CHAPTER 16

AUDIT THE PRODUCTION AND PERSONNEL

SERVICES CYCLE
Learning Check
16-1. a. The production cycle relates to the conversion of raw materials into finished goods, and
includes production planning and control of the types and quantities of goods to be
manufactured, the inventory levels to be maintained, and the transactions and events
pertaining to the manufacturing process.
b. The major transaction class within this cycle is manufacturing transactions.
c. The production cycle interfaces with (1 the e!penditure cycle through the purchase of raw
materials and incurrence of various overhead costs, (" the personnel services cycle through
the incurrence of factory labor costs, and (# the revenue cycle through the sale of finished goods.
16-". a. The transaction class audit objectives for the production cycle are$
Occurrence. %ecorded manufacturing transactions represent material, labor, and overhead transferred to
production and the movement to completed production to finished goods during the current period (EO1.
%ecorded cost of sales represent the sale of inventory during the year (EO2.
Completeness. &ll manufacturing transactions (C1 and cost of sales (C2 that occurred during the period
were recorded.
Accuracy. 'anufacturing transactions (VA1 and cost of sales (VA2 are accurately valued using (&&)
and correctly journali*ed, summari*ed and posted.
Cutoff. &ll manufacturing transactions (EO1 and C1) and cost of sales (EO2 and C2) have been
recorded in the correct accounting period.
Classification. &ll manufacturing transactions (!1) and cost of sales (!2) have been recorded in the
proper accounts.
b. +everal account balance audit objectives for the production cycle are$
E"istence. ,nventories included in the balance sheet physically e!ist (EO#.
Completeness. ,nventories include all materials, products and supplies on hand at the balance sheet date
(C#.
$ights and O%ligations. The reporting entity has legal title to recorded inventories at the balance sheet
date ($O1.
Valuation and Allocation. ,nventories costing assumptions have been properly applied (-&# and
inventories are properly stated at the lower of cost or mar.et (-&/.
16-#. a. ,n a manufacturing company, inventories and cost of goods sold are usually significant to the
company0s financial position and results of operations. 1urther, due to the cost of observing
inventory the auditor will normally allocate a significant amount of overall materiality o the
audit of inventory, without e!ceeding an amount that the auditor believes will affect the
analysis of a financial statement user.
b. +everal factors that affect inherent ris. for assertions related to the production cycle are$
The volume of purchases, manufacturing, and sales transactions that affects these accounts
is generally high, increasing the opportunities for misstatements to occur.
There are often contentious issues surrounding the identification, measurement, and
allocation of inventoriable costs such as indirect materials, labor, and manufacturing
overhead, joint product costs, the disposition of cost variances, accounting for scrap, and
other cost accounting issues.
The wide diversity of inventory items sometimes requires the use of special procedures to
determine inventory quantities, such as geometric volume measurements of stoc.piles,
aerial photography, and estimation of quantities by e!perts.
,nventories are often stored at multiple sites, adding to the difficulties associated with
maintaining physical controls over theft and damage, and properly accounting for goods in
transit between sites.
The wide diversity of inventory items may present special problems in determining their
quality and mar.et value.
,nventories 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.
,nventories may be sold subject to right of return and repurchase agreements.
c. 1ollowing are several e!amples of analytical procedures and a description of how they might
assist the auditor when auditing the production cycle.
Ratio Formula Audit Signii!an!"
Inventory Turn Days Avg. Inventory Cost of Good
Sold x 365
Prior experience in inventory turn
days co!ined "it# $no"ledge of
cost of sales can !e useful in
estiating current inventory levels. A
lengt#ening of t#e period ay indicate
existence pro!les.
Inventory Gro"t# to Cost
of Sales Gro"t#
%%Inventory n Inventory n&'( ) '(
%%Cost of Sales n Cost of
Sales n&'( ) '(
*atios larger t#an '.+ indicate t#at
inventories are gro"ing faster t#an
sales. ,arge ratios ay indicate
possi!le inventory o!solescence
pro!les.
