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

Question

What will be an ideal response?

Answer 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 these frames that may or may not be able
to be sold. A risk exists that these frames on hand are valued at higher than their realizable market
values. A related risk is that the machines used to make the metal frames are not valued properly.
A risk is also emerging that K&K is 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.
Another area of concern in the production cycle relates to the manufacturing machinery. The
auditors must address the risks involving the correct valuation and depreciation of the manufacturing
machinery. Because this is the audit firm’s first year auditing K&K, they will want to verify the
appropriateness of the depreciation methods as well as the reasonableness of the useful lives used for
depreciation. In addition, the auditor should be concerned about the correctness of the original value
used for the machinery and about the accuracy of the depreciation calculations.
As with all audits of inventory, the auditors must also address the risk pertaining to the accuracy
of the company’s inventory count. 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.
Another risk that exists with K&K’s audit is the accuracy of the costing of finished goods inventory.
One risk to address with respect to this topic involves the correctness of the direct labor hours used
for costing the frames. Because direct labor hours are used as the driver for inventory overhead costs,
the potential effects of this number being misstated could be significant. The second area requiring
attention is the risk that incorrect pricing is used for the raw materials inventory and that the same
costing method is not being consistently applied. Any evidence of error in these areas could indicate a
risk that the cost of finished goods inventory is misstated.