Design a CONCEPT MAP to illustrate the audit approach to production cycle elements and

transactions. Ensure that you cover the financial statement assertions, the risk and threats to
the cycle, internal controls that should be in place, and the appropriate audit procedures.
Transactions
Production cycle relates to production activities or transactions of converting raw material into
finished. The transactions include:
1. The use of raw material costs
2. The use of direct labor costs
3. The use of factory overhead costs
Common terms:
• Raw material & direct labor = prime costs
• Direct labor & FOC = conversion costs
Related accounts balances:
1. Raw material inventory
2. Salary and wages
3. All accounts include as factory overhead costs.
4. WIP (Work in Process)
 WIP – Raw Materials
 WIP – Direct Labor Costs
 WIP – Factory Overhead Costs
5. WIP – Inventory
6. Finished Goods Inventory
7. Cost of Goods Sold
Audit Objectives in Detail

Assertion Transaction Class Audit Objective Account Balance Audit Objectives

Category

Existence or Recorded manufacturing Inventories included in the balance sheet

occurrence transactions represent materials, physically exist.
labor, and overhead transferred to
Cost of goods sold represents the cost of
production and the movement of
goods shipped (sold) during the period.
completed production to finished
goods during the current period.

Completenes All manufacturing transactions that Inventories include all materials, products,
s occurred during the period have and supplies on hand at the balance sheet
been recorded. date.
Cost of goods sold includes the effects of all
sales transactions during the period.

Rights and The entity has rights to the The reporting entity has legal title to the
obligations inventories resulting from recorded inventories at the balance sheet date.
manufacturing transactions.

Valuation or Manufacturing transactions are Inventories are properly stated at the lower
allocation correctly journalized, summarized, of cost or market.
and posted.
Cost of goods sold is based on the
consistent application of an acceptable cost
flow method or methods.

Presentation The details of manufacturing Inventories and cost of goods sold

and transactions support their
disclosure presentation in the financial
statements including their
classification and disclosure.
are properly identified and
classified in the financial
statements.
Disclosures pertaining to basis of valuation
and the pledging or assignment of
inventories are adequate.

Inherent Risks
1. The volume of purchases, manufacturing, and sales transactions that affects these
accounts is generally high, increasing the opportunities for misstatements to occur.
2. Contentious issues surrounding the identification, measurement, and allocation of
inventory-able costs such as indirect materials, labor, and manufacturing overhead, joint
product costs, and the disposition of cost variances, accounting for scarp, and other
accounting issues.
 3. The wide diversity of inventory items sometimes requires the use of special procedures
to determine inventory quantities and estimation of quantities by experts.
4. Inventories are often stored at multiple sites, adding to the difficulties associated with
maintaining physical controls over theft and damages, and properly accounting for goods
in transit between sites.
5. The wide diversity of inventory items may present special problems in determining their
quantity and market value.
6. 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.
7. Inventory may be sold subject to right of return and repurchase agreements.
Analytical Procedures
Analytical procedures useful to test the potential misstatement. The following are the
alternatives of ratio analysis:
Inventory turn days
Avg. inventory payable: cost of goods sold x 365
Audit significant
Prior experience in inventory turns 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, or lower of cost or market problems.
Inventory growth to cost of sales growths
((inventory n: Inventory n-1) – 1): ((cost of sales n: cost of sales n-2) – 1
Audit significant
Ratio larger than 1.0 indicate that inventories are growing faster than sales. Large ratios
may indicate possible inventory obsolescence problems.
Finished goods produced to raw material used
Finished goods quantities: raw material quantities
Audit significant
Useful in estimating the efficiency of the manufacturing process. May be helpful in
evaluating the reasonableness of production costs.

Finished goods produced to direct labor

Finished goods quantities: direct labor hours
Audit significant
 Useful in estimating the efficiency of the manufacturing process. May be helpful in
evaluating the reasonableness of production costs
Product defects per million
Number of product defects as a percent of each million produced.
Audit significant
Useful in estimating the effectiveness of the manufacturing process. May be helpful in
evaluating the reasonableness of production costs and warranty expenses.