Chapter 9 Audit

materials requisition (materials transfer ticket)

A form used to obtain raw materials and supplies from inventory custodian.

Pricing and Compilation Tests

-Valuation (Price Tests) -Vendor invoices -Cost flow assumption (FIFO, LIFO, average, specific identification) -Lower of cost or market valuation of inventory •Check extensions and footings •Agree to general ledger

Production Order

A document that communicates to production personnel the specific product, product quantity, and date a product is to be produced.

Bill of materials

A list of raw materials and supplies used to build a product that is used to develop standard costs

9.3b What controls noted?

Approval signatures on requisitions and time records Approvals of journal entries Tests of accuracy of calculations Separation of duties

True or false: A sales forecast is prepared to ensure that quality products will be available at the appropriate time for the lowest costs

False

9.11 Describe how the function of authorization of production transactions can be separated among the production, inventory, and cost accounting departments.

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.

9.22 What analytical procedures might reveal obsolete or slow-moving inventory?

Inventory turnover ratios. Trend analysis of inventory levels. Days sales in inventory ratio. Sales trend analysis.

The schedule for manufacturing designed to ensure quality goods are available at the appropriate time for the lowest cost is called the _______ _________ . (Enter only one word per blank.)

Production Plan

To help detect inventory fraud auditors should Blank______. Multiple select question. a. look for excessive amounts of an inventory item b. sample lower-value inventory items c. focus test counts on high-volume items d. advise client personnel of locations to be visited as soon as possible

a, b

After observation is complete, auditors should have sufficient appropriate evidence that ______ the inventory compilation. Multiple select question. a. goods in transit (purchased but not yet received) were excluded from b. goods on hand that have been sold were excluded from c. goods on hand were counted and included in d. consigned-out goods were included in

b, c, d

A specification of the type and quantity of components required for production is found on the ______. a. raw material inventory status report b. materials requisition form c. bill of materials d. production order

c

Examining shipping and receiving documents issued before and after the manual physical inventory count is an important _______ procedure.

cutoff

When the auditors were not present for the count of beginning inventory they must ______ opinion on the income statement. Multiple choice question. issue an adverse disclaim an issue a modified issue an unmodified

disclaim an

Physical observation procedures are designed to audit for ______ and _______. (Enter only one word per blank.)

existence, completeness

Inventory disclosures must ensure that the presentation and disclosure assertions of occurrence, _________ and obligations, _______ , classification and understandability, and accuracy and __________are all met. (Enter only one word per blank.)

rights, completeness, valuation

The acquisition cycle is linked to the revenue cycle through the cycle.

Production

Why is it important for auditors to obtain control information over inventory count sheets or tickets?

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 do not obtain control information, the client can easily add amounts to the inventory count without the auditors' knowledge.

What two directions are the test of controls?

Completeness & Occurrence

9.10 What features of the cost accounting system would be expected to prevent the omission of recording materials used in production?

Failure to record materials 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 to account for a numerical sequence is also a primary means of preventing omission of transactions.

True or false: Inventory roll-forward procedures are required if inventory is counted either before or after the balance sheet date.

False

True or false: Standard costing is an acceptable, recognized method per GAAP.

False Reason: It is not recognized per se and the audit must ensure that standard costs are not materially different from the GAAP method adopted.

Because an inventory error has a cascading effect that affects many areas of the financial statement, auditors identify it as a(n) ______ error.

Pervasive error

One of the most critical jobs in any manufacturing operation is ______. Production Planner Sales Forecaster Marketing manager

Production Planner

Production activities start a marketing projection based on past performance and marketing initiatives called a(n)

Sales Forecast

9.4 How might an auditor use a client's sales forecast for general familiarity with the production cycle or for evaluation of slow-moving inventory?

Some work to obtain assurance about the reasonableness of the client's sales forecast needs to be performed. The auditors need to learn about the assumptions built into the forecast for the purpose of ascertaining their reasonableness. The auditor may gain an understanding as to how production is determined and the flow of product through the warehouse to the customer. In addition, some work on the mechanical accuracy of the forecast should be performed to avoid embarrassing reliance on faulty calculations. If sales forecasts appear to be flawed or inaccurate, finished goods may be produced that may not sell in a timely manner. This finished goods inventory may result in slow moving or overvalued inventory.

9.13a What population of documents would an auditor examine to determine whether all authorized production was completed and placed in inventory or recorded as scrap?

