Chapter 09 - Production Cycle CHAPTER Production Cycle LEARNING OBJECTIVES Review Checkpoints Exercises, Problems, and Simulations Describe the production cycle, including typical source documents and controls 1, 2, 3, 4, 41 Give examples of tests of controls for auditing the controls over conversion of materials and labor in a production process 6, 7, 8, 42, 43 Identify and describe considerations involved in the observation of physical inventory and tests of inventory pricing and compilation 10, 11, 12, 13, 14, 15, 16, 17 44, 45, 46, 47, 48, 49, 50, 51, 52, 56, 57 Describe some common errors and frauds in the accounting for production costs, and related cost of goods sold, and design some audit and investigation procedures for detecting them 18 ,19 53, 54, 55 9-1 Chapter 09 - Production Cycle SOLUTIONS FOR REVIEW CHECKPOINTS 9.1 Production planning Production Cost accounting 9.2 GAAP recognizes specific identification, weighted average, FIFO, and LIFO methods of accounting for inventory 9.3 The auditor performs a walk through by talking to employees about their duties, observing performance, and examining documents produced and agreeing them to related documents A walk-through of a production transaction will collect the following documents: • • • • • • • • • • Production order Bill of materials Materials requisitions Inventory record (raw materials issue) Journal entry (moving raw materials to work in process) Labor report (time records) Journal entry (charging labor to work in process) Production cost analysis Inventory record (finished goods addition) Journal entry (moving work in process to inventory) The requisitions should be in numerical sequence They should be agreed to production orders, based on the bill of materials The requisitions should also agree to the inventory record, which is agreed to the journal entry The labor report would be agreed to time records and the journal entry The journal entries would be summarized and agreed to the production cost The finished goods addition would be agreed to the production cost and the journal entry Controls: The auditor would look for the following • • • • 9.4 Approval signatures on requisitions, and time records Approvals of journal entries Tests of accuracy of calculations Separation of o Custody of the inventory o Record keeping o Authorization of use of materials and incurring time o Reconciliation of inventory records to physical counts Some work to obtain assurance about the reasonableness of the client’s sales forecast needs to be performed All the auditors need to accomplish is to learn about the assumptions built into the forecast for the purpose of ascertaining their reasonableness In addition some work on the mechanical accuracy of the forecast should be performed to avoid embarrassing reliance on faulty calculations 9-2 Chapter 09 - Production Cycle 9.5 If high levels of production were planned and carried out in anticipation of high sales that did not occur the inventory should show an increase The potential problem is over-valuation (overstatement) of slow-moving or obsolete inventory and understatement of cost of goods sold Another potential problem is that overhead would be absorbed on inaccurate volume expectations 9.6 Failure to record materials and labor used should be prevented by matching documents For example, dated raw materials inventory issues not matched to materials in the production cost analysis indicate a possible omission of material used in production Use of prenumbered documents and reports with accounting for numerical sequence is also a primary means of preventing omission of transactions 9.7 Auditors are looking for the separation of duties in authorization of transactions, custody of assets, recording of transactions, and periodic reconciliation In the production cycle, these duties are separated as follows: • Initial authorization is a production order prepared in production planning and control, authorizations of labor hours and material to be used are given by the supervisor when job time tickets are given to employees and material requisitions are sent to raw materials stores; • Raw materials stores maintains physical custody of raw materials and none are released without authorization (requisition) and record of withdrawal; • Supervisor maintains custody of work-in-process inventory; • Independent recording of labor and materials in production cost analyses by cost accounting clerks from records after comparing two sources 9.8 The production order record provides a control over the quantity of product manufactured by the production department This record used in combination with the bill of materials provides an approved list of materials that should be used This list can be compared to the actual materials used, as recorded by the cost accounting department 9.9 This is a question about the direction of tests of controls To determine whether all authorized production was completed and placed in inventory or written off as scrap, the auditors should select a sample of approved production orders from the production planning department files, and then trace them forward through cost accounting to inventory or write-offs To determine whether finished goods inventory was actually produced and costs were properly accumulated, the auditors should select a sample of production put in the inventory account, then vouch these production reports to approved production orders and cost calculations of material, labor, and overhead 9-3 Chapter 09 - Production Cycle 9.10 9.11 The auditor is looking for these characteristics in a review of the client’s inventory-taking instructions: Names of client personnel responsible for the count Dates and times of inventory taking Names of client personnel who will participate in the inventory taking Instructions for recording accurate descriptions of inventory items, for count and doublecount, and for measuring or translating physical quantities (such as counting by measures of