Chapter 16 nton

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CHAPTER 16

AUDIT THE PRODUCTION AND PERSONNEL SERVICES C YCLE

Learning Check

16-1. a. The production cycle relates to the conversion of raw materials into finished goods,and includes production planning and control of the types and quantities of goods to be manufactured, the inventory levels to be maintained, and the transactions andevents pertaining to the manufacturing process.

b. The major transaction class within this cycle is manufacturing transactions.

c. The production cycle interfaces with (1 the e!penditure cycle through the purchaseof raw materials and incurrence of various overhead costs, (" the personnel servicescycle through the incurrence of factory labor costs, and (# the revenue cycle through thesale of finished goods.

16-". a. The transaction class audit objectives for the production cycle are$

Occurrence. %ecorded manufacturing transactions represent material, labor, andoverhead transferred to production and the movement to completed production tofinished goods during the current period (

EO1. %ecorded cost of sales represent the

sale of inventory during the year (EO2.

Completeness. &ll manufacturing transactions (C1 and cost of sales (C2 that occurredduring the period were recorded.

Accuracy. 'anufacturing transactions (VA1 and cost of sales (VA2 are accuratelyvalued using &&) and correctly journali*ed, summari*ed and posted.

Cutoff. &ll manufacturing transactions (EO1 and C1) and cost of sales (EO2 and C2) have been recorded in the correct accounting period.

Classification. &ll manufacturing transactions (!1) and cost of sales (!2) have beenrecorded in the proper accounts.

b. +everal account balance audit objectives for the production cycle are$E"istence. nventories included in the balance sheet physically e!ist (EO#.

Completeness. nventories include all materials, products and supplies on hand at the balance sheet date (C#.

$ights and O%ligations. The reporting entity has legal title to recorded inventories atthe balance sheet date ($O1.

Valuation and Allocation. nventories costing assumptions have been properly applied(&# and inventories are properly stated at the lower of cost or maret (&/.

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16-#. a. n a manufacturing company, inventories and cost of goods sold are usuallysignificant to the company5s financial position and results of operations. urther, dueto the cost of observing inventory the auditor will normally allocate a significantamount of overall materiality o the audit of inventory, without e!ceeding an amountthat the auditor believes will affect the analysis of a financial statement user.

b. +everal factors that affect inherent ris for assertions related to the production cycleare$

• The volume of purchases, manufacturing, and sales transactions that affects these

accounts is generally high, increasing the opportunities for misstatements tooccur.

• There are often contentious issues surrounding the identification, measurement,

and allocation of inventoriable costs such as indirect materials, labor, andmanufacturing overhead, joint product costs, the disposition of cost variances,accounting for scrap, and other cost accounting issues.

• The wide diversity of inventory items sometimes requires the use of special

procedures to determine inventory quantities, such as geometric volumemeasurements of stocpiles, aerial photography, and estimation of quantities bye!perts.

• nventories are often stored at multiple sites, adding to the difficulties associated

with maintaining physical controls over theft and damage, and properly accountingfor goods in transit between sites.

• The wide diversity of inventory items may present special problems in

determining their quality and maret value.

• nventories are vulnerable to spoilage, obsolescence, and other factors such as

general economic conditions that may affect demand and salability, and thus the proper valuation of the inventories.

• nventories may be sold subject to right of return and repurchase agreements.

c. ollowing are several e!amples of analytical procedures and a description of howthey might assist the auditor when auditing the production cycle.

Ratio Formula Audit Signii!an!"

Inventory Turn Days Avg. Inventory ÷ Cost of Good

Sold x 365

Prior experience in inventory turndays co!ined "it# $no"ledge ofcost of sales can !e useful inestiating current inventory levels. Alengt#ening of t#e period ay indicateexistence pro!les.

Inventory Gro"t# toCost of Sales Gro"t#

%%Inventory n÷Inventory n&'( ) '(

÷ %%Cost of Sales n ÷ Cost of

Sales n&'( ) '(

*atios larger t#an '.+ indicate t#atinventories are gro"ing faster t#ansales. ,arge ratios ay indicatepossi!le inventory o!solescencepro!les.

-inis#ed GoodsProduced to *a"aterial /sed

-inis#ed Goods 0uantities ÷

*a" aterial 0uantities

/seful in estiating t#e efficiency oft#e anufacturing process. ay !e#elpful in evaluating t#ereasona!leness of production costs.

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-inis#ed GoodsProduced to Direct,a!or


Direct ,a!or 1ours

/seful in estiating t#e efficiency oft#e anufacturing process. ay !e#elpful in evaluating t#ereasona!leness of production costs.

Product Defects perillion 2u!er of Product Defects asa Percent of ac# illionProduced

/seful in estiating t#e effectivenessof t#e anufacturing process. ay!e #elpful in evaluating t#ereasona!leness of production costsand "arranty expenses.

16-/. a. 0ontrol environment factors that may impact the production cycle include$

• The organi*ational structure should include an officer who has overall

responsibility for production, including authority over the production planningand control department and each manufacturing department.

• The assignment of authority and responsibility should include timely

accountability for the use of the entity7s resources.

• 'anagement5s philosophy and operating style should include its approach totaing and monitoring business riss related to production decisions andinventory levels.

• The entity5s human resource policies and practices pertaining to production

department employees can significantly impact the use of, and accountability for,the factors of production.

b. 8nique elements of an entity5s accounting information system that pertain to the production cycle may include the use of control accounts and supporting recordssuch as product or master files, separate records for raw materials, wor in process,and finished goods inventories, job order and process cost systems, and standard costsystems.

16-2. The documents and records are summari*ed in the following table$

unction 9ocuments and %ecords

• nitiating production$

o )lanning and controlling production.

• )roduction orders

• 'aterial requirements reports

• )roduction of nventory$

o ssuing raw materials.

o )rocessing goods in production.

o Transferring completed wor to finishedgoods.

o )rotecting inventories.

• 'aterials issue slips or requisitions

• Time ticets

• nventory move ticets

• %ecording manufacturing and inventory

transactions$o 9etermining and recording

manufacturing costs.

• 9aily production reports

• 0ompleted production report

• +tandard cost master file

• %aw material inventory master file

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16-<. +everal ratios and their formulas that may be used in applying analytical procedures toinventory balances are$


Inventory Turn Days Avg. Inventory ÷ Cost of Good

Sold x 365

Prior experience in inventoryturn days co!ined "it#$no"ledge of cost of sales can

!e useful in estiating currentinventory levels. A lengt#eningof t#e period ay indicateexistence pro!les.

