Spencer and Loveland, LLP is a medium-sized, regional accounting firm based in the western part of the United States. A new client of the firm, K&K, Inc., which manufactures a variety of picture frames, recently contracted with Spencer and Loveland to perform an audit of the company’s financial statements for the year ended December 31, 2018. K&K, which is privately owned, expects to use the audited financial statements to obtain a more favorable line of credit with its bank. Spencer and Loveland has a reputation for providing value to its clients above and beyond the highquality auditing services the firm provides. The firm successfully looks for opportunities to leverage insights obtained during the audit as a basis for offering advice to its clients as a business advisor. K&K management is eager to receive Spencer and Loveland’s financial advice, which is especially needed because the company’s current accounting personnel primarily have clerical backgrounds. Thus, the audit engagement team has been instructed to generate suggestions that might help improve the growth and profitability of K&K, which have taken a turn for the worse during the past year. K&K’s original, labor-intensive custom-frame line appears to be struggling. Given rising costs for skilled labor over the past several years, K&K’s production manager has long believed that it was only a matter of time before the company’s older custom-frame line would begin to lose the long-term profitability it had enjoyed. He believes the custom line’s declining profitability over the past year confirms the decision to expand the company’s product line into new areas. At the beginning of last year, K&K invested in the RX-1000 system to mass-produce plastic frames. Internal cost accounting reports indicate that the new plastic-frame line has been quite profitable, despite operating at low volume levels relative to its capacity. The production manager recently recommended to K&K’s president that the company consider discontinuing the labor-intensive custom-frame line to focus on expanding the less labor-intensive, higher-volume, higher-margin line of plastic frames.

You are a second-year audit senior at Spencer and Loveland. You and your audit staff are currently auditing the inventory and production costing systems at K&K. You and the junior staff auditor on the team have performed most of the audit procedures outlined on the audit program and have documented your findings in the audit papers. As audit senior, you are responsible for reviewing the audit schedules and reporting to the audit engagement manager any areas of concern with respect to the audit. In addition, the manager asked you to analyze the client’s inventory and production situation to indicate any areas where you believe the firm can provide value-added constructive suggestions to the client.

REQUIRED 

[1] Briefly list and explain the primary audit risks in the production and inventory area of the K&K audit. 

[2] Identify any accounting or auditing issues in the way K&K handles its product costs, including overhead allocation, that need to be addressed in the current audit. 

[3] Review the analysis performed by K&K on the two product lines. K&K’s management is debating the elimination of the manual line given that it is no longer profitable. Should K&K discontinue the labor-intensive custom frame product line? Why or why not? 

[4] Based on your analysis, prepare a memo to the audit manager suggesting areas in K&K’s inventory and production-costing systems where your firm could provide advice and value-added services to the client. In addition, given K&K is a non-public company, suggest any areas in which your firm might be able to provide consulting services that would be of value to the client.