CASE STUDY: ALCO PRODUCTS, INC.

Background

The auditing department of Alco Products was contacted by the manager of accounting for the metal stamping division who informed it that one of their plants had been experiencing inventory shortages. The manager stated that he believed the finished goods book inventory had been overstated and that this condition had been discovered as a result of an analysis of material consumption that indicated that the finished goods inventory level should be higher than it was.

The manager informed the auditors that, at month's end, production employees from each production stage performed the inventory counts for the raw materials and work in process inventories and reported them to the accounting department. The finished goods inventory was controlled through perpetual inventory records that were reconciled to the general ledger at the end of each quarter. Material consumption was then calculated based on beginning inventory plus purchases or transfers-in less ending inventory and standard scrap loss currently at 10 percent (based on scrap sales remittances from the scrap dealer) of the material transferred to the finished goods inventory. Based on the material input and consumption, it was determined that there should have been more finished goods in the inventory. The auditors were asked to visit the location to review the inventory and proof of billing procedures and validate the reported shortages and determine the causes. (See exhibit for activity recap.)

Audit Plan

The auditors arrived at the location and discussed their preliminary audit plan with plant management. It was agreed that, since the raw material and work in process inventories were taken at different times, the auditors would observe the physical inventory count procedures for both and would perform these counts of the finished goods later in the day. Also, the auditors would review the prior months' inventories. The auditors were advised that they would meet with the production people taking the inventory. It was agreed that a review would be made of the production and the scrap reporting systems subsequent to completion of the inventory work. Raw material receiving procedures would be examined as well as procedures for control of finished goods shipments.

Plant Procedures

Raw Materials

The auditors learned that the aluminum was received in two pound sheets, 100 sheets to a bundle, and four bundles to a pallet and was stored in the manufacturing area to facilitate access during production. When received, a material received record was prepared, pre-numbered and used for receipt of items entering the plant. The record was sent to the accounting department where it was compared to a copy of the purchase order and held, pending receipt of the invoice. As the material was introduced into the manufacturing process, a requisition was prepared and forwarded to the accounting department.

Work in Process

After the material was requisitioned from the raw material inventory, it was fed into machines where 24 finished goods pieces were stamped out of each sheet. The skeleton (raw material sheet remainder) was then placed in a scrap bin; and the finished goods pieces were packed 200 pieces to a package, a maximum of 50 packages to a pallet. A two part load ticket was then prepared, and a copy was sent to the accounting department for updating the perpetual inventory records. The other accompanied the load to the finished goods warehouse.

Scrap Procedures

The skeletons were collected in a scrap bin, and the full bins were emptied into a trailer located at the scrap dock. At his convenience, the scrap dealer came to the plant, dropped off an empty trailer, and picked up the full one. When the scrap dealer left the plant, the gate guard recorded the scrap dealer's bill of lading number. If the guard was making his hourly security inspection, the scrap dealer was responsible for recording this number. If a filled trailer was not picked up, the scrap dealer was contacted and requested to pick it up.

The scrap dealer took the load to a local business that had a truck scale, weighed the truck, and recorded the weights. The scrap dealer sent a copy of the weight ticket to the plant along with the check and the remittance advice for the value of the scrap. These data were used to develop the scrap loss. The accounting department received the check, compared the weight tickets to the remittance advice, and verified the value per pound to the contract.

Finished Goods

When the material was received from the working process area, warehouse employees verified the load ticket count; and the pallets were stored. At the time of shipment, a pre-numbered bill of lading was prepared with copies for the accounting department, customer, shipping department files, and a gate guard who verified the load. The accounting department verified the shipping information on the bill of lading to the original shipping authorization and invoice to the customer, accounted for the bills of lading through a sequential numerical check off list, and posted the perpetual inventory records from the copy of the bill of lading forwarded from the gate guard.

Audit Procedures

The auditors observed the current month's physical inventory of raw material and work in process and verified that the counts and summarizations were accurate. They made test counts of the finished goods and agreed on the counts in the perpetual records. They reviewed the prior month's physical inventories of raw materials and work in process and agreed on the tabulations in the general ledger. They tested the preceding month's receipts and issuances of raw material, verified the accuracy of material reported as used in work in process, and verified the reported work-in process production by reference to load ticket recaps and finished goods storage reports. Reported scrap shipments were reviewed by comparison of the gate log to remittances received from the scrap dealer, and finished goods shipments were verified by examination of the bill of lading check-off list for completeness and tracing to the related invoices.

Required

1. Evaluate the plant systems and procedures and identify the key weaknesses.
2. What is the probable source of the shortage? Please provide support for your conclusion (i.e., you should try to quantify).
3. Recommend changes to the plant procedures to facilitate control.

Exhibit
Inventory and Activity Recap

Subject                        Material Requisitioned/Received
Raw Materials                           45,000 Sheets
Work in Process                       35,000 Sheets
Finished Goods                        672,000 Pieces

Subject                        Production and Shipping
Raw Materials                         35,000 Sheets
Work in Process                     672,000 Pieces
Finished Goods                      816,000 Pieces