-inis#ed Goods
Produced to *a"
.aterial /sed
-inis#ed Goods 0uantities
*a" .aterial 0uantities
/seful in estiating t#e efficiency of
t#e anufacturing process. .ay !e
#elpful in evaluating t#e
reasona!leness of production costs.
-inis#ed Goods
Produced to Direct
,a!or
-inis#ed Goods 0uantities
Direct ,a!or 1ours
/seful in estiating t#e efficiency of
t#e anufacturing process. .ay !e
#elpful in evaluating t#e
reasona!leness of production costs.
Product Defects per
.illion
2u!er of Product Defects as
a Percent of 3ac# .illion
Produced
/seful in estiating t#e effectiveness
of t#e anufacturing process. .ay
!e #elpful in evaluating t#e
reasona!leness of production costs
and "arranty expenses.
16-/. a. 2ontrol environment factors that may impact the production cycle include$
The organi*ational structure should include an officer who has overall responsibility for
production, including authority over the production planning and control department and
each manufacturing department.
The assignment of authority and responsibility should include timely accountability for
the use of the entity3s resources.
'anagement0s philosophy and operating style should include its approach to ta.ing and
monitoring business ris.s related to production decisions and inventory levels.
The entity0s human resource policies and practices pertaining to production department
employees can significantly impact the use of, and accountability for, the factors of
production.
b. 4nique elements of an entity0s accounting information system that pertain to the production
cycle may include the use of control accounts and supporting records such as product or
master files, separate records for raw materials, wor. in process, and finished goods
inventories, job order and process cost systems, and standard cost systems.
16-5. The documents and records are summari*ed in the following table$
1unction 6ocuments and %ecords
,nitiating production$
o )lanning and controlling production.
)roduction orders
'aterial requirements reports
)roduction of ,nventory$
o ,ssuing raw materials.
o )rocessing goods in production.
o Transferring completed wor. to finished
goods.
o )rotecting inventories.
'aterials issue slips or requisitions
Time tic.ets
,nventory move tic.ets
%ecording manufacturing and inventory
transactions$
o 6etermining and recording manufacturing
costs.
o 'aintaining correctness of inventory
balances.
6aily production reports
2ompleted production report
+tandard cost master file
%aw material inventory master file
7or. in process inventory master file
1inished goods inventory master file
16-6. 2ontrols that are important in determining and recording manufacturing costs are$
2omputer chec.s on the agreement of entries for the allocation of manufacturing costs to wor. in
process with data on materials and labor usage in daily production activity reports.
2omputer chec.s on the agreement of entries for the transfer of wor. in process to finished goods
with data in completed production reports.
16-8. 2ontrols important in protecting inventories include$
+torage of raw materials and finished goods inventories in loc.ed storerooms with access
restricted to authori*ed individuals.
+urveillance of production areas by supervisory and plant security employees.
Tagging goods in production.
4sing prenumbered move tic.ets to control the transfer of wor. in process through the plant.
2ontrols relating to the correctness of inventory balances include$
)eriodic independent counts of inventory on hand and comparison with recorded quantities per the
perpetual inventory records.
)eriodic independent chec.s on the agreement of the dollar carrying amounts for the raw
materials, wor. in process, and finished goods inventory master files with their respective general
ledger control accounts.
)eriodic inspections of inventory condition and management review of inventory activity reports
for the purpose of determining the need for adjustments to reduce inventory carrying values to
mar.et when required.
16-9. a. 1actors that should be considered by an auditor in specifying the acceptable level of detection
ris. for assertions pertaining to merchandise inventory include the relevant transaction class
inherent and control ris. assessments for the purchases and sales transactions that affect the
merchandise inventory account, as well as inherent and control ris. factors associated directly
with the merchandise inventory balance.
b. 1actors that should be considered by an auditor in specifying the acceptable level of detection
ris. for assertions pertaining to manufactured finished goods inventory include relevant
inherent and control ris. assessments for the manufacturing and sales transactions that affect
the finished goods inventory account, as well as inherent and control ris. factors associated
directly with the manufactured finished goods inventory balance.
