New cycles...same story

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1 Instructor Michael Brownlee B.Comm(Hons),CGA Course AU1 Module 9: Inventory and property, plant, and equipment balances, production and payroll cycles, and finance and investment cycle New cycles...same story Again this week we look at cycles and the MO is the same as last week: Gain knowledge of the business in order to identify where risks may lie; Assess risks Test controls Test balances... 1

2 9.1 Inventory Knowledge of the business Explain the knowledge of the entity s business that is relevant to the audit of inventory, and describe the types of analysis used to audit inventory. (Level 1) Risks and sources of error Inventory can be most material current asset so presents certain challenges; can take the most time to audit. Usually has high inherent risk of misstatement inventory count at year end has challenges; because of difficulty in auditing it is a prime target for management when looking to manipulate net income. Challenges that may result in misstatements (risk) and affect time required: Physical attributes of inventory may require expert knowledge Large variety of inventory hardware store; nuts/bolts etc. Which are obsolete and will never sell Largest current asset a material misstatement will usually result in significantly misleading financial statements 2

3 Knowledge - inventory Need to be aware of management attitude and biases including factors that would lead to net income manipulation (declining demand, increased competition, etc) Need to know company s product, locations, distribution and internal controls over inventory. Also need to know methods and policies for accounting for inventory (FIFO, LIFO) and is it periodic or perpetual inventory. Finally need to know major vendors and customers. Analysis as a tool for inventory Review gross profit and compare to prior year and industry standards Review inventory turnover and compare to P/Y and I/S Scan inventory GL for unusual sources of entry, absence of normal or recurring entries and uncommonly large entries. 3

4 9.2 Inventory Substantive procedures Identify the most significant assertions with respect to inventory, and explain the substantive procedures used to support these assertions. (Level 2) Key Assertions for Inventory Existence, Valuation and ownership Important but less critical are completeness and presentation Procedures by assertion Existence: Review inventory count procedures and attend inventory count Investigate any adjusting entries made to bring book values to actual inventory values Confirm inventory held by 3 rd parties Cut-off procedures vouch last shipping and receiving amounts from year-end inventory to related documents and first of new year 4

5 Valuation Enquire of management and staff valuation methods Are methods reasonable Recalculate Evaluate allowance for obsolete items Trace from inventory to supplier invoices Without perpetual system difficult to determine pricing if prices fluctuate throughout year Test inventory recorded at lower of cost or market value Compare cost to current market value or current selling price; may need to write down to a net realizable value (obsolete?) Identify slow moving items are they obsolete and has an appropriate allowance for obsolescence been made. Ownership: More important for inventory than other assets physical presence of inventory does not provide enough evidence of ownership (consignment, sold not shipped) 5

6 9.3 Inventory Observation Identify the issues related to the observation of physical inventory counts. (Level 1) Physical inventory observation CAS 501 lists requirements for year end inventory and specific substantive procedures during inventory observation Must observe year end inventory unless not feasible Important to get procedures and time/location in advance See page 509 for list of procedures in a well designed inventory count Auditors will rely on their observation (test of controls) as well as substantive procedures (see page ) Client count is effective, auditor can rely more on the count (test of controls) and reduce substantive testing. 6

7 Substantive procedures Perform test counts random sample of inventory items and recount to match to count done by staff see page 511 for difficult to identify, value and measure items. Control the tags number tags (sequential), make sure all counted inventory is tagged, control unused tags Note obsolete or damaged goods Observe completeness of count Review accuracy of the count sheets relative to tagged info Perform cut off tests. 9.4 Manufacturing inventory Substantive procedures Describe the knowledge of the entity s business that is relevant for the audit of manufacturing inventory, and describe the analytical and substantive procedures used to support the most significant assertions. (Level 2) 7

8 knowledge 9.1 to 9.3 dealt with finished goods or retail goods Now we deal with Raw materials and work-in-progress Need to be aware of: Market value of comparable goods Price fluctuations based on industry inventory availability or foreign competition Knowledge of market conditions imperative for identifying obsolete items History of new good development and ability to sell above cost Industry treatments of development costs (capitalized/allocated to overhead) 8

9 Analysis for manufacturing Same procedures as 9.1 plus analysis of periodic cost accounting reports prepared for mgmt control purposes. Substantive procedures Valuation is big issue as auditor must know cost accounting methods in order to ascertain unit cost Verify unit costs: Verify quantity and description of raw materials(production reports and material requisitions) Verify cost of materials (supplier invoices) Verify labour hours ( production reports, time cards) Verify labour rate applied (payroll records) Evaluate reasonableness and consistency in allocating overhead Pricing tests 9