gallons, barrels, feet, dozens) Instructions for making notes of obsolete or worn items Instructions for the use of tags, punched cards, count sheets, computers, or other media devices and for their collection and control (a typical inventory count sheet is illustrated at Exhibit 9.6) Plans for shutting down plant operations or for taking inventory after store closing hours, and plans for having goods in proper places (such as on store shelves instead of on the floor, or of raw materials in a warehouse rather than in transit to a job) Plans for counting or controlling movement of goods in receiving and shipping areas if those operations are not shut down during the count Instructions for computer compilation of the count media (such as tags, count sheets) into final inventory listings or summaries 10 Instructions for review and approval of the inventory count; notations of obsolescence or other matters by supervisory personnel 11 Instructions for making changes and corrections to count tickets Dual-direction sampling in the context of inventory test counts proceeds as follows: In one direction, a sample of inventory items can be chosen from the perpetual records or inventory count tags for test count to ascertain that recorded inventory was counted (existence) In the other direction, the auditor can count a sample of items in their locations, record these, and later trace them to the perpetual records and inventory summary count sheets to ascertain whether all inventory in place was recorded and counted (completeness) 9.12 Amounts on inventory count sheets and tickets become the amounts in the inventory, so a fictitious item on the count sheet or ticket becomes a fictitious item in inventory If the auditors not obtain control information, the client can easily add amounts to the inventory count without the auditors’ knowledge 9.13 The auditor should document: • Whether the client’s personnel were following the inventory instructions • Test counts taken, including description, and quantity • The ticket or count sheet numbers that were used as well as the numbers of voided and unused tickets 9-4 Chapter 09 - Production Cycle • • • • The last receiving reports and shipping documents used, and the number of the next unused item The condition of the inventory Any inventory on hand that is not owned by the client Any unusual items noticed during the count 9.14 The auditor must obtain shipping and receiving cut-off information during the physical inventory observation to ensure that items recorded as receipts or shipments in the accounting records match purchase included and sales excluded from inventory in the perpetual records The perpetual records are compared to the count to determine the book to physical inventory adjustment 9.15 In this type of situation, the auditor will arrange to be present during one more of the test counts, and importantly, he will evaluate the cycle or statistical plan for validity During his observation of the inventory-taking, the auditor will employ the usual inventory audit procedures, perform test counts and be responsible for a conclusion concerning the reasonable accuracy of perpetual quantity records 9.16 The client’s managers may be making record of the auditors’ test counts so they can fraudulently change the counts on items the auditors did not count 9.17 Obsolete or slow-moving inventory is often indicated by: • Its location in an area far from the shipping dock • Layers of dust • Water-damaged containers • Date codes on packaging • Informal discussions with warehouse personnel • Old inventory count tags • Rust or other damage 9.18 If a client is counting inventory at multiple locations, the auditor must visit a sample of the locations on a surprise basis to observe the counts The number of locations depends on the materiality of the inventory and the quality of the client’s controls The auditor should notify the client that he/she will be visiting some locations so personnel will know to be cooperative, but he/she should not tell the client which locations will be visited 9.19 An inventory roll-forward is the client’s process for updating the inventory balance for shipments and receipts from the time of the physical count to the end of the fiscal year Auditors will normally be concerned with reviewing the controls over the roll-forward, and testing the entries to supporting documents The auditor can also use analytical procedures to determine the reasonableness of the ending inventory SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 9.20 a b c d Incorrect Incorrect Incorrect Correct This is allowed by GAAP This is allowed by GAAP This is allowed by GAAP Although standard costs are commonly used, they must not be materially different than one of the allowed methods 9.21 a Incorrect b Incorrect Raw materials and supplies purchased are linked through the acquisition and expenditure cycle Labor and costs are linked through the payroll cycle 9-5 Chapter 09 - Production Cycle c Incorrect d Correct a Incorrect b c d Incorrect Correct Incorrect 9.23 c Correct The job cost sheets indicate the cost used in determining the value of inventory produced 9.24 a b c Incorrect Incorrect Correct d Incorrect This is a common practice that enhances efficiency See answer a The weakness is an improper combination of inventory custody and record keeping responsibilities See answer a a Incorrect b Incorrect c d Correct Incorrect 9.26 a b c Incorrect Incorrect Correct This might detect the theft but wouldn’t prevent it This wouldn’t necessarily detect the theft The separate space facilitates security, and the frequent counts enable company personnel to detect shortages in a timely manner 9.27 a b c Incorrect Incorrect Incorrect d Correct This step would not provide evidence whether the items are owned This step would not detect obsolescence Ensuring physical presence would require tracing from the listing to inventory tickets If the sample is from the inventory in the physical location, the tracing has the