Summary and Case Audit for Production Cycle (Ch 16) PDF

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Summary

Bernadeta Ratri Dewi / 181524419Summary Audit Chapter 16 Auditing for Production Cycle A. Introduction to Auditing of Production Cycles ● Production cycle relates to the conversion of raw materials into finished goods ● This cycle includes: production planning and control of the types and quantities...

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Bernadeta Ratri Dewi

/ 181524419

Summary Audit Chapter 16 Auditing for Production Cycle A. Introduction to Auditing of Production Cycles ● Production cycle relates to the conversion of raw materials into finished goods ● This cycle includes: -

production planning and control of the types and quantities of goods to be manufactured

-

the inventory levels to be maintained

-

the transactions and events pertaining to the manufacturing process

● The cycle interfaces with the following three other cycles: -

the expenditure cycle in purchasing raw materials and incurring various overhead cost

B.

-

the personnel services cycle in incurring factory labor cost

-

the revenue cycle in selling finished goods

The Nature of the Production Cycle ● Manufacturing inventory is a core process, because a well-managed manufacturing process represents the ability of the entity to generate earnings and cash flows. ● In industries like hotel industries and school districts, inventories are immaterial. In service industries like those two industries, the audit of inventory is usually insignificant to overall audit strategy ● In retail grocer, the manufacture of construction machinery and equipment, and the computer manufacturer à the audit of inventory is a core process that is both material and crucial to the entity’s success. The auditor who will audit the manufacturing company has to understand the capital intensiveness of the manufacturing process

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C.

Purpose of Specific Audits of Stock Accounts Specific Audit Objectives

Transaction Objectives

1. Occurrence. Recorded manufacturing transactions represent material, labor, and overhead transferred to production and the movement to completed production to finished goods during the current period Recorded cost of sales represents the sale of inventory during the year (EO2) 2. Completeness. All manufacturing transactions (C1) and cost of sales (C2) that occurred during the period were recorded. 3. Accuracy. Manufacturing transactions (VA1) and cost of sales (VA2) are accurately valued using GAAP and correctly journalized, summarized, and posted. 4. Cutoff. All manufacturing transactions (EO1 and C1) and cost of sales (EO2 and C2) have been recorded in the correct accounting period 5. Classifications All manufacturing transactions (PD1) and cost of sales (PD2) have been recorded in the proper accounts

Balance Objectives

1. Existence. Inventories included in the balance sheet physically exist (EO3). 2. Completeness. Inventories include all materials, products, and supplies on hand at the balance sheet date (C3). 3. Rights and Obligations. The reporting entity has legal title to record inventories at the balance sheet date (RO1). 4. Valuation or Allocation.

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Inventories costing assumptions have been properly applied (VA3), and inventories are properly stated at the lower cost or market. Disclosure Objectives

1. Occurrence and Rights and Obligations. Disclosed inventory transactions and balance have occurred and pertain to the entity (PD3). 2. Completeness. All inventory disclosures that should have been included in the financial statements have been included (PD4). 3. Classification and Understandability. Production cycle information is appropriately presented and described and information in disclosures is clearly expressed (PD5). 4. Accuracy and Valuation. Inventory information is disclosed accurately and at appropriate amounts (PD6).

D.

Internal Control of Preparations ● All five components of an entity internal controls are applicable for the manufacturing transaction in the production cycle. ● Function and Related Controls: 1. Initiating Production 2. Production of Inventory 3. Recording manufacturing and inventory transactions

E.

Potential Misstatements of Inventory Accounts 1. Excessive production may be ordered 2. Use of raw material is not authorized 3. Direct labor hours may not be charged to production orders 4. Finished goods personnel may claim goods were not received from production 5. Inventory may be stolen from the warehouse 6. Work in process may be stolen or misrouted during production 7. Manufacturing costs may be recorded in incorrect amounts 3

8. Direct manufacturing costs allocated to work in process may not be recorded or may be recorded at incorrect amount 9. Inappropriate overhead rates or standard costs may be used 10. Cost of completed production may not be transferred to completed goods or be transferred in incorrect amount 11. Recorded inventory quantities may not agree with inventory owned quantities in hand 12. Inventory carrying values in subsidiary ledger or master files may not agree with control accounts. 13. Inventories may be carried at amounts in excess of market values 14. Management may not be held accountable for management of inventory resources resulting in a variety of misstatements in the financial statements

F.

Introduction to Inventory Taking Procedures The taking of a physical inventory by a client is usually done according to a plan or a list of instructions. Auditors must conduct advanced planning if an inventory observation is to be done efficiently and effectively. Experienced auditor is responsible for planning the procedure, determining manpower needs, and assigning members of the audit team to specific locations.

