Written Report Substantive Tests of Transactions and Balances

Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Santa Maria, Bulacan Campus
Substantive Tests of Transactions and Balances: CONTINUATION
VI. Production Transactions
A. Substantive Tests of Transactions
Assertion Potential Misstatements Substantive Audit

Procedures
A. Existence/ Transaction that did not For selected transactions,
B. Occurence occur may be recorded examine signed materials
requisitions1, approved
2
Recorded labor tickets , and allocation
production of overhead.
transactions
occurred
1
A material requisition form lists the items to be picked from inventory and used in
the production process or in the provision of a service to a customer, usually for a
specific job. The form usually has three purposes:
To pick items from stock

To relieve the inventory records in the amount of the items picked
To charge the targeted job for the cost of the items requisitioned
The form can also be used as the basis for the reordering of any inventory items that
are not currently in stock.
The information most commonly found on a material requisition form includes:

Header section: Job number to be charged
Header section: Date of requisition
Header section: Date by which inventory is required
Main body: Item number or description to be pulled from stock
Main body: Unit quantity to be pulled from stock
Footer section: Authorization signature line
Page 1 of 35
If the materials are to be delivered to a specific location, there may also be space in the
header in which to identify the delivery location. Unless a service invoice is to be
prepared from this document, it usually does not include item costs or prices.
The requesting person retains a copy of the material requisition form, as does the
warehouse staff. Another copy accompanies the picked goods to their eventual
destination. If items listed on the form are not in stock, another copy may be sent to the
purchasing department for ordering purposes.
Auditors may trace the flow of material requisition forms through a company, to see if
inventory items are being appropriately used and recorded as mandated by company
materials handling procedures. If not, the auditors may conclude that they cannot rely
upon certain aspects of a company's control systems as part of their audit activities, and
so will bolster other audit activities.
The material requisition form is not used in a computerized production planning

environment, where this picking information is instead sent to the warehouse as an
electronic message.
A material requisition form may also be known as a purchase requisition form, though
a purchase requisition can be used for all types of purchases, not just those involved in the
production process.
Page 2 of 35
2
In job order costing system, the method of measuring and recording direct labor cost is
similar tomeasuring and recording direct materials cost.
Direct labor hours worked, direct labor rate per hour, and total amount in dollars for
each individual job or task is recorded on a document known as time ticket or employee
time ticket. A separate time ticket is prepared by each worker for every working day.
Accounting department collects all time tickets at the end of the day. These time tickets
are used to enter direct labor cost on the job cost sheet of each individual job order. An
example/sample of complete time ticket is given below:
Employee Time Ticket
In job order costing system, any labor charges that are not directly traceable to a
particular job are known as indirect labor cost. In example of time ticket given above
maintenance is indirect labor. Other examples of indirect labor are cleanup costs and
supervision etc. Indirect labor is not included in direct labor cost and, therefore,
becomes a part of the manufacturing overhead.
These days, many companies have replaced the manual process of recording direct
materials cost with the computerized approaches. They use a bar code technology to
enter data into a computer. This technology increases the speed and accuracy of the
whole process.
Page 3 of 35

Procedures
C. Completeness Completed production may Account for a sequence
D. Rights/Obligations not be recorded of production reports1
All production Account for a sequence

transactions that Goods may be issued but of material requisitions
ocurred are not recorded
recorded Reconcile time cards and
labor tickets
Time may be worked in
production but not
recorded
1
A departmental cost of production report (CPR) shows all costs chargeable to a
department. It is not only the source for summary journal entries at the end of the
month but also a most convenient vehicle for presenting and disposing of costs
accumulated during the month. A production cost report shows:
1. Total unit costs transferred to it from a preceding department.
2. Materials, labor, and factory overhead added by the department.
3. Unit cost added by the department.
4. Total and unit costs accumulated to the end of operations in the department.
5. The cost of the beginning and ending work in process inventories.
6. Cost transferred to a succeeding department or to a finished goods storeroom.
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Assertion Potential Misstatements