10 9.5 Property, plant & Equipment Knowledge of the business Summarize how knowledge of the entity s business is relevant to the audit of PP&E, and describe the analytical procedures used to audit such assets. (Level 2) Although usually the largest asset on the balance sheet, audit time is usually minimal as majority of balance is made up of prior year acquisitions already audited. Therefore audit procedures are limited to current year asset additions (and disposals). Knowledge Types of assets used by client and location Know of potential for lease agreements, mgmt estimates for FMV and useful life Policies for capital acquisition and amortization Plans for major expansion or downsizing that would increase/decrease the accounts 10

11 Analysis Compare balances to prior years look for changes (up or down) Compare amortization expense/asset ratio to prior year Compare R&M account to prior years Compare additions to budget 9.6 Property, plant & equipment Substantive procedures Summarize the most significant assertions with respect to PP&E, and describe the substantive procedures used to support these assertions with examples of specific substantive procedures. (Level 2) Key Assertions PP&E Existence Completeness Ownership Valuation 11

12 Substantive procedures Existence and completeness Obtain continuity schedule: Agree to opening balance Vouch additions Vouch disposals Review details of R&M (and office) for large or unusual items Tour the facilities to perform physical inspection Ownership Review title documents for assets purchased Enquire of management about liens, review terms of mortgages, bond indentures and equipment trust certificates Review insurance policies for appropriate coverage.(won t have insurance if they don t own an asset) Valuation Review purchase invoices and contracts for costs Assess mgmt estimate of useful life and residual values, vouch to supporting documentation Assess client amortization procedures, recalculate expense for reasonableness 12

13 Determine if proper disposal entries made Leased assets and obligations properly accounted for Assets without future benefits written off for impairment Property tax assessments (ownership and valuation) Leased assets Meet criteria for capital lease? Consider estimates for useful life Reasonableness for FMV Appropriate discount rate Disclosure requirements adhered to 9.7 Production and payroll cycles The basics Describe the main activities, accounts, segregation of functional responsibilities, and sources of evidence for the production and payroll cycles. (Level 2) 13

14 Production Manufacturing Interacts with all other cycles Production planning set, goods and materials acquired (acquisition and expenditure) Machinery and factory obtained (PP & E, finance and investment) Labour (payroll) Inventory sold (revenue and collections) Functional responsibilities Authorization production planning, sales forecast, manager approval, bill of materials/labour Custody moving of raw materials to workin-process to finished goods WIP more difficult to control hold supervisors and workers accountable for use of materials or timely completion and quality of finished goods good cost accounting, analysis and quality control Recording cost accounting; documents come from inventory reports, payroll, etc to calculate unit cost, standard cost, variances, allocation of overhead used for inventory valuation and COGS may also be responsible for manufacturing equipment depreciation and intangible amortization 14

15 Compare physical assets and liabilities with amounts recorded in company accounts Sources of evidence Reports from cost accounting system Sales forecasts Production plans and cost variances Amortization schedules for capital assets Material requisition forms Suppliers invoices for raw material Payroll records Payroll Cycle Present in almost all organizations Large Includes salaries and wages plus all employer EI & CPP, pensions and healthcare MB Payroll tax (under 1.25 million exempt; 1.25 to % on payroll over 1.25m; over % of entire payroll including first 1.25m) 15

16 Functional responsibilities Personnel and labour relations (HR) Supervision approve and verify time Timekeeping and cost accounting Payroll accounting Payroll distribution Sources of evidence Personnel files Timekeeping records Payroll register Labour cost analysis Government and tax reports YTD earnings records Employee income tax reports 9.8 Production and payroll cycles Tests of controls Summarize the control objectives and test of controls procedures for the production and payroll cycles. (Level 2) 16

17 Control objectives - production Production cycle internal control important as it affects accuracy of cost of inventory which influences pricing decisions margin costing poor control can lead to over pricing of finished goods impairing competitiveness General control objectives Segregation of duties Detail checking procedures Production orders list of materials/quantities and approval Material requisitions compared by cost accounting dept with list of materials of production order and approved by production dept and materials inventory stock keeper Job labour time signed by production supervisors and costing dept reconciles with labour report from payroll Production reports of finished goods signed by production supervisors and FG inventory custodian and forwarded to cost accounting Make enquiries with mgmt using internal control questionnaire 17