G. Prepared Working Paper 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. Materials 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.

5. Move ticket 4

-

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

6. Daily production 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. Standard cost master file -

A computer file containing standard costs.

9. Raw materials inventory master file -

A computer file with both the quantities of raw materials inventory on hand and actual cost of raw materials.

10. Work-in-process inventory master file -

A computer file with both the quantities of work-in-process inventory on hand, and actual cost of work in process.

11. Finished goods inventory master file -

A computer file with both the quantities of finished goods inventory on hand and actual cost of finished goods.

H. Functions and Related Controls 1. Initiating Production: -

Planning and controlling production

2. Production of Inventory: -

Issuing raw materials,

-

Processing goods in production,

-

Transferring completed work to finished goods,

-

Protecting inventories

3. Recording manufacturing and inventory transactions: -

Determining and recording manufacturing cost

-

Maintaining correctness of inventory balances

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I. Substantive Testing of Preparations Category

Substantive Test

Specific Audit Objectives

Initial

1. Obtain an understanding of the business and

All

industry and determine:

Procedures

a) The significance of cost of sales and inventory to the business b) Key economic drivers that influence the entity's cost of sales gross margins

and

the

possibility

of

obsolete inventory. c) The extent to which the client has consignment inventories (in or out) d) The

existence

of

purchase

commitments and concentration of activities with suppliers.

2. Perform initial procedures on inventory balances and records that will be subjected to further testing. a) Trace beginning inventory balances to prior

VA3

year's working papers. b) Review activity in inventory accounts and

EO3, VA3, PD3

investigate entries that appear unusual in amount or source. c)

Verify totals of perpetual records and other

VA3

inventory schedules and their agreement with general ledger balances. Analytical Procedures

3. Perform analytical procedures. a) Review industry experience and trends. b) Examine analysis of inventory turnover.

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All

c) Review relationship of inventory balances to recent purchasing, production, and sales activities. d) Compare inventory balances to anticipated sales volume. Tests of

4. On a test basis, vouch entries in inventory to

Details of

support documentation, such as: vendor's invoices,

Transactions

manufacturing cost records, completed production

EO1, EO2, VA1 V2, PD1, PD2

reports, and sales and sales return records.

5. On a test basis, trace data from purchases,

C1, C2

manufacturing, completed production, and sales records to inventory accounts.

6. Test cutoff of purchases and sales returns (receiving), movement of goods through

EO1, EO2, C1

manufacturing departments (routing), and sales (shipping).

Tests of

7. Observe client's physical inventory count.

Details of

a) Decide on timing and extent of tests.

EO3, C3

Balances

b) Evaluate adequacy of client’s inventory

EO3, C3

taking plans. c) Observe care taken in client's counts and

EO3, C3

make test counts. d) Look for indications of slow-moving,

VA4

damaged, or obsolete inventory. e) Account for all inventory tags and count sheets used in physical count.

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EO3, C3

8. Test clerical accuracy of inventory listings. a) Recalculate totals and extensions of quantities times unit prices.

VA3

b) Trace test counts (from item 7c) to listings. c) Vouch items on listings to inventory tags and count sheets.

C3 EO3

d) Reconcile physical counts to perpetual records and general ledger balances and review adjusting entries.

EO3, C3, VA3, PD3

9. Test inventory pricing. a) Examine vendors' paid invoices for

VA3

purchased inventories. b) Examine propriety of direct labor and

VA3

overhead rates, standard costs, and disposition of variances pertaining to manufactured inventory.

10. Confirm inventories at locations outside the

EO3, C3, RO1

entity.

11. Examine consignment agreements and contracts.

RO1

12. Based on the tests of beginning inventory,

EO2, C2, VA2,

production costs, and inventory, determine the

PD2

appropriateness of cost of sales.

Tests of Details of

13. Evaluate the net realizable value of inventory: a) Examine sales invoices after year-end and

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VA4

Balances:

perform lower of cost or market test.

Accounting

b) Compare inventories with entity's current

Estimates

VA4

sales catalogue and sales reports. c) Inquire about slow-moving, excess, or

VA4

obsolete inventories and determine need for write-down. d) Evaluate management's process for

VA4

estimating the net realizable value of inventory using hindsight. e) Evaluate the net realizable value of

VA4

inventory given information about: ㆍ Industry trends ㆍ Inventory turnover trends ㆍ Specific slow-moving inventory

Required

14. Observation of physical inventory count

Procedure

included as step 7 above.