Inventory Gro"t# toCost of Sales Gro"t#

%%Inventory n÷Inventory n&'( ) '(

÷ %%Cost of Sales n ÷ Cost of

Sales n&'( ) '(

*atios larger t#an '.+ indicatet#at inventories are gro"ingfaster t#an sales. ,arge ratiosay indicate possi!le inventoryo!solescence pro!les.

-inis#ed GoodsProduced to *a"aterial /sed


*a" aterial 0uantities

/seful in estiating t#eefficiency of t#e anufacturingprocess. ay !e #elpful inevaluating t#e reasona!leness

of production costs.-inis#ed GoodsProduced to Direct,a!or


Direct ,a!or 1ours

/seful in estiating t#eefficiency of t#e anufacturingprocess. ay !e #elpful inevaluating t#e reasona!lenessof production costs.

Product Defects perillion

2u!er of Product Defects asa Percent of ac# illionProduced

/seful in estiating t#eeffectiveness of t#eanufacturing process. ay !e#elpful in evaluating t#ereasona!leness of productioncosts and "arranty expenses.

16-1. a. ive tests of details of balances that may be applied to inventories are$• =bserve client5s physical inventory count.

• Test clerical accuracy of inventory listings.

• Test inventory pricing.

• 0onfirm inventories at locations outside the entity.

• >!amine consignment agreements and contracts.

b. 1. The observation of inventories is required whenever inventories are materialto a company5s financial statements and it is practicable and reasonable tomae the observation.

". The timing of an inventory observation depends on the client5s inventorysystem and the effectiveness of internal controls. n a periodic inventorysystem, the observation of the inventory should occur at or near the balancesheet date. n a perpetual inventory system with well-ept records,observation may occur during or after the end of the period under audit.




#. n evaluating the client5s inventory taing plans, the auditor should determinethat the plan includes all of the following$

• ?ames of employees responsible for supervising the inventory taing.

• 9ate of the counts.

• @ocations to be counted.

• 9etailed instructions on how the counts are to be made.• 8se and control of prenumbered inventory tags and summary

(compilation sheets.

• )rovisions for handling the receipt, shipment, and movement of goods

during the counts if such activity is unavoidable.

• +egregation or identification of goods not owned.

/. n observing inventories, the auditor should

• +crutini*e the care with which client employees are following the

inventory plan.

• +ee that all merchandise is tagged and no items are double tagged.• 9etermine that prenumbered inventory tags and compilation sheets are

properly controlled.

• 'ae some test counts and trace quantities to compilation sheets.

• Ae alerts for empty containers and hollow squares (empty spaces that

may e!ist when goods are staced in solid formations.

• 4atch for damaged and obsolete inventory items.

• &ppraise the general condition of the inventory.

• dentify the last receiving and shipping documents used and determine

that goods received during the count are properly segregated.

•nquire about the e!istence of slow-moving inventory items.

16-11. a. n testing inventory pricing for purchased inventories, the auditor should (1 vouchcosts to representative vendor invoices and (" verify both cost and maret when thelower of cost or maret method is used. n testing inventory pricing for manufacturedinventories, the auditor should review the methods used in costing the inventories for propriety and the accuracy and consistency of application. or e!ample, whenstandard costs are used, the auditor should test the calculation of the standards,compare the calculations with engineering specifications, determine that thestandards are current, and evaluate whether the standards appro!imate actual costs by e!amining the variance accounts.

b. 0onfirmations may be used in the audit of inventories to obtain evidence about thee!istence of inventories stored in public warehouses or with other outside custodianssuch as consignees.

16-1". a. 4hen the auditor is testing net reali*able value the auditor needs to determine if theclient will be able to sell inventory on hand at year-end in the normal operating cycleand not suffer a loss (brea-even in the process. The auditor is testing the client7s




estimates of future outcomes B the value of future sales. This is particularly problematic with inventory that is considered obsolete.

b. 4hen auditing the net reali*able value of inventory the auditor will want tounderstand management7s process for estimating any allowance for obsolete

inventory. The auditor will need to understand how long it taes the client to turn itsinventory and evaluate recent history (the last several inventory turn cycles forevidence of the client7s ability to turn its inventory and brea even. The auditor willalso want to review sales prices after year-end to the e!tent possible.

16-1#. a. The personnel services cycle involves the events and activities that pertain toe!ecutive and employee compensation.

b. This cycle interfaces with two other cycles$ (1 the paying of the payroll and payrollta!es involves cash disbursements in the e!penditure cycleC (" the distribution offactory labor costs to wor in process pertains to the production cycle.

16-1/. a. ross earnings of personnel are generally the largest operating e!pense inmerchandising (after costs of goods sold and service companies. They also are amajor component in costing wor in process. >mployee fraud is a major inherent risthat the auditor should consider.

b. The auditor5s usual strategy is to use a lower assessed level of control ris approachin auditing payroll transactions because$

• The audit ris is primarily in the processing of payroll transactions.

• 'ost companies have e!tensive internal controls for the routine nature of payroll

transactions.

• Dear-end payroll liability balances are often immaterial.

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16-12. The audit objectives for payroll transactions and related assertions are$

&pecific Audit O%'ecties

ransaction O%'ecties

Occurrence. %ecorded employee compensation, benefits and payroll ta! e!penses

relate to compensation for services rendered during the year (EO1).Completeness. %ecorded employee compensation, benefits and ta! e!penses includeall such e!penses incurred for personnel services during the year (C1).

Accuracy. >mployee compensation, benefits and payroll ta! e!penses are accuratelycomputed and recorded (VA1.

Cutoff. >mployee compensation, benefits and payroll ta! e!penses have been recordedin the correct accounting period (EO1 and C1).

Classification. >mployee compensation, benefits and payroll ta! e!penses are properlyidentified and classified in the income statement (!1.

*alance O%'ecties

E"istence. >mployee compensation, benefits and payroll ta! liabilities representamounts owed at the balance sheet date (EO2.

Completeness. >mployee compensation, benefits and payroll ta! liabilities include allsuch amounts owed at the balance sheet date (C2.

$ights and O%ligations. >mployee compensation, benefits and payroll ta! liabilitiesare obligations of the reporting entity ($O1.

Valuation and Allocation. >mployee compensation, benefits and payroll ta! liabilitiesare accurately computed and recorded (VA2.

!isclosure O%'ecties

Occurrence and $ights and O%ligations. 9isclosed employee compensation and

benefits transactions and balance have occurred and pertain to the entity (!#).Completeness. &ll employee compensation and benefits disclosures that should have been included in the financial statements have been included (!+).

,nderstanda%ility. &ll employee compensation and benefits information isappropriately presented and information in disclosures is understandable to users (!-).

Accuracy and Valuation. &ll employee compensation and benefits information isdisclosed accurately and at appropriate amounts (!).

