CHAPTER 16 AUDIT THE PRODUCTION AND PERSONNEL SERVICES CYCLE

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 and events pertaining to the manufacturing process. The major transaction class within this cycle is manufacturing transactions. The production cycle interfaces with (1) the expenditure cycle through the purchase of raw materials and incurrence of various overhead costs, (2) the personnel services cycle through the incurrence of factory labor costs, and (3) the revenue cycle through the sale of finished goods.

b. c.

16-2. a. The transaction class audit objectives for the production cycle are: Occurrence. Recorded manufacturing transactions represent material, labor, and overhead transferred to production and the movement to completed production to finished goods during the current period (EO1). Recorded cost of sales represent the sale of inventory during the year (EO2). Completeness. All manufacturing transactions (C1) and cost of sales (C2) that occurred during the period were recorded. Accuracy. Manufacturing transactions (VA1) and cost of sales (VA2) are accurately valued using GAAP and correctly journalized, summarized and posted. Cutoff. All manufacturing transactions (EO1 and C1) and cost of sales (EO2 and C2) have been recorded in the correct accounting period. Classification. All manufacturing transactions (PD1) and cost of sales (PD2) have been recorded in the proper accounts. b. Several account balance audit objectives for the production cycle are: Existence. Inventories included in the balance sheet physically exist (EO3). Completeness. Inventories include all materials, products and supplies on hand at the balance sheet date (C3). Rights and Obligations. The reporting entity has legal title to recorded inventories at the balance sheet date (RO1). Valuation and Allocation. Inventories costing assumptions have been properly applied (VA3) and inventories are properly stated at the lower of cost or market (VA4). Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-1

16-3. a.

In a manufacturing company, inventories and cost of goods sold are usually significant to the company's financial position and results of operations. Further, due to the cost of observing inventory the auditor will normally allocate a significant amount of overall materiality o the audit of inventory, without exceeding an amount that the auditor believes will affect the analysis of a financial statement user. Several factors that affect inherent risk for assertions related to the production cycle are: The volume of purchases, manufacturing, and sales transactions that affects these accounts is generally high, increasing the opportunities for misstatements to occur. There are often contentious issues surrounding the identification, measurement, and allocation of inventoriable costs such as indirect materials, labor, and manufacturing 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 volume measurements of stockpiles, aerial photography, and estimation of quantities by experts. Inventories are often stored at multiple sites, adding to the difficulties associated with maintaining physical controls over theft and damage, and properly accounting for goods in transit between sites. The wide diversity of inventory items may present special problems in determining their quality and market value. Inventories 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. Inventories may be sold subject to right of return and repurchase agreements. Following are several examples of analytical procedures and a description of how they might assist the auditor when auditing the production cycle.
Ratio Inventory Turn Days Formula Avg. Inventory Cost of Good Sold x 365 Audit Significance Prior experience in inventory turn days combined with knowledge of cost of sales can be useful in estimating current inventory levels. A lengthening of the period may indicate existence problems. Ratios larger than 1.0 indicate that inventories are growing faster than sales. Large ratios may indicate possible inventory obsolescence problems. Useful in estimating the efficiency of the manufacturing process. May be helpful in evaluating the reasonableness of production costs.

b.

c.

Inventory Growth to Cost of Sales Growth

((Inventory n Inventory n-1) 1) ((Cost of Sales n Cost of Sales n-1) 1) Finished Goods Quantities Raw Material Quantities

Finished Goods Produced to Raw Material Used

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Ratio Finished Goods Produced to Direct Labor Product Defects per Million

Formula Finished Goods Quantities Direct Labor Hours Number of Product Defects as a Percent of Each Million Produced

Audit Significance Useful in estimating the efficiency of the manufacturing process. May be helpful in evaluating the reasonableness of production costs. Useful in estimating the effectiveness of the manufacturing process. May be helpful in evaluating the reasonableness of production costs and warranty expenses.

16-4.

a.

Control environment factors that may impact the production cycle include: The organizational structure should include an officer who has overall responsibility for production, including authority over the production planning and control department and each manufacturing department. The assignment of authority and responsibility should include timely accountability for the use of the entitys resources. Management's philosophy and operating style should include its approach to taking and monitoring business risks related to production decisions and inventory levels. The entity's human resource policies and practices pertaining to production department employees can significantly impact the use of, and accountability for, the factors of production. Unique elements of an entity's accounting information system that pertain to the production cycle may include the use of control accounts and supporting records such as product or master files, separate records for raw materials, work in process, and finished goods inventories, job order and process cost systems, and standard cost systems.

b.

16-5. The documents and records are summarized in the following table: Function Initiating production: o Planning and controlling production. Production of Inventory: o Issuing raw materials. o Processing goods in production. o Transferring completed work to finished goods. o Protecting inventories. Recording manufacturing and inventory transactions: o Determining and recording manufacturing costs. o Maintaining correctness of Documents and Records Production orders Material requirements reports Materials issue slips or requisitions Time tickets Inventory move tickets

Daily production reports Completed production report Standard cost master file Raw material inventory master file Work in process inventory master file 16-3

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inventory balances.

Finished goods inventory master file

16-6. Controls that are important in determining and recording manufacturing costs are: Computer checks on the agreement of entries for the allocation of manufacturing costs to work in process with data on materials and labor usage in daily production activity reports. Computer checks on the agreement of entries for the transfer of work in process to finished goods with data in completed production reports. 16-7. Controls important in protecting inventories include: Storage of raw materials and finished goods inventories in locked storerooms with access restricted to authorized individuals. Surveillance of production areas by supervisory and plant security employees. Tagging goods in production. Using prenumbered move tickets to control the transfer of work in process through the plant. Controls relating to the correctness of inventory balances include: Periodic independent counts of inventory on hand and comparison with recorded quantities per the perpetual inventory records. Periodic independent checks on the agreement of the dollar carrying amounts for the raw materials, work in process, and finished goods inventory master files with their respective general ledger control accounts. Periodic inspections of inventory condition and management review of inventory activity reports for the purpose of determining the need for adjustments to reduce inventory carrying values to market when required. 16-8. a. Factors that should be considered by an auditor in specifying the acceptable level of detection risk for assertions pertaining to merchandise inventory include the relevant transaction class inherent and control risk assessments for the purchases and sales transactions that affect the merchandise inventory account, as well as inherent and control risk factors associated directly with the merchandise inventory balance. Factors that should be considered by an auditor in specifying the acceptable level of detection risk for assertions pertaining to manufactured finished goods inventory include relevant inherent and control risk assessments for the manufacturing and sales transactions that affect the finished goods inventory account, as well as inherent and control risk factors associated directly with the manufactured finished goods inventory balance.

b.

