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Auditing and Professional Practice

Question

Answered

Thomas Smith, a senior accountant with Dalen & Jay, CPAs, has recently been assigned as in charge

auditor of Mathra Tool, Inc. (MTI), a long time audit client of his firm. MTI is owned by George Mathra, an

experienced machinist. George established the business over 20 years ago, and it has grown into a $10

million-a-year business, with an excellent reputation for high quality machined parts. MTI has clients in

the automobile sector and the health care sector and has recently begun producing parts for

environmentally friendly products, such as recycling containers, due to the business's versatility in

dealing with a variety of metals as well as plastics.

Information Systems and Business Processes

The following description is based upon Thomas's review of prior working paper files and planning

discussions with personnel of MTI.

MTI has a broad range of equipment, ranging from grinders, stampers, cutters and small presses to

numerically controlled machining and turning centers, some that individually cost over $250,000. This

latter group of equipment is tied into the company's computer aided design and manufacturing

(CAD/CAM) system, used by the four senior tool and die personnel.

Machining and turning center suppliers have helped MTI develop efficient operations, by furnishing

sample numerical control programs for standard machine operations and by providing training to

employees. One of the suppliers unfortunately sent sample programs that had been infected with a virus.

George's daughter, Tiffany, had to cleanse the servers and each of the machines, using her copy of an

anti-virus software. When contacted, the supplier did not know that his software was infected and

apologized profusely.

The four CAD/CAM terminals and printers are connected to the company's local area network (LAN),

which is maintained by Tony Lee, the owner of a computer shop conveniently located three blocks away.

All computer equipment, software and supplies are purchased from Mr. Lee, who is responsible for

attaching and maintaining equipment, upgrading software and maintaining user security profiles on the

network. There is one user identification and password for accounting (shared by Tiffany, George and

the accounting clerk). Each of the plant supervisors has his own password, and a common password is

used to initiate the timekeeping system. The two word processing staff members have their own

password and use the common accounting password when they need to do data entry.

A standard routine has been set up to back up the accounting systems. One of the accounting staff

inserts one of seven tape cartridges into the system at the end of the day (they are labeled with the day

of the week), so that the company has a full set of backups for the week. Tiffany keeps these in her

office. These are particularly important, since during the last office move, two years ago, the original

disks for the accounting system were misplaced.

Tiffany Mathra, George's youngest daughter, has been working in the business for 15 years. She started

as a machine operator and has finished several college diplomas in numeric control and in accounting

over the years. She is being groomed to take over the business in two years and is proving herself

competent both on the shop floor and in administration. She works along with the tool and die machinists

and the shop supervisors, discussing design problems, quality control methods and costing of quotes for

potential orders. Wednesday morning 7:00 AM meetings are held by Tiffany and George to maintain a

good working relationship with the supervisors (one purchasing, three production, one design, one

quality control) and to review any problems that need to be addressed in the coming week. This includes

any potential scheduling changes required due to "rush" jobs that have been accepted or are being

quoted.

This good working relationship is extremely important for satisfying some of the company's larger

customers. MTI has paid for computer equipment for each of the supervisors, so that they have fully

functioning microcomputers at home. If a rush job requires weekend work, then these senior personnel 3

can work at home to get the necessary quoting or design work completed. Since the "at home" systems

are identical with the office systems (Mr. Lee simply copied the image from the MTI systems to the home

computer hard drives), diskettes can easily be taken home and then brought back to the office. It is

understood that when work slows down, a day off can be taken to compensate for this weekend work.

Almost ten years ago Tiffany arranged for the implementation of the network and the purchase of a

standard integrated accounting package (general ledger, order entry/accounts receivable,

purchases/payable, payroll), and for the purchase of the job costing and timekeeping system. The job

costing package is used to prepare and print quotes. For automotive customers, the quote is entered into

the stand alone electronic data interchange (EDI) system for transmission. Customer purchase orders

received via EDI are simply printed and filed. Once a quote has been accepted, the job is given a unique

job number. The job control sheets include a list of the machining center, labor and quality control tasks,

each with a unique optical scanning label used by the employees to "sign in" and "sign out" of particular

tasks by machine type and by operation. Standard control sheets are also used for overhead tasks, such

as cleaning or machine setup. Employees have plastic cards with their employee number coded. They

use a laser pen to scan their employee number, the job number and the operation label for each activity,

as it is commenced or completed. To sign out, they simply scan their employee card again.

