CHAPTER 16

AUDIT THE PRODUCTION AND PERSONNEL

SERVICES CYCLE
Learning Check
16-1.

a.

16-2. 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.

b.

The major transaction class within this cycle is manufacturing transactions.

c.

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.

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).
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.
b.

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.

c.

16-4.

a.

b.

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

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
Produced to Raw
Material Used

Finished Goods Quantities

Raw Material Quantities

Finished Goods
Produced to Direct
Labor

Finished Goods Quantities

Direct Labor Hours

Product Defects per

Million

Number of Product Defects as

a Percent of Each Million
Produced

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.

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.

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 inventory balances.

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
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.

b.

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.

16-9.

Several ratios and their formulas that may be used in applying analytical procedures to inventory
balances are:
Ratio
Formula
Audit Significance
Inventory Turn Days
Prior experience in inventory
Avg. Inventory Cost of Good
turn days combined with
Sold x 365
knowledge of cost of sales can
be useful in estimating current
inventory levels. A lengthening
of the period may indicate
existence problems.
Inventory Growth to
Ratios larger than 1.0 indicate
((Inventory n Inventory n-1) 1)
Cost of Sales Growth
that inventories are growing
((Cost of Sales n Cost of
faster than sales. Large ratios
Sales n-1) 1)
may indicate possible inventory
obsolescence problems.
Finished Goods
Useful in estimating the
Finished Goods Quantities
Produced to Raw
efficiency of the manufacturing
Raw Material Quantities
Material Used
process. May be helpful in
evaluating the reasonableness
of production costs.
Finished Goods
Useful in estimating the
Finished Goods Quantities
Produced to Direct
efficiency of the manufacturing
Direct Labor Hours
Labor
process. May be helpful in
evaluating the reasonableness
of production costs.
Product Defects per
Number of Product Defects as
Useful in estimating the
Million
a Percent of Each Million
effectiveness of the
Produced
manufacturing process. May be
helpful in evaluating the
reasonableness of production
costs and warranty expenses.

16-10. a.

b.

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.

2.

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.

16-11. a.

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.

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.
b.

16-12. a.

b.

16-13. a.

3.

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

b.

16-14. a.

b.

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.

16-15.

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).

16-16.

16-17.

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

Revenue per
employee

Total Revenue number of

full time equivalent
employees.

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

Total payroll expenses total

revenues

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

Reasonableness test for payroll

liability if the ratio is significantly
different from 1.0

Total benefits expenses

gross payroll

Reasonableness test of benefits

expenses. This is often compared
with industry statistics.

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

Reasonableness test for payroll tax

expense based on prior year ratio of
payroll tax expense to total payroll.

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.
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.


16-19. a.

b.

16-20. a.

b.

Paying the payroll including (a) paying the payroll and protecting unclaimed wages, and (b) filing
payroll tax returns.
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.

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.

Personnel Services
Assertion (Audit Objective)
Existence and Occurrence
(Occurrence)

Completeness (Completeness)
Existence and Occurrence /
Completeness (Cutoff)
Valuation and Allocation
(Accuracy)
Presentation and Disclosure
(Classification)
Rights and Obligations
16-22. a.
b.

16-23. a.

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.

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

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.

b.

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

c.

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.

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
16-25. (Estimated Time 30 minutes)
Unaudited
Audited
Audited
20X4
20X3
20X2
$
12,005,336 $
10,291,333 $
8,892,133

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

$
$
$
$
$

3,923,336
1,696,081
580,060
1,088,885
7,288,362

$
$
$
$
$

3,173,333
1,364,314
439,309
1,094,930
6,071,886

$
$
$
$
$

2,800,000
1,190,000
383,180
962,100
5,335,280

Beginning Inventory
Ending Inventory

$
$

330,587
470,016

$
$

274,764
330,587

$
$

156,577
274,764

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

b.

10,000,000
8,780,800
8,750,000
415,000
445,800

10,000,000
7,840,000
7,775,000
350,000
415,000

10,000,000
7,000,000
6,850,000
200,000
350,000

92,429
46

76,863
38

70,000
35

2,276,140

7,473
21

$
$

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

1.054

6,222
18

34.2%
$

1,803,623

5,600
16

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

0.797

1,573,180

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

0.785

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).
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.
16-27. (Estimated time - 25 minutes)
a. Substantive Test
1.

Observe client's inventory taking

2.

Verify accuracy of schedules and

perpetual records and agreement with
inventory balances
Consider evidence from sales and
purchases cutoff tests
Observe client's

3.
4.
5.

Confirm inventories in public

warehouses

6.

Observe client's inventory taking

7.

Test inventory pricing

8.

Observe client's inventory taking

9.

Inquire of management regarding

ownership
Compare statement presentation with
GAAP

10.

b. Financial Statement Assertions

c. Type of Evidence

All except rights and obligations and

presentation and disclosure
Valuation or allocation

Physical, oral

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

All except rights and obligations and

presentation and disclosure
Rights and obligations, and
presentation and disclosure
Presentation and disclosure

Mathematical

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

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.
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-of-date
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

16-33.

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.

(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 computer-generated 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.