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16-9. Several ratios and their formulas that may be used in applying analytical procedures to inventory balances are:
Ratio Inventory Turn Days Formula Avg. Inventory Cost of Good Sold x 365 Audit Significance Prior experience in inventory turn days combined with knowledge of cost of sales can be useful in estimating current inventory levels. A lengthening of the period may indicate existence problems. Ratios larger than 1.0 indicate that inventories are growing faster than sales. Large ratios may indicate possible inventory obsolescence problems. Useful in estimating the efficiency of the manufacturing process. May be helpful in evaluating the reasonableness of production costs. Useful in estimating the efficiency of the manufacturing process. May be helpful in evaluating the reasonableness of production costs. Useful in estimating the effectiveness of the manufacturing process. May be helpful in evaluating the reasonableness of production costs and warranty expenses.

Inventory Growth to Cost of Sales Growth

((Inventory n Inventory n-1) 1) ((Cost of Sales n Cost of Sales n-1) 1) Finished Goods Quantities Raw Material Quantities

Finished Goods Produced to Raw Material Used Finished Goods Produced to Direct Labor Product Defects per Million

Finished Goods Quantities Direct Labor Hours

Number of Product Defects as a Percent of Each Million Produced

16-10. a.

Five tests of details of balances that may be applied to inventories are: Observe client's physical inventory count. Test clerical accuracy of inventory listings. Test inventory pricing. Confirm inventories at locations outside the entity. Examine consignment agreements and contracts. 1. The observation of inventories is required whenever inventories are material to a company's financial statements and it is practicable and reasonable to make the observation. The timing of an inventory observation depends on the client's inventory system and the effectiveness of internal controls. In a periodic inventory system, the observation of the inventory should occur at or near the balance sheet date. In a perpetual inventory system with well-kept records, observation may occur during or after the end of the period under audit.

b.

2.

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3.

In evaluating the client's inventory taking plans, the auditor should determine that the plan includes all of the following: Names of employees responsible for supervising the inventory taking. Date of the counts. Locations to be counted. Detailed instructions on how the counts are to be made. Use and control of prenumbered inventory tags and summary (compilation) sheets. Provisions for handling the receipt, shipment, and movement of goods during the counts if such activity is unavoidable. Segregation or identification of goods not owned.

4. In observing inventories, the auditor should Scrutinize the care with which client employees are following the inventory plan. See that all merchandise is tagged and no items are double tagged. Determine that prenumbered inventory tags and compilation sheets are properly controlled. Make some test counts and trace quantities to compilation sheets. Be alerts for empty containers and hollow squares (empty spaces) that may exist when goods are stacked in solid formations. Watch for damaged and obsolete inventory items. Appraise the general condition of the inventory. Identify the last receiving and shipping documents used and determine that goods received during the count are properly segregated. Inquire about the existence of slow-moving inventory items. 16-11. a. In testing inventory pricing for purchased inventories, the auditor should (1) vouch costs to representative vendor invoices and (2) verify both cost and market when the lower of cost or market method is used. In testing inventory pricing for manufactured inventories, the auditor should review the methods used in costing the inventories for propriety and the accuracy and consistency of application. For example, when standard costs are used, the auditor should test the calculation of the standards, compare the calculations with engineering specifications, determine that the standards are current, and evaluate whether the standards approximate actual costs by examining the variance accounts. Confirmations may be used in the audit of inventories to obtain evidence about the existence of inventories stored in public warehouses or with other outside custodians such as consignees. When the auditor is testing net realizable value the auditor needs to determine if the client will be able to sell inventory on hand at year-end in the normal operating cycle and not suffer a loss (break-even) in the process. The auditor is testing the clients

b.

16-12. a.

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estimates of future outcomes the value of future sales. This is particularly problematic with inventory that is considered obsolete. b. When auditing the net realizable value of inventory the auditor will want to understand managements process for estimating any allowance for obsolete inventory. The auditor will need to understand how long it takes the client to turn its inventory and evaluate recent history (the last several inventory turn cycles) for evidence of the clients ability to turn its inventory and break even. The auditor will also want to review sales prices after year-end to the extent possible. The personnel services cycle involves the events and activities that pertain to executive and employee compensation. This cycle interfaces with two other cycles: (1) the paying of the payroll and payroll taxes involves cash disbursements in the expenditure cycle; (2) the distribution of factory labor costs to work in process pertains to the production cycle. Gross earnings of personnel are generally the largest operating expense in merchandising (after costs of goods sold) and service companies. They also are a major component in costing work in process. Employee fraud is a major inherent risk that the auditor should consider. The auditor's usual strategy is to use a lower assessed level of control risk approach in auditing payroll transactions because: The audit risk is primarily in the processing of payroll transactions. Most companies have extensive internal controls for the routine nature of payroll transactions. Year-end payroll liability balances are often immaterial.

16-13. a. b.

16-14. a.

b.

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16-15. The audit objectives for payroll transactions and related assertions are: Specific Audit Objectives Transaction Objectives Occurrence. Recorded employee compensation, benefits and payroll tax expenses relate to compensation for services rendered during the year (EO1). Completeness. Recorded employee compensation, benefits and tax expenses include all such expenses incurred for personnel services during the year (C1). Accuracy. Employee compensation, benefits and payroll tax expenses are accurately computed and recorded (VA1). Cutoff. Employee compensation, benefits and payroll tax expenses have been recorded in the correct accounting period (EO1 and C1). Classification. Employee compensation, benefits and payroll tax expenses are properly identified and classified in the income statement (PD1). Balance Objectives Existence. Employee compensation, benefits and payroll tax liabilities represent amounts owed at the balance sheet date (EO2). Completeness. Employee compensation, benefits and payroll tax liabilities include all such amounts owed at the balance sheet date (C2). Rights and Obligations. Employee compensation, benefits and payroll tax liabilities are obligations of the reporting entity (RO1). Valuation and Allocation. Employee compensation, benefits and payroll tax liabilities are accurately computed and recorded (VA2). Disclosure Objectives Occurrence and Rights and Obligations. Disclosed employee compensation and benefits transactions and balance have occurred and pertain to the entity (PD3). Completeness. All employee compensation and benefits disclosures that should have been included in the financial statements have been included (PD4). Understandability. All employee compensation and benefits information is appropriately presented and information in disclosures is understandable to users (PD5). Accuracy and Valuation. All employee compensation and benefits information is disclosed accurately and at appropriate amounts (PD6).

