Table of Contents

Summary of Contributions .................................................................................................................... 2

I. Understanding Internal Control and Test of Controls.................................................................. 3
Nature of the Production Cycle ........................................................................................................................... 3
Functions and Documentations in the Inventory Cycle ...................................................................................... 4
Documents used in Production Activities and their Audit Significance ............................................................. 5
Accounting Records Involved in Production Activities ...................................................................................... 5
Control Activities – Manufacturing Transactions ............................................................................................... 6
Test of Controls: Production Transactions .......................................................................................................... 7
Substantive Tests of Transactions: Production Transactions .............................................................................. 9
II. Audit of Conversion Activities ..................................................................................................... 10
Flow of Cost ...................................................................................................................................................... 10
Initial Recognition............................................................................................................................................. 10
Initial Measurement .......................................................................................................................................... 10
Excluded from Cost of Inventories ................................................................................................................... 11
Illustration ......................................................................................................................................................... 12
III. Audit of Work in Process and Finished Goods .......................................................................... 16
Pricing of Merchandise and Materials .............................................................................................................. 16
Test of Pricing of Work-in-process and Finished goods inventory................................................................... 17
Year-end Inventory/Purchase Cutoff ................................................................................................................ 18
Illustration ......................................................................................................................................................... 18
IV. Audit of Cost of Goods Sold ......................................................................................................... 21
Journal entries under the Perpetual Inventory System ...................................................................................... 21
Cost of Goods Sold Computation ..................................................................................................................... 22
Discounts ........................................................................................................................................................... 22
Inventory Shortage or Overage ......................................................................................................................... 22
Sample Exercises ................................................................................................................................... 23
Problem 1 (OCMP) Sales and purchases cutoff examination ........................................................................... 24
Problem 2 (CBR) Computation of Inventory Loss .......................................................................................... 268
Problem 3 (CPAR) Cut-Off Test ....................................................................................................................... 31
Problem 4 (RQ) Valuation of Inventories ......................................................................................................... 34
Sources ................................................................................................................................................... 38

1
 Summary of Contributions

Page
Contributor Task Number
1. Altar, Sheila Mae Audit of Conversion Activities 10
Sample Problem No. 2 28
Sample Problem No. 3 31

2. Lalican, Dominic Audit of Work in Process and Finished Goods 16

3. Sevilleno, Mikee Audit of Cost of Goods Sold 21

Sample Problem No. 1 24

Understanding Internal Control and Tests of Controls of

4. Terol, Rens Genesis Production Cycle 3
Sample Problem No. 4 34

Clerical Work(s)
1. Altar, Sheila Mae Compilation of Output
2. Lalican, Dominic Compilation of Output
3. Sevilleno, Mikee Finalizing of Output
4. Terol, Rens Genesis Printing of Output

2
 The Production Cycle

I. Understanding Internal Control and Test of Controls

Nature of the Production Cycle

The production cycle involves the conversion of raw materials into finished goods. It includes
production planning and control of the types and quantities of products to be manufactured, the
inventory levels (raw materials, finished goods) to be maintained, and the activities pertaining to the
manufacturing process.
The production cycle interfaces with:

1. The expenditure cycle in buying raw materials

2. The revenue cycle in selling finished goods

The Production Cycle

3
Procedures flow in inventory cycle

(a) Requisition and ordering of goods or raw materials

(b) Receipts of goods or raw materials
(c) Recording receipts and issues of goods or raw materials
(d) Issuing of raw materials/finished goods from inventory
(e) Storekeeping procedures of raw materials/finished goods

Functions and documentations in the inventory cycle

FLOW OF INVENTORY RELATED DOCUMENTATION

Process Purchase 1. Purchase Requisition

Order 2. Purchase Order

1. Receiving report
Receive Raw Material 2. Vendor Invoice

Put raw materials in 1.Raw Material Inventory

storage Perpetual Master file

1. Raw Material
Put Materials into Requisition Form
production 2.Cost Accounting Record

1. Finished Goods perpetual

Put Materials into inventory master file
production 2. Cost Accounting Record

1.Shipping Documents
Ship to customer 2.FG Perpetual Inventory
3.Cost Accounting Record

4
 Documents used in Production Activities and their Audit Significance
Documents Audit Significance
Production Order
A prenumbered form used to instruct production Records approval for production personnel to
personnel to produce a quantity of a particular produce products.
product.
Bill of Materials
A list of raw material components required to Indicates components to be used in producing a
produce a product. product.
Materials Requisition
A prenumbered form used to request and approve Records approval to issue materials to production.
the issuance of materials from inventory.
Materials Requisition Summary
A form that summarizes the materials requisitioned Records materials used in any given period and is
by job or by process, for a period such as day, a the basis for assigning costs to an account.
week, or a month.
Cost Accumulation Report
A form that accompanies goods as they are Records cost of raw materials placed in
transferred through production. As additional costs production.
are incurred, the costs are recorded on the report.
Labor Ticket
A prenumbered form on which time worked on a Record the specific activity of a laborer and is the
job is recorded basis for assigning costs to an account.
Labor Ticket Summary
A form that summarizes the daily labor tickets by Records labor used in production on any given
job or by process day.
Completed Production Report
A report that summarizes costs for cost control Provides a basis for inventory valuation.
purposes and for determining the amount of cost to
assign to goods remaining in the production
process.