Substantive Audit
Procedures
E. Valuation/ Values may not be based Test cost records by
F. Measurement on costs incurred tracing to underlying
documents, such as bill
Production of materials1, labor
transactions are tickets, authorized labor
recorded for the rates, and standard
proper amounts overhead rates. Review
variances.
1
A bill of materials or product structure is a list of the raw materials, sub-assemblies,
intermediate assemblies, sub-components, parts and the quantities of each needed to
manufacture an end product or to finish a particular job.
Page 6 of 35
Assertion Potential Misstatements

Substantive Audit
Procedures
G. Presentation and Costs may be assigned to Check accuracy of
Disclosure wrong account account coding by
reference to chart of
Production accounts.
transactions are
recorded to result in
presentation and
disclosure in
accordance with
PFRS.
B. Analytical Procedures
Auditors substantive tests of balances relating to production are primarily

analytical procedures and variance analyses.
Compare actual costs per unit produced to budgeted costs

Compare actual costs per unit produced to prior years costs
Compare actual costs per unit produced to standard costs
Significant variations should raise questions about whether costs are

misclassified.
Page 7 of 35
VII. Inventory Warehousing Transactions
A. Substantive Tests of Transactions
Assertion Potential MisstatementsSubstantive Audit

Procedures
A. Existence/ Receipts or issues of For selected transactions
B. Occurrence inventory that did not recorded in the inventory
occur may be recorded control account, examine
Recorded inventory signed receiving report1.
warehousing
transactions
occurred
1
A receiving report is an important record of the goods that an entity has actually
received from a supplier because it documents what is owed to the supplier in terms of
payment for the goods received or the return of the goods, in some cases.
A receiving report is used to document the contents of a delivery to a business. The form is
filled out by the receiving staff of the business accepting the delivered goods. The following
information is typically included on a receiving report:
Date and time on which the delivery was received
Name of the shipping company that delivered the goods
Name of each item received
Quantity of each item received
The authorizing purchase order number, if noted on the delivery documentation

or box
Page 8 of 35
Condition of the items received. This can be a negative entry, where only
damaged goods are noted.
The receiving report can be used in several ways, including the following:
Returns. If certain goods are to be returned, the receiving report documents the
reason for the return, such as damaged goods.
Payables. The receiving report can be used as evidence of receipt in the three-
way matching process. This approach is more commonly used for larger-dollar
purchases.
Accruals. The accounting staff may use receiving reports that were completed
near month-end to accrue expenses for supplier invoices that have not yet
arrived.
A master copy of each receiving report is stored in the receiving department. Copies are
sent to other departments as required by company procedures, such as the copy sent to
the payables staff to document received goods.
From a control perspective, it can be useful to uniquely number each receiving report.
The sequence of numbers can then be examined to see if any receiving reports are
missing.
Page 9 of 35

Procedures
C. Completeness Goods may have been Account for a sequence of
received or issued but not receiving reports and
All inventory recorded. requisitions. Perform
warehousing records-to-floor and
1
transactions that floor-to-records tests.
ocurred are
recorded
1
This is a blog post of Kellen, an auditor, in his blog Accountant by Day
What are inventory counts and why do you need to fly there?
For those who dont know, inventory counts are what manufacturing companies do
around the end of the year to see exactly how much inventory they have. The inventory
count must be done after production for the past year ends, and before production for
the new year begins, otherwise it becomes much more difficult to keep track of what to
count as inventory as of 12/31.
As auditors, we participate in inventory counts soon after the client has finished
counting the inventory. We only have this small window of opportunity, because in a
few days, the inventory levels will be different. We want to make sure that the inventory
records are correct as of 12/31.
Inventory Counting Process
The clients employees will spend a few days counting everything in the warehouse (or
warehouses.) When the clients employees count the inventory, they keep track of what
they count on count sheets. They should also put stickers or tags on each piece of
inventory to make it clear which pieces have already been counted.
Inventory Audit Test: Sheet-to-Floor
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Our first inventory count test is called sheet-to-floor. For this test, we selected
inventory items from the count sheets. Then we traced these sheets to the actual
inventory on the floor, and recounted it. For inventory, auditors are most worried about
the existence assertion: Does the inventory recorded on the books really exist?
Inventory Audit Test: Floor-to-Sheet
However, as auditors we are also making sure that they count was done well. We
perform a second test called floor-to-sheet where we select an item of inventory out
on the warehouse floor. We count the items, and then trace them to their count sheet to
make sure that the clients counters recorded to same number that we did. This tests for
completeness: Is all the existing inventory recorded on the books?
In the case of fraud, it is much more likely that a company would overstate inventory, so
existence is the most important test. However, counters can also make mistakes, and
auditors are also checking for errors - in fact, most of the discrepancies we find as
auditors are due to errors, not fraud.

