Auditing the Production Cycle

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Auditing the Production Cycle
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Transactions

• Production cycle relates to production activities
  or transactions of converting raw material into
  finished. The transactions includes
• The use of raw material costs
• The use of direct labor costs
• The use of factory overhead costs
• Common terms
• Raw material direct labor prime costs
• Direct labor FOC conversion costs

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Accounts Balances

• Related accounts balances
• Raw material inventory
• Salary and wages
• All accounts include as factory overhead costs.
• 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

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Interfaces Transactions

• The production cycle interfaces with
• Expenditures cycle on preparing raw material
  and FOC.
• HRM payroll cycle on preparing human
  resources for production.
• Investing cycle on providing facilities for
  production.
• Revenue cycle on providing information of
  customer demand or order.

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Audit Objectives

• Testing the fairness of management assertion
  relates to production cycle, they are
• The usage of raw material costs
• The usage of labor costs
• The usage of FOC
• The WIP inventory
• The finished goods inventory
• The cost of goods sold

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Audit Objectives in Detail
Assertion 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.
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Audit Objectives in Detail
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.
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Audit Objectives in Detail
Assertion 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.
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Inherent Risks

1. 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.

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Inherent Risks

1. The wide diversity of inventory items sometimes
   requires the use of special procedures to
   determine inventory quantities and estimation of
   quantities by experts.
2. 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.

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Inherent Risks

• The wide diversity of inventory items may present
  special problems in determining their quantity
  and market value.
• 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.
• Inventory may be sold subject to right of return
  and repurchase agreements.

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Analytical Procedures

• Analytical 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 significant
• Prior 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.

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Analytical Procedures

• Inventory growth to cost of sales growths
• ((inventory n Inventory n-1) 1) ((cost of
  sales n cost of sales n-2) 1
• Audit significant
• Ratio 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
  quantities
• Audit significant
• Useful in estimating the efficiency of the
  manufacturing process. May be helpful in
  evaluating the reasonableness of production costs.

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Analytical Procedures

• Finished goods produced to direct labor
• Finished goods quantities direct labor hours
• Audit significant
• Useful in estimating the efficiency of the
  manufacturing process. May be helpful in
  evaluating the reasonableness of production costs
  
• Product defects per million
• Number of product defects as a percent of each
  million produced.
• Audit significant
• Useful in estimating the effectiveness of the
  manufacturing process. May be helpful in
  evaluating the reasonableness of production costs
  and warranty expenses.

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Common Documents and Records

• 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.
• Material requirements report. Listing of raw
  materials and parts needed to fill a production
  order.
• Material issue slip. Written authorization from a
  production department for stores to release
  materials for use on an approved production
  order.
• Time ticket. Record of time worked by an employee
  on a specific job.

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Common Documents and Records

• Move ticket. Notice authorizing the physical
  movement of work in process between production
  departments, and between work in process and
  finished goods.
• Daily production activity report. Report showing
  raw materials and labor used during the day.
• Completed production report. Report showing that
  work has been completed on a production order.
• Inventory subsidiary ledgers or master file
  (perpetual inventory records). Records maintained
  separately for raw materials, work in process,
  and finished goods.
• Standard cost master file. A computer file
  contains standard costs.

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Common Documents and Records

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

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Manufacturing Functions

• Initiating Production (a) planning and
  controlling production, (b) issuing raw
  materials.
• Movement of goods (a) processing goods in
  production, (b) transferring completed work to
  finished goods, (c) protecting inventories.
• Recording manufacturing and inventory
  transactions (a) determining and recording
  manufacturing costs, (b) maintaining correctness
  of inventory balances.

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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.

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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,

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Control Risks

• Movement 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,

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Control Risks

• Movement 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
  Transactions
• Determining 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.

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Control Risks

• Recording 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.

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Control Risks

• Recording 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.

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Control Risks

• Recording 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.

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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
  years 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.

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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.

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Substantive Tests of Inventory

• Tests of Details of Transactions
• On a test basis, vouch entries in inventory
  accounts to supporting documentation (e.g.
  vendors 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).

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Substantive Tests of Inventory

• Test of Details of Balances
• Observe clients physical inventory count
• Decide on timing and extent of test.
• Evaluate adequacy of clients inventory taking
  plans.
• Observe care taken in clients 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.

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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.

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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.

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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 entitys current sales
  catalog and sales reports.
• Inquire about slow-moving, excess, or obsolete
  inventories and determine need for write-down.
• Evaluate managements process for estimating the
  net realizable value of inventory using
  hindsight.

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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.

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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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Thank You