16-:. +everal ratios and their formulas that may be used in applying analytical procedures to inventory
balances are$
Ratio Formula Audit Signii!an!"
Inventory Turn Days Avg. Inventory Cost of Good
Sold x 365
Prior experience in inventory turn
days co!ined "it# $no"ledge
of cost of sales can !e useful in
estiating current inventory
levels. A lengt#ening of t#e
period ay indicate existence
pro!les.
Inventory Gro"t# to Cost
of Sales Gro"t#
%%Inventory n Inventory n&'( ) '(
%%Cost of Sales n Cost of
Sales n&'( ) '(
*atios larger t#an '.+ indicate
t#at inventories are gro"ing
faster t#an sales. ,arge ratios
ay indicate possi!le inventory
o!solescence pro!les.
-inis#ed Goods
Produced to *a"
.aterial /sed
-inis#ed Goods 0uantities
*a" .aterial 0uantities
/seful in estiating t#e
efficiency of t#e anufacturing
process. .ay !e #elpful in
evaluating t#e reasona!leness of
production costs.
-inis#ed Goods
Produced to Direct
,a!or
-inis#ed Goods 0uantities
Direct ,a!or 1ours
/seful in estiating t#e
efficiency of t#e anufacturing
process. .ay !e #elpful in
evaluating t#e reasona!leness of
production costs.
Product Defects per
.illion
2u!er of Product Defects as
a Percent of 3ac# .illion
Produced
/seful in estiating t#e
effectiveness of t#e
anufacturing process. .ay !e
#elpful in evaluating t#e
reasona!leness of production
costs and "arranty expenses.
16-1;. a. 1ive tests of details of balances that may be applied to inventories are$
<bserve client0s physical inventory count.
Test clerical accuracy of inventory listings.
Test inventory pricing.
2onfirm inventories at locations outside the entity.
=!amine consignment agreements and contracts.
b. 1. The observation of inventories is required whenever inventories are material to a
company0s financial statements and it is practicable and reasonable to ma.e the
observation.
". The timing of an inventory observation depends on the client0s inventory system and
the effectiveness of internal controls. ,n a periodic inventory system, the observation
of the inventory should occur at or near the balance sheet date. ,n a perpetual
inventory system with well-.ept records, observation may occur during or after the
end of the period under audit.
#. ,n evaluating the client0s inventory ta.ing plans, the auditor should determine that the
plan includes all of the following$
>ames of employees responsible for supervising the inventory ta.ing.
6ate of the counts.
?ocations to be counted.
6etailed instructions on how the counts are to be made.
4se and control of prenumbered inventory tags and summary (compilation
sheets.
)rovisions for handling the receipt, shipment, and movement of goods during the
counts if such activity is unavoidable.
+egregation or identification of goods not owned.
/. ,n observing inventories, the auditor should
+crutini*e the care with which client employees are following the inventory
plan.
+ee that all merchandise is tagged and no items are double tagged.
6etermine that prenumbered inventory tags and compilation sheets are properly
controlled.
'a.e some test counts and trace quantities to compilation sheets.
@e alerts for empty containers and hollow squares (empty spaces that may e!ist
when goods are stac.ed in solid formations.
7atch for damaged and obsolete inventory items.
&ppraise the general condition of the inventory.
,dentify the last receiving and shipping documents used and determine that
goods received during the count are properly segregated.
,nquire about the e!istence of slow-moving inventory items.