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16-16. Following are several examples of analytical procedures and a description of how they might assist the auditor when auditing the production cycle.
Ratio Average payroll cost per employee classification Formula Total payroll costs for an employee group divided by the number of employees in the group Total Revenue number of full time equivalent employees. Total payroll expenses total revenues Total payroll tax expenses gross payroll Current year payroll expenses prior year payroll expenses Audit Significance Reasonableness test of gross payroll for a group of employees. Many companies have more than one class of employee, and it is important to evaluate the reasonableness of payroll based on employee class. This may be a measure of productivity per full time equivalent employee. This is particularly important in services industries and would be compared with industry statistics. Reasonableness test of payroll costs. This is often compared with industry statistics. Reasonableness test of payroll taxes. This can often be compared with standard tax rates. Reasonableness test for payroll expenses if the ratio is significantly different from 1.0

Revenue per employee

Total payroll costs as a percentage of revenues Payroll tax expense as a percent of gross payroll Compare payroll expenses (salaries and wages, commissions, bonuses, employee benefits, etc) with prior year balances or budgets Compare current year payroll liability with prior year payroll liability Compute ratio of payroll tax expense to total payroll expenses Employee benefits expenses as a percent of gross payroll

Current year payroll tax liability prior year payroll tax liability adjusted for growth in payroll volume Payroll tax expense total payroll expense Total benefits expenses gross payroll

Reasonableness test for payroll liability if the ratio is significantly different from 1.0 Reasonableness test for payroll tax expense based on prior year ratio of payroll tax expense to total payroll. Reasonableness test of benefits expenses. This is often compared with industry statistics.

16-17. 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 which controls are established over putting new employees on the payroll is essential to good control. Management should actively assess the risks associated with errors and fraud and design appropriate controls to reduce these risks consider the cost-benefit tradeoff when implementing controls.

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Finally, management should monitor the system of internal controls, perhaps as a responsibility of the internal audit function. Management needs to review the results control failures that result in errors or fraud in the personnel services function and take actions to correct exiting problems. 16-18. The functions in processing payroll transactions are: Initiating payroll transactions including (a) hiring employees and (b) authorizing payroll changes. Receiving services including preparing attendance and timekeeping data. Recording payroll including (a) preparing and (b) recording the payroll. Paying the payroll including (a) paying the payroll and protecting unclaimed wages, and (b) filing payroll tax returns. 16-19. a. The responsibilities of the personnel department include: (1) hiring employees, (2) preparing personnel authorization forms for new hires, (3) authorizing payroll changes and terminations, and (4) maintaining employee personnel files. The control procedures in preparing attendance and timekeeping data include (1) using time clocks to record hours worked, (2) supervising clock card punching, (3) supporting time clock hours with time tickets, (4) approving time worked in writing by a supervisor, and (5) reconciling time tickets and clock cards. Tests of controls for terminated employees involve making inquiries and observing the processes for removing personnel from the payroll. Many companies create a report of terminated employees that is reviewed in personnel. The auditor might substantively for subsequent payment of terminated employees using generalized audit software and selecting a sample of termination notices and scanning subsequent payroll registers to determine that the terminated employees did not continue to receive pay checks. In witnessing the distribution of payroll checks, the auditor observes that: Segregation of duties exists between the preparation and payment of the payroll. Each employee receives only one check. Each employee is identified by a badge or employee ID card. There is proper control and disposition of unclaimed checks.

b.

16-20. a.

b.

16-21. The following table provides example controls and tests of controls for each assertion (and transaction level audit objective) related to the personnel services cycle. Examples emphasize programmed control procedures where appropriate. Student should note that tests of controls should also emphasize testing computer general controls, observing exception reports, and testing manual follow-up of items that appear on exception reports.

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Personnel Services
Assertion (Audit Objective) Existence and Occurrence (Occurrence) Control Only a few key employees in personnel can add a new employee to the master payroll file. Computer reports all changes to the personnel data master file. Management in personnel reviews report of all master file changes. Batch total of hours worked prepared by payroll department and verified by the computer. Manual controls check payroll cutoff and accrue payroll when pay periods do not coincide with month end. Computer limit test on the number of hours worked and the amount of each payroll check. Computer compares account classification for hours worked with account classification on time cards. N/A Test of Controls Observe the process for changing the master payroll file, review the accuracy of reports of changes to the master file, and reperform control.

Completeness (Completeness) Existence and Occurrence / Completeness (Cutoff) Valuation and Allocation (Accuracy) Presentation and Disclosure (Classification) Rights and Obligations

Use CAATs to test the control by submitting data that should be rejected by the control. Observe the process testing payroll cutoff and accruing payroll costs, and reperform control. Use CAATs to test the control by submitting data that should be rejected by the control. Use CAATs to test the control by submitting data that should be rejected by the control. N/A

16-22. a. b.

The likely acceptable level of detection risk for payroll balances is moderate or high because moderate or low assessments of control risk are usually possible. When moderate or high detection risk levels are acceptable, substantive tests may be limited to applying analytical procedures and limited tests of details. If unexpected fluctuations are found, more extensive tests of details will be required. To obtain evidence about the reasonableness of management's accrued payroll liabilities, the auditor should review management's calculations or make independent calculations, compare the accruals with amounts shown on payroll tax returns, and examine subsequent payments where applicable. Officers' compensation is audit sensitive because it must be separately disclosed in 10-K reports filed with the SEC, and because officers may be able to override controls and receive salaries, bonuses, stock options, and other forms of compensation in excess of authorized When auditing pension expenses, the auditor should also evaluate the reasonableness of the key 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 the expected return on plan assets. The discount rate should be in line with current annuity purchase rates for high-quality fixed income investments. The long-term rate of return assumption should reflect the actual and anticipated returns for the plans assets.

16-23. a.

b.

c.

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d.

With respect to accounting for stock option expense, most companies structure their stock option plans to meet the requirements of APB No. 25, so that they may use the intrinsic value approach and report no compensation expense associated with the use of stock options. Stock appreciation rights, however, require the recognition of compensation expense, regardless of whether the right is exercised during the period. FASB No. 123 requires these companies to disclose pro forma net income and earnings per share as if the fair value approach were used. As a result the auditor must audit the valuation model used to determine the fair value of the stock options. When evaluating fair presentation in the financial statements, the auditor evaluates assumptions that include the risk-free rate, the expected life of the option, the expected volatility of the stock price, and expected dividends.

Comprehensive Questions
16-24. (Estimated Time: 30 minutes) a. The following table includes the calculations for part a. (Note the calculations use ending balances rather than average balances. Also note that AP turn days is calculated by using Accounts Payable Purchases x 365.)
Exhibit 16-25: CTI Selectied Financial Information ($000) 20x1 20x2 20x3
Accounts Receivable, net Inventory Accounts Payable Sales Cost of Sales

20x4 $ $ $ $ $ $ 962 1,003 201 4,022 1,923 2,099 $ $ $ $ $ $

20x5 822 1,027 175 3,905 1,859 2,046

$ $ $

837 1,025 164 3,780 1,812 1,968

$ $ $ $ $ $ $

1,335 1,327 380 5,638 2,691 2,947

$ $ $ $ $ $

1,121 1,099 225 4,623 2,399 2,224

$ $ Gross Margin $

Purchases Gross Margin % Inventory Turn Days AR Turn Days Gross Operating Cycle AP Turn Days Net Operating Cycle

2,993 $ 2,171 $ 1,827 $ 1,883 52.3% 48.1% 52.2% 52.4% 180 167 190 202 86 89 87 77 266 256 278 278 46 38 40 34 220.08 217.89 237.52 244.55

b.