objective of auditing the completeness of the final inventory schedule a b Incorrect Correct c d Incorrect Incorrect low 9.22 9.25 9.28 Cost of goods sold and reduction to finished goods inventory is linked through the revenue and collection cycle The finance and investment cycle is not directly linked to the production cycle, although it is indirectly linked through investments in property, plant, and equipment This is what the company plans to sell, not produce Some of the planned sales may come from existing inventory, and some of the production may be sold in future periods These reports indicate what was actually produced The production plan shows what is planned to be actually produced Shows what was actually purchased during the period The most meaningful analytical procedures are performed at the most disaggregated level, in this case, the product level The most meaningful analytical procedures are performed at the most disaggregated level, in this case, the product level This is the most disaggregated level of the choices given The most meaningful analytical procedures are performed at the most disaggregated level, in this case, the product level This would make the count lower than the perpetual records Unrecorded credit memos means that the returned inventory is not in the perpetual records, thus the recorded amount will be smaller than the amount on hand This would make the perpetual records too high This would make both the physical count and perpetual records too 9-6 Chapter 09 - Production Cycle 9.29 a b Incorrect Correct c d Incorrect Incorrect a b c Incorrect better Incorrect Correct d Incorrect 9.31 a Correct An auditor does not expect all inventories to which the auditee has title to be on hand at the date of the count Some purchased goods may still be in transit at that time Also, some inventory may be on consignment or in public warehouses although properly included in the count 9.32 a This may be done, but the persuasiveness is low because of the weak b c Incorrect controls Incorrect Correct d Incorrect a b Incorrect Correct c d Incorrect occurrence Incorrect a Incorrect b Correct c d Incorrect Incorrect 9.30 9.33 9.34 Controls must be strong for the roll-forward to be reliable Auditors rely on accurate perpetual records to maintain an accurate inventory balance during the intervening period between the physical count and the balance sheet date Slow moving inventory is easier to roll-forward This has nothing to with when the count should be taken This step helps ensure existence as well as completeness Answer c is This ensures goods will not be stolen (existence assertion) Checking the numbering sequence on pre-numbered receiving reports is a way to detect omission of the recording of inventory received These are not incompatible duties that must be separated NO! Controls are tested when they are strong and can be relied on If control risk is high, a timelier audit procedure may be necessary, and extending the results of work done on an interim basis to year-end might be inappropriate Thus, observation of inventory at year-end would provide the best evidence as to existence This can only be done if controls can be relied on This procedure does not provide evidence about rights and obligations Tracing the details of test counts to the final inventory schedule assures the auditor that items in the observed physical inventory are included in the inventory records The auditor should compare the inventory tag sequence numbers in the final inventory schedule to those in the records of his/her test counts made during the client’s physical inventory The auditor would go in the opposite direction to test existence and This pertains to the presentation and disclosure assertion Physical presence does not necessarily imply ownership The goods may be pledged or on consignment The major audit objective of testing the assertion of rights and obligations for inventories is to determine that the entity has legal title or similar rights of ownership to the inventories Typically, the auditor will examine paid vendors’ invoices, consignment agreements, and contracts This is a test for cut-off The wording of the question implies that this is a test for presentation and disclosure The procedure does, however, reveal obligations for purchase commitments Answer b is better because of the way the question is worded 9-7 Chapter 09 - Production Cycle 9.35 a b c d Incorrect Incorrect Incorrect Correct Turnover has little to with the existence assertion Turnover has nothing to with rights and obligations See answer b Assertions about valuation or allocation concern whether asset, liability, revenue, and expense components have been included in the financial statements at appropriate amounts An examination of inventory turnover pertains to the audit objective of identifying slowmoving, excess, defective, and obsolete items included in inventories This audit objective relates to the valuation or allocation assertion 9.36 a b c d Incorrect Incorrect Incorrect Correct Inspecting documents for approvals is a typical test of controls See answer d See answer d Policy and procedure manuals are least important because the most important features are the actual workings of the controls as indicated by the other three choices 9.37 a b c Incorrect Incorrect Incorrect d Correct This is the focus of substantive tests See answer a Financial statements should be produced in accordance with GAAP but not accounting systems per se Auditors need to determine whether the cost accounting system assigns costs properly to the inventories a b c Incorrect Incorrect Incorrect d Correct a Incorrect b Incorrect c d Incorrect Correct a Incorrect b c d Incorrect Correct Incorrect 9.38 9.39 9.40 Cost ledgers are focused more on cost than on quantities The perpetual inventory records are not original documents Receiving reports usually reflect materials going into raw materials, not work in process Inventory requisitions are the authorization for the inventory