AC 425 memo

K&K, Inc. Case Study
Chenrong Li
AC 425
Fall 2018
I acknowledge the Academic Honesty standards of the program, school,
and the course. I understand that I may not share or discuss the case in
striving to achieve those standards.
To: Audit Manager and File, K&K, Inc.
From: Chenrong Li
Date: December 1, 2018
Subject: Analysis of K&K auditing risks and issues and recommendations to the problems
Audit Risks in the Production and Inventory Area
A thorough review of the current situation of K&K, Inc. indicates that the company is
experiencing a couple of issues in its production and inventory area. First of all, due to the
varying quality, the sales of metal frames were not as good as K&K expected, which left K&K’s
warehouse with a relatively large remaining inventory of unsold metal frames. Because the
supply of metal frames exceeds the demand, K&K is suffering a loss from the price difference
between the cost of the frames and the market value. Moreover, since K&K stopped producing
the metal frames, two used machines remained idle through the second half of last year, which
led to the wasting of resources.
Secondly, even though the management expected that the mass-produced plastic frames would
generate a reasonable profit through higher percentage profit margins, there was no conclusive
evidence which supported the anticipation that the produced plastic frames would be all sold.
Instead, the sales of the plastic frames turned out to be not good again, and K&K was left with a
large number of finished goods and raw materials. Therefore, the management should always
pay additional attention to the potential issue of remaining stocks before mass production.
Thirdly, the production cycle related to the machinery and manufacturing system should arise
auditors’ attention. Two used machines for metal frames production remained idle. The RX-1000
system was costly to maintain and periodically sat idle despite its effectivity in mass-producing
defect-free frames. What should also be noted is that K&K production level is well below the
system’s capacity, which means that the system is not achieving its maximum efficiency. As a
result, the auditors should carefully verify the original values of the machines and their useful
lives. Additionally, the auditors should also choose the most appropriate depreciation methods to
calculate the depreciation expense for each year and give constructional advice on whether it is a
good idea to establish a new line which is highly machine-driven.
Fourthly, since K&K rented an additional storage facility to store the finished inventory
produced by the new machinery, the probability of miscounting and misstatement tends to
increase. Therefore, the auditors should pay extra attention to the audits of inventory and may
even physically examine the inventory to make sure the stated quantity on hand is accurate.
Fifthly, the auditors should check the accuracy of the costing of finished goods inventory. Even
though other than a specially trained employee who operates and monitors the system, the only
manual labor required are those who place the promotional photo and package the frames, the
correctness of the recorded direct labor hours should be still carefully verified since direct labor
hours are the driver for determining the overhead costs. Any misstatement in direct labor hours
can lead to significant loss. Moreover, another potential risk lies in the incorrectness of pricing
for the raw materials and the probability that K&K does not use the same costing method
consistently, which may lead to the misstatement of the value of the finished goods inventory.
Accounting and Auditing Issues in Product Costs
K&K currently has two different production lines. One is the old labor-intensive production line,
and the other is the new machine-intensive line for plastic frame production. The cost drivers for
the two lines should be different. While the old line should apply overhead costs based on direct
labor hours, a new costing system that is separated from the former one should be introduced and
applied to the new product line. Using the same costing system for different lines is
Moreover, according to K&K’s Breakdown of Overhead Costs, $225 of Sales Bonuses was
included in overhead costs, which was a misclassification since it should be part of period costs.
This indicates the potential issues with K&K’s internal controls.
Additionally, what should be noted is the potential misstatements in Cost of Goods Sold.
According to Exhibit 2, there is a huge disparity between the cost of the custom frame line and
that of plastic frame line. While the custom frames are sold at the moment when they are
finished, most of the plastic frames are left in the K&K’s storage without realizing their values.
As a result, the Ending Inventory for plastic frames is more likely to be understated while the
Cost of Goods Sold be overstated.
Comparison of the Two Lines
There are several issues with K&K’s current overhead allocation system. First of all, as
discussed in Accounting and Auditing Issues in Product Costs section, it is inappropriate to use
the same costing system for both manual and automated production lines. The manual line is
labor-intensive with few overhead costs, while the automated production line is less laborintensive but has much more overhead costs, including machinery maintenance, replacement,
and depreciation. K&K’s current allocation system distributes a lot of overhead costs to the
manual line, hence reduces the cost of the automated line and makes it seem to be more
profitable than the manual line. However, this is not the case. According to Appendix A attached
below, the updated Breakdown of Overhead Costs, if K&K eliminates the custom line, it will
suffer a significant loss.
The updated Breakdown of Overhead Costs is modified based upon the following assumptions.
First of all, Sales Bonuses were excluded from the overhead costs. Second, half of the total
overhead costs are attributed to the plastic line. Other overhead costs are allocated to each
product line based upon its related cost driver. For example, utility costs are distributed
according to each line’s finished units, and the two lines evenly share facility rent. As a result,
the overhead per unit for the manual line drops to $0.842 while the overhead per unit for the
automated line increases to $0.409. Therefore, the further review and analysis of the overhead
costs indicate that the custom line is profitable while the plastic frame line is causing a deficit for
K&K. Discontinuing the custom line will bring mass loss to K&K and hence should be avoided.
However, K&K can take a modified measure by increasing the sales and prices of plastic frames
while keeping the custom line to operate and generate a reasonable profit for the company.
Nevertheless, if the plastic frames line still turns out to be losing money, K&K should consider
eliminating this product line and focus more on the operation of the custom line or establishing
other new lines that have relatively large potential for profits.
Discussion and Recommendations
First of all, K&K should do thorough market research on its products, picture frames, before
investing a considerable amount of funds purchasing and maintaining the machines used for
mass production, which led to a large quantity of slow-moving inventory and a relatively low
turnover rate. The management should always give conclusive evidence to support its decisions,
especially on its anticipation on the sales of specific products in the future. A carefully made
decision can more or less avoid the current situation K&K has been suffered.
Secondly, the management should choose the manufacturing machines that best fit the
company’s production level. Maintaining high-end machines while the production amounts are
far below the machines’ capacities is costly and indeed a waste of resource. Therefore, K&K
should carefully verify each machine’s original value and useful life, and choose the best
depreciation methods to calculate the depreciation expense.
Thirdly, the management should always check the accuracy of the data recorded, such as the
costing of finished goods inventory, direct labor hours, and pricing of raw materials. Any
misstatement of these data can lead to inadequate decisions and further cause the company to
lose money.
Fourthly, K&K should be more careful with implementing a new cost allocation system that is
entirely different from the old system it relies on. The management should always analyze and
determine the primary cost drivers for different systems since the more accurately evaluated, the
more likely the company will not be adversely affected by relevant audit risks and issues in the
valuation of inventory and Cost of Goods Sold. As a result, the management can make better
decisions based on accurate information and hence avoid significant losses.
Appendix A
Overhead Costs
Custom Line
Overhead Costs
Plastic Line
½ of Indirect Materials
½ of Indirect Materials
RX-1000 Maintenance
RX-1000 Replacement
RX-1000 Depreciation
Total Costs
Total Costs
Other Cost Allocations
Custom Line
Other Cost Allocations
Plastic Line
Production Facility Rent
Production Facility Rent
Production Facility Utilities
Production Facility Utilities
Overhead Allocations
Overhead Allocations
Total Overhead
Total Overhead
Total Units
Total Units
Per Unit
Per Unit
Works Cited
Beasley, Mark S. Auditing Cases: An Interactive Learning Approach. Pearson, 2019.