Procedures
D. Rights and Items held on Examine invoice2 for goods
Obligations consignment1 may be received.
included in inventory.
Inventory
warehousing
transactions are for
goods that belong to
the entity.
1
Consignment occurs when goods are sent by their owner (the consignor) to an agent
(the consignee), who undertakes to sell the goods. The consignor continues to own the
goods until they are sold, so the goods appear as inventory in the accounting records
of the consignor, not the consignee.
Page 11 of 35
2
An invoice is a document sent to a buyer that specifies the amount and cost of products or
services that have been provided by a seller
An invoice indicates what must be paid by the buyer according to the payment terms of
the seller. Payment terms usually specify the period of time that a buyer has to send
payment to the seller for the goods and/or services that they have purchased.
An invoice provides a detailed account of the products or service and a set of other
information that can vary a bit depending on the requirements in the country the
invoice is issued and the type of product or service being sold.
Page 12 of 35

Procedures
E. Valuation/ Inventory may be Trace allocated costs back
F. Measurement misvalued. to supporting documents.
Verify mathematical
Allocations are accuracy and trace
recorded for the postings.
proper amounts.

Procedures
G. Presentation and Receipt or issue may be Check accuracy of accounts
Disclosure charged or credited to on invoices by referring to
the wrong accounts. chart of accounts1.
Inventory
warehousing
transactions are
recorded to result in
presentation and
disclosure in
accordance with
PFRS.
1The chart of accounts is a listing of all accounts used in the general ledger of an
organization. The chart is usually sorted in order by account number, to ease the task of
locating specific accounts.
Page 13 of 35
B. Substantive Test of Details of Balances
Assertion Substantive Audit Procedures

A. Existence/
B. Occurence
Recorded inventory exists. 1. Before the client takes the physical

inventory, review and approve the
clientss written plan1 for it.
2. Observe the client personnel physically
counting inventory.
3. Confirm inventories on consignment
and held in public warehouses.
1
Example of a companys written plan for taking the physical count of their inventories
is presented on the succeeding pages.
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C. Completeness
All inventories of the entity 4. Obtain a copy of prenumbered

are recorded. inventory tags1 used by the client in
taking inventory and reconcile the tags
to the listing.
5. For selected items, trace from tags to
listing.
6. Perform cutoff procedures. Obtain the
receiving report number for the last
shipment received prior to year-end and
determine that the item is included in
inventory. Also, identify the last
shipping terms, when the item was
properly recorded in sales or inventory.
7. Perform analytical procedures.
Page 20 of 35
1
Example of an inventory tag
INVENTORY TAG is a tag attached to inventory items that identifies the inventory items
to aid in counting the physical inventory.

D. Rights and obligations
Inventory is owned by the 8. Determine that consigned inventory has

entity. been excluded from inventory and that
inventory pledged has been
appropriately disclosed. Examine
confirmations from financial institutions
and read minutes of the board of
directors meetings.
Page 21 of 35

E. Valuation/
F. Measurement
Recorded inventory is valued 9. Considering the method the client uses

in accordance with PFRS. for inventory valuation, examine
invoices for inventory on hand or trace
to prior years inventory listing to verify
cost.
10. For selected items, determine
replacement cost of the inventory and
apply lower of cost or market value.
11. Verify computations in inventory listing.
12. Review the obsolescence of inventory
by
a. Being alert while observing
inventory being taken for
damaged, slow-moving or scrap
inventory.
b. Scanning perpetual records for
slow moving items and
discussing their valuation with
the client.