Accounting Systems

A variety of reports are printed daily, weekly, or monthly from the costing system; these are used for

monitoring employee hours, the status of jobs, the costs accumulated for particular jobs and the work-inprogress

inventory. The weekly report of hours from the costing system is approved by the production

supervisors and is used as a data entry input source into the payroll system for hours worked. The

accounting clerk enters the hours into the accounting system, so that weekly payroll checks and reports

can be produced. When volume is high, one or both of the administrative staff assist. The administrative

staff also do filing or document matching, as necessary.

Tiffany is really pleased with her accounting clerk, Isabel, who has been with the company for three

years. She insists that fate had a hand in getting Isabel for MTI. Isabel was "pounding the pavement,"

having recently immigrated, and had no local business experience. Her accounting skills were

rudimentary, but she quickly learned the accounting software and has reorganized the filing system.

Tiffany considers her indispensable. When Isabel goes on vacation, many things simply don't get done.

Tiffany can do the payroll in a pinch, but Isabel always does accounts payable and cash disbursements.

If she's away, suppliers are simply told to wait, or Tiffany issues a manual check, which is recorded later.

Isabel is very good at responding to queries from suppliers and ensuring that new suppliers are set up

properly. The purchasing supervisor and his staff rely on Isabel, for she checks the account allocation of

purchases and makes any necessary corrections. Isabel also ensures that necessary EDI

acknowledgments are sent and reports printed.

Tiffany and George are signing officers, although Tiffany realizes that she checks supporting materials

more thoroughly than George, who usually just queries Isabel verbally about larger purchases. George

normally handles the bank deposits, while Tiffany does the monthly bank reconciliation. Every three

months, an accountant from Dalen & Jay reviews the regulatory returns for reasonableness, as well as

journal entries made in the last three months. He updates the recurring journal entries and advises

Tiffany of any changes in procedures or modifications to monthly journal entries that are required to help

ensure accuracy and completeness of transaction processing. Tiffany runs the standard financial

statements every month from the accounting package, but normally some additional adjustments are

required when the accountant comes in. These are adjustments to depreciation expenses, changes to

prepaid expenses and some account reallocation (e.g., repairs and maintenance to capital accounts)

based on discussions with Tiffany. The regular technician assigned to MTI is Louis Jaborwock, who has

just completed the most recent month end entries.

Louis informed Thomas that MTI had a problem one of their systems on Friday. Apparently, one of the

servers might have "crashed." Luckily, this was the server with the accounting systems and was fully

backed up on tape. A new server was to be installed the next day, and Mr. Lee was reconfiguring the

network so that the remaining systems could function from the single server.4

Work-in-Process Inventory

The engagement partner from Dalen & Jay believes that MTI's growth may have expanded the comsufficiently to warrant increased levels of controls reliance during the audit. She is particularly interested

in work-in-progress (WIP) inventory, the largest item on the balance sheet, typically close to three

months' sales. She has requested an updated controls analysis and that computer assisted audit

techniques using the firm's generalized audit software be considered. To this end, Thomas has updated

the narrative description associated with WIP inventory.

To calculate the WIP inventory for any particular month, one of the purchasing staff transfers data from a

report in the job costing system into a spreadsheet (exhibit 1). 2 Since the job costing system does not

have sales information, progress billings are added manually, and the spreadsheet total is used for the

monthly financial statement's work-in-progress figure.

The purchasing clerk has explained the contents of her spreadsheet and described the origin of the

information. Following is an explanation of the spreadsheet on a column by column basis:

Job number: A unique job number is assigned by one of the production supervisors. There is a manual

log in the production area, and the supervisors write down the customer, purchase order number and the

job numbers used. Where a purchase order lists multiple parts, a different job number must be used for

each part produced.

Customer code: Each customer has a unique customer code. Tiffany assigns these codes, so that the

same code can be used in the accounting and in the job-costing system.

Customer Purchase Order Number: These match the purchase orders received from customers.

Due Date and Scheduled Completion Date: The customer purchase order will indicate the date that an

order is due. The production supervisors will schedule the job so that it is completed prior to the due

date.

Customer Part Number and Part Description: MTI always uses the part numbers of its customers and the

customer description when describing parts being produced. These must match customer purchase

orders.

