chapter 9 production cycle “there is one rule for industrialists and that is: make the best...
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Chapter 9
Production Cycle
“There is one rule for industrialists and that is: Make the best quality of goods possible at the lowest cost possible, paying the highest wages possible.”—Henry Ford
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Importance of Inventory
• Major component of current assets on the balance sheet.
• Significant effect on net income.• Valuation is usually very subjective.
– Potential obsolescence
– Goods have not been sold, so marketability may be uncertain.
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Inherent Risks in Production Cycle
• Complexity (e.g. dollar value LIFO)
• Susceptibility to theft
• Lower-of-Cost-or-Market valuation
• Effects on gross profits
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Typical Activities
• Planning– Production plan
• Production– Bill of materials– Requisitions
• Cost Accounting– Standard costs– Overhead allocation
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Exhibit 9.2Production Cycle
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Production Cycle: Control Considerations
• Production runs are authorized.
• Raw Materials should be counted, and inspected
• As production is undertaken, materials and labor quantities should be summarized.
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Production Cycle: Control Considerations
• Use of TRANSFER tickets• Count/inspect the items and compare quantities• The cost accounting department reviews
– Quantity of raw materials to materials requisition
– Quantity of direct labor to time sheets and labor distribution report
– Cost accounting applies overhead costs to production using OVERHEAD TICKETS
– Cost summary
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Production Cycle: Control Procedures• Physical Controls
– Production Order and Materials Requisition.– Physical inventories reconciled to perpetual inventory records.– Restrict access to inventories– Transfer Tickets
• Separation of Duties– Authorization– Recording– Custody– Reconciliation
• Performance Reviews– Scrap reports– Variance analysis
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Management Reports
• Sales Forecasts
• Inventory reports– Items on hand
• Production plans and reports
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Test of Controls
• Observe separation of duties
• Vouch costs to labor and material reports– Time tickets– Receiving reports– Transfer tickers
• Check proper authorizations
• Examine review of cost reports
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Substantive Procedures
• Observation of inventory count
• Tests of pricing and compilation
• Analytical procedures
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Physical Inventory Observation
• “…it will always be necessary for the auditor to make, or observe, some physical counts of the inventory and apply appropriate tests of intervening transactions" (AU 331.12).
• May make test counts at a time other than year-end. – test roll-forward.
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Physical Inventory Observation
• Review client instructions
• Stop flow of goods• Make TEST COUNTS
– From INVENTORY LISTING– From WAREHOUSE FLOOR– Record some counts in working papers
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Client Count Instructions
• Names and dates• Instructions for descriptions and counts• Noting obsolete or worn items• Tag control—compilation of counts• Shutting down production• Controlling movement• Supervisory approval• Making changes and corrections
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Exhibit 9.7Inventory Count Sheet
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Physical Inventory Observation
• Listen to instructions provided to count teams• Understand the use of control tags, count sheets, scanners,
or RFID • Be wary of "hollow squares" and "empty boxes”• Tour shipping and receiving areas• Watch for OBSOLETE and SLOW-MOVING inventory • CONFIRM inventory on CONSIGNMENT and at other
locations• Consider the use of SPECIALISTS• Confirm inventory in transit.
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Examples Challenges/ Special procedures.
Lumber Problem identifying quality or grade. /Employ a specialist
Piles of sugar, coal, scrap steel Geometric computations, aerial photos./ Employ a specialist
Items weighed on scales Accuracy of scales./Examine certification.
Bulk materials (oil, grain, liquids in storage tanks)
Measuring volume, ensuring composition of content/Climb the tanks Dip measuring rods. Sample for assay or chemical analysis.
Diamonds, jewelry Identification and quality determination problems/ Hire a specialist.
Pulp wood Quantity measurement estimation/Examine aerial photos.
Livestock Movement not controllable/Use chutes to control animals.
Inventory Count and Measurement Challenges
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Pricing and Compilation Tests
• Valuation (Price Tests) – VENDOR INVOICES– COST FLOW ASSUMPTION (FIFO, LIFO,
average, specific identification)– LOWER OF COST OR MARKET for
inventory
• Check Extensions and Footings. • Agree to G/L
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Purchase Cutoffs
• Verify CUT-OFFs for purchases and sales– Examine Receiving Reports and Vendor Sales
Invoices occurring around year-end.– Examine bills of lading and sales invoices– Agree to inclusion/exclusion from inventory
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Analytic Procedures
• Verify REASONABLENESS of COGS– Gross Profit Margin
– Compare to prior year, industry averages
• Verify REASONABLENESS of ending inventory– Days Sales in Inventory
– Inventory Turnover
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Fraud Detection Procedures
• Focus on high-dollar items.
• Unpredictable counts.
• Be skeptical of large differences.
• Be alert for signs of damage, obsolescence or excess quantities.
• Ensure interplant transfers are kept to a minimum.
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