Study unit 8

Inventory and
production cycle
Mrs Krysta Heathcote
GEAR111

Auditing Fundamentals 2nd edition

Chapter 8 (page 321 to 356)
 Learning outcomes
After completion of this study unit, you should be able to:
• describe the control objectives for the inventory and production cycle;
• demonstrate an understanding of how internal controls may assist in achieving the control objectives in the inventory and
production cycle and how these control objectives relate to management's assertions in the financial statements;
• describe the internal control activities for the inventory and production cycle;
• describe the activities, responsible parties, documents and records, risks and manual controls applicable to each of the functional
areas of the inventory and production cycle;
• describe the activities, responsible parties, documents and records, risks and manual controls applicable to the inventory count of
the inventory and production cycle;
• analyse internal control systems in order to identify and explain weaknesses in the manual control system of the inventory and
production cycle, including the inventory count, and recommend improvements by describing the required internal controls;
• recommend a manual system of internal controls for the inventory and production cycle, that will achieve the cycle's control
objectives; and
• apply all of the above-mentioned in a case study.

Please note that some the outcomes are focused on a retail industry, as a manufacturing entity will be dealt with in the
following years of studies.
 Content
Control objectives
Link to cycle
Link to assertions
Internal control activities
Manual system – internal control tables
Weaknesses vs Recommendations vs Risks
 Control objectives
Risks

Validity Completeness Accuracy

Authorised No omissions Correct

Occurred

Auditing Fundamentals page 337 - 338

 Control objectives
CONSEQUENCE

Overstatement?
Validity
Understatement?

Authorised Inventory Unauthorised transactions (purchase / sell).

Occurred Inventory Fictitious transactions (purchase / sell).

Auditing Fundamentals page 337 - 338

 Control objectives
CONSEQUENCE

Overstatement?
Completeness
Understatement?

No omissions Inventory Incomplete transactions (purchase / sell).

Auditing Fundamentals page 337 - 338

 Control objectives
CONSEQUENCE

Overstatement?
Accuracy
Understatement?

Inaccurate transactions.
Correct Inventory Inaccurate allocations.

Auditing Fundamentals page 337 - 338

 INVENTORY Valid?

Receive the goods

Storing the goods

Complete?
Despatch the goods
Link to cycle

Accurate?

Auditing Fundamentals page 338

 Link to assertions
Validity Completeness Accuracy

Assertions (Representations by the board (AFS))

Occurrence Accuracy
Completeness
Cut-off Classification

Accuracy,
Existence Completeness valuation & allocation
Rights Classification

Auditing Fundamentals page 338 - 339

 Documentation and records:
Document design, stationery controls, chart of accounts
PO properly designed and placed under proper stationery control

Used in conjunction with a proper chart of accounts

Internal control activities Authorisation and approval:

Levels of authorisation, isolation of responsibility
Ordering inventory from a supplier

Picking the goods for despatch to a customer

Segregation of duties:
Incompatible duties performed by different employees
Initiation of a transaction vs Approval of the transaction

Execution of the transaction vs Recording of the transaction

Auditing Fundamentals page 340 - 342

 Access control:
Control / restrict access, safeguarding
Physical safekeeping of inventory & physical access to storage areas

Periodic counting of inventory & reconciliation to inventory records

Internal control activities Independent checks and reconciliation:

Checks / reviews, signatures, reconciliations
Agreeing the quantities physically on hand (actual quantities) to those
quantities recorded on the entity’s perpetual inventory system

Auditing Fundamentals page 340 - 342

 Functional areas
Storage of raw Transfer of raw materials to
Production planning
materials (not examinable) production (not examinable)
(not examinable)

Transfer of finished goods

Production Storage of finished
to finished goods
(not examinable) goods
warehouse (not examinable)

Cost allocation and

Maintenance of
updating of inventory
inventory records
records

Auditing Fundamentals page 342 - 353

 Manual system – internal
control tables

Most common People / responsible

activity party

Risk (what could go

Documents and wrong)
records

Manual control

Auditing Fundamentals page 342 - 353

 Manual system – internal
control tables
Storage of finished
goods
People / responsible party Documents & records

It is the same as function

Finished goods 1 storage of raw Inventory
warehouse materials. records
manager

Risks

Inventory could Inventory could

be damaged be stolen

Auditing Fundamentals page 342 - 353

 Manual system – internal
control tables
Cost allocation and
updating of inventory
records
People / responsible party Documents & records