The trends show 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 of improvement as gross operating cycle due to the decrease in payable turn days.

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c.

If tolerable misstatement is $45,000 this translates to an expectation range of plus or mine 9 days based on the following calculation. $45,000 $1,859,000 *365 = 8.8 days which rounds to 9 days. The increase in inventory turn days indicates that inventory may be overstated. A further risk may be associated with unrecorded liabilities. The combination may result in an overstatement of net income.

d.

16-25. (Estimated Time 30 minutes)

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Sales Cost of Raw Materials Used Direct Labor Cost Cost of Payroll Taxes and Benefits Indirect Costs

Unaudited 20X4 $ 12,005,336 $ $ $ $ $ $ $ 3,923,336 1,696,081 580,060 1,088,885 7,288,362 330,587 470,016 10,000,000 8,780,800 8,750,000 415,000 445,800 92,429 46 $ 2,276,140 7,473 21

Audited 20X3 $ 10,291,333 $ $ $ $ $ $ $ 3,173,333 1,364,314 439,309 1,094,930 6,071,886 274,764 330,587 10,000,000 7,840,000 7,775,000 350,000 415,000 76,863 38 $ 1,803,623 6,222 18

Audited 20X2 $ 8,892,133 $ $ $ $ $ $ $ 2,800,000 1,190,000 383,180 962,100 5,335,280 156,577 274,764 10,000,000 7,000,000 6,850,000 200,000 350,000 70,000 35 $ 1,573,180 5,600 16

Beginning Inventory Ending Inventory Capacity Units Produced Units Sold Beginning Inventory Ending Inventory Direct Labor Hours Number of Manufacturing Employees Labor Cost including benefits Tons of Raw Material Used Tons of Ending Raw Materials Inventory a. Calcualtions Cost of Goods Sold Gross Profit Margin Inventory Turn Days Number of Units per Ton of Raw Mat'l Number of Units per Direct Labor Hr. Cost per ton of materials Cost per direct labor hour Payroll taxes and benefits as a% o direct labor cost Cost per unit of inventory

$ $

7,148,933 $ 40.5% 24.0 1175 95 525.00 $ 24.63 $ 34.2%

6,016,063 $ 41.5% 20.1 1260 102 510.00 $ 23.47 $ 32.2%

5,217,093 41.3% 19.2 1250 100 500.00 22.47 32.2%

1.054

0.797

0.785

b.

Analytical procedures indicate that ending inventory appears to be overstated due to pricing problems in the valuation of inventory. Manufacturing productivity appears to have decreased due to the decreases in the number of units produced per ton of raw materials and decreases in the number of units produced per direct labor hour. Further, the cost of raw materials increased during the years, as did payroll cost (both the cost per direct labor hour and the cost of benefits).

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Increases in gross profit margin are inconsistent with this underlying information related to the cost of production. The dramatic increase in inventory turn days, and the cost per unit of inventory are consistent with the fact that inventory appears to be overvalued, probably as a result of problems with the valuation of inventory (or possibly the existence of inventory). Audit tests need to focus carefully on the cost build-up for ending inventory, and the allocation of cost between ending inventory and cost of sales. 16-26. (Estimated time - 30 minutes) Ingredients Inventory a. Weaknesses b. Recommended Improvements Failure to delegate authority for If feasible a separate receiving department receiving material. should be established. At least specific employees should be given responsibility for receiving merchandise. Receivers are currently accepting whatever is delivered and simply taking some sort of count or tally. Ingredients inventory is stored in the production area. Apparently a periodic inventory system is being employed. No mention is made of adjustment and reconciliation of book to physical inventory, including appropriate cut-off procedures. There appears to be a lack of accountability for inventory throughout the production process. Receivers should be given a copy of purchase orders with complete descriptions except quantities. These copies should be used instead of tallies. Ingredients inventory should be placed in a protected storage area which has controlled access. A perpetual system should be installed if possible. All differences between physical and book inventory should be re-viewed and investigated when deemed appropriate. Ingredients inventory items should only be released from stores upon written requisition. Appropriate documentation should follow the production process.

2. Maintenance Materials and Supplies Inventory a. Weaknesses b. Recommended Improvements Access to inventory is unrestricted The room should be locked and a clerk present at various times during the first two at all times when the room is open. shifts and during the entire third Requisitions should be required for all shift and on Saturday. withdrawals of materials and supplies. A periodic inventory system A perpetual system should be used if possible. appears to be in effect. Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-15

No indication is given of book to physical inventory adjustments. 16-27. (Estimated time - 25 minutes) a. Substantive Test 1. 2. Observe client's inventory taking Verify accuracy of schedules and perpetual records and agreement with inventory balances Consider evidence from sales and purchases cutoff tests Observe client's Confirm inventories in public warehouses Observe client's inventory taking Test inventory pricing Observe client's inventory taking

Book to physical inventory adjustments should be made and investigated when appropriate. b. Financial Statement c. Type of Evidence Assertions All except rights and Physical, oral obligations and presentation and disclosure Valuation or allocation Mathematical

3. 4. 5. 6. 7. 8. 9. 10.

Existence or occurrence and completeness All except rights and obligations and presentation and disclosure Existence or occurrence, completeness, and rights and obligations All except rights and obligations and presentation and disclosure Valuation or allocation

Documentary Physical, oral Confirmation Physical, oral Documentary, mathematical Physical, oral

All except rights and obligations and presentation and disclosure Inquire of management Rights and obligations, and Oral regarding ownership presentation and disclosure Compare statement presentation Presentation and disclosure Documentary with GAAP

16-28. (Estimated time - 25 minutes) a. During an audit of a manufacturing company the CPA reviews the cost system for the following purposes: To determine that costs are properly allocated to current and future periods and hence that cost figures used in arriving at balance sheet and income statement amounts are supported by the accounting records.

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To obtain assurance that the cost system, as an integral part of the system of internal control, provides proper accounting control over costs incurred and related 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 data necessary for informed managerial decisions.

b.