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16-16. ollowing are several e!amples of analytical procedures and a description of how theymight assist the auditor when auditing the production cycle.


Average payroll costper eployee

classification

Total payroll costs for aneployee group divided !y

t#e nu!er of eployees int#e group

*easona!leness test of gross payrollfor a group of eployees. any

copanies #ave ore t#an one classof eployee4 and it is iportant toevaluate t#e reasona!leness ofpayroll !ased on eployee class.

*evenue pereployee

Total *evenue ÷ nu!er of

full tie euivalenteployees.

T#is ay !e a easure of productivityper full tie euivalent eployee.T#is is particularly iportant inservices industries and "ould !ecopared "it# industry statistics.

Total payroll costs asa percentage ofrevenues

Total payroll expenses ÷ total

revenues

*easona!leness test of payroll costs.T#is is often copared "it# industrystatistics.

Payroll tax expense

as a percent of grosspayroll

Total payroll tax expenses ÷

gross payroll

*easona!leness test of payroll taxes.

T#is can often !e copared "it#standard tax rates.

Copare payrollexpenses %salariesand "ages4coissions4!onuses4 eployee!enefits4 etc( "it#prior year !alancesor !udgets

Current year payroll expenses

÷ prior year payroll expenses

*easona!leness test for payrollexpenses if t#e ratio is significantlydifferent fro '.+

Copare currentyear payroll lia!ility

"it# prior year payrolllia!ility

Current year payroll tax

lia!ility ÷ prior year payroll tax

lia!ility adusted for gro"t# inpayroll volue

*easona!leness test for payrolllia!ility if t#e ratio is significantly

different fro '.+

Copute ratio ofpayroll tax expenseto total payrollexpenses

Payroll tax expense ÷ total

payroll expense

*easona!leness test for payroll taxexpense !ased on prior year ratio ofpayroll tax expense to total payroll.

ployee !enefitsexpenses as apercent of grosspayroll

Total !enefits expenses ÷

gross payroll

*easona!leness test of !enefitsexpenses. T#is is often copared"it# industry statistics.

16-1:. The control environment is as relevant to the personnel services cycle as it is to any cycle.The elements of human resources associated with hiring practices and the care with whichcontrols are established over putting new employees on the payroll is essential to goodcontrol.

'anagement should actively assess the riss associated with errors and fraud and designappropriate controls to reduce these riss consider the cost-benefit tradeoff whenimplementing controls.

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inally, management should monitor the system of internal controls, perhaps as aresponsibility of the internal audit function. 'anagement needs to review the results controlfailures that result in errors or fraud in the personnel services function and tae actions tocorrect e!iting problems.

16-1;. The functions in processing payroll transactions are$• nitiating payroll transactions including (a hiring employees and (b authori*ing payroll

changes.

• %eceiving services including preparing attendance and timeeeping data.

• %ecording payroll including (a preparing and (b recording the payroll.

• )aying the payroll including (a paying the payroll and protecting unclaimed wages, and

(b filing payroll ta! returns.

16-1<. a. The responsibilities of the personnel department include$ (1 hiring employees, (" preparing personnel authori*ation forms for new hires, (# authori*ing payrollchanges and terminations, and (/ maintaining employee personnel files.

b. The control procedures in preparing attendance and timeeeping data include (1using time clocs to record hours wored, (" supervising cloc card punching, (#supporting time cloc hours with time ticets, (/ approving time wored in writing by a supervisor, and (2 reconciling time ticets and cloc cards.

16-". a. Tests of controls for terminated employees involve maing inquiries and observingthe processes for removing personnel from the payroll. 'any companies create areport of terminated employees that is reviewed in personnel. The auditor mightsubstantively for subsequent payment of terminated employees using generali*edaudit software and selecting a sample of termination notices and scanning subsequent

payroll registers to determine that the terminated employees did not continue toreceive pay checs.

b. n witnessing the distribution of payroll checs, the auditor observes that$

• +egregation of duties e!ists between the preparation and payment of the payroll.

• >ach employee receives only one chec.

• >ach employee is identified by a badge or employee 9 card.

• There is proper control and disposition of unclaimed checs.

16-"1. The following table provides e!ample controls and tests of controls for each assertion (andtransaction level audit objective related to the personnel services cycle. >!amplesemphasi*e programmed control procedures where appropriate. +tudent should note thattests of controls should also emphasi*e testing computer general controls, observinge!ception reports, and testing manual follow-up of items that appear on e!ception reports.




ersonnel &erices&ssertion (&udit =bjective 0ontrol Test of 0ontrols

>!istence and =ccurrence(=ccurrence

=nly a few ey employees in personnel can add a new employee tothe master payroll file.

0omputer reports all changes to the personnel data master file.'anagement in personnel reviewsreport of all master file changes.

=bserve the process for changing themaster payroll file, review the accuracy ofreports of changes to the master file, andreperform control.

0ompleteness(0ompleteness

Aatch total of hours wored prepared by payroll department and verified by the computer.

8se 0&&Ts to test the control bysubmitting data that should be rejected bythe control.

>!istence and =ccurrence E0ompleteness (0utoff

'anual controls chec payroll cutoffand accrue payroll when pay periodsdo not coincide with month end.

=bserve the process testing payroll cutoffand accruing payroll costs, and reperformcontrol.

aluation and &llocation(&ccuracy

0omputer limit test on the number of hours wored and the amount of each payroll chec.


)resentation and 9isclosure(0lassification 0omputer compares accountclassification for hours wored withaccount classification on time cards.


%ights and =bligations ?E& ?E&

16-"". a. The liely acceptable level of detection ris for payroll balances is moderate or high because moderate or low assessments of control ris are usually possible.

b. 4hen moderate or high detection ris levels are acceptable, substantive tests may belimited to applying analytical procedures and limited tests of details. f une!pectedfluctuations are found, more e!tensive tests of details will be required.

16-"#. a. To obtain evidence about the reasonableness of management5s accrued payrollliabilities, the auditor should review management5s calculations or mae independentcalculations, compare the accruals with amounts shown on payroll ta! returns, ande!amine subsequent payments where applicable.

b. =fficers5 compensation is audit sensitive because it must be separately disclosed in1-F reports filed with the +>0, and because officers may be able to overridecontrols and receive salaries, bonuses, stoc options, and other forms ofcompensation in e!cess of authori*ed

c. 4hen auditing pension e!penses, the auditor should also evaluate the reasonableness

of the ey actuarial estimates such as the discount rate that is used to determine the projected benefit obligation and the long-term rate of return assumption used for thee!pected return on plan assets. The discount rate should be in line with currentannuity purchase rates for high-quality fi!ed income investments. The long-termrate of return assumption should reflect the actual and anticipated returns for the plan7s assets.




d. 4ith respect to accounting for stoc option e!pense, most companies structure theirstoc option plans to meet the requirements of &)A ?o. "2, so that they may use theintrinsic value approach and report no compensation e!pense associated with the useof stoc options. +toc appreciation rights, however, require the recognition ofcompensation e!pense, regardless of whether the right is e!ercised during the period.