Cost Inventory
accountant records

Accounting General
clerk journal

Risks

Allocation Allocation
incorrectly invalid
calculated
Allocation
Allocation incomplete
incorrectly
recorded

Auditing Fundamentals page 342 - 353

 Manual system – internal
control tables
Maintenance of
inventory records
People / responsible party Documents & records

Accounting Inventory
clerk adjustment form

Inventory
master file

Risks

Items could be Quantities on

incorrectly added hand adjusted Inventory
/ deleted incorrectly count

Auditing Fundamentals page 342 - 353

 Planning inventory
counts

Conducting /
performing
inventory counts
Inventory count

Finalising inventory
counts Risks

Auditing Fundamentals page 353 - 355

Weaknesses vs Recommendations vs
Weaknesses are control activities that are not in place or not working as
they should (“no / not”).

If a weakness is written with a “should / must / etc.”, it is incorrect – NO

MARKS WILL BE GIVEN. This represents a control activity and not a
weakness.

You need to identify the weakness by writing it in a negative format – if

you write it in a positive format or a recommendation format – NO
MARKS WILL BE GIVEN.

Example (Mr R Bhayat):

The scenario states:
"All inventory was counted once.”

• The inventory count was not performed twice. CORRECT

• The inventory count was performed once. INCORRECT
(not provided in the negative format).
• The inventory count should be performed twice. INCORRECT
(this is a recommendation, not a weakness).
Risks

Auditing Fundamentals page 342 - 355

Weaknesses vs Recommendations vs
Recommendations are things that SHOULD / MUST be implemented
(“must / should / is supposed to / etc.”).

A recommendation is the action the entity SHOULD implement to

overcome / address the weakness AND the reason why it overcomes /
addresses the weakness.

Example (Mr R Bhayat):

The scenario states:
"All inventory was counted once.”

• The inventory count should be performed twice so that inventory is

counted correctly. CORRECT
Risks

Auditing Fundamentals page 342 - 355

Weaknesses vs Recommendations vs
Explanation means to further explain the weakness by possible risks.
These risks are from the business’ point of view – possible consequences
because of a weakness / what would happen if the weakness is there.

What could happen…. Might…

It is not a recommendation / an improvement (which are control

activities).

Example (Mr R Bhayat):

The scenario states:
"All inventory was counted once.”

• The inventory might be counted incorrectly. CORRECT

• The inventory count should be performed twice. INCORRECT
(this is a recommendation, and not an explanation).
Risks

Auditing Fundamentals page 342 - 355

 Weaknesses vs
Recommendations vs Risks

Weaknesses are control activities that are not in place or not working
as they should (“no / not”).

The physical controls in place includes – access controls e.g. locked, restricted entry, minimal entry
and exit points into the warehouse as well as surveillance cameras and security guards

The physical controls in place includes – access controls e.g. locked, restricted entry, minimal entry
and exit points into the warehouse only

After the date for the inventory count and the number of people needed has been determined,
a plan of all the areas where inventory is kept and detailed instructions for the inventory count are
prepared

After the date for the inventory count and the number of people needed has been determined,
detailed instructions for the inventory count are prepared

Auditing Fundamentals page 342 - 355

 Learning outcomes
After completion of this study unit, you should be able to:
• describe the control objectives for the inventory and production cycle;
• demonstrate an understanding of how internal controls may assist in achieving the control objectives in the inventory and
production cycle and how these control objectives relate to management's assertions in the financial statements;
• describe the internal control activities for the inventory and production cycle;
• describe the activities, responsible parties, documents and records, risks and manual controls applicable to each of the functional
areas of the inventory and production cycle;
• describe the activities, responsible parties, documents and records, risks and manual controls applicable to the inventory count of
the inventory and production cycle;
• analyse internal control systems in order to identify and explain weaknesses in the manual control system of the inventory and
production cycle, including the inventory count, and recommend improvements by describing the required internal controls;
• recommend a manual system of internal controls for the inventory and production cycle, that will achieve the cycle's control
objectives; and
• apply all of the above-mentioned in a case study.

Please note that some the outcomes are focused on a retail industry, as a manufacturing entity will be dealt with in the
following years of studies.
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Copyright © 2024 edition.
Prepared by: Me Rolé van der Merwe
North-West University, Potchefstroom, South Africa.

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