You are the audit manager of JDM, an accounting firm with offices in the Sydney metropolitan area. JDM is a middle tier auditing firm specialising in the audit of firms in the manufacturing and property development industries. During May 2020 you met with the audit senior of JDM, Tyrone Vickery, to discuss a number of findings and issues Tyrone has identified relating to several of JDM's clients.

Evaluation and testing of controls at Hales Ltd

Tyrone has provided a narrative of controls over inventory at Hales Ltd and would like you to provide some advice on making the preliminary control risk assessment. Hales is a distributor of haircare products, including shampoos, conditioners and styling products throughout Australia. Hales uses an on-line ordering system. Hales does not manufacture any goods in house, instead, an inventory of raw materials is kept, with manufacturing being outsourced to other companies. Hales has around 35 suppliers and 15 manufacturers. These companies have proven to be reliable in the past. Tyrone has made the following notes about three particular elements of the inventory system.

Purchase of raw materials

Purchase orders are generated by the computer when the inventory level of a particular material falls below 75% of what was used in the previous month. Purchase orders include the date, the suppliers name and the raw material required. Three copies of the purchase order are created. The first copy goes to the warehouse where it is used to enable the following up of overdue orders. The second copy is filed by the accounts clerk by order of date and the third copy goes to the supplier. Upon receipt of materials, barcodes on the delivery packages are scanned into the computer system. A two part receiving report is then generated. The first part is matched to the purchase order by the warehouse manager. The second is sent to the accounts clerk who files it. If the scanning of barcodes does not match data on the master file then the process is stopped.

Procedures for finished goods

When finished goods fall below 65% of the previous months sales, production orders are triggered. Production orders include a date, the manufacturers name, the raw materials needed and the volume of finished goods required. Two copies of the production order are generated. The first copy is sent to the raw materials warehouse where it is used as a picking slip by the warehouse staff. It is then included with materials which are sent to the manufacturer. The second copy is filed by the production manager by order of date. When finished goods arrive at Hales, barcodes on the delivery packets are scanned. A two part receiving report is generated, with the first copy being matched to the production order by the production manager and the second copy being filed by the accounts clerk. As with materials purchases, if the scanning of barcodes does not match the codes on the master file then the process is stopped.

Changes to the master file

The inventory master file contains information on the volumes of inventory on hand including barcode information and locations within the warehouse. The master file also has details of approved suppliers and manufacturers. Orders can only be made to suppliers and manufacturers on the master file. Changes to the master file can be made by the production manager. This applies to both raw materials and finished goods. To make changes the production manager completes an amendment form which is then kept as a record of any changes made.

Other information

There are separate warehouses, staff and procedures in place for the raw materials and finished goods. The selection of suppliers of raw materials and manufacturers is done automatically by the computer based on the latest price as per the last invoice and delivery time. Password access to the computer permits the following:

• Raw materials store staff have access to purchase order printing and goods received notes printing for materials.
• Finished goods store staff have access to goods received notes printing for finished goods.
• The production manager has access to production order printing and master file changes.
• The acounts clerk has access to master file changes.

Question

In relation to Hales Ltd:

• The weaknesses in the internal controls for each of the three aspects of the inventory system identified (raw materials, finished goods and changes to the master file).
• An assessment of the implications of each of the weaknesses you have identified.
• Three tests of control JDM's IT audit division could perform to assist Tyrone with verifying the effectiveness of the internal controls (assuming that JDM will be performing tests of control).
• Two Computer Assisted Audit Techniques (CAATs) that Tyrone could request the IT auditors run to assist him in testing the valuation of inventory.