Production and Payroll Cycle

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Chapter 9

• Production and Payroll Cycle
• There is one rule for industrialists and that
  is Make the best quality of goods possible at
  the lowest cost possible, paying the highest
  wages possible.Henry Ford

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Learning Objectives

1. Describe the production cycle, including typical
   source documents and controls.
2. Identify and describe considerations involved in
   the observation of physical inventory and tests
   of inventory pricing and compilation.
3. Describe some common errors and frauds and design
   some audit and investigation procedures for
   detecting them.
4. Describe some common errors and frauds in
   payroll, and design some audit and investigation
   procedures for detecting them.

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Production and Payroll (Conversion) Cycle

• Concerned with the production/manufacture of the
  organization's inventory.

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Importance of Inventory

• Major component of current assets on the balance
  sheet.
• Significant effect on net income.
• Valuation is usually very subjective.
• Potential obsolescence
• Goods have not been sold, so marketability may be
  uncertain.

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Inherent Risks in Production Subcycle

• Complexity (e.g. dollar value LIFO)
• Susceptibility to theft
• Lower-of-Cost-or-Market valuation
• Effects on gross profits

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Exhibit 9.1
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Substantive Procedures

• Observation of inventory count
• Tests of pricing and compilation
• Analytical procedures

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Physical Inventory Observation

• it will always be necessary for the auditor to
  make, or observe, some physical counts of the
  inventory and apply appropriate tests of
  intervening transactions" (AU 331.12).
• May make test counts at a time other than
  year-end.
• test roll-forward.

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Physical Inventory Observation

• Review client instructions
• Stop flow of goods
• Make TEST COUNTS
• From INVENTORY LISTING,
• From WAREHOUSE FLOOR
• Record all counts in working papers

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Physical Inventory Observation

• Control tags or count sheets
• Be wary of "hollow squares" and "empty boxes
• Tour shipping and receiving areas
• Watch for OBSOLETE and SLOW-MOVING inventory
• CONFIRM inventory on CONSIGNMENT and at other
  locations
• Consider the use of SPECIALISTS
• Confirm inventory in transit.

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Pricing and Compilation Tests

• Valuation (Price Tests)
• VENDOR INVOICES
• COST FLOW ASSUMPTION (FIFO, LIFO, average,
  specific identification)
• LOWER OF COST OR MARKET for inventory
• Check Extensions and Footings.
• Agree to G/L

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Purchase Cutoffs

• Verify CUT-OFFs for purchases
• Examine Receiving Reports and Vendor Sales
  Invoices occurring around year-end.

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Analytic Procedures

• Verify REASONABLENESS of COGS
• Gross Profit Margin
• Compare to prior year, industry averages
• Verify REASONABLENESS of ending inventory
• Days Sales in Inventory
• Inventory Turnover

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Fraud Detection Procedures

• Focus on high-dollar items.
• Unpredictable counts.
• Be skeptical of large differences.
• Be alert for signs of damage, obsolescence or
  excess quantities.
• Ensure interplant transfers are kept to a minimum.

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Payroll

• Often processed by service bureaus
• Balance sheet accounts usually small.
• Rely on tests of controls/substantive tests of
  transactions.

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Inherent Risks in the Payroll Subcycle

• Ghost employees
• Overpaying for time or production
• Incorrect accounting (classification)

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Payroll Subcycle Control Activities

• Physical Controls
• Payroll Checks and signature plates kept in a
  secure location
• Payroll Checks distributed by a person not
  involved in processing or recording payroll
• Payroll Checks distributed to individuals with
  proper identification
• Unclaimed Payroll Checks stored in a secure
  location
• Segregation of Duties
• The Personnel Department and the Hiring/Employing
  Department AUTHORIZE payroll transactions and
  payroll-related changes.
• Payroll is RECORDED by the Payroll Department and
  General Accounting
• The Cash Disbursements Department/Treasurer has
  CUSTODY of the Payroll Checks
• Performance Reviews
• Payroll transaction data compared to prior-year
  data or budgeted/expected data.
• Review of Payroll Register for reasonableness
• Reconcile the Payroll bank account

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Exhibit 9.7
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Payroll Subcycle Management Reports and Files

• Personnel files
• Payroll register
• Labor cost analysis
• Clearing accounts
• Government and tax reports
• Year-to-date earnings records