The audit procedures to be applied to determine that cost standards and related variance accounts applicable to materials are acceptable and have not distorted the financial statements would include the following: Review the internal control structure to estimate the amount of testing necessary. Test check the arithmetic of the standard cost cards. Determine that the data on the standard cost cards are reasonably current. Out-ofdate standards may result in abnormal variances. Ascertain the accuracy of the specifications on the standard cost cards by comparison with engineering specifications or other independent sources. Determine that the procedure for establishing standard material yields gives consideration to spoilage, scrap loss and by-products of the process. Determine that, in establishing standard material prices, consideration was given to the following factors: normal quality, normal quantity, normal sources, and delivery by normal carrier. The treatment in the accounts of discounts, whether excluded or included in the standard costs, should be investigated for consistency. The accounting system for recording standard costs should be reviewed for reasonableness, and test checks should be applied to determine that the system is functioning effectively. Source documents (vendors' invoices, requisitions, production reports, and other internally generated accounting evidence) should be examined and related to the transactions flowing through the cost system. In this connection reference would be made to the standard cost cards to determine that standard cost data flowing through the accounting system are being accurately compiled. Review the material price variance and material usage variance accounts for over-all reasonableness. The variance accounts should also be reviewed for excessive variations in the month to month charges, and satisfactory explanations should be obtained where necessary. The impact of the variances on the financial statements should be considered. If the variances are of amounts so substantial that placing them in the income statement would distort current operating results and inventory valuations, then consideration should be given to allocating them on a pro rata basis to cost of goods sold and inventories. How General-Purpose Computer Software Package and Copy of 16-17

16-29. (Estimated time - 25 minutes) Inventory Substantive Tests

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Inventory File Data Might Be Helpful Observe the physical count, Determining which items are to be test counted by making and recording test counts making a random sample of a representative where applicable. number of items from the inventory file as of the data of the physical count. Test the mathematical accuracy of Mathematically computing the dollar value of each the inventory compilation inventory item counted by multiplying the quantity (summary). on hand by the cost per unit and verifying the addition of the extended dollar values. Compare the auditor's test counts Arranging test counts in a file format identical to to the inventory records. the inventory file and matching the records Compare physical count data to Comparing the total extended values of all items inventory records. counted and the extended values of each inventory item counted to the inventory Test the pricing of the inventory Preparing a file in a format identical to the by obtaining a list of costs per inventory file and matching the files. item from buyers, vendors, or other sources. Examine purchases and sales Listing a sample of items on the inventory file for cutoffs. which the date of last purchase and date of the last sale are on or immediately prior to the date of the physical count. Ascertain the propriety of items Listing items located in public warehouses. of inventory located in public warehouses. 16-30. (Estimated time - 30 minutes) The substantive auditing procedures Brown may consider performing include the following: Using the perpetual inventory file: Recalculate the beginning and ending balances (prices x 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 year's working papers). Calculate the quantity balances as of the physical inventory date for comparison to the physical inventory file. (Alternatively, update the physical inventory file for purchases and sales from January 6 to January 31, 20x2, for comparison to the perpetual inventory at January 31, 20x2.) Select and print out a sample of items received and shipped for the periods (a) before and after January 5 and 31, 20x2, for cut-off testing, (b) between January 5 and January 31, 20x2, for vouching or analytical procedures, and (c) prior to January 5, 20x2, for test of details or analytical procedures. Compare quantities sold during the year to quantities on hand at year end. Print out a report of items for which turnover is less than expected. (Alternatively, calculate the number of days' sales in inventory for selected items.)

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Select items noted as possibly unsalable or obsolete during the physical inventory observation and print out information about purchases and sales for further consideration. Recalculate the prices used to value the year-end FIFO inventory by matching prices and quantities to the most recent purchases. Select a sample of items for comparison to current sales prices. Identify and print out unusual transactions. (These are transactions other than purchases or sales for the year, or physical inventory adjustments as of January 5, 20x2.) Recalculate the ending inventory (or selected items) by taking the beginning balances plus purchases, less sales, (quantities and/or amounts) and print out the differences. Recalculate the cost of sales for selected items sold during the year.

Using the physical inventory and test count files: Account for all inventory tag numbers used and print out a report of missing or duplicate numbers for follow-up. Search for tag numbers noted during the physical inventory observation as being voided or not used. Compare the physical inventory file to the file of test counts and print out a report of differences for auditor follow-up. Combine the quantities for each item appearing on more than one inventory tag number for comparison to the perpetual file. Compare the quantities on the file to the calculated quantity balances on the perpetual inventory file as of January 5, 20x2. (Alternatively, compare the physical inventory file updated to year end to the perpetual inventory file.) Calculate the quantities and dollar amounts of the book-to-physical adjustments for each item and the total adjustment. Print out a report to reconcile the total adjustment to the adjustment recorded in the general ledger before year end. Using the calculated book-to-physical adjustments for each item, compare the quantities and dollar amounts of each adjustment to the perpetual inventory file as of January 5, 20x2, and print out a report of differences for follow-up.

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16-31. (25 Minutes)

SUTTER COMPANY PPS SAMPLE INVENTORY DECEMBER 31, 20X1
OBJECTIVE: POPULATION AND SAMPLING UNIT: SAMPLE SIZE:

W/P REF: ______ PREPARED BY: ________DATE______________ REVIEWED BY: ________DATE______________

SAMPLE SELECTION:

EXECUTION OF SAMPLING PLAN: EVALUATION OF SAMPLE RESULTS: 1 2 3 4 5

TO OBTAIN EVIDENCE THAT THE BOOK VALUE OF INVENTORY AT DECEMBER 31, 20X1 IS NOT MATERIALLY MISSTATED. POPULATION IS THE DOLLAR BALANCE OF INVENTORY; LOGICAL SAMPLING UNIT = LINE ITEM ON INVENTORY LISTING. BOOK VALUE OF POPULATION 2,960,000 (BV) RISK OF INCORRECT ACCEPTANCE 5 % RF= 3.00 TOLERABLE MISSTATEMENT 200,000 (TM) ANTICIPATED MISSTATEMENT 50,000 (AM) RF= 1.60 SAMPLE SIZE = n = (BV * RF)/(TM - (AM * EP)) 74 (n) SAMPLING INTERVAL = BV/n 40,000 (SI) RANDOM START 34,189 LOGICAL SAMPLING UNITS SELECTED LISTED ON W/P AUDIT PROCEDURES APPLIED LISTED ON W/P BOON AND AUDIT VALUES FOR SAMPLE ITEMS WITH MISSTATEMENTS LISTED BELOW PROJECTED MISSTATEMENT PROJECTED BOOK AUDIT TAINTING SAMPLING MISSTATEMENT VALUE VALUE % (TP) = INTERVAL (TP * SI) OR (BV) (AV) ((BV - AV)/BV) (SI) (BV - AV) 15,700 12,500 20.00 40,000 8,000 56,000 50,400 NA NA 5,600 23,000 22,040 5.00 40,000 2,000

94,900 85,000 TOTAL ALLOWANCE FOR SAMPLING RISK: BASIC PRECISION = RF * SI INCREMENTAL ALLOWANCE: RANKED INCREMENTAL CHANGE IN PROJECTED RELIABILITY FACTOR MISSTATEMENTS MINUS ONE 1 2 3 4 5 8,000 2,000 0 0 0 0.75 0.55 0.46 0.40 0.36 TOTAL ASR = BP + IA UPPER MISSTATEMENT LIMIT: UML = PM + ASR

15,600 120,000 INCREMENTAL ALLOWANCE FOR SAMPLING RISK 6,000 1,100 0 0 0 7,100 127,100 142,700

(PM) (BP)

(IA) (ASR)

(UML <= TM) CONCLUSION: Because the UML of $142,700 is less than the tolerable misstatement of $200,000, the sample results support the conclusion that the book value is not materially misstated.