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.

9.13b What population of documents would an auditor examine to determine whether finished goods inventory was actually produced and the costs were accounted for properly?

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 and then vouch these production reports to approved production orders and cost calculations of material, labor, and overhead.

What inventory information should auditors 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. 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.

To help detect inventory fraud auditors should ______. Multiple select question. a. focus test counts on high-value items b. be skeptical of client personnel making notes sample lower-volume inventory items c. Sample lower-value items. d. follow a predictable pattern in all locations will not be observed

a, b

Physical counts of selected inventory throughout the year are called ________ _________.

cycle counts

When the auditor is satisfied that controls have been examined and transactions and balances are fairly presented according to GAAP, the audit ______ Multiple choice question. work related to inventory is complete focus must move to required disclosures

focus must move to required disclosures

The use of scanner and computers ______ the number of inventory counts required. Multiple choice question. -has no impact on -may decrease -may increase

has no impact on

Physical inventory count

he client's procedure for determining actual amount of inventory on hand.

Auditors generally ______. Multiple choice question. -observe but do not actually do any inventory counting -count the entire inventory -make test counts of inventory

make test counts of inventory

If auditors were not present for the count of beginning inventory, and cannot perform alternative procedures to provide evidence the number is not materially misstated they ______. Multiple choice question. -must issue a modified opinion on the financial statements -may have concerns about statement of cash flows -must withdraw from the audit -must issue an adverse opinion on the income statement

may have concerns about statement of cash flows

If the risk of material misstatement is high, inventory observations and test counts should be scheduled ______. Multiple choice question. -monthly -early in the year -near the year-end date

near the year-end date

The headings on an Internal Control Questionnaire for the production cycle typically include ______. Multiple select question. rights cutoff existence accuracy completeness classification

occurrence, completeness, accuracy, cutoff, and classification

A record of all counts must be obtained and used for the existence-direction tests if a company does not maintain ______ inventory records. Multiple choice question. -either periodic or perpetual -perpetual -periodic

perpetual

The pricing and compilation tests audit for Blank______. Multiple choice question. valuation completeness occurrence existence

valuation

Holding supervisors accountable for production is an important component of control over ______ inventory. Multiple choice question. finished goods raw materials all types of work in process

work in process

raw material inventory status report

A periodic report (usually daily or weekly) that includes a list of all raw materials and the inventoried quantity of each material.

Internal control questionnaire (ICQ)

A preconstructed array of questions used to elicit key information about internal control. Helps identify assertion: Occurrence, completeness, accuracy, cutoff, and classification.

Production Plan

A schedule of goods to be produced for a period based on sales forecasts. So that quality products will be available at the appropriate time for the lowest cost.

overhead allocation

An accounting procedure used to assign indirect costs to various products.

9.24a What is an inventory roll-forward?

An accounting process from date of physical inventory count to the end of the period; includes additions for purchases and production and reductions for sales, scrap, and so on.

9.14 Why should receiving reports be prenumbered? What assertion would an auditor test using the receiving reports, and how would the auditor do this?

Any document is prenumbered in order to account for the items and ensure that no document is missing. A missing receiving report would allow physical items to be entered into inventory without being entered into the inventory records. Such an inaccurate inventory record may result in unnecessary purchases by the company. In addition, if goods were received that had "street" value (e.g. computers) these items could be stolen and the receiving report destroyed. A Prenumbering of the receiving reports would allow management to determine that goods were unaccounted. The auditor could trace receiving reports to the inventory records to determine that these items were properly recorded in the inventory records (valuation and completeness). The auditor could trace the receiving report to the actual items receiving (e.g. equipment, parts, etc.) (existence). The auditor could vouch the receiving reports to the purchase orders to ensure these goods were actual ordered by the client (occurrence and rights).

Selecting items from a perpetual inventory record and obtaining a test count can be done to produce evidence for the _______ balance assertion, while tracing items from the inventory floor to the inventory records produces evidence for the _______ balance assertion.

Existence, completeness

Production planner

One of the most critical. Creates a production plan, must identify the total qty of raw materials necessary for production based on the production plan and the bill of materials. Once raw materials requirements are known, they use the raw material inventory status report to determine whether enough raw materials are in stock to complete production.

Sales Forecast

The amount of a product a company expects to sell during a specific period at a specified level of marketing activities

net realizable value (NRV)

The selling price less costs to sell (e.g., sales commissions).

