Chapter 8: Inventory and Production Cycle

Chapter 8
Inventory and production
cycle
Chapter 8: Inventory and Production Cycle

8.1 What are the nature, purpose and accounting implications of the
cycle?

8.1.1 Nature and purpose

 Inventory and production cycle relates to:
 Managing, safeguarding of inventory
 If manufacturing entity: controlling the production process
and movement of inventory
 Consequences if the entity fails to safeguard inventory.
 i.e., theft & damage of inventory = cash flow issues
 Consequences if the entity fails to control the production
process
 Poor quality and obsolete inventory
 Cycle is also about accounting for inventory and
production.

Slide 2 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.1 Nature and purpose (continued)

 “Inventory” from accounting perspective:
• Raw materials
• Work-in-progress
• Finished goods.
 Important that costing relating to transformation is
appropriate
 Focus is on financial internal controls more than
operational.

Slide 3 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.2 Types of inventory and production

 Different entities = different types of inventory and
production processes.
 The purpose of the cycle remains the same
• Examples:
– Retailer selling clothes, food or vehicles
– Wholesaler selling bulk products to retailers
– Forestry/resources selling wood to furniture manufacturing
entity
– A resource entity e.g. Mining entity

Slide 4 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.3 The varied nature of the cycle

 Varies amongst different entities’ inventory/ production
cycles
• Names of source documents and records may differ
 However, the ff remains the same:
• Principles and Control objectives
• Risks.

Must understand the purpose of the cycle and the risk an entity
faces.

Slide 5 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.4 The link between this cycle and the

other cycles
Purchases
and
payments

Inventory
and
production

Revenue Payroll
and and
receipts personnel

Slide 6 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.5 How transactions in the cycle are

triggered
 Manufacturing
• Commence – Job order received from the client or
preparation and authorization of internal production
• End – finished goods transferred to the warehouse & cost
recorded.

 Retail/wholesale
• Commence – receipt of requisitioned inventory into the
warehouse.
• End - despatch

 When triggered: cycle internal controls activated.

Slide 7 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.6 Example of a typical transaction in the

inventory and production cycle

Retail entity

Order, receive, transfer goods to warehouse (P&P)

Store & safeguard goods (I&P)

Goods to dispatch, delivered to customer (R&R)

P&P I&P R&R

Key
Purchases and payments cycle Inventory and production cycle Revenue and receipts cycle

Slide 8 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.6 Example of a typical transaction in the

inventory and production cycle

Manufacturing

Order and receive, store at raw materials warehouse (P&P)

Transfer to factory, then finished goods warehouse (I&P)

Store and safeguarding of finished goods (I&P)

Goods to despatch, delivered to customer (R&R)

P&P I&P R&R

Key
Purchases and payments cycle Inventory and production cycle Revenue and receipts cycle

Slide 9 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.7 Major accounts affected by the cycle

Statement of comprehensive income

 Cost of sales
 Purchases (periodic inventory system)

Statement of financial position

 Inventory
• Raw materials
• Work-in-process
• Finished goods.

Slide 10 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.1 The nature, purpose and accounting implications of the cycle

8.1.8 IAS 2: Accounting treatment for inventory

 Definition of inventory assets (IAS 2.06)

 Assets held for sale in the ordinary course of business
(finished goods)
 In the production process (WIP)
 In the form of raw materials or supplies to be consumed in
the production process (RM)
 Measurement: Lower of cost and net realisable value
 Cost of purchase, conversion cost, other
 Sale: Cost must be expensed
 Expense = Write-downs.

Slide 11 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.2 What functional areas exist in the cycle?

8.2.1 Description of the functional areas

For a typical manufacturing entity
 Storage of raw materials
 Purpose: Safeguard raw material against theft and damage
 Main activities: protecting the raw materials
 People: RM warehouse personnel
 Production planning
 Purpose: Plan production process
 Main activities: determine production needs, determine RM needed
and request RM
 People: marketing manager, production and factory manager
 Transfer of raw materials to production
 Purpose: control RM issued to the factory
 Main activities: preparation of raw materials to be transferred, transfer
of RM to the factory, receipt of RM at the factory
 People: RM warehouse personnel, factory personnel, inventory clerk
and other accounting personnel.
Slide 12 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.2 What functional areas exist in the cycle?

8.2.1 Description of the functional areas

For typical manufacturing entity
 Production
 Purpose: control the production process
 Main activities: comparison & reconciliation of RM received, and FG
manufactured, an inspection of quality.
 People: factory personnel
 Transfer of finished goods to finished goods warehouse
 Purpose: control FG transferred to the FG warehouse
 Main activities: transfer of FG from the warehouse, receipt of FG at the
FG warehouse
 People: factory personnel, FG warehouse personnel, inventory clerk &
other accounting personnel
 Storage of finished goods
 Purpose: safeguard FG against theft and damage
 Main activities: inspecting goods received into FG warehouse, protecting
the inventory in storage
 People: FG warehouse personel
Slide 13 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.2 What functional areas exist in the cycle?

8.2.1 Description of the functional areas

For typical manufacturing entity
 Cost allocation and updating of inventory records
 Purpose: updating costing for the manufactured inventory
 Main activities: calculation, review, and recording of labour
and overhead costs, recoding inventory movements,
performing inventory counts, and updating inventory
records.
 People: accounting personnel and warehouse personnel

 Maintenance of inventory records.