18 See Exhibit 13-2 for detail of control objectives and activities on page 551 Examples: Recorded production transactions are valid and documented Valid production transactions are recorded and not omitted Production job cost transx computations are accurate Labour and material properly classified as direct or indirect Control activity examples: Cost accounting separated from production, payroll and inventory control All documents pre-numbered and numerical sequence reviewed Material and labour use prepared by foreman and approved by supervisor Open job cost sheets periodically reconciled to WIP inventory accounts Test of controls - production Page Examples: Reconcile open production cost reports to the WIP inventory control account Select sample of open and closed production cost reports: Recalculate all costs Vouch labour reports with summary of payroll Trace overhead amounts from analysis schedules to cost allocations or A/P vouchers 18

19 Control risk assessment After testing controls as in other areas the original control risk is reassessed based on the gathered audit know the options. Test of controls - payroll I won t spend a lot of time on this as the process is the same as for all the other cycles. Just pay attention to the risks (paying fictitious employees, etc.) the control objectives (valid, documented, recorded, authorized, accurate, proper classification, etc) and the different tests of control (personnel files complete with info, wage rate, authorized deductions, etc; trace management compensation to board minute approval; sample payroll recalculate deductions/net pay); vouch to cancelled payroll cheque and examine endorsement signature where possible, etc) Production cycle the focus is cost information while internal control over payroll is more concerned with fraud prevention and detection (unauthorized overtime, etc) 19

20 9.9 Payroll Substantive procedures Explain the knowledge of the entity s business that is relevant for the audit of payroll, and describe the analytical and substantive procedures used to support the most significant assertions. (Level 2) Knowledge of business Need to know number of employees, compensation methods and rates and average dollar value of payroll Analysis Compare accruals/expenses to budgets and/or prior periods Recalculate payroll accruals/deductions/expenses If organization fiscal year follows calendar year does the salary and wages/benefits account tie in to the T4 summary? 20

21 Substantive procedures Most important assertions: Occurrence evidence that work was actually performed (timecards, supervisor authorization) and wages have been paid (cancelled cheques with endorsement) Valuation payroll expense calculated using appropriate wage rates/salaries Completeness payroll liabilities recorded (source deductions, vacation accruals, benefit accruals and proper cut off) 9.10 Finance and investment cycle The basics Identify the activities, accounts, segregation of functional responsibilities, and sources of evidence for the finance and investment cycle. (Level 1) Activities Financial planning Investing Acquiring and repaying funds Loans Mortgages Bond issuances Share issuances 21

22 Functional responsibilities Source of funds debt or shareholder capital Use of funds investments and intangibles Each of the functional responsibilities has the same categories of control related duties: Authorization Custody Recordkeeping Periodic reconciliation Review for detail Risk areas Off-balance-sheet transactions (leases, etc) Goodwill Pension plans Future income taxes Capital leases and sale and leaseback capital transactions Financial instruments, hedging and derivatives Related party capital transactions (loans to management) 22

23 Sources of evidence Cash flow forecast Capital budget Minutes to board meetings Corporate code of conduct Contracts, agreements, guarantees Shareholder records, certificate book Etc Finance and investment cycle Tests of controls Describe the control objectives and test of controls procedures for the finance and investment cycle. (Level 2) Control objectives Most transactions in this category are done at the upper management/board level there is control risk due to lack of segregation of duties. Controls are important to make up for this. Also at risk due to potential for poor corporate governance (lack of competent, independent board) 23

24 A lot of assertions in this cycle are estimates need consistent and well documented process for arriving at significant estimates See page Authorization board approval or more than one manager involved in process Accuracy Completeness Validity Test of controls has least impact in this cycle as the transactions are few in number and material in nature so substantive testing is more thorough for this cycle. Test of controls Since transactions in this cycle are few in number, test of controls procedures are usually more focused on enquiry, observations, study of documentation (board minutes for authorization), comparison with related data (ie tax returns, loan agreements) and supplemented with some detail audit of transactions. Internal control questionnaire important 24

25 Issuance of debt Biggest control objective is completeness; has highest risk. Auditors spend most time in this area trying to corroborate the completeness assertion. Finance and investment The remaining part of this cycle, substantive testing, is covered in module 10 Assignment 3 due end of the week. On to the last module. Review class Saturday May 30th- 2-5pm Have a great week. 25