16-11. a. ,n testing inventory pricing for purchased inventories, the auditor should (1 vouch costs to
representative vendor invoices and (" verify both cost and mar.et when the lower of cost or
mar.et method is used. ,n testing inventory pricing for manufactured inventories, the auditor
should review the methods used in costing the inventories for propriety and the accuracy and
consistency of application. 1or e!ample, when standard costs are used, the auditor should test
the calculation of the standards, compare the calculations with engineering specifications,
determine that the standards are current, and evaluate whether the standards appro!imate
actual costs by e!amining the variance accounts.
b. 2onfirmations may be used in the audit of inventories to obtain evidence about the e!istence
of inventories stored in public warehouses or with other outside custodians such as
consignees.
16-1". a. 7hen the auditor is testing net reali*able value the auditor needs to determine if the client will
be able to sell inventory on hand at year-end in the normal operating cycle and not suffer a
loss (brea.-even in the process. The auditor is testing the client3s estimates of future
outcomes A the value of future sales. This is particularly problematic with inventory that is
considered obsolete.
b. 7hen auditing the net reali*able value of inventory the auditor will want to understand
management3s process for estimating any allowance for obsolete inventory. The auditor will
need to understand how long it ta.es the client to turn its inventory and evaluate recent history
(the last several inventory turn cycles for evidence of the client3s ability to turn its inventory
and brea. even. The auditor will also want to review sales prices after year-end to the e!tent
possible.
16-1#. a. The personnel services cycle involves the events and activities that pertain to e!ecutive and
employee compensation.
b. This cycle interfaces with two other cycles$ (1 the paying of the payroll and payroll ta!es
involves cash disbursements in the e!penditure cycleB (" the distribution of factory labor
costs to wor. in process pertains to the production cycle.
16-1/. a. (ross earnings of personnel are generally the largest operating e!pense in merchandising
(after costs of goods sold and service companies. They also are a major component in costing
wor. in process. =mployee fraud is a major inherent ris. that the auditor should consider.
b. The auditor0s usual strategy is to use a lower assessed level of control ris. approach in
auditing payroll transactions because$
The audit ris. is primarily in the processing of payroll transactions.
'ost companies have e!tensive internal controls for the routine nature of payroll
transactions.
Cear-end payroll liability balances are often immaterial.
16-15. The audit objectives for payroll transactions and related assertions are$
&pecific Audit O%'ecti(es
)ransaction O%'ecti(es
Occurrence. %ecorded employee compensation, benefits and payroll ta! e!penses relate to compensation
for services rendered during the year (EO1).
Completeness. %ecorded employee compensation, benefits and ta! e!penses include all such e!penses
incurred for personnel services during the year (C1).
Accuracy. =mployee compensation, benefits and payroll ta! e!penses are accurately computed and
recorded (VA1.
Cutoff. =mployee compensation, benefits and payroll ta! e!penses have been recorded in the correct
accounting period (EO1 and C1).
Classification. =mployee compensation, benefits and payroll ta! e!penses are properly identified and
classified in the income statement (!1.
*alance O%'ecti(es
E"istence. =mployee compensation, benefits and payroll ta! liabilities represent amounts owed at the
balance sheet date (EO2.
Completeness. =mployee compensation, benefits and payroll ta! liabilities include all such amounts
owed at the balance sheet date (C2.
$ights and O%ligations. =mployee compensation, benefits and payroll ta! liabilities are obligations of
the reporting entity ($O1.
Valuation and Allocation. =mployee compensation, benefits and payroll ta! liabilities are accurately
computed and recorded (VA2.
!isclosure O%'ecti(es
Occurrence and $ights and O%ligations. 6isclosed employee compensation and benefits transactions
and balance have occurred and pertain to the entity (!#).
Completeness. &ll employee compensation and benefits disclosures that should have been included in
the financial statements have been included (!+).
,nderstanda%ility. &ll employee compensation and benefits information is appropriately presented and
information in disclosures is understandable to users (!-).
Accuracy and Valuation. &ll employee compensation and benefits information is disclosed accurately
and at appropriate amounts (!.).
16-16. 1ollowing are several e!amples of analytical procedures and a description of how they might assist the
auditor when auditing the production cycle.