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16-32. (Estimate Time 25 Minutes) Young Computers, Inc Internal Control Questionnaire - Payroll Question
Are payroll changes (hires, separations, salary changes, overtime, bonuses, promotions, etc.) properly authorized and approved? Are discretionary payroll deductions and withholdings authorized in writing by employees? Are the employees who perform each of the following payroll functions independent of the other functions? o Personnel and approval of payroll changes. o Preparation of payroll data. o Approval of payroll. o Signing of paychecks. o Distribution of paychecks. o Reconciliation of payroll account. Are changes in standard data on which payroll is based (hires, separations, salary changes, promotions, deduction and withholding changes, etc.) promptly input to the system to process the payroll? Is gross pay determined by using authorized salary rates and time and attendance records? Is there a suitable chart of accounts and/or established guidelines for determining salary account distribution and for recording payroll withholding liabilities? Are clerical operations in payroll preparation verified? Is payroll preparation and recording reviewed by supervisors or internal audit personnel? Are payrolls approved by a responsible official before payroll checks are issued. Are payrolls disbursed through an imprest account? Is the payroll bank account reconciled monthly to the general ledger? Are payroll bank reconciliations properly approved and differences promptly followed up? Is the custody and follow-up of unclaimed salary checks assigned to a responsible official? Are differences reported by employees followed up on a timely basis by persons not involved in payroll preparation? Are there procedures (e.g., tickler files) to assure proper and timely payment of withholdings to appropriate bodies and to file required information returns? Are employee compensation records reconciled to control accounts? Is access to personnel and payroll records, checks, forms, signature plates, etc., limited?

Yes

No

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16-33. (Estimated time - 25 minutes) a. There are three basic shortcomings in the payroll procedures currently used at the Galena plant: Actual payroll hours are not approved by production management. There is inadequate segregation of duties within the payroll department. Personnel department should not have access to payroll checks on a regular basis. The following corrective action should be taken to improve the internal control of payroll processing procedures: All incoming time cards should be signed by both the employee and supervisor. The payroll clerk who prepares the input for data processing should not do the reconciliation but, rather, a second clerk should reconcile the payroll register to the time cards. An employee of supervisory level should authorize voiding of computergenerated checks and the subsequent preparation of a manual replacement check. Replacement checks should be processed following good internal control procedures. All payroll checks, including unsigned replacement checks, should then be given to the accounting department rather than to the personnel department for storage in a secure location until payday. b. Each of the three basic shortcomings mentioned above could lead to material errors and irregularities. The inadequate segregation of duties within the payroll department clearly is a material weakness. The payroll clerk is in a position to submit fictitious input data and to conceal the irregularities by 'fudging" the reconciliations of the payroll register. Furthermore, the procedures over the voiding of computer-generated checks and issuing of manual replacement checks could result in major irregularities that might not be detected by others in the normal course of their duties. 16-34. (Estimated time - 25 minutes) a. Misstatements Hirings are made by factory foreman on basis of interview. b. Recommended Improvements A system of advice forms should be installed so that hirings, terminations, rate changes, etc., are reported to the payroll department in writing. Such forms should be approved by the foreman's superior. The background of Before an applicant is hired, his or her background should be applicants is not checked. investigated by contacting references to determine that he or she is not dishonest and has no other undesirable personal characteristics. Rate adjustments are Rate adjustments should be in writing and signed by both the made verbally by foreman and a superior or personnel manager. foreman. Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-22

a. Misstatements A supply of blank time cards is kept near the entrance. Time worked is penciled on the time card by each worker. Time cards are dropped in a box at the end of the week. Payroll clerks divide the cards alphabetically and have full responsibility for each section. Payroll checks are manually numbered. Employees are automatically removed from the payroll when they fail to turn in a time card. Payroll checks are signed by the chief accountant. The foreman distributes the checks. The foreman arranges for the distribution of unclaimed wages. The payroll bank account is reconciled by the chief accountant.

b. Recommended Improvements The supply of blank time cards should be removed. At the beginning of each week the payroll department should provide each worker with a time card stamped with the worker's name. A time clock should be installed and the workers required to punch in and out. A responsible employee should be stationed at the time clock to determine that workers are not punching the time cards of other workers who may be late or absent, or who may have left work early. The foreman should collect the time cards at the end of the week, approve them, and turn them over to the payroll clerk. All time cards should be accounted for and any missing cards investigated. The payroll clerks' work should be arranged so that they check each other. Under the existing system of computing the payroll, the clerk who does not do the original computing should check the original work of the other clerk. As an alternative, one clerk may make the original computations for the full payroll and the other clerk do all the rechecking. Payroll checks should be prenumbered to control their issuance. Employees should only be removed upon written notice signed by the foreman and personnel manager.

Checks should be signed by the treasurer. The checks should be distributed by a paymaster or a responsible person other than the foreman. Unclaimed wages should be kept by the treasurer or some other responsible personnel. The payroll bank account should be independently reconciled.

16-35. (Estimated time - 25 minutes) 1. 2. a. Possible Misstatement Fictitious payroll transactions may be recorded. Fictitious payroll transactions may be b. Possible Test of Controls Examine authorizations. Examine evidence of supporting 16-23

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3. 4. 5. 6. 7. 8. 9. 10.

a. Possible Misstatement recorded. Actual payroll transactions may not be authorized. Payroll checks may be distributed to unauthorized recipients. Payroll checks may be incorrect. Unclaimed wages may be stolen. Unauthorized changes may be made to master files. Actual payroll transactions may not be authorized. Fictitious time data may be processed. Payroll tax returns may not be filed.

b. Possible Test of Controls documentation. Examine authorizations and approvals. Witness distribution of checks. Examine evidence of internal verifications; reperform verifications. Observe storage area; inquire about access. Observe security over files; inquire about access. Examine authorizations and approvals. Observe time clock punching procedures. Inquire of personnel responsible for filing; examine tax returns.