custodian to release raw materials and supplies to production personnel This tests whether the reductions in inventory for shipments were accurate This tests whether the additions to raw materials inventory for purchases were accurate This provides an overall test of the accuracy of the perpetual records If the controls are excellent and the roll-forward is tested, a re-count is not necessary If controls are weak and control risk is high, the auditor of a non-public company would not test the controls Tests of controls not test inherent risk The auditor tests the controls to reduce substantive tests This is not a requirement of GAAS for non-public companies 9-8 Chapter 09 - Production Cycle SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 9.41 Internal Control Questionnaire Items: Possible Error or Fraud Due to Weakness Question Possible Error or Irregularity Fraud or error in production, payroll, or reporting concealed in cost records Unauthorized production for personal products Materials withdrawn from inventory or hours worked for unauthorized projects Materials withdrawn for personal use Production may be started for uneconomic jobs or personal projects Materials and labor may be used for uneconomic jobs or personal projects Errors in material usage or theft by storeroom employees Errors in labor costs Foreman incorrectly requests material or assigns job skills 10 Not all material or labor accounted for correctly foreman could also conceal unauthorized material or labor in authorized job 11 Production orders lost and accounting incomplete 12 Lost forms resulting in labor or material used but not recorded 13 Labor or material used but not recorded 14 Issue slips not compared to material used reports Material withdrawn from inventory not accounted for Lost forms resulting in inventory not charged to cost of goods sold 15 Failure to disclose agreements in footnotes 16 Inclusion of goods on consignment in inventory accounts 17 Scrap reporting incorrect Incorrect perpetual inventories 18 Differences not investigated Labor used not accounted for by assigning to a job 19 Incorrect costs used, inventory improperly valued 20 Comparison not made or difference not investigated Production completed not put into inventory 21 Inventory transactions posted in wrong-period Cut-off errors 22 Errors in summary entries not detected and corrected 23 Accounting entries may get put in the wrong account 9-9 Chapter 09 - Production Cycle 9.42 Tests of Controls Related to Controls and Assertions Procedure (1) (a) Strength Preparation of summary material and labor entries (b) Assertion Valid work-in-process inventory transactions are recorded and none omitted (completeness) (2) Production cost sheets prenumbered and accounted for Valid finished goods inventory transactions are recorded and none omitted (completeness) (3) Independent check on materials and labor used Recorded labor and material transactions are valid (occurrence) (4) Issue forms secure and used by authorized personnel Prenumbered and accounted for All material issues are authorized (occurrence) All issue forms are recorded (completeness) (5) Use of control account Production transactions are recorded properly (presentation) (6i) Recording of materials used Material used is recorded in proper period (allocations) (6ii) Standard control number Job accounting is complete (completeness) (6iii) Material received, custody Material used is authorized (occurrence) (6iv) Proper material received Job cost accounting accurate (valuation) (6v) Proper release of correct materials Material release recorded accurately (valuation) (6vi) Material release authorized and timely Authorized issue of material and in proper period (occurrence, completeness) Timely recording Inventory recorded in proper period (completeness) (7) 9.43 Cost Accounting Test of Controls Procedure Evidence Sample of Cost Accounting Payroll Analyses: Reconcile periodic totals with payroll register record of payments Incomplete costing deviation Vouch costs to time records Invalid time analyzed deviation Trace cost accounting labor distributions to management reports and postings in general ledger and subsidiary account(s) Inaccurate reporting deviation Incomplete accounting deviation Wrong classification deviation Sample of Recorded Labor Cost Items: Vouch labor cost entries to supporting labor cost analyses 9-10 Invalid entries deviation Chapter 09 - Production Cycle 9.44 9.45 Inventory Count Observation: Planning and Substantive Procedures a Sammy should find in the audit working papers a planning memo describing the client’s inventory-taking plan and notes about the auditors’ first-hand observation of the instructions being given to counters, along with a memo about the auditors’ observation of the counting This memo should tell about supervision of the audit staff, and the working papers (test counts) should show the review signatures of the supervising auditors b Working papers should document performance of these substantive procedures for the existence and completeness assertions: Conduct an observation of the company’s physical inventory count Scan the inventory compilation for items added from sources other than the physical inventory count At year end, obtain the number of the last shipping and receiving documents Use these to scan the sales, inventory/cost of sales, and accounts payable entries for proper cutoff Confirm or inspect inventories held in public warehouses Sales/Inventory Cutoff In view of the information given, the following adjusting entries would be necessary: For the first item: Inventory Control Inventory Variation (CGS) 28,400 28,400 For the third item: Sales 21,300 Accounts Receivable 21,300 Inventory Control Cost of Sales 18,900 18,900 Since the goods in the first item were shipped prior to the taking of the physical inventory, the Inventory Control account was reduced by the cost of these goods in the adjustment that arose from the physical inventory Since the client