Ratio Formula Audit Signii!an!"
Average payroll cost
per eployee
classification
Total payroll costs for an
eployee group divided !y
t#e nu!er of eployees in
t#e group
*easona!leness test of gross payroll
for a group of eployees. .any
copanies #ave ore t#an one class
of eployee4 and it is iportant to
evaluate t#e reasona!leness of
payroll !ased on eployee class.
*evenue per
eployee
Total *evenue nu!er of
full tie e5uivalent
eployees.
T#is ay !e a easure of productivity
per full tie e5uivalent eployee.
T#is is particularly iportant in
services industries and "ould !e
copared "it# industry statistics.
Total payroll costs as
a percentage of
revenues
Total payroll expenses total
revenues
*easona!leness test of payroll costs.
T#is is often copared "it# industry
statistics.
Payroll tax expense
as a percent of gross
payroll
Total payroll tax expenses
gross payroll
*easona!leness test of payroll taxes.
T#is can often !e copared "it#
standard tax rates.
Copare payroll
expenses %salaries
and "ages4
coissions4
!onuses4 eployee
!enefits4 etc( "it#
prior year !alances
or !udgets
Current year payroll expenses
prior year payroll expenses
*easona!leness test for payroll
expenses if t#e ratio is significantly
different fro '.+
Copare current
year payroll lia!ility
"it# prior year payroll
lia!ility
Current year payroll tax
lia!ility prior year payroll tax
lia!ility ad6usted for gro"t# in
payroll volue
*easona!leness test for payroll
lia!ility if t#e ratio is significantly
different fro '.+
Copute ratio of
payroll tax expense
to total payroll
expenses
Payroll tax expense total
payroll expense
*easona!leness test for payroll tax
expense !ased on prior year ratio of
payroll tax expense to total payroll.
3ployee !enefits
expenses as a
percent of gross
payroll
Total !enefits expenses
gross payroll
*easona!leness test of !enefits
expenses. T#is is often copared
"it# industry statistics.
16-18. The control environment is as relevant to the personnel services cycle as it is to any cycle. The
elements of human resources associated with hiring practices and the care with which controls are
established over putting new employees on the payroll is essential to good control.
'anagement should actively assess the ris.s associated with errors and fraud and design appropriate
controls to reduce these ris.s consider the cost-benefit tradeoff when implementing controls.
1inally, management should monitor the system of internal controls, perhaps as a responsibility of the
internal audit function. 'anagement needs to review the results control failures that result in errors or
fraud in the personnel services function and ta.e actions to correct e!iting problems.
16-19. The functions in processing payroll transactions are$
,nitiating payroll transactions including (a hiring employees and (b authori*ing payroll changes.
%eceiving services including preparing attendance and time.eeping data.
%ecording payroll including (a preparing and (b recording the payroll.
)aying the payroll including (a paying the payroll and protecting unclaimed wages, and (b filing
payroll ta! returns.
16-1:. a. The responsibilities of the personnel department include$ (1 hiring employees, (" preparing
personnel authori*ation forms for new hires, (# authori*ing payroll changes and terminations,
and (/ maintaining employee personnel files.
b. The control procedures in preparing attendance and time.eeping data include (1 using time
cloc.s to record hours wor.ed, (" supervising cloc. card punching, (# supporting time cloc.
hours with time tic.ets, (/ approving time wor.ed in writing by a supervisor, and (5
reconciling time tic.ets and cloc. cards.
16-";. a. Tests of controls for terminated employees involve ma.ing inquiries and observing the
processes for removing personnel from the payroll. 'any companies create a report of
terminated employees that is reviewed in personnel. The auditor might substantively for
subsequent payment of terminated employees using generali*ed audit software and selecting a
sample of termination notices and scanning subsequent payroll registers to determine that the
terminated employees did not continue to receive pay chec.s.
b. ,n witnessing the distribution of payroll chec.s, the auditor observes that$
+egregation of duties e!ists between the preparation and payment of the payroll.