&+A ?o. 1"# requires these companies to disclose pro forma net income andearnings per share as if the fair value approach were used. &s a result the auditormust audit the valuation model used to determine the fair value of the stoc options.4hen evaluating fair presentation in the financial statements, the auditor evaluatesassumptions that include the ris-free rate, the e!pected life of the option, thee!pected volatility of the stoc price, and e!pected dividends.

Comprehensie /uestions

16-"/. (>stimated Time$ # minutes

a. The following table includes the calculations for part a. (?ote the calculations useending balances rather than average balances. &lso note that &) turn days is calculated byusing &ccounts )ayable G )urchases ! #62.

b. The trends show an increase in inventory turn days, a decrease in accounts payableturn days, and a steady gross margin. The gross operating cycle is constant due tothe improvement in accounts receivable turn days. The net operating cycle does notshow the same level of improvement as gross operating cycle due to the decrease in payable turn days.

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c. f tolerable misstatement is H/2, this translates to an e!pectation range of plus ormine < days based on the following calculation.H/2, G H1,;2<, I#62 J ;.; days which rounds to < days.

d. The increase in inventory turn days indicates that inventory may be overstated. &

further ris may be associated with unrecorded liabilities. The combination mayresult in an overstatement of net income.

16-"2. (>stimated Time B # minutes

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/naudited Audited Audited

7+89 7+83 7+87

Sales '74++54336: '+47;'4333: <4<;74'33:

Cost of *a" aterials /sed 34;734336: 34'=34333: 74<++4+++:

Direct ,a!or Cost '46;64+<': '436943'9: '4';+4+++:

Cost of Payroll Taxes and >enefits 5<+4+6+: 93;43+;: 3<34'<+:Indirect Costs '4+<<4<<5: '4+;94;3+: ;674'++:

=47<<4367: 64+='4<<6: 5433547<+:

>eginning Inventory 33+45<=: 7=94=69: '5645==:

nding Inventory 9=+4+'6: 33+45<=: 7=94=69:

Capacity '+4+++4+++ '+4+++4+++ '+4+++4+++

/nits Produced <4=<+4<++ =4<9+4+++ =4+++4+++

/nits Sold <4=5+4+++ =4==54+++ 64<5+4+++

>eginning Inventory 9'54+++ 35+4+++ 7++4+++

nding Inventory 9954<++ 9'54+++ 35+4+++

Direct ,a!or 1ours ;7497; =64<63 =+4+++

2u!er of anufacturing ployees 96 3< 35

,a!or Cost including !enefits 747=64'9+: '4<+34673: '45=34'<+:

Tons of *a" aterial /sed =49=3 64777 546++

Tons of nding *a" aterials Inventory 7' '< '6

a. Calcualtions

Cost of Goods Sold =4'9<4;33: 64+'64+63: 547'=4+;3:

Gross Profit argin 9+.5? 9'.5? 9'.3?

Inventory Turn Days 79.+ 7+.' ';.7

2u!er of /nits per Ton of *a" at@l ''=5 '76+ '75+

2u!er of /nits per Direct ,a!or 1r. ;5 '+7 '++

Cost per ton of aterials 575.++: 5'+.++: 5++.++:

Cost per direct la!or #our 79.63: 73.9=: 77.9=:

Payroll taxes and !enefits as a? o

direct la!or cost 39.7? 37.7? 37.7?

Cost per unit of inventory '.+59: +.=;=: +.=<5:

b. &nalytical procedures indicate that ending inventory appears to be overstated due to pricing problems in the valuation of inventory. 'anufacturing productivity appearsto have decreased due to the decreases in the number of units produced per ton ofraw materials and decreases in the number of units produced per direct labor hour.urther, the cost of raw materials increased during the years, as did payroll cost (boththe cost per direct labor hour and the cost of benefits.

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ncreases in gross profit margin are inconsistent with this underlying informationrelated to the cost of production. The dramatic increase in inventory turn days, andthe cost per unit of inventory are consistent with the fact that inventory appears to beovervalued, probably as a result of problems with the valuation of inventory (or possibly the e!istence of inventory. &udit tests need to focus carefully on the cost

build-up for ending inventory, and the allocation of cost between ending inventoryand cost of sales.

16-"6. (>stimated time - # minutes Ingredients Inventory

a. 0eaknesses %. $ecommended mproements

ailure to delegate authority forreceiving material.

f feasible a separate receiving departmentshould be established. &t least specificemployees should be given responsibility forreceiving merchandise.

%eceivers are currently acceptingwhatever is delivered and simplytaing some sort of count or tally.

%eceivers should be given a copy of purchaseorders with complete descriptions e!ceptquantities. These copies should be used in-stead of tallies.

ngredients inventory is stored in the production area.

ngredients inventory should be placed in a protected storage area which has controlledaccess.

&pparently a periodic inventorysystem is being employed.

& perpetual system should be installed if possible.

?o mention is made of adjustmentand reconciliation of boo to physical inventory, includingappropriate cut-off procedures.

&ll differences between physical and booinventory should be re-viewed and investigatedwhen deemed appropriate.

There appears to be a lac ofaccountability for inventorythroughout the production process.

ngredients inventory items should only bereleased from stores upon written requisition.&ppropriate documentation should follow the production process.

2. Maintenance Materials and Supplies Inventory

a. 0eaknesses %. $ecommended mproements

&ccess to inventory is unrestrictedat various times during the first twoshifts and during the entire thirdshift and on +aturday.

The room should be loced and a cler presentat all times when the room is open.%equisitions should be required for allwithdrawals of materials and supplies.

& periodic inventory systemappears to be in effect.

& perpetual system should be used if possible.






• To obtain assurance that the cost system, as an integral part of the system of

internal control, provides proper accounting control over costs incurred andrelated inventories.

• To ascertain, as a service to management, that the cost system is economical and

effectively provides information for reducing or controlling costs and for

determining the cost and profitability of products, and other related datanecessary for informed managerial decisions.

b. The audit procedures to be applied to determine that cost standards and relatedvariance accounts applicable to materials are acceptable and have not distorted thefinancial statements would include the following$

• %eview the internal control structure to estimate the amount of testing necessary.

• Test chec the arithmetic of the standard cost cards.

• 9etermine that the data on the standard cost cards are reasonably current. =ut-of-

date standards may result in abnormal variances.