credited Inventory Control for the cost of these goods on December 16, one of these two credits must be removed The above entry reverses that made on December 15 with respect to these goods and leaves Cost of Sales properly charged with the $28,400 as a result of the December 16 entry The sales entry was made properly and requires no adjustment In the second item, the client has reduced the control account at the date of shipment, prior to the taking of the physical inventory The control was in agreement with the physical count on December 15 so far as these goods were concerned, and the December 15 adjustment did not relate to these goods Since the accounts involved are in agreement with the facts at both December 15 and December 31, no adjustment is necessary 9-11 Chapter 09 - Production Cycle The third item is a sale recorded too early, and both the revenue and cost recognition need to be revised 9.46 Audit Simulation: Purchasing Cutoff a Correcting entry under periodic system Inventory (RR#1183, 1184) 29,335.13 Accounts payable (RR# 1183) Purchases b Correcting entry under perpetual system Inventory (RR#1183, 1184) 29,335.13 Accounts payable (RR# 1183) Cost of Goods Sold 9.47 11,482.57 17,852.56 11,482.57 17,852.56 Statistical Sampling Used to Estimate Inventory a The following procedures are based upon, but not copied from Appendix 9B: 10 11 12 13 14 b Review and be satisfied with the client’s physical inventory-taking procedures Observe the physical count Make test counts where appropriate Trace selected count data to the inventory compilation Select items from the compilation and trace them to original count data Select items from the warehouse at random and trace these items to the perpetual inventory record Verify footings Compare inventory compilation amounts to the subsidiary ledger control and investigate significant differences Ascertain that there was a proper purchases and sales cutoff Review the treatment of merchandise in transit and consigned merchandise Confirm merchandise in public warehouses Perform an overall analytic review of inventories Account for all client inventory count sheets Be sure inventory items are properly classified, in good condition, and of proper quality When a client uses statistical sampling to estimate inventories, the auditor should perform procedures similar to the following: The auditor should review the client’s procedures and methods for determining inventories to ascertain that they are sufficiently reliable to produce results substantially the same as those that would be obtained by a 100 percent inventory count The auditor should be satisfied that the statistical sampling plan to be used by the client has statistical validity, that it will be properly applied, and the planned tolerable misstatement and sampling risk as defined statistically, will be reasonable 9-12 Chapter 09 - Production Cycle 9.47 9.48 The auditor should ascertain that proper steps have been taken to ensure that all parts and supplies in the warehouse are included in the perpetual inventory record This would normally be checked before the physical count The auditor should be present when the sample is drawn to make sure that the requirements for random selection are properly observed and that all items in the inventory have an equal or determinable probability of selection Statistical Sampling Used to Estimate Inventory (part b, Continued) The auditor must be present to observe counts and must be satisfied with the client’s counting procedures The inventory observation can be made either during or after the year end of the period under audit if well-kept perpetual records are maintained and the client makes periodic comparisons of physical counts with such records The auditor should review the statistical evaluation and be satisfied that the estimated value of the tolerable misstatement at a given level of sampling risk meets the materiality requirements set for the audit Inventory Procedures Using Computer-Assisted Audit Techniques (CAATs) Basic Inventory Audit Procedures How Audit Software and Inventory Data Files can Help Observe the physical count, making and recording test counts where applicable Determine which items are to be test counted by making a random sample of items from the inventory file as of the date of the physical count Test the mathematical accuracy of the inventory compilation (summary) Mathematically compute the dollar value of each inventory item counted by multiplying the quantity on hand by the cost per unit and verify the addition of the extended dollar values Compare the auditors’ test counts to the inventory records Arrange test counts in a tape-format identical to the inventory file and matching the tapes Compare physical count data to inventory records Compare the total extended values of all inventory items counted and the extended values of each inventory item counted to the inventory records Test the pricing of the inventory by obtaining a list of costs per item from buyers, vendors or other sources Prepare a tape in a format identical to the tape of the inventory file and matching the tapes Examine purchase and sale cutoff List a sample of items on the inventory file for which the date of last purchase and date of the last sale are on or immediately prior to the date of the physical count 9-13 Chapter 09 - Production Cycle 9.49 Ascertain the propriety of items of inventory located in public warehouses List items located in public warehouses Analyze inventory for evidence of possible obsolescence List items on the inventory file for which the date of the last sale indicted a lack of recent transactions Analyze inventory for evidence of overstocking or slow-moving items List items for which the quantity on hand is excessive in relation to the quantity sold during the year 10 Perform overall test for accuracy of inventory master file List items, if any, with negative quantities or costs CAATs Application: Inventory a The purpose of a computer audit software package