G. Presentation and
disclosure
Inventory is classified and 13. Determine whether the accountsare

disclosed in accordance with classified and disclosed in the financial
PFRS. statements in accordance withe PFRS.
Page 22 of 35
C. Analytical Procedures
1. Compare gross profit with historical results and industry averages.
2. Compare inventory with that of budget and prior period.
3. Compare inventory turnover with that of other entities in the same
industry and that of prior periods.
4. Scan for unusual and slow-moving items.
INVENTORY FRAUD CASE: McKesson & Robins
McKesson & Robbins was a drug and chemical company in the mid-1920s
that attracted the attention of Philip Musica, an individual with an unsavory
past that included criminal acts and multiple fake names.
Under the name Frank D. Costa, Musica greeted the advent of U.S.
Prohibition in 1919 with the creation of a company that manufactured hair tonic
and other products that had high alcohol content. These products were sold to
bootleggers, which used the alcohol to produce liquor to sell to customers.
Musica purchased McKesson & Robbins in 1924 using the name F. Donald
Coster, and seeded the company with family members to help loot the company.
The fraud involved fake purchase orders, inflated inventory and skimming cash
from company sales, and occurred despite the presence of Price Waterhouse as
the company's auditors. When the scam was finally detected in 1937, the SEC
determined that $19 million in fictitious inventory was on the balance sheet of
the company. This is equal to approximately $285 million in current dollars.
McKesson & Robbins had a profound impact on the accounting industry

and led to the adoption of Generally Accepted Auditing Standards (GAAS),
including the concept of an independent audit committee. Another change
included having auditors personally inspect inventory to verify its existence.
Page 23 of 35
VIII. Property, Plant and Equipment

A. Existence/
B. Occurence
Recorded property, plant and 1. Physically inspect the assets for a

equipment assets exist. sample of property, plant and
equipment recorded in the plant
ledger1.
2. Physically inspect the assets and
examine supporting documentations for
additions to property, plant and
equipment.
3. Verify that existing retirements and
disposals are recorded and properly
valued.
1
Plant Ledger: A subsidiary ledger that records detailed information on each capital
asset, including acquisition date, cost, description, location, depreciation, and
disposition.

C. Completeness
All property, plant and

equipment are recorded. 4. Perform analytical procedures.
5. Analyze repairs and maintenance for
expenditures that should have been
capitalized1.
6. Examine lease and loan agreements to
identify any liabilities that should be
recorded.
Page 24 of 35
1
General Principle of Capitalization
The IRS indicates what constitutes a real property capital improvement as follows:
Fixing a defect or design flaw
Creating an addition, physical enlargement or expansion
Creating an increase in capacity, productivity or efficiency
Rebuilding property after the end of its economic useful life
Replacing a major component or structural part of the property
Adapting property to a new or different use

D. Rights and Obligations
Property, plant and 7. Determine whether any liens1 or

equipment are owned by the mortgages2 have been placed on plant
entity. and equipment by examining bank
confirmations and reading minutes of
the board of directors meetings.
1
a right to keep possession of property belonging to another person until a debt owed
by that person is discharged.
2
a legal agreement by which a bank or other creditor lends money at interest in
exchange for taking title of the debtor's property, with the condition that the
conveyance of title becomes void upon the payment of the debt.
Page 25 of 35

E. Valuation/
F. Measurement
Recorded property, plant and 8. Verify the accuracy of recorded

equipment are valued in property, plant and equipment.
accordance with PFRS. 9. Verify depreciation.

G. Presentation and
Disclosure
10. Review the financial statements and

Property, plant and perform analytical procedures to
equipment are classified and determine whether accounts are
disclosed in accordance with classified and disclosed in accordance
PFRS. with PFRS.
IX. Investments

A. Existence/
B. Occurence
1. Inspect securities on hand and trace to

Recorded investments and list.
investment income exist. 2. Confirm securities held by others.
Page 26 of 35

C. Completeness
All investments and 3. Apply analytical procedures.

investment income are
recorded.

Investments and investment 4. Examine supporting brokers advices

income are owned by the and paid checks for investments aquired
entity. during the period.
5. Examine remittance advices for
dividends, interest, and disposal of
investments.