• &scertain the accuracy of the specifications on the standard cost cards by

comparison with engineering specifications or other independent sources.9etermine that the procedure for establishing standard material yields givesconsideration to spoilage, scrap loss and by-products of the process.

• 9etermine that, in establishing standard material prices, consideration was given

to the following factors$ normal quality, normal quantity, normal sources, anddelivery by normal carrier. The treatment in the accounts of discounts, whethere!cluded or included in the standard costs, should be investigated forconsistency.

• The accounting system for recording standard costs should be reviewed for

reasonableness, and test checs should be applied to determine that the system isfunctioning effectively. +ource documents (vendors5 invoices, requisitions, production reports, and other internally generated accounting evidence should be e!amined and related to the transactions flowing through the cost system. nthis connection reference would be made to the standard cost cards to determinethat standard cost data flowing through the accounting system are beingaccurately compiled.

• %eview the material price variance and material usage variance accounts for

over-all reasonableness. The variance accounts should also be reviewed fore!cessive variations in the month to month charges, and satisfactory e!planationsshould be obtained where necessary.

• The impact of the variances on the financial statements should be considered. fthe variances are of amounts so substantial that placing them in the incomestatement would distort current operating results and inventory valuations, thenconsideration should be given to allocating them on a pro rata basis to cost ofgoods sold and inventories.

16-"<. (>stimated time - "2 minutesnentory 3o4 5eneral6urpose Computer

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-1:



&u%stantie ests &oft4are ackage and Copy of

nentory ile !ata 7ight *e 3elpful

=bserve the physical count,maing and recording test countswhere applicable.

9etermining which items are to be test counted bymaing a random sample of a representativenumber of items from the inventory file as of the

data of the physical count.Test the mathematical accuracy of the inventory compilation(summary.

'athematically computing the dollar value of eachinventory item counted by multiplying the quantityon hand by the cost per unit and verifying theaddition of the e!tended dollar values.

0ompare the auditor5s test countsto the inventory records.

&rranging test counts in a file format identical tothe inventory file and matching the records

0ompare physical count data toinventory records.

0omparing the total e!tended values of all itemscounted and the e!tended values of each inventoryitem counted to the inventory

Test the pricing of the inventory

by obtaining a list of costs peritem from buyers, vendors, orother sources.

)reparing a file in a format identical to the

inventory file and matching the files.

>!amine purchases and salescutoffs.

@isting a sample of items on the inventory file forwhich the date of last purchase and date of the lastsale are on or immediately prior to the date of the physical count.

&scertain the propriety of itemsof inventory located in publicwarehouses.

@isting items located in public warehouses.

16-#. (>stimated time - # minutesThe substantive auditing procedures Arown may consider performing include the following$

8sing the perpetual inventory file$

• %ecalculate the beginning and ending balances (prices ! quantities, foot, and print out a

report to be used to reconcile the totals with the general ledger (or agree beginning balance with the prior year5s woring papers.

• 0alculate the quantity balances as of the physical inventory date for comparison to the

physical inventory file. (&lternatively, update the physical inventory file for purchasesand sales from 3anuary 6 to 3anuary #1, "!", for comparison to the perpetual inventoryat 3anuary #1, "!".

• +elect and print out a sample of items received and shipped for the periods (a beforeand after 3anuary 2 and #1, "!", for cut-off testing, (b between 3anuary 2 and 3anuary#1, "!", for vouching or analytical procedures, and (c prior to 3anuary 2, "!", for testof details or analytical procedures.

• 0ompare quantities sold during the year to quantities on hand at year end. )rint out a

report of items for which turnover is less than e!pected. (&lternatively, calculate thenumber of days5 sales in inventory for selected items.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-1;



• +elect items noted as possibly unsalable or obsolete during the physical inventory

observation and print out information about purchases and sales for furtherconsideration.

• %ecalculate the prices used to value the year-end = inventory by matching prices and

quantities to the most recent purchases.

• +elect a sample of items for comparison to current sales prices.• dentify and print out unusual transactions. (These are transactions other than purchases

orsales for the year, or physical inventory adjustments as of 3anuary 2, "!".

• %ecalculate the ending inventory (or selected items by taing the beginning balances

plus purchases, less sales, (quantities andEor amounts and print out the differences.

• %ecalculate the cost of sales for selected items sold during the year.

8sing the physical inventory and test count files$

• &ccount for all inventory tag numbers used and print out a report of missing or duplicate

numbers for follow-up.• +earch for tag numbers noted during the physical inventory observation as being voided

or not used.

• 0ompare the physical inventory file to the file of test counts and print out a report of

differences for auditor follow-up.

• 0ombine the quantities for each item appearing on more than one inventory tag number

for comparison to the perpetual file.

• 0ompare the quantities on the file to the calculated quantity balances on the perpetual

inventory file as of 3anuary 2, "!". (&lternatively, compare the physical inventory fileupdated to year end to the perpetual inventory file.

• 0alculate the quantities and dollar amounts of the boo-to-physical adjustments for each

item and the total adjustment. )rint out a report to reconcile the total adjustment to theadjustment recorded in the general ledger before year end.

• 8sing the calculated boo-to-physical adjustments for each item, compare the quantities

and dollar amounts of each adjustment to the perpetual inventory file as of 3anuary 2,"!", and print out a report of differences for follow-up.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-1<



16-#1. ("2 'inutes

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0=?0@8+=?$ Aecause the 8'@ of H1/",: is less than the tolerable misstatement of H",, the sample results support the conclusion that the boo value is not materially misstated.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-"



16-#". (>stimate Time B "2 'inutes

8oung Computers9 nc

nternal Control /uestionnaire 6 ayroll

/uestion 8es :o

• &re payroll changes (hires, separations, salary changes, overtime, bonuses, promotions, etc. properly authori*ed and approvedR

• &re discretionary payroll deductions and withholdings authori*ed in

writing by employeesR

• &re the employees who perform each of the following payroll functions

independent of the other functionsRo )ersonnel and approval of payroll changes.

o )reparation of payroll data.

o &pproval of payroll.

o +igning of paychecs.

o 9istribution of paychecs.

o %econciliation of payroll account.• &re changes in standard data on which payroll is based (hires,

separations, salary changes, promotions, deduction and withholdingchanges, etc. promptly input to the system to process the payrollR

• s gross pay determined by using authori*ed salary rates and time and

attendance recordsR

• s there a suitable chart of accounts andEor established guidelines for

determining salary account distribution and for recording payrollwithholding liabilitiesR

• &re clerical operations in payroll preparation verifiedR

• s payroll preparation and recording reviewed by supervisors or internal

audit personnelR

• &re payrolls approved by a responsible official before payroll checs are

issued.