Accounting Records Involved in Production Activities

General Journal

The journal in which entries not entered in a special journal, such as the transfer of raw
materials to work in process, are made.

5
Subsidiary Ledgers/ Share Cards

Subsidiary ledgers are maintained for raw materials, work in process, finished goods, and
manufacturing overhead. Each subsidiary ledger includes a group of detailed records. For
example, a subsidiary ledger for raw materials includes a record for each type of material.

Control Activities--Manufacturing Transactions

Here we have four categories of activities that compose the control activities component of
internal control:

1. Information processing controls that include proper authorization, documents and records,
and independent checks
2. Segregation of duties
3. Physical controls
4. Performance reviews

Functions and Related Controls

Below is a list of various manufacturing functions:
1. Planning and controlling production
2. Issuing raw materials
3. Processing goods in production
4. Transferring completed work to finished goods
5. Protecting inventories
6. Determining and recording manufacturing costs

Obtaining an Understanding and Assessing Control Risk

The auditor tries to identify potential misstatements, necessary controls and tests of controls
relevant to assessing CR for production cycle transactions. This means the auditor should
become familiar with the functions, potential misstatements, necessary controls, tests of
controls and audit objectives.

6
Tests of Controls: Production Transactions
Controls related to production transactions are important to auditors because they affect the
assertions embodied in the financial statements. Auditors perform one or more audit procedures
to test the assertions, including the following:

General Specific
1. Existence or Occurrence Recorded production transactions occurred.
2. Completeness All production transactions that occurred are
recorded.
3. Valuation or Allocation Production transactions are recorded for the proper
amounts.
4. Presentation and disclosure Production transactions are recorded to result in
presentation and disclosure in accordance with
PAS/PFRS

The following sections present the controls an entity should have to ensure the propriety of
each assertion, and the tests and auditor might perform to determine the effectiveness of the
controls on production transactions.

A. Existence or Occurrence: Recorded production transactions occurred

Controls Test of Controls

1. A material requisition should be 1. To test this control, the auditor should

prepared by operating personnel and observe separation of duties and
signed by a warehouse custodian when examine approval signatures.
goods are transferred to production.
Requiring materials to be completed
by two persons – one who releases
raw materials and another who accepts
responsibility for merchandise –
provides evidence that a transaction
exists. Properly completed materials
requisitions should be on file in
accounting, where an employee
accounts for their sequence.

2. Labor tickets bearing a signature 2. The auditor should examine labor

indicating that work was actually tickets.
performed should be the basis in
7
 recording labor
B. Completeness: All production transactions that occurred are recorded.

3. Production orders are prenumbered 3. To test this control, the auditor should
and accounted for to determine that all observe the procedure and account for
production is recorded. a numerical sequence of production
orders.

4. Materials requisitions are 4. The auditor should observe the

prenumbered and accounted for by an procedure and account for numerical
accounting clerk. sequence of materials requisitions.

5. Time charged on labor tickets is 5. The auditor could observe if a clerk

reconciled to employee time cards reconciles the time charged on
completed labor tickets to the total
hours for which production workers
are paid.

C. Valuation or Allocation: Production transactions are recorded for the proper amount.

6. Value for transactions are based on a 6. To test this control, the auditor should
bill of materials, approved tickets and trace the amounts to the bill of
rates for labor, and predetermined materials time cards and overhead
overhead rates. rates assigned costs may then be
traced to authorized price lists and
underlying schedules.

7. Overapplied or underapplied overhead 7. The auditor should observe the

is reviewed periodically, and rates are signature indicating that the overhead
adjusted as necessary. rate has been reviewed.

D. Presentation and Disclosure: Transactions are recorded to result in presentation and

disclosure in accordance with PAS/PFRS.

8. The chart of accounts should 8. The auditor should examine the chart
adequately describe the accounts to be of accounts and examine the signature
used; and account coding is of the employee performing the
independently checked. procedure.

8
Discussion of Audit Procedures
Auditors perform substantive tests of production transactions by examining documents such as
materials requisitions and labor tickets that support particular transactions; accounting for the
sequence of documents to ascertain that all transactions have been recorded; testing allocations
by tracing costs to bills of materials, labor tickets, authorized labor rates, and overhead rates;
verifying mathematical accuracy; and testing account coding.