16-36. (25 minutes) a. An important source of information for benchmarking performance in the personnel services cycle is industry statistics. Often the best industry statistics can be obtained from trade associations that represent an industry, which often report quite detailed breakdowns of payroll costs for various industry sectors. Further, many larger auditing firms develop their own information based on a nationwide or worldwide database developed from a depth of clients in a particular industry.
Evidence Obtained During the Audit Production Cycle The auditor notes significant increases in overhead allocation rates and observes under utilization of capacity The auditor notes a significant amount of slow moving inventory. Personnel Services Cycle The auditor vouches labor costs on a test basis and compares labor costs against industry standards Audit Objective Satisfied with the Evidence Valuation of inventory and valuation of plant and equipment (depreciation rates). Valuation of inventory at net realizable value. Example of How Evidence Would Support Value-added Services The auditor develops strategies for more effective utilization of production facilities or strategies to dispose of nonproductive facilities. The auditor develops strategies to identify and liquidate slow moving inventory to speed the inventory turn cycle. The auditor identified that labor costs are increasing faster than expected for the industry.

b.

Valuation assertion.

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Cases
16-37. See separate file with answers to the comprehensive case related to the audit of Mt. Hood Furniture that is included with this chapter. 16-38. (Estimated Time 2 hours) Phase I This case allows the professor to explore the challenges of auditing privately held companies. While privately held companies do not receive the attention of public companies, they represent a significant portion of audits performed by CPAs. This case allows students to explore the control environment issues associated with an owner-managed company with a domineering owner manager. This case was developed based on an actual case that led to fraudulent financial reporting in a privately held company. Question 1: Control Environment Issues The control environment at CTI is representative of that in a number of owner-managed businesses. The following issues all represent control environment weaknesses. o Jessica, the owner-manger, was increasing her intrusion into the companys financial reporting process. o Jessica paid particular attention to accounting results, particularly in the last two quarters of the year. o Jessica regularly discussed accounting for particular transactions. Jessica was monitored the year-end close on a daily basis, to discuss closing entries and their impact on earnings. o Jessica would override policies and tell someone in account to change a sales invoice to offer a particular price discount to a customer. o Jessica would not accept explanations for draft financial statements that showed performance falling below her expectations. o Accounting was not a high priority in the company. o Accounting was understaffed (not allowing for adequate segregation of duties) and everyone worked long hours. Question 2: Analytical Procedures 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 of improvement as gross operating cycle due to the decrease in payable turn days. The increase in inventory turn days indicates that inventory may be overstated. A further risk may be associated with unrecorded liabilities. The combination may result in an overstatement of net income.

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Exhibit 16-25: CTI Selectied Financial Information ($000) 20x1 20x2 20x3
Accounts Receivable, net Inventory Accounts Payable Sales Cost of Sales

20x4 $ $ $ $ $ $ 962 1,003 201 4,022 1,923 2,099 $ $ $ $ $ $

20x5 822 1,027 175 3,905 1,859 2,046

$ $ $

837 1,025 164 3,780 1,812 1,968

$ $ $ $ $ $ $

1,335 1,327 380 5,638 2,691 2,947

$ $ $ $ $ $

1,121 1,099 225 4,623 2,399 2,224

$ $ Gross Margin$

Purchases Gross Margin % Inventory Turn Days AR Turn Days Gross Operating Cycle AP Turn Days Net Operating Cycle

2,993 $ 2,171 $ 1,827 $ 1,883 52.3% 48.1% 52.2% 52.4% 180 167 190 202 86 89 87 77 266 256 278 278 46 38 40 34 220.08 217.89 237.52 244.55

Question 3: Risk Assessment a. Many of the financial statement level risks that have a pervasive effect on the financial statements also involve control environment issues. In particular: o Jessica, the owner-manger, was increasing her intrusion into the companys financial reporting process. o Jessica paid particular attention to accounting results, particularly in the last two quarters of the year. o Jessica regularly discussed accounting for particular transactions. Jessica was monitored the year-end close on a daily basis, to discuss closing entries and their impact on earnings. o Jessica had a history of overriding accounting decisions. o Jessica would not accept explanations for draft financial statements that showed performance falling below her expectations. o Accounting was not a high priority in the company. o Accounting was understaffed (not allowing for adequate segregation of duties) and everyone worked long hours. b. When it comes to incentives and pressures, Jessica put considerable pressure on the accounting staff to achieve accounting results. In addition, the company had to met particular debt covenants, and Jessica wanted particular year-end results to support distribution of earnings to shareholders in a Subchatper S Corporation. The person who had the opportunity to influence the outcome of the accounting system was the CFO, Rob Kaiser. There were no controls over Robs activities in the financial reporting process.

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Rob was under considerable pressure from Jessica to deliver expected results. Jessicas intrusion into the financial reporting process lessened only when reported results matched the owner-mangers expectations. Question 4: Management Performance Reviews Management performance reviews can be effective at identifying misstatements when senior management encourages representational faithfulness in financial reporting. In these situations management might review inventory levels or inventory pricing and identify accounting results that are not consistent with actual experience. These controls do not work well, however, when management is under considerable pressure to deliver desired results. Hence, management performance reviews performed by Jessica and Rob would likely not be effective at identifying financial statement misstatements. Question 5: Internal Control Recommendations A number of recommendations can be discussed in this letter, most of which will deal with the control environment. Students could focus on any of the issues raised in question 1. Following is an example letter.

Date To the Board of Directors Circuits Technology, Inc. In planning and performing our audit of the financial statements of Circuits Technology, Inc. (CTI) for the year ended December 31, 2002, we considered its internal control in order to determine our audit procedures for the purpose of expressing an opinion on the financial statements and not to provide assurance on internal control. However, we noted certain matter involving the internal control and its operation that we consider to be reportable conditions under standards established by the American Institute of Certified Public Accountants. Reportable conditions involve matters coming to our attention related to significant deficiencies in the design or operation of internal controls that, in our judgment, could adversely affect the organizations ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements. Control Environment The control environment represents the tone set by management of an organization that influences the control consciousness of its people. It is important because it represents the foundation for all other components of internal control, providing discipline and structure. A weak control environment will lessen the effectiveness of other control activities that may prevent or detect misstatements on a timely basis.