• &re payrolls disbursed through an imprest accountR

• s the payroll ban account reconciled monthly to the general ledgerR

• &re payroll ban reconciliations properly approved and differences

promptly followed upR

• s the custody and follow-up of unclaimed salary checs assigned to a

responsible officialR

• &re differences reported by employees followed up on a timely basis by

persons not involved in payroll preparationR

• &re there procedures (e.g., ticler files to assure proper and timely

payment of withholdings to appropriate bodies and to file requiredinformation returnsR

• &re employee compensation records reconciled to control accountsR

• s access to personnel and payroll records, checs, forms, signature

plates, etc., limitedR

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-"1



16-##. (>stimated time - "2 minutesa. There are three basic shortcomings in the payroll procedures currently used at the

alena plant$

• &ctual payroll hours are not approved by production management.• There is inadequate segregation of duties within the payroll department.

• )ersonnel department should not have access to payroll checs on a regular basis.

The following corrective action should be taen to improve the internal control of payroll processing procedures$

• &ll incoming time cards should be signed by both the employee and supervisor.

• The payroll cler who prepares the input for data processing should not do the

reconciliation but, rather, a second cler should reconcile the payroll register tothe time cards.

• &n employee of supervisory level should authori*e voiding of computer-

generated checs and the subsequent preparation of a manual replacement chec.

• %eplacement checs should be processed following good internal control

procedures.

• &ll payroll checs, including unsigned replacement checs, should then be given

to the accounting department rather than to the personnel department for storagein a secure location until payday.

b. >ach of the three basic shortcomings mentioned above could lead to material errorsand irregularities. The inadequate segregation of duties within the payroll departmentclearly is a material weaness. The payroll cler is in a position to submit fictitious

input data and to conceal the irregularities by 5fudgingS the reconciliations of the payroll register.

urthermore, the procedures over the voiding of computer-generated checs andissuing of manual replacement checs could result in major irregularities that mightnot be detected by others in the normal course of their duties.

16-#/. (>stimated time - "2 minutes

a. 7isstatements %. $ecommended mproements

Kirings are made byfactory foreman on basisof interview.

& system of advice forms should be installed so that hirings,terminations, rate changes, etc., are reported to the payrolldepartment in writing. +uch forms should be approved by theforeman5s superior.

The bacground ofapplicants is not checed.

Aefore an applicant is hired, his or her bacground should beinvestigated by contacting references to determine that he orshe is not dishonest and has no other undesirable personalcharacteristics.

%ate adjustments are %ate adjustments should be in writing and signed by both the

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-""



a. 7isstatements %. $ecommended mproements

made verbally byforeman.

foreman and a superior or personnel manager.

& supply of blan time

cards is ept near theentrance.

The supply of blan time cards should be removed. &t the

beginning of each wee the payroll department should provide each worer with a time card stamped with theworer5s name.

Time wored is penciledon the time card by eachworer.

& time cloc should be installed and the worers required to punch in and out. & responsible employee should bestationed at the time cloc to determine that worers are not punching the time cards of other worers who may be late orabsent, or who may have left wor early.

Time cards are droppedin a bo! at the end of thewee.

The foreman should collect the time cards at the end of thewee, approve them, and turn them over to the payroll cler.&ll time cards should be accounted for and any missing cards

investigated.)ayroll clers divide thecards alphabetically andhave full responsibilityfor each section.

The payroll clers5 wor should be arranged so that theychec each other. 8nder the e!isting system of computingthe payroll, the cler who does not do the original computingshould chec the original wor of the other cler. &s analternative, one cler may mae the original computationsfor the full payroll and the other cler do all the rechecing.

)ayroll checs aremanually numbered.

)ayroll checs should be prenumbered to control theirissuance.

>mployees areautomatically removedfrom the payroll whenthey fail to turn in a timecard.

>mployees should only be removed upon written noticesigned by the foreman and personnel manager.

)ayroll checs are signed by the chief accountant.

0hecs should be signed by the treasurer.

The foreman distributesthe checs.

The checs should be distributed by a paymaster or aresponsible person other than the foreman.

The foreman arrangesfor the distributionof unclaimed wages.

8nclaimed wages should be ept by the treasureror some other responsible personnel.

The payroll ban account

is reconciled by the chiefaccountant.

The payroll ban account should be independentlyreconciled.

16-#2. (>stimated time - "2 minutes

a. ossi%le 7isstatement %. ossi%le est of Controls

1. ictitious payroll transactions may be >!amine authori*ations.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-"#



a. ossi%le 7isstatement %. ossi%le est of Controls

recorded.". ictitious payroll transactions may be

recorded.>!amine evidence of supportingdocumentation.

#. &ctual payroll transactions may not be

authori*ed.

>!amine authori*ations and approvals.

/. )ayroll checs may be distributed tounauthori*ed recipients.

4itness distribution of checs.

2. )ayroll checs may be incorrect. >!amine evidence of internalverificationsC reperform verifications.

6. 8nclaimed wages may be stolen. =bserve storage areaC inquire aboutaccess.

:. 8nauthori*ed changes may be made tomaster files.

=bserve security over filesC inquire aboutaccess.

;. &ctual payroll transactions may not be

authori*ed.

>!amine authori*ations and approvals.

<. ictitious time data may be processed. =bserve time cloc punching procedures.1. )ayroll ta! returns may not be filed. nquire of personnel responsible for filingC

e!amine ta! returns.

16-#6. ("2 minutes

a. &n important source of information for benchmaring performance in the personnelservices cycle is industry statistics. =ften the best industry statistics can be obtainedfrom trade associations that represent an industry, which often report quite detailed breadowns of payroll costs for various industry sectors. urther, many largerauditing firms develop their own information based on a nationwide or worldwidedatabase developed from a depth of clients in a particular industry.

b.Eidence O%tained

!uring the Audit

Audit O%'ectie &atisfied

4ith the Eidence

E"ample of 3o4 Eidence

0ould &upport Value6added

&erices

roduction Cycle

The auditor notessignificant increases inoverhead allocation ratesand observes under

utili*ation of capacity

aluation of inventory andvaluation of plant andequipment (depreciationrates.

The auditor develops strategiesfor more effective utili*ation of production facilities orstrategies to dispose of

nonproductive facilities.The auditor notes asignificant amount of slowmoving inventory.

aluation of inventory atnet reali*able value.

The auditor develops strategiesto identify and liquidate slowmoving inventory to speed theinventory turn cycle.

ersonnel &erices Cycle

The auditor vouches laborcosts on a test basis and

aluation assertion. The auditor identified thatlabor costs are increasing faster

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-"/



compares labor costsagainst industry standards

than e!pected for the industry.




Cases

16-#:. +ee separate file with answers to the comprehensive case related to the audit of 't. Kood

urniture that is included with this chapter.