Substantive Tests of Transactions: Production Transactions

Assertions Audit Objectives Audit Procedures

I. Existence or Occurrence A. To determine that recorded 1. For selected transactions,
production transactions examine signed materials
occurred. requisitions, approved labor
tickets, and allocation of
overhead.
II. Completeness B. To determine that all 2. a. Account for a sequence
production transactions that of production reports.
occurred are recorded. 2. b. Account for a sequence
of materials
requisitions.
2. c. Reconcile time cards
and
labor tickets.
III. Valuation or Allocation C. To determine that 3. Test cost records by tracing
production transactions are to underlying documents,
recorded for the proper such as bill of materials, labor
amounts. tickets, authorized labor rates,
and standard overhead rates.
Review variances/
IV. Presentation and D. To determine that 4. Check accuracy of account
Disclosure production transactions are coding by reference to chart
recorded to result in of accounts.
presentation and disclosure in
accordance with PAS/PFRS.

9
II. AUDIT OF CONVERSION ACTIVITIES

A. Flow of Cost
a. Manufacturing Company

Balance Sheet Income Statement

Costs Inventories Expenses

Material Purchases Raw Material

Direct Labor
Work in Process
Manufacturing
Overhead
Finished Goods Cost of Goods Sold

Operating
PROCUREMENT PRODUCTION STORAGE SELLING
Workflow
 Raw Materials
 Payroll
Accounting Cost Of Goods
 Factory Work In Process Finished Goods
Workflow Sold
Overhead
Control

B. Initial Recognition
a. The entity controls the asset as a result of past events; and
b. It is probable that future economic benefits will flow to the entity

C. Initial Measurement: Cost of Purchase, Cost of Conversion and Other Cost

a. Cost of Purchase:
a. Purchase Price
b. Import Duties and other nonrefundable taxes
c. Transport and Handling cost
d. Other Cost directly attributable to the acquisition of finished goods, materials and
services.

10
NOTE:

o Any trade discounts, rebates and other similar items are deducted in determining the cost of
purchases.
o When an inventory is bought on a deferred credit terms, the excess of the price paid over the
amount to be paid under normal credit terms is recognized as interest expense over the period
of financing.
o PAS 2 doesn’t permit exchange differences arising directly on the recent acquisition of
inventories invoiced in a foreign currency to be included in the cost of the inventories.

b. Cost of Conversion:
a. Cost of Direct Materials
b. Cost of Direct Labor
c. Variable Production Overhead (allocated to each unit of production based on the actual
use of production facilities)
d. Fixed Production Overhead (allocated to each unit of production based on the normal
capacity of the production facilities)
e. Joint Products (allocated between them on a rational and consistent basis)

c. Other Costs:
a. Borrowing Cost (PAS 23 requires capitalizing interest on inventories which take
substantial amount of time to create. However, an entity should not capitalize borrowing
costs for inventories that are manufactured in large quantities on a repetitive basis.
b. Storage Cost (can be included for products that require a maturation process or
substantial amount of time to create)
c. Non-production overheads (Cost of designing products for specific customer)

D. Excluded from Cost of Inventories

a. Abnormal amounts of wasted materials
b. Storage costs (unless essential to production process)
c. Administrative Overheads unrelated to production
d. Selling Costs
e. Foreign Exchange Differences
f. Interest cost

11
 Illustration:
Determine which of the following items are inventoriable.

The following items have been recorded as inventoriable items by X Company as of December 31, 2018:

1 Supplier's gross price for raw materials, P150,000

150,000.00
2 Materials purchased from another supplier on extended credit amounting to
P570,000. The price to be paid under normal credit term is P550,000. 570,000.00
3 Invoice price of raw materials purchased amounting to P180,000. Quantity discounts
of 10,5 are allowed by supplier. 180,000.00
4 Materials purchased from a supplier amounting to P616,000, inclusive of 12% VAT.
The company is VAT registered and can claim this as an input VAT. 616,000.00
5 Materials purchased from a supplier amounting to P515,000, inclusive of
nonrecoverable purchases tax of P15,000 515,000.00
6 Costs of transporting raw materials to the business premises, P5,000.
5,000.00
7 Import duties paid to authorities on import of raw materials to be used during the
manufacturing process, P25,000. 25,000.00
8 Labor costs directly incurred in the processing of raw materials, P420,000
420,000.00
9 Normal amount of wasted labor, P57,000.
57,000.00
10 Abnormal amounts of wasted labor, P69,000.
69,000.00
11 Variable costs (electricity) incurred in the processing of raw materials, P10,000.
10,000.00
12 Costs of transporting goods to customers on sale, P2,500.
2,500.00
13 Non-recoverable purchase taxes charged to customers on sale, P12,000.
12,000.00
14 Non-recoverable sales taxes, P14,440.
14,440.00
15 Commission payable to salesmen on the sale of the goods, P14,500.
14,500.00
16 Provisions for bad and doubtful debt in relation to trade receivables, P56,000
56,000.00
17 Costs of the accounts department, P140,000.
140,000.00
18 Head office costs relating to the overall management of the business, P234,000. 234,000.00
19 Borrowing cost incurred on inventories that takes substantial amount of time to
create, P122,000. 122,000.00
12
20 Storage cost for a maturing product, P56,000.
56,000.00
21 Selling costs, P45,600.
45,600.00
22 Non-production overheads cost of designing products for specific customers,
P10,000. 10,000.00
23 Storage cost of finished goods, P23,000.
23,000.00
24 Fixed administration costs/ overheads (rent for office), P450,000.
450,000.00
25 Insurance on in transit inventories, P17,800.
17,800.00
3, 814, 840.00

Required:
1. What is the unadjusted balance of inventory?
2. How much is the net adjustments?
3. How much is the correct inventory balance?