 Purpose: keep inventory records up to date
 Main activities: recording any adjustments required
 People: accounting personnel
Slide 14 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.3 What information system is used in the cycle?

8.3.1 Accounting for inventory and production

transactions
 Record keeping of transactions essential.
 Consequences for financial reporting if record keeping
is not proper
 Risk where non-standard general journal entries are
used.

Slide 15 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.3 What information system is used in the cycle?

8.3.2 Supporting documents, journals and

ledgers
1. Supporting documents
Manufacturing entities Manufacturing and retail
1. Production plan/schedule 7. Inventory count sheets
2. Production order 8. Inventory tags
3. Raw materials requisition 9. Master file amendment
4. Raw materials transfer form (computerised
note systems only)
5. Finished goods transfer 10. Inventory adjustment
note form.
6. Production reports/shift
report

Slide 16 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.3 What information system is used in the cycle?

8.3.2 Supporting documents, journals

and ledgers
2. Journals and ledgers
 Manufacturing and retail
• General journal
• General ledger
• Inventory transfer journal.

Slide 17 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.3 What information system is used in the cycle?

Other information systems

8.3.3 Databases and master files
 Inventory master file (computerised systems only)
8.3.4 Reports
 Inventory listing (computerised systems only)
8.3.5 Reconciliations
 Inventory reconciliation.

Slide 18 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.3 What information system is used in the cycle?

8.3.6 Illustration: transaction flow in the

cycle
Activities
 Determine production  Complete production
needs process
 Schedule raw materials  Update inventory records
(RMs)  Transfer to finished goods
 Request from RM warehouse
warehouse  Costing
 Transfer RM to factory  Maintain inventory
records.

Refer to Auditing Fundamentals for the department where each activity occurs
and the supporting documents created.

Slide 19 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.4 What could go wrong (risks) in the cycle?

8.4 Risks in the cycle

 Direct correlation with nature and purpose
 Incorrect allocation of costs
 Inventory may be stolen and/or damaged
• While stored
• While in production

8.5 Computer technologies

 Barcode scanning
• During inventory movement
• Automatically updates inventory records
• No need for manual capture
• Fixed/handheld device
• Linked with accounting system/inventory records.
 Reduces risks of inaccurate capturing of information.
Slide 20 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.6 What are the control objectives in the cycle?

8.6.1 Control objectives in the cycle

Validity Accuracy Completeness

…of inventory/production transactions recorded in the

financial records.

What are the financial reporting consequences should a

control objective fail?

Slide 21 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.6 What are the control objectives in the cycle?

8.6.2 Achievement of the control

objectives in the cycle
 Achieved through:
• Proper information system, including accounting system
• Internal controls: manual/computerised.

 Examples (broadly, not detailed controls):

• Validity
– Approval of all transfers and adjustments
– Documentation
– Counts
– Reconciliations.

Slide 22 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.6 What are the control objectives in the cycle?

8.6.2 Achievement of the control

objectives in the cycle (continued)
 Examples (continued):
• Accuracy
– Correct quantities, amounts
– Mathematical correctness.

• Completeness
– Sequential numbering checks
– Cycle counts
– Reconciliations.

Slide 23 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.6 What are the control objectives in the cycle?

8.6.3 The link between the control objectives

in the cycle and management’s assertions
Classes of transactions and events
 Cost of Sales (CoS)/purchases transactions

Control objective Management assertion supported

• Occurrence
Validity • Cut-off of CoS
• Purchases
• Accuracy and Classification of CoS
Accuracy
• Purchases
• Completeness of CoS
Completeness
• Purchases

Slide 24 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.6 What are the control objectives in the cycle?

8.6.3 The link between the control objectives

in the cycle and management’s assertions
Account balances
 Inventory

Control objective Management assertion supported

Validity • Existence
• Rights of Inventory

Accuracy • Valuation and Allocation of Inventory

Completeness • Completeness of Inventory

Slide 25 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.7 Controls in the cycle (manual and computerised)

8.7.1 Internal controls in the cycle

1. Documentation and records
2. Authorisation and approval
3. Segregation of duties
4. Access controls
5. Independent checks and reconciliations

Slide 26 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.7 Controls in the cycle (manual and computerised)

8.7.2 Internal controls in the cycle

1. Storage of raw materials: page 340
2. Production planning: page 341
3. Transfer of raw materials to production: page 343
4. Production: page 345
5. Transfer finished goods to finished goods
warehouse: page 346
6. Storage of finished goods: page 347
7. Cost allocation and updating inventory records:
page 348
8. Maintenance of inventory records: page 349
Slide 27 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.7 Controls in the cycle (manual and computerised)

8.7.3 Controls relating to the conducting

of inventory counts
 Types of inventory counts:
• Cycle
• Year-end.
 Differences between the above types.
 Focus areas of each type of count.

Slide 28 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
Chapter 8: Inventory and Production Cycle

8.7 Controls in the cycle (manual and computerised)

8.7.3 Controls relating to the conducting

of inventory counts
1. Planning inventory counts: page 350

2. Conducting inventory counts: page 350

3. Finalising inventory counts: page 351

Slide 29 (C) Oxford University Press Southern Africa (Pty) Ltd 2014
 Chapter 8: Inventory and Production Cycle

Any questions?