Risk Assessment- Exercise #1
Social Konnections Inc. (SKI or the “Company”) is a globalInternet company that runs Social Konnections, a large social medianetworking Web site. SKI has experienced steep growth since itslaunch in 2005, and the Company went public in 2007. SKI currentlyhas over 500 million active users who visit the site to connectwith others, express themselves, and play games.
Last year, substantially all of SKI’s revenue came fromadvertisers who market their products and services to SKI’s activeusers through advertisements placed on the Web site or its variousmobile platforms.
The founder of the company serves as the CEO and is also on thechairman of the board of directors. The CFO is also one of theco-founders of the company. Both have been serving in these rolessince 2005.
In Q1 of the current fiscal year, SKI acquired CorporateCollaborations (CC), an entity that manages private and publicsocial media networks for corporations. CC’s customers areprimarily national and global companies whose employees connectover its platform. In addition to hosting private social medianetworks for corporations, CC provides services to develop thenetworks it manages. CC’s revenues are earned through theperformance of multiyear revenue contracts with its customers. Inthe current year, CC is expected to produce approximately 20percent of SKI’s consolidated revenue.
SKI’s investors are focused on the growth prospects of theCompany’s legacy open social media platform operations and its newcorporate revenue unit. The Company’s MD&A disclosures include(1) various user and revenue metrics to help financial statementusers assess its traditional operations and (2) backlog informationto help users assess CC’s operations.
Advertising Revenue
SKI creates advertising space on its Web site and mobileapplications and sells the space to advertisers either directly, orthrough advertising agencies. According to Mr. Cook, the
amount an advertiser pays is dependent on the number of viewsthe ad receives or the number of user clicks (depending on the typeof advertisement defined in the underlying contract) and therevenue is recorded in the period in which the views or clicks aremade.
Ms. Drew has learned that simple advertising can be purchaseddirectly from SKI through SKI’s advertising Web site at standardrates, with the advertisements and terms input directly into theCompany’s ad delivery platform. However, most advertising revenueis generated directly through the advertising sales team, which hasthe ability to help advertisers develop more sophisticatedadvertising campaigns. Management has established minimum pricingand volume thresholds for these advertisements; however, the salesstaff is given significant latitude in securing contracts withcustomers. Extra commissions are paid to sales individuals who signlonger-term contracts that meet minimum revenue targets.
Once a contract is signed, the ad development department createsthe ad content and obtains the customer’s approval. The approved adand the contract are electronically sent to the ad schedulingdepartment, and the advertisement is uploaded into the Company’s addelivery platform. The ad delivery platform is a robust system andis designed to capture all the nuances associated with thecontract. For example, an advertiser may wish to have its adsdisplayed only to users whose IP addresses are from a specificgeographic location, or the contract may be structured to providethe advertiser with variable pricing or incentives (such as a setof free advertisements) once a certain level has been paid for. Insummary, the delivery platform captures all the relevant pricinginformation associated with the contract to allow for real-timerevenue recognition according to the terms of the contract. Afterthe contract is entered into the system, a summary of the contractsetup is provided to the sales manager that worked with thecustomer. The sales manager then reviews the contract setup foraccuracy.
The Company’s ad delivery platform automatically tracks theadvertising activity each day and reports the activity to itscustomers, who are then billed weekly for the aggregate adactivity.
Ms. Drew’s Concern
Ms. Drew is concerned about several things she has learnedregarding the appropriateness of management’s revenue recognitionpolicies.
Financial Statements
Balance Sheet:
Account | Prior year (1 year ago)** | Two years ago |
Assets* | $100m | $80m |
Liabilities | $40m | $30m |
Equity | $60m | $50m |
Revenue | $30m | $18 |
Expenses | $22m | $19 |
Net Income | $8m | ($1m) loss |
*Assets consist primarily of cash, land/building,patents, goodwill, and other assets.
** As you plan your audit this is the latest financialinformation available.
Controls
The Company’s has various controls in place. The CFO performs achecklist on a monthly basis to review the performance of thecompany. The CFO reports to the CEO every quarter. The CEO reportsto the chairman of the board of directors once a year before thefinancial statements are prepared and released to the public.
The company has over 10 thousand employees around the world, ofwhich 4 thousand work at the headquarters. All employees receivethe company’s code of ethics that was prepared in 2005 when thecompany was founded. The CEO was in recent trouble when he postedcontroversial messages on the social platform that offended peopleof a certain group. The company has One hundred different controlsacross the company and across the world related to operations ofthe company and revenue.
The company uses 10 different IT systems as the company isgrowing quickly it has had to adopt and adds new systems wheneverthey are needed.
The leaders of one of the main divisions recently left to gowork for Facebook, and has not been replaced for the last 4months.
Controls have changed a lot since last year because the companyis so dynamic and the environment is so fast paced. Employees arealways trying to keep up with the new systems and new controls.
Audit
Because of SKI’s continued growth, the audit committee hasrequested that the Company choose a new audit firm with experiencein auditing public technology companies.
Kristine Drew, a senior auditor, is the in-charge accountant onthe proposal and planning of the SKI audit. In addition to hersupervisory and administrative responsibilities, Ms. Drew isresponsible for auditing revenue and determining the riskassessment for the audit.
Ms. Drew has read the Company’s disclosed accounting policiesand is interviewing the revenue controller, Bill Cook, and varioussales personnel to develop in-depth process flow documentation thatwill serve as the basis for the team’s risk assessment.
Required:
- What would you set Audit risk, Control Risk, Inherent Risk, andDetection risk? (Very low, low, medium, or high)
- Are there are significant or fraud risks that you haveidentified? (If any why are they fraud or significant risks?)
- What other information do you need to plan your audit approach?Where would you get this information from? For each piece ofinformation indicate where you might receive it from and how? (ex:who else is on the board of directors- obtained throughinquiry.)
- What benchmark would you use to calculate materiality? Why?(ex: revenue, EBITDA, Equity, Assets, etc)
- Using the benchmark and guidance in the book calculate “overallmateriality” for your audit? (ex: 8% of Equity ($60m)= $2.4m).
- For Revenue what assertions are the most important for you totest?
- For Revenue what are your concerns with each of thoseassertions based on the information above?
- What are the things about testing revenue that you areconcerned about (specifically what parts of the company’s processif any concern you)? (Example: An employee could steal money fromthe bank account, or revenue could be modified in the accountingsoftware by an employee.) (Focus on the actual real process for thecompany described above to make this determination.)
- For your audit approach would you choose to test controls orprimarily perform substantive procedures? If so what would be yourmix of control testing to substantive testing? (ex: 50% controls,and 50% substantive)
- Would you accept this audit? If not why not?