13
14
Solution:
X Company
Proposed Audit Adjustments
December 31, 200X

DEBIT CREDIT

1) Interest Expense 20,000

Inventory 20,000
To take up difference between the price under normal credit term and
extended credit term as interest expense over the credit term.
Computation as follows:
570,000 - 550,000 = 20,000

2) Input Vat 66,000

Inventory 66,000
To take up input vat.
Computation as follows:
616,000 / 1.12 = 550,000
616,000 - 550,000 = 66,000

3) Other Expense 69,000

Selling and Administrative Expense 2,500
Tax Expense 12,000
Tax Expense 14,440
Commission Expense 14,500
Allowance for Doubtful Accounts 56,000
Selling and Administrative Expense 869,600
Storage Cost 23,000
Inventory 1,061,040
To take up abnormal waste of labor.
To take up cost of transporting goods to customer.
To take up nonrecoverable taxes on customers.
To take up selling taxes.
To take up commission expense
To reclassify account.
To take up selling and admin expense.
To take up storage cost.

15
III. Audit of Work in Process and Finished Goods

Pricing of Merchandise and Materials

Test of pricing of merchandise and purchased parts and materials involves the following steps:

1. Prepare a list of items for testing. This will include a description of the inventory items
selected, the stock number, the tag or sheet number and the inventory quantity, unit price and
extended amount. The working papers should provide sufficient space to accommodate several
invoices making up the total of the inventory quantity.
2. After selection of items for testing, the company personnel could be asked to locate supporting
purchase invoices.
3. To determine market value review the price paid for recent purchases. Other sources include
suppliers’ price list and published quotations included in financial and trade publications.
Figure 11.2 shows an example of raw materials price test.

Raw Materials Price Test

X Company
Raw Materials Price Test
December 31, 2018

Per Inventory Records Per Vendor Invoice Inventory

Over
[Under]
Part Unit Unit Invoice
Description Quantity Quantity Date Vendor Price
Number Price Cost
Nov. 4, Luzon
1404 4" steel price 936 2.33 2.33 1,000 -
2018 Steel
Dec. 1, Gray
1406 Red paint 206 10.14 10.14 300 -
2018 Co.
Dec. 3, Blue
1407 Gaskets 10,500 0.1 0.1 5,000 -
2018 Gasket
Dec. 15, Blue
0.1 6,000
2018 Gasket

Agrees with price used in

inventory listing.

Prepared by: Received by:

Initial Date Initial Date

16
Test of Pricing of Work-in-process and Finished goods inventory
1. The auditor should determine whether the costs included in the final inventory lists are in
agreement with those in the supporting cost records as compiled in accordance with the
company’s cost system. The following procedures may be followed.

a. Materials: Test prices of materials by examining supporting invoices or by referring to the

purchased parts and materials price test.
b. Labor: Trace charges to both payroll record and time tickets. Both labor rates and hours
worked should be tested.
c. Overhead:
1. Determine client procedures in establishing rates and test computation of these rates.
2. Test application of overhead.
3. Determine whether a proper disposition was made of any over-or-under applies
manufacturing overhead for the period.

2. Market price for items in work-in-process or finished goods should be tested.

a. For Work in Process, the market price or net realizable value may be determined as
follows:
Selling price when
completed P xx
Less: Estimated cost to complete and
sell xx
Net Realizable Value xx

b. For Finished Goods:

Selling Price P xx
Less: Estimated cost to sell xx
Net realizable value xx

Selling price of the items may be obtained from the company’s price list, from
contracts, from catalogs or from recent sales invoices. Estimated cost to sell may be
determined by dividing selling expenses by sales.

As previously mentioned, the auditor should determine whether provision for losses for
damaged, slow-moving and obsolete inventories has been made.

17
Year-end Inventory/Purchase Cutoff

The auditor performs cutoff procedures on the cut-off information obtained at the inventory count to:
1. Check that the inventory transactions are recorded in the general ledger or perpetual records
in the correct period; and
2. To determine that inventories are not double-counted or missed due to movements within
the plant/warehouse or movement between entity or other parties.
Common purchase cutoff concern is:

1. Shipments received but purchase invoice received in the next period and
2. Purchase invoice received but merchandise received in the subsequent period.
The cutoff procedures may consist of:

1. Examining a sample of receiving reports for inventory receipts immediately before and
after the inventory count to check whether it is recorded in the correct accounting period;
and
2. Examining a sample of shipping documents for shipping documents for shipments
immediately prior to and subsequent to the count to check whether it is recorded in the
correct accounting period.
Note that this procedure may be performed in conjunction with the sales cut-off.