One of the most critical jobs in any manufacturing operation is ______. a. production planner b. sales forecaster c. marketing manager

a

Cycle Counts

a method of physically counting different areas of inventory throughout the year

If every product is tagged with individual RFID labels Blank______. Multiple select question. a. inventory management is more efficient b. out-of-stock situations are reduced c. inventory levels are recorded automatically d. there is still a need to two inventory counts

a, b, c

When ending inventory is overstated, ______ is (are) also overstated. Multiple select question. a. cost of goods sold b. total liabilities c. net income d. total assets

c, d

What seven items do auditors consider could go wrong?

1. Items included in inventory were in inventory on the balance sheet date (existence and cut off). 2. all inventory items have been included (completeness). 3. items included in inventory were the property of the client (right). 4. proper presentation and disclosures have been provided for inventory (presentation and disclosure). 5. cost of goods sold includes all costs of the inventory items sold during the year (completeness). 6. the amount of cost of goods sold has been properly accounted for using the acceptable gap accounting method (accuracy). the amount of cost of goods sold has been properly accounted for using an acceptable GAAP accounting method (accuracy).

Completeness Direction for Test of Controls

Auditors are interested in determining that all production that was started was recorded. The procedures trace the cost accumulation forward to the production cost reports in the cost acctg dept.

Occurrence direction for test of conrols

Auditors interested in determining that items composing WIP and finished goods inventories recorded in the inventory accounts were produced.

9.5 If the actual sales for the year are substantially lower than the sales forecasted at the beginning of the year, what potential valuation problems could arise in the production cycle accounts?

Company produce good in accordance with the sales forecast. If actual sales do not meet sales forecasts, all the finished goods produced will not sell and will remain in finished goods inventory. The auditor must determine if these goods will sell in the future and if so at what price. If substantial finished goods remain in inventory and there is a question of the salability of the goods, the auditor may require the client to write down the value of finished goods inventory.

9.11b Describe how the function of recording of these transactions can be separated among the production, inventory, and cost accounting departments.

Cost accounting clerks analyze independent recording of labor and materials in production cost from records after comparing two sources.

9.4b What duties separated?

Custody of the inventory Record keeping Authorization of use of materials and incurring time Reconciliation of inventory records to physical counts

9.2 What inventory costing methods does GAAP recognize?

GAAP recognizes specific identification, weighted average, FIFO, and LIFO methods of accounting for inventory.

Explain dual-direction sampling in the context of inventory test controls.

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 them, 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).

9.20 What procedures do auditors employ to audit inventory when the physical inventory is taken on a cycle basis or on a statistical plan but never a complete count on a single date?

In this type of situation, the auditor will arrange to be present during one more of the test counts, and importantly, he or she will evaluate the cycle or statistical plan for validity. During his or her 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.

9.9 Why do auditors consider inventory errors pervasive?

Inventory errors are pervasive because the ending inventory number appears on the balance sheet and is also used to calculate cost of goods sold. In turn, cost of goods sold is used to calculate profit and income numbers. Therefore errors in inventory affect multiple items on the financial statements.

9.6 The balance sheet of a company lists $25 million of inventory. What assertions is management making regarding inventory?

Inventory exists (existence) The company owns this inventory (rights) The inventory is properly valued (valuation) All inventory is included this amount (completeness) The valuation method for inventory is disclosed (presentation and disclosure) Only inventory is included in this amount (presentation and disclosure).

9.11c Describe how the functions of physical custody of inventories can be separated among the production, inventory, and cost accounting departments.

Raw materials stores maintain physical custody of raw materials, none of which are released without authorization (requisition) and record of withdrawal. The supervisor maintains custody of work in process inventory.

If there is an intervening period between the count date and year-end, additional inventory _______ - ________ auditing procedures must be performed on transactions during that period. (Enter only one word per blank.)

Roll-Forward

If it is incorrect and either underestimates or overestimates product demand, the cost to the company can be in the millions, which is why the ______ _______ is one of the most important documents in any organization. (Enter only one word per blank.)

Sales Forecast

9.1 What functions are normally associated with the production cycle?

Sales Forecast Production planning Production Cost accounting

9.23 What steps should auditors take if the client has multiple locations being counted?

Take a sample

9.21 What could be happening when a client's managers take notes of auditors' test counts while an inventory is being counted?

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.