16-#;. (>stimated Time B " hours

hase

This case allows the professor to e!plore the challenges of auditing privately held companies.4hile privately held companies do not receive the attention of public companies, they represent asignificant portion of audits performed by 0)&s. This case allows students to e!plore the controlenvironment issues associated with an owner-managed company with a domineering ownermanager. This case was developed based on an actual case that led to fraudulent financial reportingin a privately held company.

/uestion 1; Control Enironment ssues

The control environment at 0T is representative of that in a number of owner-managed businesses.The following issues all represent control environment weanesses.o 3essica, the owner-manger, was increasing her intrusion into the company7s financial reporting

process.o 3essica paid particular attention to accounting results, particularly in the last two quarters of the

year.o 3essica regularly discussed accounting for particular transactions. 3essica was monitored the

year-end close on a daily basis, to discuss closing entries and their impact on earnings.o 3essica would override policies and tell someone in account to change a sales invoice to offer a

particular price discount to a customer.o 3essica would not accept e!planations for draft financial statements that showed performance

falling below her e!pectations.o &ccounting was not a high priority in the company.

o &ccounting was understaffed (not allowing for adequate segregation of duties and everyone

wored long hours.

uestion "$ &nalytical )rocedures

The table below shows an increase in inventory turn days, a decrease in accounts payable turn days,and a steady gross margin. The gross operating cycle is constant due to the improvement in

accounts receivable turn days. The net operating cycle does not show the same level ofimprovement as gross operating cycle due to the decrease in payable turn days. The increase ininventory turn days indicates that inventory may be overstated. & further ris may be associatedwith unrecorded liabilities. The combination may result in an overstatement of net income.




uestion #$ %is &ssessment

a. 'any of the financial statement level riss that have a pervasive effect on the financialstatements also involve control environment issues. n particular$o 3essica, the owner-manger, was increasing her intrusion into the company7s financial

reporting process.o 3essica paid particular attention to accounting results, particularly in the last two quarters

of the year.o 3essica regularly discussed accounting for particular transactions. 3essica was monitored

the year-end close on a daily basis, to discuss closing entries and their impact on

earnings.o 3essica had a history of overriding accounting decisions.

o 3essica would not accept e!planations for draft financial statements that showed

performance falling below her e!pectations.o &ccounting was not a high priority in the company.

o &ccounting was understaffed (not allowing for adequate segregation of duties and

everyone wored long hours.

b. 4hen it comes to incentives and pressures, 3essica put considerable pressure on theaccounting staff to achieve accounting results. n addition, the company had to met particular debt covenants, and 3essica wanted particular year-end results to support

distribution of earnings to shareholders in a +ubchatper + 0orporation.

The person who had the opportunity to influence the outcome of the accounting system wasthe 0=, %ob Faiser. There were no controls over %ob7s activities in the financial reporting process.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-":



%ob was under considerable pressure from 3essica to deliver e!pected results. 3essica7sintrusion into the financial reporting process lessened only when reported results matchedthe owner-manger7s e!pectations.

uestion /$ 'anagement )erformance %eviews

'anagement performance reviews can be effective at identifying misstatements when seniormanagement encourages representational faithfulness in financial reporting. n these situationsmanagement might review inventory levels or inventory pricing and identify accounting results thatare not consistent with actual e!perience. These controls do not wor well, however, whenmanagement is under considerable pressure to deliver desired results. Kence, management performance reviews performed by 3essica and %ob would liely not be effective at identifyingfinancial statement misstatements.

uestion 2$ nternal 0ontrol %ecommendations

& number of recommendations can be discussed in this letter, most of which will deal with thecontrol environment. +tudents could focus on any of the issues raised in question 1. ollowing isan e!ample letter.

9ate

To the Aoard of 9irectors0ircuits Technology, nc.

n planning and performing our audit of the financial statements of 0ircuits Technology, nc. (0Tfor the year ended 9ecember #1, "", we considered its internal control in order to determine ouraudit procedures for the purpose of e!pressing an opinion on the financial statements and not to provide assurance on internal control. Kowever, we noted certain matter involving the internalcontrol and its operation that we consider to be reportable conditions under standards established bythe &merican nstitute of 0ertified )ublic &ccountants. %eportable conditions involve matterscoming to our attention related to significant deficiencies in the design or operation of internalcontrols that, in our judgment, could adversely affect the organi*ation7s ability to record, process,summari*e and report financial data consistent with the assertions of management in the financialstatements.

0ontrol >nvironment

The control environment represents the tone set by management of an organi*ation that influencesthe control consciousness of its people. t is important because it represents the foundation for allother components of internal control, providing discipline and structure. & wea controlenvironment will lessen the effectiveness of other control activities that may prevent or detectmisstatements on a timely basis.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-";



&n important aspect of the control environment involves a commitment to competence andinvestment in human resource polices that support a sound financial reporting system. n the pastwe have noted financial statement misstatements that have resulted from the fact that the accountstaff is stretched too thin. This lac of investment in account personnel has also led to a situationwhere a good system of checs and balances and segregation of duties cannot be achieved. 4e

recommend that 0T consider the addition of an additional staff person in accounting during pea periods to encourage better control activities.

& strong control environment also involves a management philosophy and operating style thatreinforces representational faithfulness in financial reporting. 9uring our audit we noticed severalsituations that are considered significant ris indicators including the daily involvement of theowner-manager in accounting issues associated with the closing process. & sound controlenvironment delegates a higher degree of responsibility for financial reporting to the accountingstaff and it places a premium on financial reporting that fairly presents underlying results ofoperations.

This report is intended solely for the information and use of the Aoard of 9irectors of 0ircuitsTechnology, nc., management and others within the organi*ation and is not intended for any other purposes. 4e than you for the opportunity to continue to be of service to you.

+ignature.

)art .

uestion 6. %esults of +ubstantive Tests

a. f the results of the sample of #2 are representative of the population the project the anestimated audit value of H ;#<,1:< based on the calculation below using ratio estimation.

"16,"<2 G "6/,:2 ! 1,":, J ;#<,1:<.