Illustration: Determination of Adjusted balances

The Pasay Company is a wholesale distributor of automobile replacement parts. Initial amounts
taken from Pasay’s accounting records are as follows:

Inventory at December 31, 2005 (based on

physical count on December 31, 2005) P400,000

Vendor Terms Amount

Anito Company Net 30 P 9,000
Victoria Company Net 30 36,500
Winston Company Net 30 48,000
Sogo Company Net 30 74,000
Rotonda Company Net 30 -
Accounts Payable at December 31, 2005 P167,500

Sales in 2005 P5,000,000

18
 Additional information follows:

1. Parts held on consignment from Anito to Pasay amounting to P9,000, were included in the physical
count of goods in Pasay’s warehouse on December 31, 2005, and in accounts payable at December
31, 2005.

2. P15,000 worth of parts which were purchased from Sogo and paid for in December 2005 were sold
in the last week of 2005 and appropriately recorded as sales of P21,000. The parts were included in
the physical count on December 31, 2005, because the parts were on the loading dock waiting to be
picked up by the customer.

3. Parts in transit on December 31, 2005, to customers, shipped FOB destination, December 28, 2005,
amounted to P11,000. The customers received the parts on January 6, 2006. Sales of P15,000 to
the customers for the parts were recorded by Pasay on January 2, 2006.

4. Retailers were holding P50,000, at cost, of goods on consignment from Pasay, at their stores on
December 31, 2005.

5. Goods were in transit from Rotonda to Pasay on December 31, 2005. The cost was P8,000 and
these were shipped FOB shipping point on December 29, 2005.

REQUIRED:

Determine the adjusted balances of Inventory and Accounts Payable as of December 31, 2005 and
Sales for the year 2005.

19
SOLUTION:
Pasay Company
Adjustments to Initial Amounts
December 31, 2005

Inventory Accts. Payable Sales

Unadjusted balances 400,000 167,500 5,000,000
Add (deduct) adjustments:

1. Goods held on consignment, which are

included in the physical count of goods in
(9,000) (9,000) -
Pasay’s warehouse and in accounts
payable.

2. Goods purchased from Sogo and sold in

the last week of year 2005 and
appropriately recorded as sales, it is also (15,000) - -
included in the physical count on
December 31, 2018.

3. Goods sold on December 28, 2005, FOB

destination, and in transit on December 11,000 - -
31, 2005.

4. Goods out on consignment to retailers. 50,000 - -

5. Goods purchased on December 29, 2005, 8,000

FOB shipping point, and in transit on 8,000
December 31, 2005.
Net Adjustments 45,000 (1,000) -
Adjusted balances 445,000 166,500 5,000,000

20
IV. Audit of Cost of Goods Sold

Substantial evidence on the propriety, accuracy and consistency of costs assigned to cost of goods sold
is obtained from tests of sales, purchases and manufacturing transactions and by substantive tests of
inventory balances.

Substantive tests of cost of goods sold may be limited to:

1) scanning entries for possible errors, and
2) performing analytical review procedures

The following financial relationships are frequently drawn when performing analytical review
procedures to inventories:
Financial Relationship Formula

Gross profit rate Gross profit ÷ net sales

Inventory turnover Cost of goods sold ÷ average inventory
Number of days sales in inventory 365 days ÷ Inventory turnover
Inventory × total current assets Inventory ÷ Total current assets

The above relationship when compared with prior year budget expectations and industry statistics will
enable the auditor to obtain additional corroborating evidence on the reasonableness and completeness
of inventory balances.

Journal entries under the Perpetual Inventory System

1. To record sale of goods

Accounts receivable or cash xx

Sales xx

Cost of goods sold xx

Inventory xx

2. To record sales returns

Sales return xx
Accounts receivable or cash xx

Inventory xx
Cost of goods sold xx

21
Cost of Goods Sold Computation

Beginning inventory
+ Net purchases
+ Freight in charges
– Ending inventory
Cost of goods sold

Discounts

Trade discounts are deducted from the list/catalog price to arrive at the invoice price which is
the amount actually charged to the buyer. These discounts are not recorded.

Cash discounts are deductions from the invoice price when payment is made within the
discount period. They are recorded as purchase discount by the buyer and sales discount by
the seller. These discounts are deducted from purchases/sales to arrive at net purchases/sales

Inventory Shortage or Overage

If a physical count conducted at the end of the accounting period indicates a different amount,
an adjustment is necessary to recognize any inventory shortage or overage. Inventory shortage
is usually closed to cost of goods sold because this is often a result of normal shrinkage and
breakage in inventory. However, abnormal and material shortage shall be separately classified
and presented as other expense.