is to provide computer programs that can process a variety of file media and record formats to perform a number of functions A package can be used to perform or verify mathematical calculations; to include, exclude, or summarize items having specified characteristics to provide subtotals and final totals; to compute, select and evaluate statistical samples for audit tests; to print results in a form specified by the auditor; to arrange detailed items in a format or sequence that will facilitate an audit step; to compare, merge or match the contents of two or more files, and to produce machine-readable files in a format specified by the auditor b Ways in which a general purpose computer audit software package can be used to assist in the audit of inventory of Boos & Becker, Inc., include the following: Compare data on the CPA’s set of pre-punched inventory count cards to data on the disk inventory master file and list all differences This will assure that the set of count cards furnished to the CPA is complete Determine which items and part are to be test-counted by making a random selection of a sample from the audit deck of count cards or the disk inventory master file Exclude from the population items with a high unit cost or total value that have already been selected for test counting Read the client’s disk inventory master file and list all items or parts for which the date of last sale or usage indicates a lack of recent transactions This list provides basic data for determining possible obsolescence Read the client’s disk inventory master file and list all items or parts of which the quantity on hand seems excessive in relation to quantity used or sold during the year This list provides basic data for determining overstocked or slow-moving items or parts Read the client’s disk inventory master file and list all items or parts of which the quantity on hand seems excessive in relation to economic order quantity This list should be reviewed for possible slow-moving or obsolete items 9-14 Chapter 09 - Production Cycle Enter the audit test-count quantities into the computer Match these counts against the client’s adjusted disk inventory file comparing the quantities on the cards to the quantities on the disk file and list any differences This will indicate whether the client’s year-end inventory counts and the master file are substantially in agreement Use the adjusted disk inventory master file and independently extend and total the year-end inventory and print the grand total on an output report When compared to the balance determined by the client, this will verify the calculations performed by the client Use the client’s disk inventory master file and list all items with a significant cost per unit The list should show cost per unit and both major and secondary vendor codes This list can be used to verify the cost per unit Use the costs per unit on the client’s disk inventory master file and extend and total the dollar value of the counts on the audit test count cards When compared to the total dollar value of the inventory, this will permit evaluation of audit coverage 9.50 Audit Simulation: Inventory Evidence and Long-Term Purchase Contracts a Gathering evidence about the contract would involve reading the contract, discussing the terms with management, asking if any attempt would be made to renegotiate the price, and confirming the terms of the contract with All-Purpose b Facts cited that the auditor would have to discover consist of the current market price information and the informed expectations about the duration of the price level A general awareness of economic conditions, newspaper reports, aluminum industry trade sources, and consultation with metals commodity experts are sources and means of confirming these “facts” c By all indications, there should be a write-down of inventory to market and a current recognition of loss on the firm purchase commitment Current inventory write-down: Inventory per books Inventory at market 400 tons@ $.20/lb Write-down to market Loss on purchase contracts: Contract purchases 500 tons 700 tons 1,000 tons 2,200 tons @ $400/ton market Loss on purchase contract 9-15 $ 240,000 $ $300,000 420,000 500,000 160,000 80,000 $1,220,000 880,000 $ 340,000 Chapter 09 - Production Cycle 9.51 Audit Simulation: Tracing the Inventory Count a Inventory program steps for tracing in inventory count information Obtain client’s listing of final inventory count a Use CAATs to foot listing and check for numeric sequence of inventory b c Agree total to final inventory in general ledger Agree test counts obtained during the count to the listing for quantity and description tags Follow up on any unusual items noted during the count b Possible causes of items noted It may be that the client did discover additional items However, the client may be attempting to fraudulently inflate inventory These may be honest errors, or again this may indicate possible fraud These items are clearly obsolete Even if the goods aren’t broken, they are not being sold c Follow-up procedures Request to see the items and documentation of when they were received Inquire of count personnel about why they were missed, and how they were found Select a large sample of additional tickets and agree them to the listing Consider having client re-input all the tickets Determine if there is a pattern to the errors (all inventory increasing, all in one area, all by one employee) Determine client’s plans for selling Include these items in the Lower of Cost or Market testing, incorporating any planned discounts or other costs of disposing Ask about any other slow-moving items 9-16 Chapter 09 - Production Cycle 9.52 Audit Simulation: FIFO Inventory Pricing a The cost of the jump suits should be: 600 @ $782= 663 @ $777= $469,200 $515,151 $984,351 The adjusting entry should be: Cost of Goods Sold Inventory b 3,315 3,315 Yes, market value is replacement cost Since the replacement cost is $750 Assuming this is between the net realizable