This represents a potential overstatement of inventory of H1;:,;"1. n each instance, theerrors resulted not from errors in counting the quantity of inventory, but they resulted fromerrors in pricing inventory.

n addition, payroll costs in the amount of H"1,6 were capitali*ed as part of wor in process inventory when the project was complete and billed to the customer. n totalinventory was overstated, cost of goods sold was understated, and gross margin wasoverstated by H";,;;1. This represents "N of the boo value of inventory and is material.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-"<



b. &t a minimum, the auditor should e!tend the sample for price testing inventory to determineif the nown misstatements are representative of the inventory as a whole. The pricingerrors are e!tensive and all in the same direction. iven the fraud ris indicators, it is lielythat misstatements are intentional with the intent of overstating inventory to achieve budgeted results. The auditor might want to approach the accounting personnel, and the

0=, with the results and determine the e!tent of their involvement with the pricing ofinventory. f these pricing errors and inappropriate capitali*ation of payroll costs rest solelywith the 0=, the auditor needs to question %ob Faiser to determine the e!tent ofmisstatements in inventory and other areas. =nce presented with the audit evidence, the0= might admit to his involvement in financial statement misstatements. f the 0= doesnot admit to involvement in the misstatements, the audit needs to be e!tended to determinethe full e!tent of the misstatements.

inally, the auditor should consider the implication for other aspects of the audit. fevidence suggests that prices and inventory values were changed to hit earnings targets, thescope of other audit wor should also be increased throughout the audit. The auditor might

want to suggest that management hire a forensic auditor to perform a fraud audit todetermine the e!tent of misstatements in the financial statements.

uestion :. 9raft 'anagement @etter 0omments

ollowing is a draft of a management letter comment that should be discussed with the board ofdirectors. This comment is drafted based on the audit evidence alone.

9uring the audit we found evidence of overstatements of inventory by the 0hief inancial=fficer in order to overstate gross margins with the purpose of achieving desired financialresults. n a sample of #2 items we found 1: items with pricing errors, all of which resultedin the overpricing of the value of inventory. n addition, we found evidence of inappropriatecapitali*ation of payroll costs as part of wor in process inventory. n total, we estimatethat inventory values presented for audit were overstated by almost H"1, (or "N of thevalue of inventory. 9ue to the e!tensiveness of the misstatements, 1: out of #2 itemssampled, we recommend retesting the entire inventory for pricing errors.

f %ob Faiser admits to his involvement in overstating inventory, this should also be discussed withthe board of directors. The auditor needs to recommend (1 changes in the control environment thatled to the fraudulent financial reporting and (" replacement of the 0=.

uestion ;. 9iscussion with irst +tate Aan

The auditor cannot have any conversations with the ban about the potential fraud or financialstatement misstatements due to ethical rules on confidential client information. f 0T corrects thefinancial statements, the irst +tate Aan will get financial statements that present fairly in allmaterial respects.

f the corrected financial statements disclose violations of debt covenants, the client shouldapproach irst +tate Aan about the potential violations of debt covenants and as the Aan to

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-#



waive the violations. f the ban is unwilling to waive the debt covenant violations, the auditorneeds to consider whether long-term debt to the ban should be reclassified as current beforeissuing an opinion on the financial statements.

rofessional &imulation

ayroll

Controls

&ituation

$esearch nentory

Audit

rocedures

The suggested evaluation of the system of internal controls presented above is included in thefollowing table.

Assertion Ade<uacy of Controls

$ecommend mproements for &ignificant

!eficiencies

>!istence and=ccurrence

0ontrols are sufficient

& significant deficiency e!its

Time cards should be preprinted andEor prepunchedand prenumbered.

oreman should approve (sign all time cards and jobticets.

)aychecs should not be distributed by foremen. Theyshould be mailed directly to the employee, ordistributed by the internal audit staff or by authori*edtreasurer5s office personnel not involved in preparingor recording the payroll.

=perators should not be allowed to mae datachanges at the console, the console log should bereviewed regularly for operator interruptions and the programming and operator functions should beseparated.

0ompleteness 0ontrols are sufficient


mplement programmed batch controlsC e.g., hashtotal of employee number and record count. The payroll record count should be compared with thenumber of timecards processed.

aluation and&llocation

0ontrols are sufficient


& limit test should be incorporated into the program tohalt the processing of any employee record whoselabor hours e!ceed 6C a listing of all e!ceptionswould be prepared for review to determine if thehours were right or needed to be corrected.

& limit test should be incorporated into the program tohalt the processing of any employee5s recordswhenever the gross wages e!ceed H# per weeC alisting of all e!ceptions would be prepared for reviewto determine if the amounts were accurate or needed

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-#1



to be corrected.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-#"



$esearch

&ituation

ayroll

Controls

nentory

Audit

rocedures

The issues associated with the client7s use of statistical sampling to determine inventory quantitiesis addressed in &8 ##1.11 which is stated below.

.11 n recent years, some companies have developed inventory controls or methods of determininginventories, including statistical sampling, which are highly effective in determining inventoryquantities and which are sufficiently reliable to mae unnecessary an annual physical count ofeach item of inventory. n such circumstances, the independent auditor must satisfy himself thatthe client5s procedures or methods are sufficiently reliable to produce results substantially thesame as those which would be obtained by a count of all items each year. The auditor must be present to observe such counts as he deems necessary and must satisfy himself as to theeffectiveness of the counting procedures used. f statistical sampling methods are used by theclient in the taing of the physical inventory, the auditor must be satisfied that the sampling planis reasonable and statistically valid, that it has been properly applied, and that the results arereasonable in the circumstances. U%evised, 3une 1<;1, to reflect conforming changes necessarydue to the issuance of +tatement on &uditing +tandards ?o. #<.V

nentory

Audit

rocedures

&ituation

ayroll

Controls

$esearch

Audit procedure&. 8nderstand the ey economic drivers that influence the entity7s cost of sales, gross margins and

the possibility of obsolete inventory.A. =n a test basis, trace data from purchases, manufacturing, completed production, and sales

records to inventory accounts.0. ouch the items on the final inventory listing to inventory tags, count sheets and test counts

taen during the inventory observation.9. Trace test counts taen during the inventory observation to the final inventory listing.>. >!amine sales invoices after year-end and determine the net reali*able value of inventory.. 0onfirm inventories at locations outside the entity.

. Aased on test of beginning inventory, production costs, and ending inventory, determine theappropriateness of cost of goods sold.

K. 0onfirm agreements for assigning and pledging inventories.. >!amine vendors paid invoices for purchased inventory prior to year-end.3. >valuate the completeness of presentation of disclosures to determine conformity with &&)

by reference to a disclosure checlist.

!etermine the audit procedure that %est addresses the follo4ing risks.

+olutions 'anual to Modern Auditing: 0opyright © "2, 3ohn 4iley and +ons, nc. 16-##



Risk (A) (*) (C) (!) (E) () (5) (3) () (=)

1. nventory that was counted and on hand at year-endmay not be included in the final inventory listing.

". nventory quantities may be correct, but inventorymay be incorrectly valued at =.

#. nventory that is said to be on hand in a publicwarehouse may not e!ist.

/. nventory may have to be sold at a loss in order tomove inventory.

2. &ll manufacturing costs may not be included in theunderlying accounting records supporting costs ofsales.

Documents

Chapter 16 nton