22
Audit of Production Cycle
Sample Exercises

23
Problem No. 1 (OCMP) Sales and purchases cutoff examination
You were engaged by Swift Corp. for the audit of the company’s financial statements for the year
ended December 31, 2017. The company is engaged in the wholesale business and makes all sales at
25% over cost.

The following were gathered from the client’s accounting records:

SALES PURCHASES
Date Reference Amount Date Reference Amount
Balance forwarded P7,800,000 Balance forwarded P4,200,000
12/27 SI No. 865 60,000 12/28 RR #2059 36,000
12/28 SI No. 866 225,000 12/30 RR #2061 105,000
12/28 SI No. 867 15,000 12/31 RR #2062 63,000
12/31 SI No. 869 69,000 12/31 RR #2063 96,000
12/31 SI No. 870 102,000 12/31 Closing entry (4,500,000)
12/31 SI No. 871 24,000 P -
12/31 Closing entry (8,295,000)
P -

Note: SI = Sales Invoice RR = Receiving Report

Accounts receivable P750,000

Inventory 900,000
Accounts Payable 600,000

You observed the physical inventory of goods in the warehouse on December 31 and were satisfied
that it was properly taken.

When performing sales and purchases cutoff tests, you found that at December 31, the last Receiving
Report which had been used was No. 2063 and that no shipments had been made on any Sales Invoices
whose number is larger than No. 868. You also obtained the following additional information:

a) Included in the warehouse physical inventory at December 31 were goods which had been
purchased and received on Receiving Report No. 2060 but for which the invoice was not received until
the following year. Cost was P27,000.

b) On the evening of December 31, there were two trucks in the company siding:

 Truck No. XXX 888 was unloaded on January 2 of the following year and received on
Receiving Report No. 2063. The freight was paid by the vendor.
 Truck No. MGM 357 was loaded and sealed on December 31 but left the company premises on
January 2. This order was sold for P150,000 per Sales Invoice No. 868.

24
c) Temporarily stranded at December 31 at the railroad siding were two delivery trucks enroute to
MSY Trading Corporation. MSY received the goods, which were sold on Sales Invoice No. 866 terms
FOB Destination, the next day.

d) Enroute to the client on December 31 was a truckload of goods, which was received on Receiving
Report No. 2064. The goods were shipped FOB Destination and freight of P2,000 was paid by the
client. However, the freight was deducted from the purchase price of P800,000.

Questions:

1. Sales for the year ended December 31, 2017

a. P8,100,000 c. P7,875,000
b. P7,725,000 d. P8,025,000

2. Purchases for the year ended December 31, 2017

a. P4,500,000 c. P5,631,000
b. P5,727,000 d. P4,527,000

3. Accounts receivable as of December 31, 2017

a. P330,000 c. P525,000
b. P555,000 d. P180,000

4. Inventory as of December 31, 2017

a. P1,452,000 c. P1,200,000
b. P1,221,000 d. P1,296,000

5. Accounts payable as of December 31, 2017

a. P600,000 c. P531,000
b. P627,000 d. P1,827,000

25
Answers: 1. C 2. D 3. A 4. D 5. B
SOLUTION:

Swift Corp.
Adjustments to Initial Amounts
As of December 31, 2017

Accounts Accounts
Sales Purchases Receivable Inventory Payable
Balance per client P8,295,000 P4,500,000 P750,000 P900,000 P600,000
Add(deduct) adjustments:
1. Unshipped goods (195,000) (195,000)

2. Unrecorded purchases 27,000 27,000

3. Goods under RR no.

2063 96,000

4. Unshipped goods
under SI no. 868 120,000

5. SI no. 866 reversing

entry (225,000) (225,000)

6. Goods under SI no.

866 180,000
Net adjustments (P420,000) P27,000 (P420,000) P396,000 P27,000
Balance per audit P7,875,000 P4,527,000 P330,000 P1,296,000 P627,000

26
 Swift Corp.
Proposed Audit Adjustments
December 31, 2017

1) Sales P195,000
Accounts Receivable P195,000
To adjust unshipped goods recorded as
sales computed as follows:
SI No. 869 P69,000
SI No. 870 P102,000
SI No. 871 P24,000
Total P195,000

2) Purchases P27,000
Accounts Payable P27,000
To take up unrecorded purchases
(RR No. 2060)

3) Inventory P96,000
Profit or loss summary P96,000
To take up goods under RR No. 2063

4) Inventory P120,000
Profit or loss summary P120,000
To take up unshipped goods under SI
No. 868

5) Sales P225,000
Accounts Receivable P225,000
To reverse entry made to record SI No.
866

6) Inventory P180,000
Profit or loss summary P180,000
To take up goods under SI No. 866

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Problem No. 2 (CBR) Computation of Inventory Loss
On February 16, 2018, a flood destroyed the goods in process inventory and half the raw materials
inventory of the LRT Company. There was no damage to the finished goods inventory. A physical
inventory taken after the flood indicated the following values:
Raw materials ₱ 35,000
Finished goods 75,000

A review of the accounting records indicated the following:

Inventories, December 31, 2017:
Raw Materials ₱ 65,000
Goods in process 80,000
Finished goods 72,000
Sales (to February 16) 40,000
Raw Materials Purchases 20,000
Direct Labor Cost 30,000
Manufacturing Overhead Cost 15,000
Gross Profit Rate (On Sales) 40%

Required: Compute the value of the inventory destroyed by the flood.

