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 Balances
Related 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 Transactions
The 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 Objectives
Testing 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 Detail
Assertion Transaction Class Audit Account Balance Audit
Category Objective Objectives
Existence or Recorded manufacturing Inventories included in the
occurrence transactions represent balance sheet physically
materials, labor, and overhead exist.
transferred to production and Cost of goods sold
the movement of completed represents the cost of goods
production to finished goods shipped (sold) during the
during the current period. period.
Completeness All manufacturing transactions Inventories include all
that occurred during the period materials, products, and
have been recorded. supplies on hand at the
balance sheet date.
Cost of goods sold includes
the effects of all sales
transactions during the
period.
 Audit Objectives in Detail
Assertion Transaction Class Audit Account Balance Audit
Category Objective Objectives
Rights and The entity has rights to the The reporting entity has
obligations inventories resulting from legal title to the inventories
recorded manufacturing at the balance sheet date.
transactions.
Valuation or Manufacturing transactions Inventories are properly
allocation are correctly journalized, stated at the lower of cost
summarized, and posted. or market.
Cost of goods sold is
based on the consistent
application of an
acceptable cost flow
method or methods.
 Audit Objectives in Detail
Assertion Transaction Class Audit Account Balance Audit
Category Objective Objectives
Presentation The details of Inventories and cost of
and manufacturing transactions goods sold are properly
disclosure support their presentation in identified and classified
the financial statements in the financial
including their classification statements.
and disclosure. Disclosures pertaining to
basis of valuation and
the pledging or
assignment of
inventories are
adequate.
 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.
 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 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.
 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.
 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.
Common Documents and Records
1. 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 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,
 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.
 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.
 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.
 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.
 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 Inventory
Tests 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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Thank You