value (ceiling) and the net realizable value less a normal margin (floor), the jumpsuits should be valued at (1263 @ $750) $947,250 The adjusting entry should be: Cost of Goods Sold Inventory 9.53 40,416 40,416 Toying Around With the Numbers AUDIT APPROACH The sales forecast should be based on realistic assumptions and expectations The company should have documentation or plausible explanations for the assumptions underlying the forecast Detail records of tooling cost balances by toy line should carry forward from the end of the prior year to the beginning of the current year in the same amount and for the same toy lines, just like the cost of fixed assets Tests of Controls: There is nothing routine about reviewing a sales forecast for reasonableness The company’s documentation, if any, should be studied Persons responsible for its preparation should be interviewed One typical procedure is to track the record of management’s past sales forecasts with subsequent actual sales experience Responses to inquiries should be analyzed for reasonableness on whatever bases are available (excluding wild optimism) Test of Balances: Much of the balance-audit work on inventory obsolescence flows directly from the control testing In this case, the reliability of the forecast was the crucial step because inventory was not even flagged for LCM calculation unless it exceeded the forecast (Not much could be determined from the physical observation because toys don’t show signs of mold or rust When oversupplied, they are sold at close-out prices However, a few kinds of parts and raw materials might be “observed” as questionably obsolete.) Review the forecast for curious discrepancies In this case zero differences between inventory quantity on hand and forecast sales of toys and usage of parts should bring suspicion that the forecast was “plugged.” Further inquiry into the forecast process is warranted 9-17 Chapter 09 - Production Cycle Beginning balances of unamortized tooling costs should be traced to prior year working papers or the client’s prior year records This should have showed the movement of prior year amounts to different toy lines Amortization rates should be tested against the forecasts, and the forecast experience should be reviewed DISCOVERY SUMMARY (Adapted; ASR 292) The auditors did not notice anything curious about inventory quantities and forecast quantities being equal in 19 of 128 lines sampled for detailed audit They did not notice the interchangeable part numbers’ reference to the part itself instead of to a new toy In one of the years, they did not compare prior forecast to subsequent actual sales experience; in the other year, the auditors made the comparison, but accepted management’s explanation of how sales would increase The auditors apparently did not trace the beginning tooling balances to prior year-end balances and failed to notice the movement of the amounts to other toy lines However, they did notice the poor forecast experience for tooling amortization and recommended an additional $2 million amortization of the prepaid expense After discussion with management, an adjustment to amortize another $1.4 million tooling cost was recorded That still left the balance overstated because the auditors recommended an adjustment only for the sample of items they tested and did not project the misstatement to the entire deferred cost population 9.54 No Defense for These Charges AUDIT APPROACH Objective: Obtain evidence of the reliability of labor costs deferred as tooling and the amount claimed as cost overrun reimbursement on defense contracts Obtain evidence of the “existence” of the labor cost reimbursement claim in terms of its being supported by sufficient documentation to justify carrying as an asset Control: The major control lies in the procedures for documenting the reliability of labor cost assignments identifying the time and cost specifically to the categories claimed For the reimbursement claim, the circumstances also need to meet the terms of the contract respecting cost overrun reimbursement Tests of Controls: The test of control procedure is to select a sample of journal entries that created the assets— deferred tooling cost and cost reimbursement claim Vouch them to supporting documentation The transactions can be audited for control over validity and accuracy However, these procedures will also satisfy the dual purpose of auditing the asset balances that arise directly from the transactions 9-18 Chapter 09 - Production Cycle Test of Balances: The account balances created by the deferral journal entries are audited (“dual purpose procedure”) by auditing the supporting documentation These balances were created entirely by the journal entries and their “existence” as legitimate assets—cost deferral and reimbursement claim depends on the believability of the supporting explanations In connection with the defense contract claim, auditors can review it with knowledge of the contract and the extent of documentation required by government contract auditors DISCOVERY SUMMARY By performing the procedures outlined above, the manager, senior, and staff accountants on the engagement discovered all the questionable and improper accounting They noticed that the tooling cost deferral labor cost was “supported” by work orders of recent date and numerical sequence, but the labor charge tickets were created several months prior This finding tipped them off that the later journal entry establishing the deferred charge was invented for income manipulation purposes later in the fiscal year The government contract cost overrun claim had similar deficient documentation The labor cost had no associated work orders connected with the government contracts in progress Collectibility was very doubtful The account was adjusted to “write off” the claim 9.55 Detecting Errors and Fraud Effect on financial statements Auditing procedures that might have detected the misstatement a Total assets overstated Net income overstated