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SOLUTION:

LRT COMPANY
Computation of Value of Inventory Lost
February 16, 2018

Raw materials, December 31, 2017 ₱ 65,000

Raw materials purchases 20,000
Raw materials available for production ₱ 85,000
Raw materials before flood (₱ 35,000 ÷ ½) 70,000
Raw materials used ₱ 15,000
Direct labor 30,000
Manufacturing overhead cost 15,000
Goods in process, December 31, 2017 80,000
Cost of production ₱ 140,000
Less: Cost of goods completed
Sales ₱ 40,000
Less: Gross profit (40%) 16,000
Cost of goods sold ₱ 24,000
Finished goods, February 16 75,000
Cost of goods available for sale ₱ 99,000
Less: Finished goods, December 31, 2017 72,000 27,000
Goods in process inventory lost in flood ₱ 113,000
Raw materials lost 35,000
Total value of inventory destroyed by flood ₱ 148,000

29
Another way of presenting the solution:

LRT COMPANY
Computation of Value of Inventory Lost
February 16, 2018

TOTAL RAW MATERIAL WORK IN PROCESS FINISHED GOODS

Beginning Balance, Jan. 1, 2018 217,000.00 65,000.00 80,000.00 72,000.00
Raw Material Purchased 20,000.00 20,000.00
Raw Material Used - (15,000.00) 15,000.00
Direct Labor 30,000.00 30,000.00
Manufacturing Overhead Cost 15,000.00 15,000.00
Cost of Goods Completed - (27,000.00) 27,000.00
Cost of Goods Sold (24,000.00) (24,000.00)
Total Amount of Inventory as of Feb.16, 2018 258,000.00 70,000.00 113,000.00 75,000.00
Physical Count 110,000.00 35,000.00 75,000.00
Loss 148,000.00 35,000.00 113,000.00 -

30
Problem No. 3 (CPAR) Cut-Off Test
CPA Company is preparing its 2017 financial statements. Prior to any adjustments, inventory is
valued at P1,605,000. During your audit, you found the following information relating to certain
inventory transactions from your cutoff test.

a. Goods valued at P110,000 are on consignment with a customer. These goods were not included
in the ending inventory figure.

b. Goods costing P87,000 were received from a vendor on January 5, 2018. The related invoice
was received and recorded on January 12, 2018. The goods were shipped on December 31, 2017,
terms FOB shipping point.

c. Goods costing P85,000, sold for P102,000, were shipped on December 31, 2017, and were
delivered to the customer on January 2, 2018. The terms of the invoice were FOB shipping
point. The goods were included in the ending inventory for 2017 and the sale was recorded in
2018.

d. A P35,000 shipment of goods to a customer on December 31, terms FOB destination was not
included in the year-end inventory. The goods cost P26,000 and were delivered to the customer
on January 8, 2018. The sale was properly recorded in 2018.

e. The invoice for goods costing P35,000 was received and recorded as a purchase on December 31,
2017. The related goods, shipped FOB destination were received on January 2, 2018, and thus
were not included in the physical inventory.

f. Goods valued at P154,000 are on consignment from a vendor. These goods are not included in
the physical inventory.

g. A P60,000 shipment of goods to a customer on December 30, 2017, terms FOB destination, was
recorded as a sale in 2018. The goods, costing P37,000 and delivered to the customer on January
6, 2018, were not included in the 2017 ending inventory.

REQUIRED:

Compute the proper inventory amount to be reported on CPA’s balance sheet for the year ended
December 31, 2017.

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SOLUTION:

CPA Company
Inventory Schedule
December 31, 2017

Balance per client ₱ 1,605,000

Add (Deduct) audit adjustments
1. Goods on Consignment with a customer 110,000
2. Goods purchased FOB shipping point 87,000
3. Goods sold FOB shipping point (85,000)
4. Goods sold FOB destination 61,000
Net Adjustments ₱ 173,000
Balance per audit ₱ 420,612

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Adjusting Entries:

CPA Company
Proposed Audit Adjustments
December 31, 2017
DEBIT CREDIT
1. Inventory 110,000
Income Summary 110,000
To take up goods consigned to a customer.

2. Inventory 87,000
Accounts Payable 87,000
To take up goods purchased FOB shipping point.

3. Accounts Receivable 85,000

Inventory 85,000
To recognize goods shipped to customers with
Terms FOB shipping point.