=ach employee receives only one chec..
=ach employee is identified by a badge or employee ,6 card.
There is proper control and disposition of unclaimed chec.s.
16-"1. The following table provides e!ample controls and tests of controls for each assertion (and transaction
level audit objective related to the personnel services cycle. =!amples emphasi*e programmed control
procedures where appropriate. +tudent should note that tests of controls should also emphasi*e testing
computer general controls, observing e!ception reports, and testing manual follow-up of items that
appear on e!ception reports.
ersonnel &er(ices
&ssertion (&udit <bjective 2ontrol Test of 2ontrols
=!istence and <ccurrence
(<ccurrence
<nly a few .ey employees in
personnel can add a new employee
to the master payroll file.
2omputer reports all changes to the
personnel data master file.
'anagement in personnel reviews
report of all master file changes.
<bserve the process for changing the
master payroll file, review the accuracy
of reports of changes to the master file,
and reperform control.
2ompleteness
(2ompleteness
@atch total of hours wor.ed
prepared by payroll department and
verified by the computer.
4se 2&&Ts to test the control by
submitting data that should be rejected
by the control.
=!istence and <ccurrence D
2ompleteness (2utoff
'anual controls chec. payroll
cutoff and accrue payroll when pay
periods do not coincide with month
end.
<bserve the process testing payroll cutoff
and accruing payroll costs, and reperform
control.
-aluation and &llocation
(&ccuracy
2omputer limit test on the number
of hours wor.ed and the amount of
each payroll chec..
4se 2&&Ts to test the control by
submitting data that should be rejected
by the control.
)resentation and 6isclosure
(2lassification
2omputer compares account
classification for hours wor.ed with
account classification on time cards.
4se 2&&Ts to test the control by
submitting data that should be rejected
by the control.
%ights and <bligations >D& >D&
16-"". a. The li.ely acceptable level of detection ris. for payroll balances is moderate or high because
moderate or low assessments of control ris. are usually possible.
b. 7hen moderate or high detection ris. levels are acceptable, substantive tests may be limited to
applying analytical procedures and limited tests of details. ,f une!pected fluctuations are
found, more e!tensive tests of details will be required.
16-"#. a. To obtain evidence about the reasonableness of management0s accrued payroll liabilities, the
auditor should review management0s calculations or ma.e independent calculations, compare
the accruals with amounts shown on payroll ta! returns, and e!amine subsequent payments
where applicable.
b. <fficers0 compensation is audit sensitive because it must be separately disclosed in 1;-E
reports filed with the +=2, and because officers may be able to override controls and receive
salaries, bonuses, stoc. options, and other forms of compensation in e!cess of authori*ed
c. 7hen auditing pension e!penses, the auditor should also evaluate the reasonableness of the
.ey actuarial estimates such as the discount rate that is used to determine the projected benefit
obligation and the long-term rate of return assumption used for the e!pected return on plan
assets. The discount rate should be in line with current annuity purchase rates for high-quality
fi!ed income investments. The long-term rate of return assumption should reflect the actual
and anticipated returns for the plan3s assets.
d. 7ith respect to accounting for stoc. option e!pense, most companies structure their stoc.
option plans to meet the requirements of &)@ >o. "5, so that they may use the intrinsic value
approach and report no compensation e!pense associated with the use of stoc. options. +toc.
appreciation rights, however, require the recognition of compensation e!pense, regardless of
whether the right is e!ercised during the period. 1&+@ >o. 1"# requires these companies to
disclose pro forma net income and earnings per share as if the fair value approach were used.
&s a result the auditor must audit the valuation model used to determine the fair value of the
stoc. options. 7hen evaluating fair presentation in the financial statements, the auditor
evaluates assumptions that include the ris.-free rate, the e!pected life of the option, the
e!pected volatility of the stoc. price, and e!pected dividends.