As part of the roll-forward procedure Auditors would examine the entries to reduce inventory for the cost of sales b Total assets overstated Net income overstated Locations should be visited for an inventory count on a surprise basis c Total assets overstated Net income overstated Examination of purchase records should reveal the automobiles were not purchased Inquiry of the client about consignments should also alert auditors to the presence of consigned goods d Total assets overstated Net income overstated Examination of purchase invoices should indicate that the pricing is by thousand feet Also, comparison to prior periods should show the large increase in the value of wiring e Total assets overstated Net income overstated During the observation of the physical inventory, auditors should request that some boxes be opened Also, purchase records should indicate that they have only six baseballs per box 9-19 Chapter 09 - Production Cycle 9.56 Kaplan CPA Exam Simulation: Inventory Assertions Assertion A Procedure L The valuation assertion addresses whether the inventory balances are recorded at the proper cost Verifying the recorded cost of inventory items to the relevant vendor invoices (from Amberly’s supplier) will provide evidence to support the recorded cost of inventory (assuming that the market price is greater than cost at the end of Year 2) Additionally, a further audit procedure to confirm valuation would be to test for compliance with the “lower of cost or market” rule at the end of Year by comparing the cost amounts of specific inventory items at the end of Year to recent sales invoices in early Year involving those same inventory items B G The existence assertion addresses whether the raw material inventory balance is reasonably stated (i.e., not overstated) at the end of Year By selecting a sample of items from the inventory listing and tracing them back to the corresponding invoices, receiving reports, and purchase orders, one is able to confirm both the cost of the items and whether Amberly actually received what it recorded In contrast, tracing a sample of transactions from the check register back through the system to the original purchase order merely indicates that Amberly paid for items that were ordered, but it does not prove that Amberly actually received those items D M The completeness assertion deals with whether the inventory transactions that occurred close to the end of Year are properly included in Year Tracing the inventory transactions recorded shortly after the end of Year and tying them back to the sales and purchases accounting records for Year will help substantiate that the inventory transactions for Year are complete A H The valuation assertion addresses whether the inventory is properly valued to account for obsolete and slow-moving items since it deals with whether the inventory is being carried at the proper value By reviewing for items with few or no purchases or sales during the year, the auditor can investigate whether the items should be included in the allowance 9-20 Chapter 09 - Production Cycle 9.57 Kaplan CPA Exam Simulation: Inventory Method NOTE TO INSTRUCTOR: The following solution is presented by Kaplan at the time of publication SAS 41 has been superseded by SAS 103 (Audit Documentation) and the guidance provided by that pronouncement is shown below Working Papers (SAS 41) The auditor should prepare and maintain working papers, the form and content of which should be designed to meet the circumstances of a particular engagement The information contained in working papers constitutes the principal record of the work that the auditor has done and the conclusions that he has reached concerning significant matters Content of Working Papers The quantity, type, and content of working papers vary with the circumstances, but they should be sufficient to show that the accounting records agree or reconcile with the financial statements or other information reported on and that the applicable standards of field work have been observed Working papers ordinarily should include documentation showing that: • The work has been adequately planned and supervised, indicating observance of the first standard of field work • The internal control structure has been considered to the degree necessary to determine whether, and to what extent, other auditing procedures are to be restricted, indicating observance of the second standard of field work • The audit evidence obtained, the auditing procedures applied, and the testing performed have provided sufficient competent evidential matter to afford a reasonable basis for an opinion, indicating observance of the third standard of field work Audit Documentation (SAS 103) The auditor must prepare audit documentation in connection with each engagement in sufficient detail to provide a clear understanding of the work performed (including the nature, timing and extend, and results of audit procedures performed), the audit evidence and its source, and the conclusion reached Audit documentation: a Provides the principal support for the representation in the auditor’s report that the auditor performed the audit in accordance with generally accepted auditing standards b Provides the principal support for the opinion expressed regarding the financial information or assertion to the effect that an opinion cannot be expressed 9-21 ... control and investigate significant differences Ascertain that there was a proper purchases and sales cutoff Review the treatment of merchandise in transit and consigned merchandise Confirm merchandise... recorded and none omitted (completeness) (3) Independent check on materials and labor used Recorded labor and material transactions are valid (occurrence) (4) Issue forms secure and used by authorized... inventory SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 9.20 a b c d Incorrect Incorrect Incorrect Correct This is allowed by GAAP This is allowed by GAAP This is allowed by GAAP Although standard costs