4. Inventory 61,000
Accounts Receivable 61,000
To take up goods shipped to customer with terms
FOB Destination.

33
Problem No. 4 (RQ) Valuation of Inventories
MALOX Specialty Company manufactures three models of gear shift components for bicycles that are
sold to bicycle manufacturers, retailers, and catalog outlets. Since its inception, Malox has used normal
absorption costing and has assumed a first-in, first-out cost flow in its perpetual inventory system. The
balances of the inventory accounts at the end of Malox's fiscal year, November 30, 2018, are shown
below. The inventories are stated at cost before any year-end adjustments.

Finished Goods P1,941,000

Work in process 337,500
Raw Materials 792,000
Factory Supplies 207,000

The following information relates to Malox's inventory and operations.

1. The finished goods inventory consists of the items analyzed below.

Cost NRV
Down tube shifter
Standard model P202,500 P201,000
Click adjustment model 283,500 267,000
Deluxe model 324,000 330,000
Total down tube shifters 810,000 798,000

Bar end shifter

Standard model 249,000 270,150
Click adjustments model 297,000 292,650
Total bar end shifters 546,000 562,800

Head tube shifter

Standard model 234,000 232,950
Click adjustments model 351,000 357,900
Total head tube shifters 585,000 590,850
Total finished goods P1,941,000 P1,951,650

2. One-half of the head tube shifter finished goods inventory is held by catalog outlets on
consignment.
3. Three-quarters of the bar end shifter finished goods inventory had been pledged as collateral for
a bank loan.

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 4. One-half of the raw materials balance represents derailleurs acquired at a contracted price 20
percent above the net realizable value. The net realizable value of the rest of the raw materials
is P382,200.
5. The total net realizable value of the work in process inventory is P326,100.
6. Included in the cost of factory supplies are obsolete items with historical cost of P12,600. The
net realizable value of the remaining factory supplies is P197,700.
7. Malox applies the lower of cost or net realizable value method to each of the three types of
shifters in finished goods inventory. For each of the other three inventory accounts, Malox
applies the lower of cost or net realizable value method to the total of each inventory account.
8. Consider all amounts presented above to be material in relation to Malox's financial statements
taken as a whole.

Based on the preceding information, determine the proper values of the following on November 30,
2018.

1. Finished Goods inventory

A. P1,941,000
B. P1,929,000
C. P1,951,650
D. P1,963,650

2. Work in process inventory

A. P324,900
B. P337,500
C. P326,100
D. P313,500

3. Raw Materials inventory

A. P792,000
B. P682,200
C. P726,000
D. P712,200

4. Factory supplies
A. P194,400
B. P197,700
C. P185,100
D. P207,000

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 SOLUTION:

Malox Specialty Company

Inventory Valuation
November 30, 2018
Finished Work in Process Raw Materials Factory
Goods Supplies
Unadjusted Balances ₱ ₱ 337,500.00 ₱ 792,000.00 ₱ 207,000.00
1,941,000.00
Add (Deduct) Audit Adjustments:
# 1 Down Tube Shifter
Recorded Amount ₱ 810,000.00
Lower of Cost or Net Realizable Value 798,000.00
Overstatement ₱ 12,000.00 (12,000.00)

# 2 Work in Process
Recorded Amount ₱ 337,500.00
Lower of Cost or Net Realizable Value 326,100.00
Overstatement ₱ 11,400.00 (11,400.00)

# 3 Derailleurs
Recorded Amount ₱ 792,000.00 / 2 ₱ 396,000.00
₱ 396,000.00 /
Lower of Cost or Net Realizable Value 330,000.00
1.2
Overstatement ₱ 66,000.00 (66,000.00)

# 4 Remaining Items of Raw Materials

Recorded Amount ₱ 792,000.00 / 2 ₱ 396,000.00
Lower of Cost or Net Realizable Value 382,200.00
Overstatement ₱ 13,800.00 (13,800.00)

# 5 Obsolete Items included in Factory

(12,600.00)
Supplies
Adjusted Balances ₱ 1,929,000.00 ₱ 326,100.00 ₱ 712,200.00 ₱ 194,400.00
36
 Malox Specialty Company
Proposed Audit Adjustments
December 31, 2018
Debit Credit
#1 - #5 Loss on inventory writedown 115,800
Allowance for inventory writedown 115,800
To adjust inventory to lower of cost and
net realizable value
Raw Materials Inventory 79,800
Work in Process Inventory 11,400
Finished Goods Inventory 12,000
Factory Supplies 12,600
115,800

37
Sources:
1. Asuncion, D.J., Ngina, M.A., Escala R.F. (2018, pp. 350-355)
2. Cabrera M.E.B., Cabrera, G.A.B. (2017)
3. Ocampo, R.B.(2010)
4. Johnstone, Gramling, Rittenberg, (9th edition)
5. Gelinas U., Sutton S., Hunton J. (7th edition)

38