Comprehensi(e /uestions
16-"5. (=stimated Time A #; minutes
/naudited Audited Audited
7+89 7+83 7+87
Sales '74++54336 : '+47;'4333 : <4<;74'33 :
Cost of *a" .aterials /sed 34;734336 : 34'=34333 : 74<++4+++ :
Direct ,a!or Cost '46;64+<' : '436943'9 : '4';+4+++ :
Cost of Payroll Taxes and >enefits 5<+4+6+ : 93;43+; : 3<34'<+ :
Indirect Costs '4+<<4<<5 : '4+;94;3+ : ;674'++ :
=47<<4367 : 64+='4<<6 : 5433547<+ :
>eginning Inventory 33+45<= : 7=94=69 : '5645== :
3nding Inventory 9=+4+'6 : 33+45<= : 7=94=69 :
Capacity '+4+++4+++ '+4+++4+++ '+4+++4+++
/nits Produced <4=<+4<++ =4<9+4+++ =4+++4+++
/nits Sold <4=5+4+++ =4==54+++ 64<5+4+++
>eginning Inventory 9'54+++ 35+4+++ 7++4+++
3nding Inventory 9954<++ 9'54+++ 35+4+++
Direct ,a!or 1ours ;7497; =64<63 =+4+++
2u!er of .anufacturing 3ployees 96 3< 35
,a!or Cost including !enefits 747=64'9+ : '4<+34673 : '45=34'<+ :
Tons of *a" .aterial /sed =49=3 64777 546++
Tons of 3nding *a" .aterials Inventory 7' '< '6
a. Calcualtions
Cost of Goods Sold =4'9<4;33 : 64+'64+63 : 547'=4+;3 :
Gross Profit .argin 9+.5? 9'.5? 9'.3?
Inventory Turn Days 79.+ 7+.' ';.7
2u!er of /nits per Ton of *a" .at@l ''=5 '76+ '75+
2u!er of /nits per Direct ,a!or 1r. ;5 '+7 '++
Cost per ton of aterials 575.++ : 5'+.++ : 5++.++ :
Cost per direct la!or #our 79.63 : 73.9= : 77.9= :
Payroll taxes and !enefits as a? o
direct la!or cost 39.7? 37.7? 37.7?
Cost per unit of inventory '.+59 : +.=;= : +.=<5 :
!. Analytical procedures indicate t#at ending inventory appears to !e overstated due to
pricing pro!les in t#e valuation of inventory. .anufacturing productivity appears to
#ave decreased due to t#e decreases in t#e nu!er of units produced per ton of ra"
aterials and decreases in t#e nu!er of units produced per direct la!or #our.
-urt#er4 t#e cost of ra" aterials increased during t#e years4 as did payroll cost %!ot#
t#e cost per direct la!or #our and t#e cost of !enefits(.
,ncreases in gross profit margin are inconsistent with this underlying information related to the
cost of production. The dramatic increase in inventory turn days, and the cost per unit of
inventory are consistent with the fact that inventory appears to be overvalued, probably as a
result of problems with the valuation of inventory (or possibly the e!istence of inventory.
&udit tests need to focus carefully on the cost build-up for ending inventory, and the allocation
of cost between ending inventory and cost of sales.