Presentation

15. Compare statement presentation with GAAP.

and

a) Confirm agreements for assigning and

Disclosure

EO3, C3

PD3, PD6

pledging inventories. b) Review presentation and disclosure for

PD3, PD6

inventories in drafts of the financial statements and determine conformity with GAAP. c) Evaluate the completeness of presentation

PD4

and disclosures for inventories in drafts of financial statements to determine conformity to GAAP by reference to disclosure checklist. d) Read disclosures and independently

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PD5

evaluate their classification and understandability.

● Analytical Procedure Commonly Used to Audit the Production Cycle

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Case Study 16.21 Inventory — stocktake You attended the inventory count of your client Davis Hydraulics Ltd. You observed the following during the count. 1. Warehouse staff counted specific areas of the stock as determined by the warehouse supervisor; staff members, including the warehouse supervisor, were allocated their own area to count. 2. Several blank paper sheets were issued to count staff for recording stock counted. 3. Staff were instructed to write down the stock description and number counted. 4. Staff were told to write the stock quantities in pencil on the sheets to ensure errors can be corrected. 5. Any staff that completed a section early were allocated to another area to help out one of the other staff. 6. The supervisor collected all sheets at the end of the count to finalize the stock count. Required: Identify the weaknesses in the stocktake procedures above and identify how they could be improved. Answer: No 1.

Weakness

Improvement

Warehouse staff used for counting - Non-warehouse staff could be used to this could lead to staff covering up carry out the count to create a level of their errors

2.

independence

Each individual counts a specific Count team should be two people, one area - errors could be made without

counting and one recording and each can

being detected

check the work of other to prevent count errors

3.

Blank sheets are used - stock sheets Pre-numbered stock sheets should be handed out to ensure that completeness of

could be lost

stock sheets returned can be checked 4.

Staff

writing

down

the

stock Pre-printed sheets should have stock 12

description - this could lead to details already included; staff then only incorrect details being recorded

have to write the quantity counted on the stock sheet

5.

Writing quantities in pencil give All stock counts should be recorded in opportunities for changes to be pen made after the count

6.

to

prevent

unknown

changes

occurring

Staff finishing their section are All stock counted should be marked on allocated to another area which

the stock itself to ensure it is clear that the

creates risk that stock is counted

stock has already been counted

more than once 7.

Supervisor collects sheets at the end Copies of the sheets should be collected of the count - the supervisor could by the accounting department as evidence make changes to the count details

of the count so any changes made will be

without being detected

apparent

16.22 Physical inventory — substantive procedures

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Stenton Toys Pty Ltd is a toy retailer with shops in each of the Australian state capitals. Stenton has a head office and a central warehouse in Brisbane. All stock purchases are made centrally and are held in the Brisbane warehouse; they are then dispatched around the country as needed by each of the shops. Details of stock movements are recorded on a perpetual inventory system and Stenton carries out year-end stock takes at all locations. You are the auditor of Stenton and are planning the audit of the stocktake that is about to take place; you have established the following from your planning procedures. 1. An inventory report will be produced from the inventory system for each shop and the warehouse. The report gives details of inventory code, stock description, units held and unit selling price. The report also gives a breakdown of where inventory items are held and the total value of items held at each location. 2. A sales movement report is also produced which gives details of: inventory code, unit descriptions, units purchased for the period and their cost price, units sold in the period. 3. The largest shop is in Melbourne and 35% of all stock is held there. 4. The Perth shop has suffered significant levels of stock shrinkage recently. 5. To facilitate the stocktake an additional report is produced which includes only the inventory code and description. Stock counters use this report to indicate the units of stock held at the time of the count. Required: Describe how you would select samples to test the existence and completeness of inventory units. Indicate how the sample sizes used in the Melbourne and Perth shops would differ. Answer: Test the Existence -

The assertion of existence should be verified by selecting a sample of inventory recorded by the company’s count teams on the stocktake sheets that they have completed and agreeing the quantity by identifying the item and counting it. The existence of inventory claimed to be on hand according to the company’s records is thus confirmed.

-

More attention should be paid to the existence assertion, as the inherent risk that stock may be overstated to improve reported performance is greater than the risk 14

that inventory may be understated. There is also a greater risk that staff engaged in stocktaking may have an incentive to conceal a stock shortage for which they might be held accountable. Test the Completeness -

The assertion of completeness should be verified by selecting a sample of inventory physically present, ascertaining its description and counting it. The item and quantity should then be agreed to the count prepared by the company’s own count teams and recorded on the stocktake sheet. In that way, the risk that the company had omitted to include all items in its count would be reduced.

Difference between Perth and Melbourne -

The higher stock value at Melbourne indicates a higher risk of material error, therefore a larger sample should be selected from this shop. Inherent and control risk will be higher in Perth than other locations and therefore the sample size should be higher than other locations.

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