E. Valuation/
F. Measurement
Investments are valued in 6. Reconcile the investment list to the

accordance with PFRS and subsidiary ledger and general ledger
investments and investment account.
income are matematically 7. Recalculate interest revenue and verify
accurate. dividend income by reference to
published report of dividends.
Page 27 of 35

H. Presentation and
Disclosure
Investments and investment 8. Review the financial statements and

income are presented in perform analytical procedures to
accordance with PFRS. determine whether accounts are
classified and disclosed in accordance
with PFRS.
X. Notes Payable

A. Existence/
B. Occurence
Recorded notes payable 1. Confirm notes with lenders, including

actually exist. the principal amounts, interest rate,
interest payments, due date, collateral
and other terms.
2. Determine whether proceeds of notes
are recorded and used as the board of
directors intended.
Page 28 of 35

C. Completeness
All notes payable are 3. Perform analytical procedures.

recorded. 4. Reconcile interest expense to notes
payable and compare interest expense
for the current period with that for the
previous period.
5. Review standard bank confirmations to
determine that all loans are recorded.

Recorded notes payable 6. Read the loan agreement for terms and
represent obligations of the conditions that should be disclosed and
entity. for pledging of assets.

E. Valuation/
F. Measurement
Notes payable are valued 7. Recalculate the portion of notes

properly. currently due, interest expense, interest
payments, and accrued interest; foot the
schedule of notes payable.
Page 29 of 35

G. Presentation and
Disclosure
Notes payable are recorded 8. Review the financial statements and

to result in presentation and perform analytical procedures to
disclosure in accordance with determine whether accounts are
PFRS. classified and disclosed in accordance
with PFRS.
XI. Shareholders Equity

A. Existence/
B. Occurence
Share capital recorded as 1. Examine the corporate charter for the

issued actually was issued, number of authorized shares and
and recorded dividends determine that the entity is in
actually were declared. compliance.
2. Examine minutes of board of directors
meetings for authorization to issue
shares, pay dividends, pay dividends,
split shares, or purchase treasury shares.
3. Perform analytical procedures.
Page 30 of 35

C. Completeness
All issued share capital and 4. Based on reading of minutes of board

declared dividends are of directors meetings, determine that
recorded. all declared cash or share dividends and
approved share splits have been
recorded.
5. Confirm with the outside share registrar
and ahre transfer agent (a) the number
of shares issued and outstanding and
(b) the dividends paid. Or foot
shareholders ledger and reconcile it to
the general ledger and the share
certificate book. Account for all
certficates.

Share capital transactions 6. Examine remittance advices for cash

represent ownership interests receipts for shares issued during the
in the entity. period under audit. Examine paid checks
and share certificates for shares
repurchased. Trace authorization for
dividends to minutes of the board of
directors meetings.
Page 31 of 35

E. Valuation/
F. Measurement
Shareholders equity 7. Recalculate EPS and dividends. Trace

transactions are recorded for postings of dividends to the RE acct.
the proper amounts. 8. Reconcile SHE Ledger with the general
ledger.
9. Verify amount transferred from RE for
share dividends by reference to the
published market price of the shares.

G. Presentation and
Disclosure
SHE transactions are 10. Review the financial statements to

recorded to result in determine that share capital, retained
presentation and disclosure earnings, and earnings per share are
in accordance with PFRS. properly classified, described, and
disclosed.
Page 32 of 35
References
Auditing Theory by Ma. Elenita B. Cabrera
https://www2.deloitte.com/content/dam/Deloitte/za/Documents/risk/ZA_RA_DecodingFrauds
_101115.pdf
http://www.accountingtools.com/material-requisition-form
http://www.accountingformanagement.org/measuring-and-recording-direct-labor-cost/
http://3.bp.blogspot.com/-
oU_qWl9HqTY/UMiaMYJlfYI/AAAAAAAAA5M/JP1pFeuA5Uo/s1600/Bill+of+materail+gar
ment.png
https://en.wikipedia.org/wiki/Bill_of_materials
http://www.arxisfinancial.com/images/pdfs/Inventory_Fraud.pdf
http://www.accountingtools.com/receiving-report
www.businessdictionary.com/definition/receiving-report.html
http://accountantbyday.com/2011/01/03/life-of-an-auditor-inventory-counts/
www.accountingtools.com/consignment-accounting
https://www.ventureline.com/accounting-glossary/I/inventory-tag-definition/
http://www.investopedia.com/articles/economics/12/four-unknown-massive-frauds.asp
http://www.vakilno1.com/nri/investment/remittance.html
Page 33 of 35
End-of Report Questions
1. Which of the following is the least useful when performing substantive tests
on production transactions?
A. Materials Requisition Form
B. Labor tickets
C. Bill of Materials
D. Inventory Tag
2. In performing a search for unrecorded retirements of fixed assets, an auditor

