K&k Case Study

1.

The primary risk in the inventory segment is the inventory of metal frames that didn’t sell as well as K&K anticipated. K&K’s inventory may include a number of frames that could potentially never sell and are valued higher than their realizable market values. A related risk is that the machines used to make the metal frames are not valued properly. Another possible risk is that K&K may be producing more plastic frames than the company is currently capable of selling. K&K could be left with large amounts of raw materials and finished goods currently on-hand, raising both managerial and auditing concerns associated with excess inventory. During the year, K&K stored their finished goods inventory in more than one location, which increases the risk that the company’s records of the inventory count could be misstated.

2.

Upon reviewing K&K’s breakdown of overhead costs, $275 worth of Sales Bonuses has been included as part of overhead. These bonuses should not be included as a part of the overhead computation, as they qualify as period costs rather than product costs. This misclassification indicates a risk that other classification errors may exist in overhead or other areas of the audit and may point to a weakness in internal controls. Due to the fact that K&K has historically produced a homogeneous, labor-intensive product line, it was probably appropriate for them to apply overhead costs based on a direct labor cost driver. However, because the new plastic frame production line is machine intensive, applying overhead based on direct labor hours from a common overhead pool is not appropriate. A new costing system involving separate cost pools and cost drivers should be used to apply the overhead for the two product lines. This problem in overhead allocation may be a concern from an auditing perspective, because Cost of Goods Sold may not be correctly stated. Too much cost is being allocated to the custom frame line and too little is being allocated to the plastic frame line. Since inventory of plastic frames is relatively large, ending inventory for plastic frames is likely to be understated and Cost of Goods Sold is likely to be overstated.

3.

K&K’s current overhead allocation system uses a single cost pool and direct labor hours to allocate overhead. This is not appropriate because