clerical accuracy of inventory listings:

– Recalculate totals and extensions of quantities times unit prices.

– Trace test counts (from item 6.c.) to listings.– Vouch items on listings to inventory tags

and count sheets.– Reconcile physical counts to perpetual

records and general ledger balances and review adjusting entries.

Substantive Tests of Inventory

Test of Details of Balances• Test inventory pricing:

– Examine vendors’ paid invoices for purchased inventories.

– Examine propriety of direct labor and overhead rates, standard costs, and disposition of variances pertaining to manufactured inventories.

• Confirm inventories at locations outside the entity.

• Examine consignment agreements and contracts.

Substantive Tests of Inventory

Tests of Details of Balances: Accounting Estimates•Evaluate the net realizable value of inventory:

– Examine sales invoices after year-end and perform lower-of-cost-or-market test.

– Compare inventories with entity’s current sales catalog and sales reports.

– Inquire about slow-moving, excess, or obsolete inventories and determine need for write-down.

– Evaluate management’s process for estimating the net realizable value of inventory using hindsight.

Substantive Tests of Inventory

Tests of Details of Balances: Accounting Estimates

– Evaluate the net realizable value of inventory given information about: industry trends, inventory turnover trends, and specific slow-moving inventory.

Mandatory Procedures•Observation of physical inventory count included as step 6 above.

Substantive Tests of Inventory

Presentation and Disclosure• Compare statement presentation with GAAP:

– Confirm agreements for assignment and pledging of inventories.

– Review presentation and disclosures for inventories in drafts of financial statements and determine conformity with GAAP.

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