most likely would:
A. tour the clients facilities, and then analyze the repair and
maintenance account.
B. inspect the property ledger and the insurance and tax records,
and then tour the clients facilities.
C. analyze the repair and maintenance account, and then tour the
clients facilities.
D. tour the clients facilities, and then inspect the property ledger
and the insurance and tax records.
In searching for unrecorded retirements of fixed assets, the auditor would select
items included in the property ledger and other records and then, by touring the
clients facilities, look to see if they are on hand. A fixed asset that is not on hand but
is included in the records may indicate that a retirement was not recorded.
Page 34 of 35
3. Auditors try to identify predictable relationships when using analytical

procedures. Relationships involving transactions from which of the following
would most likely yield the highest level of evidence?
A. Interest expense
B. Accounts payable.
C. Accounts receivable.
D. Travel and entertainment expense.
When using analytical procedures to identify predictable relationships,

higher levels of evidence will be obtained when those relationships are most
predictable. Relationships involving income statement accounts, such as
interest expense, tend to be more predictable than relationships involving
only balance sheet accounts. This is because income statement accounts
represent transactions over a period of time, rather than a point in time, as a
balance sheet amount represents. Also, interest expense, which can be
related to debt, is more predictable than the travel and entertainment
expense, which is more unpredictable and subject to management discretion.
Page 35 of 35

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Republic of the Philippines

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Substantive Tests of Transactions and Balances: CONTINUATION

VI. Production Transactions

A. Substantive Tests of Transactions

Assertion Potential Misstatements Substantive Audit

To pick items from stock

The information most commonly found on a material requisition form includes:

The material requisition form is not used in a computerized production planning

Employee Time Ticket

Assertion Potential Misstatements Substantive Audit

All production Account for a sequence

Assertion Potential Misstatements

Assertion Potential Misstatements

Auditors substantive tests of balances relating to production are primarily

Compare actual costs per unit produced to budgeted costs

Significant variations should raise questions about whether costs are

VII. Inventory Warehousing Transactions

A. Substantive Tests of Transactions

Assertion Potential MisstatementsSubstantive Audit

Date and time on which the delivery was received

Name of the shipping company that delivered the goods

Name of each item received

Quantity of each item received

The authorizing purchase order number, if noted on the delivery documentation

Assertion Potential Misstatements Substantive Audit

Inventory Counting Process

Inventory Audit Test: Sheet-to-Floor

Inventory Audit Test: Floor-to-Sheet

Assertion Potential Misstatements Substantive Audit

Assertion Potential Misstatements Substantive Audit

Assertion Potential Misstatements Substantive Audit

B. Substantive Test of Details of Balances

Assertion Substantive Audit Procedures

Recorded inventory exists. 1. Before the client takes the physical

Assertion Substantive Audit Procedures

All inventories of the entity 4. Obtain a copy of prenumbered

Assertion Substantive Audit Procedures

Inventory is owned by the 8. Determine that consigned inventory has

Assertion Substantive Audit Procedures

Recorded inventory is valued 9. Considering the method the client uses

Assertion Substantive Audit Procedures

Inventory is classified and 13. Determine whether the accountsare

INVENTORY FRAUD CASE: McKesson & Robins

McKesson & Robbins had a profound impact on the accounting industry

VIII. Property, Plant and Equipment

Assertion Substantive Audit Procedures

Recorded property, plant and 1. Physically inspect the assets for a

Assertion Substantive Audit Procedures

All property, plant and

Fixing a defect or design flaw

Creating an addition, physical enlargement or expansion

Creating an increase in capacity, productivity or efficiency

Rebuilding property after the end of its economic useful life

Replacing a major component or structural part of the property

Adapting property to a new or different use

Assertion Substantive Audit Procedures

Property, plant and 7. Determine whether any liens1 or

Assertion Substantive Audit Procedures

Recorded property, plant and 8. Verify the accuracy of recorded

Assertion Substantive Audit Procedures

10. Review the financial statements and

Assertion Substantive Audit Procedures

1. Inspect securities on hand and trace to