16-"8. (=stimated time - "5 minutes
a. &u%stanti(e )est %. 0inancial &tatement Assertions c. )ype of E(idence
1. <bserve client0s inventory ta.ing &ll e!cept rights and obligations and
presentation and disclosure
)hysical, oral
". -erify accuracy of schedules and
perpetual records and agreement with
inventory balances
-aluation or allocation 'athematical
#. 2onsider evidence from sales and
purchases cutoff tests
=!istence or occurrence and
completeness
6ocumentary
/. <bserve client0s &ll e!cept rights and obligations and
presentation and disclosure
)hysical, oral
5. 2onfirm inventories in public
warehouses
=!istence or occurrence,
completeness, and rights and
obligations
2onfirmation
6. <bserve client0s inventory ta.ing &ll e!cept rights and obligations and
presentation and disclosure
)hysical, oral
8. Test inventory pricing -aluation or allocation 6ocumentary,
mathematical
9. <bserve client0s inventory ta.ing &ll e!cept rights and obligations and
presentation and disclosure
)hysical, oral
:. ,nquire of management regarding
ownership
%ights and obligations, and
presentation and disclosure
<ral
1;. 2ompare statement presentation with
(&&)
)resentation and disclosure 6ocumentary
16-"9. (=stimated time - "5 minutes
a. During an audit of a anufacturing copany t#e CPA revie"s t#e cost syste for t#e
follo"ing purposesA
To determine that costs are properly allocated to current and future periods and hence that
cost figures used in arriving at balance sheet and income statement amounts are supported
by the accounting records.
To obtain assurance that the cost system, as an integral part of the system of internal
control, provides proper accounting control over costs incurred and related inventories.
To ascertain, as a service to management, that the cost system is economical and
effectively provides information for reducing or controlling costs and for determining the
cost and profitability of products, and other related data necessary for informed
managerial decisions.
!. T#e audit procedures to !e applied to deterine t#at cost standards and related
variance accounts applica!le to aterials are accepta!le and #ave not distorted t#e
financial stateents "ould include t#e follo"ingA
%eview the internal control structure to estimate the amount of testing necessary.
Test chec. the arithmetic of the standard cost cards.
6etermine that the data on the standard cost cards are reasonably current. <ut-of-date
standards may result in abnormal variances.
&scertain the accuracy of the specifications on the standard cost cards by comparison
with engineering specifications or other independent sources. 6etermine that the
procedure for establishing standard material yields gives consideration to spoilage, scrap
loss and
by-products of the process.
6etermine that, in establishing standard material prices, consideration was given to the
following factors$ normal quality, normal quantity, normal sources, and delivery by
normal carrier. The treatment in the accounts of discounts, whether e!cluded or included
in the standard costs, should be investigated for consistency.
The accounting system for recording standard costs should be reviewed for
reasonableness, and test chec.s should be applied to determine that the system is
functioning effectively. +ource documents (vendors0 invoices, requisitions, production
reports, and other internally generated accounting evidence should be e!amined and
related to the transactions flowing through the cost system. ,n this connection reference
would be made to the standard cost cards to determine that standard cost data flowing
through the accounting system are being accurately compiled.
%eview the material price variance and material usage variance accounts for over-all
reasonableness. The variance accounts should also be reviewed for e!cessive variations in
the month to month charges, and satisfactory e!planations should be obtained where
necessary.
The impact of the variances on the financial statements should be considered. ,f the
variances are of amounts so substantial that placing them in the income statement would
distort current operating results and inventory valuations, then consideration should be
given to allocating them on a pro rata basis to cost of goods sold and inventories.
16-##. (=stimated time - "5 minutes
a. T#ere are t#ree !asic s#ortcoings in t#e payroll procedures currently used at t#e
Galena plantA
&ctual payroll hours are not approved by production management.
There is inadequate segregation of duties within the payroll department.
)ersonnel department should not have access to payroll chec.s on a regular basis.
T#e follo"ing corrective action s#ould !e ta$en to iprove t#e internal control of
payroll processing proceduresA
&ll incoming time cards should be signed by both the employee and supervisor.
The payroll cler. who prepares the input for data processing should not do the
reconciliation but, rather, a second cler. should reconcile the payroll register to the time
cards.
&n employee of supervisory level should authori*e voiding of computer-generated chec.s
and the subsequent preparation of a manual replacement chec..
%eplacement chec.s should be processed following good internal control procedures.
&ll payroll chec.s, including unsigned replacement chec.s, should then be given to the
accounting department rather than to the personnel department for storage in a secure
location until payday.