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An important aspect of the control environment involves a commitment to competence and investment in human resource polices that support a sound financial reporting system. In the past we have noted financial statement misstatements that have resulted from the fact that the account staff is stretched too thin. This lack of investment in account personnel has also led to a situation where a good system of checks and balances and segregation of duties cannot be achieved. We recommend that CTI consider the addition of an additional staff person in accounting during peak periods to encourage better control activities. A strong control environment also involves a management philosophy and operating style that reinforces representational faithfulness in financial reporting. During our audit we noticed several situations that are considered significant risk indicators including the daily involvement of the owner-manager in accounting issues associated with the closing process. A sound control environment delegates a higher degree of responsibility for financial reporting to the accounting staff and it places a premium on financial reporting that fairly presents underlying results of operations. This report is intended solely for the information and use of the Board of Directors of Circuits Technology, Inc., management and others within the organization and is not intended for any other purposes. We thank you for the opportunity to continue to be of service to you. Signature. Part II. Question 6. Results of Substantive Tests a. If the results of the sample of 35 are representative of the population the project the an estimated audit value of $ 839,179 based on the calculation below using ratio estimation. 216,295 264,705 x 1,027,000 = 839,179. This represents a potential overstatement of inventory of $187,821. In each instance, the errors resulted not from errors in counting the quantity of inventory, but they resulted from errors in pricing inventory. In addition, payroll costs in the amount of $21,060 were capitalized as part of work in process inventory when the project was complete and billed to the customer. In total inventory was overstated, cost of goods sold was understated, and gross margin was overstated by $208,881. This represents 20% of the book value of inventory and is material. b. At a minimum, the auditor should extend the sample for price testing inventory to determine if the known misstatements are representative of the inventory as a whole. The pricing errors are extensive and all in the same direction. Given the fraud risk indicators, it is likely that misstatements are intentional with the intent of overstating inventory to achieve budgeted results.

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The auditor might want to approach the accounting personnel, and the CFO, with the results and determine the extent of their involvement with the pricing of inventory. If these pricing errors and inappropriate capitalization of payroll costs rest solely with the CFO, the auditor needs to question Rob Kaiser to determine the extent of misstatements in inventory and other areas. Once presented with the audit evidence, the CFO might admit to his involvement in financial statement misstatements. If the CFO does not admit to involvement in the misstatements, the audit needs to be extended to determine the full extent of the misstatements. Finally, the auditor should consider the implication for other aspects of the audit. If evidence suggests that prices and inventory values were changed to hit earnings targets, the scope of other audit work should also be increased throughout the audit. The auditor might want to suggest that management hire a forensic auditor to perform a fraud audit to determine the extent of misstatements in the financial statements. Question 7. Draft Management Letter Comments Following is a draft of a management letter comment that should be discussed with the board of directors. This comment is drafted based on the audit evidence alone. During the audit we found evidence of overstatements of inventory by the Chief Financial Officer in order to overstate gross margins with the purpose of achieving desired financial results. In a sample of 35 items we found 17 items with pricing errors, all of which resulted in the overpricing of the value of inventory. In addition, we found evidence of inappropriate capitalization of payroll costs as part of work in process inventory. In total, we estimate that inventory values presented for audit were overstated by almost $210,000 (or 20% of the value of inventory). Due to the extensiveness of the misstatements, 17 out of 35 items sampled, we recommend retesting the entire inventory for pricing errors. If Rob Kaiser admits to his involvement in overstating inventory, this should also be discussed with the board of directors. The auditor needs to recommend (1) changes in the control environment that led to the fraudulent financial reporting and (2) replacement of the CFO. Question 8. Discussion with First State Bank The auditor cannot have any conversations with the bank about the potential fraud or financial statement misstatements due to ethical rules on confidential client information. If CTI corrects the financial statements, the First State Bank will get financial statements that present fairly in all material respects. If the corrected financial statements disclose violations of debt covenants, the client should approach First State Bank about the potential violations of debt covenants and ask the Bank to waive the violations. If the bank is unwilling to waive the debt covenant violations, the auditor needs to consider whether long-term debt to the bank should be reclassified as current before issuing an opinion on the financial statements.

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Professional Simulation
Payroll Controls Research Situation Inventory Audit Procedures

The suggested evaluation of the system of internal controls presented above is included in the following table.
Assertion Existence and Occurrence Adequacy of Controls Controls are sufficient A significant deficiency exits Recommend Improvements for Significant Deficiencies Time cards should be preprinted and/or prepunched and prenumbered. Foreman should approve (sign) all time cards and job tickets. Paychecks should not be distributed by foremen. They should be mailed directly to the employee, or distributed by the internal audit staff or by authorized treasurer's office personnel not involved in preparing or recording the payroll. Operators should not be allowed to make data changes at the console, the console log should be reviewed regularly for operator interruptions and the programming and operator functions should be separated. Implement programmed batch controls; e.g., hash total of employee number and record count. The payroll record count should be compared with the number of timecards processed. A limit test should be incorporated into the program to halt the processing of any employee record whose labor hours exceed 60; a listing of all exceptions would be prepared for review to determine if the hours were right or needed to be corrected. A limit test should be incorporated into the program to halt the processing of any employee's records whenever the gross wages exceed $300 per week; a listing of all exceptions would be prepared for review to determine if the amounts were accurate or needed to be corrected.

Completeness

Controls are sufficient A significant deficiency exits Controls are sufficient A significant deficiency exits

Valuation and Allocation

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Research Situation Payroll Controls Inventory Audit Procedures

The issues associated with the clients use of statistical sampling to determine inventory quantities is addressed in AU 331.11 which is stated below. .11 In recent years, some companies have developed inventory controls or methods of determining inventories, including statistical sampling, which are highly effective in determining inventory quantities and which are sufficiently reliable to make unnecessary an annual physical count of each item of inventory. In such circumstances, the independent auditor must satisfy himself that the client's procedures or methods are sufficiently reliable to produce results substantially the same 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 the effectiveness of the counting procedures used. If statistical sampling methods are used by the client in the taking of the physical inventory, the auditor must be satisfied that the sampling plan is reasonable and statistically valid, that it has been properly applied, and that the results are reasonable in the circumstances. [Revised, June 1981, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards No. 39.] Inventory Audit Procedures Situation Payroll Controls Research

Audit procedure A. Understand the key economic drivers that influence the entitys cost of sales, gross margins and the possibility of obsolete inventory. B. On a test basis, trace data from purchases, manufacturing, completed production, and sales records to inventory accounts. C. Vouch the items on the final inventory listing to inventory tags, count sheets and test counts taken during the inventory observation. D. Trace test counts taken during the inventory observation to the final inventory listing. E. Examine sales invoices after year-end and determine the net realizable value of inventory. F. Confirm inventories at locations outside the entity. G. Based on test of beginning inventory, production costs, and ending inventory, determine the appropriateness of cost of goods sold. H. Confirm agreements for assigning and pledging inventories. I. Examine vendors paid invoices for purchased inventory prior to year-end. J. Evaluate the completeness of presentation of disclosures to determine conformity with GAAP by reference to a disclosure checklist. Solutions Manual to Modern Auditing: Copyright 2005, John Wiley and Sons, Inc. 16-32

Determine the audit procedure that best addresses the following risks. 1. 2. 3. 4. 5. Risk Inventory that was counted and on hand at year-end may not be included in the final inventory listing. Inventory quantities may be correct, but inventory may be incorrectly valued at FIFO. Inventory that is said to be on hand in a public warehouse may not exist. Inventory may have to be sold at a loss in order to move inventory. All manufacturing costs may not be included in the underlying accounting records supporting costs of sales.
(A) (B) (C) (D) (E) (F) (G) (H) (I) (J)

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