Quantity Ordered: The quantity ordered on the purchase order is entered into the job costing system.

Quantity on Hand: The quantity on hand is based upon the figures in the costing system. This is initiated

with the first operation. For example, if component parts are purchased and then additional work is done

on a component part, then the quantity on hand is based upon the parts purchased. If raw material is

purchased and cut on the premises, then the person who completes the first operation notes the quantity

cut, for subsequent entry by the production supervisor. Any damaged parts that cannot be passed on to

the next operation are reported to the quality control staff, who enter the part into the system as

damaged, thereby reducing the quantity on hand. All data entry is accomplished using the common job

costing password. Such entries will show on a damaged-parts report, which is discussed every

Wednesday at the supervisors' meeting.

Percentage Complete: Each operation on the job control sheet is assigned a percentage of the job. The

system tracks which operations have been completed and reports the percentage complete based upon

the last operation that has been fully completed for all the parts.

Quoted Costs (labor center, materials, total): These costs are all listed at a rate-per-individual-unit part.

Labor center rates are based upon standard rates that have been developed by George and Tiffany.

They include the labor rate of the employee multiplied by a factor, depending upon the machine used.

The factor incorporates both plant overhead charges plus machine charges. The lowest factor is 2.5, the

highest 23. Thus, an employee earning $10 per hour would result in a labor center cost at the lowest 5

factor of $25 per hour and $230 per hour at the highest factor. Material cost is based upon quotes from

suppliers, plus a Thomasup. Some customers have a fixed arrangement with the Thomasup as low as 5

percent, while others are Thomased up as much as 150 percent. During the last year, the company has

changed its costing and overhead allocation methods to absorption costing, based upon the accounting

firm's advice. MTI reduced its labor center factors by 10 percent and added a flat materials handling

charge ($50) and ordering charge ($25) to each of its quotes.

Actual Cost-to-Date: As work is completed and supplier invoices are received, these costs are entered

into the job costing system. Actual hours worked on an operation may be higher or lower than quoted.

The hours worked are automatically posted using the timekeeping system. The production supervisors

review each daily printout of hours worked, to ensure that employees have properly clocked out.

Production supervisors must approve any job cost system adjustments, which are entered by one of the

purchasing staff. As supplier invoices are received, they are recorded into the job-costing system by the

purchasing staff and then forwarded to Isabel for entry into the accounts payable system.

Sales Price: This is the price that the customer has agreed to pay, according to the purchase order.

Progress Billings: Normally, MTI does not request advance payments or progress billings. However, if a

customer is new or a part requires a substantial material purchase, an advance payment is requested to

cover the cost of the material. MTI then considers this material as already owned by the customer and

deducts this progress billing from the cost of its WIP.

Work-in-Progress Inventory Value: Isabel updated the spreadsheet template this year, applying a

formula to calculate inventory as follows: ([quantity on hand] x [percentage complete /100] x [actual cost

to date]) - progress billings. She reviews the inventory list prepared by purchasing for one of two

necessary adjustments. First, if a job has not been started it will show as zero percentage complete.

Sometimes, parts have been ordered on a subcontract basis and been placed into production. Then, the

WIP value must be increased from zero to the value of these parts. Second, if a job has an overrun and

the actual costs exceed the sales price, then the value of the inventory must be reduced so that it does

not exceed the sales price. Isabel makes these changes by manually scanning the inventory listing and

changing the inventory value for these items.

Required

The engagement partner has requested a meeting tomorrow to discuss audit plan for MTI She has

requested several documents for that meeting.

1. A preliminary audit plan assessing internal control risk and providing preliminary judgment for

detection risk.

2. A description of specific substantive procedures that could be conducted for the WIP inventory.

You are required to justify the audit plan by referring to theoretical grounds learnt from this unit.

Expected length: 2,500 words6

Demonstration of early stage learning about:

ï‚· Explain and analyse the nature, underlying concepts and principles of auditing

ï‚· Identify, apply and critically analyse the processes and auditing standards used to determine appropriate audit

procedures

ï‚· Apply an appropriate level of independent thinking and creativity, and critical analytical skills to be able to reach,

explain and implement decisions relating to the audit function and critically evaluate selected audit issues (including

auditing standards) that relate to different types of accounting transactions.

 

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