9.7 What information is used in the cost accounting department to calculate the cost of goods sold for a production operation? What are the significant risks that would make this calculation inaccurate?

The cost accounting department uses director labor, direct materials and an application of overhead costs to determine product costs. Risks included in this process include inaccurate reporting of labor hours or labor rates, an overstatement of materials used, inaccurate scrap rates (scrap materials are usually charged to the production run), and an inappropriate overhead rate.

Standard Costs

The estimates of cost to produce a product; used for transferring products between departments and to finished goods and to record cost of goods sold; compared to actual costs to obtain variances.

Consignment (consigned-out) goods

The goods that are given by one party, the consignor, to another party, the consignee, to sell; however, the consignee retains title until the goods are sold.

9.12 How does the production order record provide a control over the quantity of materials used in production?

The production order record provides a control over the quantity of product manufactured by the production department. Used in combination with the bill of materials, this record 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.

Observation can be used to help determine ______. Multiple select question. a. separation of duties in the inventory area b. proper inventory authorizations c. proper recording and allocation of labor and material costs d. physical controls over inventory

a, b, d

Cycle counts ______. Multiple select question. a. assist with maintaining accurate perpetual inventory records b. are most appropriate when a high level of control risk is present c. require the auditors' presence at some of the counts only

a, c

Which of the following statements are correct? Multiple select question. a. The manipulation of inventory has a double effect on financial statements. b. Inventory errors are easily identified by auditors. c. A small inventory cost manipulation can result in a large misstatement. d. Unethical managers generally prefer to manipulate direct labor costs instead of inventory.

a, c

What characteristics should be considered in reviewing a 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 double-count, 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 9.7). 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. Instructions for review and approval of the inventory count; notations of obsolescence or other matters by supervisory personnel. Instructions for making changes and corrections to count tickets.

9.19 Why is it important to obtain shipping and receiving cutoff information during the inventory observation?

The auditor must obtain shipping and receiving cutoff information during the physical inventory observation to ensure that items recorded as receipts or shipments in the accounting records match purchases 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.

9.3 Describe a walkthrough of a production transaction from receiving production orders to making an entry in the finished goods perpetual inventory records.

The auditor performs a walkthrough by talking to employees about their duties, observing performance, and examining documents produced and agreeing them to related documents.

Auditors must ensure that cost of goods sold has been properly accounted for using an acceptable GAAP method. This addresses the ______________assertion. (Enter only one word per blank.)

accuracy

Why is control risk important for inventory?

It governs the nature, timing, and extent of substantive procedures that will be performed in the audit inventory.

9.8 What makes the recording of inventory at its proper amount difficult on the financial statements?

It is often difficult to get an accurate count of inventory Because often inventory is purchased at many different times at many different values inventory valuation assumptions are necessary (e.g. LIFO) All inventory items may not be usable and therefore have no value.

Physical inventory observation

- Best opportunity to detect errors and fraud - Observe the physical inventory count taken by company personnel (test of controls) - Client provides listing of all inventory counts and auditor decides which inventory count to attend (substantive test)

9.3a What document copies would be collected?

Documents 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.

9.24b What roll-forward tests should be performed?

Examine material account transactions that occur between the interim testing date and the date of the financial statements

Observing the movement of inventory from raw materials to finished goods can help the auditor ensure proper ______. Multiple choice question. -authorizations and documentation -labor and material cost allocations -valuation of inventory -separation of duties

authorizations and documentation

Select all that apply RFID technology ______. Multiple select question. a. eliminates the need for a physical inventory b. switches the major focus to sampling items c. eliminates the need for a second count

b, c

Cost accounting generally records finished goods at ______ costs. Multiple choice question. a. estimated b. actual c. standard

c

Significant risk in the production cycle relates to the correct valuation of ______. Multiple choice question. a. direct materials b. overhead c. cost of goods sold

c

The release of raw materials and supplies to production is authorized by a ______. Multiple choice question. a. bill of materials b. raw material inventory status report c. materials requisition d. production order

c

Which of the following statements are true? Multiple select question. a. Cost build-ups for inventory can be complex, especially when valued using FIFO. b. Management can use inventory manipulation to understate assets and income. c. Inventory is a high-risk areas that is susceptible to errors. d. Work-in process inventory can be especially difficult to value.

c, d

The production planner uses the ______ to determine if there is sufficient stock to complete production Multiple choice question. -bill of materials -production order -raw material inventory status report -materials requisition form

raw material inventory status report