Question

Risk Assessment- Exercise #1

Social Konnections Inc. (SKI or the “Company”) is a global Internet company that runs Social Konnections, a large social media networking Web site. SKI has experienced steep growth since its launch in 2005, and the Company went public in 2007. SKI currently has over 500 million active users who visit the site to connect with others, express themselves, and play games.

Last year, substantially all of SKI’s revenue came from advertisers who market their products and services to SKI’s active users through advertisements placed on the Web site or its various mobile platforms.

The founder of the company serves as the CEO and is also on the chairman of the board of directors. The CFO is also one of the co-founders of the company. Both have been serving in these roles since 2005.

In Q1 of the current fiscal year, SKI acquired Corporate Collaborations (CC), an entity that manages private and public social media networks for corporations. CC’s customers are primarily national and global companies whose employees connect over its platform. In addition to hosting private social media networks for corporations, CC provides services to develop the networks it manages. CC’s revenues are earned through the performance of multiyear revenue contracts with its customers. In the current year, CC is expected to produce approximately 20 percent of SKI’s consolidated revenue.

SKI’s investors are focused on the growth prospects of the Company’s legacy open social media platform operations and its new corporate revenue unit. The Company’s MD&A disclosures include (1) various user and revenue metrics to help financial statement users assess its traditional operations and (2) backlog information to help users assess CC’s operations.

Advertising Revenue

SKI creates advertising space on its Web site and mobile applications and sells the space to advertisers either directly, or through advertising agencies. According to Mr. Cook, the

amount an advertiser pays is dependent on the number of views the ad receives or the number of user clicks (depending on the type of advertisement defined in the underlying contract) and the revenue is recorded in the period in which the views or clicks are made.

Ms. Drew has learned that simple advertising can be purchased directly from SKI through SKI’s advertising Web site at standard rates, with the advertisements and terms input directly into the Company’s ad delivery platform. However, most advertising revenue is generated directly through the advertising sales team, which has the ability to help advertisers develop more sophisticated advertising campaigns. Management has established minimum pricing and volume thresholds for these advertisements; however, the sales staff is given significant latitude in securing contracts with customers. Extra commissions are paid to sales individuals who sign longer-term contracts that meet minimum revenue targets.

Once a contract is signed, the ad development department creates the ad content and obtains the customer’s approval. The approved ad and the contract are electronically sent to the ad scheduling department, and the advertisement is uploaded into the Company’s ad delivery platform. The ad delivery platform is a robust system and is designed to capture all the nuances associated with the contract. For example, an advertiser may wish to have its ads displayed only to users whose IP addresses are from a specific geographic location, or the contract may be structured to provide the advertiser with variable pricing or incentives (such as a set of free advertisements) once a certain level has been paid for. In summary, the delivery platform captures all the relevant pricing information associated with the contract to allow for real-time revenue recognition according to the terms of the contract. After the contract is entered into the system, a summary of the contract setup is provided to the sales manager that worked with the customer. The sales manager then reviews the contract setup for accuracy.

The Company’s ad delivery platform automatically tracks the advertising activity each day and reports the activity to its customers, who are then billed weekly for the aggregate ad activity.

Ms. Drew’s Concern

Ms. Drew is concerned about several things she has learned regarding the appropriateness of management’s revenue recognition policies.

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 financial information available.

Controls

The Company’s has various controls in place. The CFO performs a checklist on a monthly basis to review the performance of the company. The CFO reports to the CEO every quarter. The CEO reports to the chairman of the board of directors once a year before the financial statements are prepared and released to the public.

The company has over 10 thousand employees around the world, of which 4 thousand work at the headquarters. All employees receive the company’s code of ethics that was prepared in 2005 when the company was founded. The CEO was in recent trouble when he posted controversial messages on the social platform that offended people of a certain group. The company has One hundred different controls across the company and across the world related to operations of the company and revenue.

The company uses 10 different IT systems as the company is growing quickly it has had to adopt and adds new systems whenever they are needed.

The leaders of one of the main divisions recently left to go work for Facebook, and has not been replaced for the last 4 months.

Controls have changed a lot since last year because the company is so dynamic and the environment is so fast paced. Employees are always trying to keep up with the new systems and new controls.

Audit

Because of SKI’s continued growth, the audit committee has requested that the Company choose a new audit firm with experience in auditing public technology companies.

Kristine Drew, a senior auditor, is the in-charge accountant on the proposal and planning of the SKI audit. In addition to her supervisory and administrative responsibilities, Ms. Drew is responsible for auditing revenue and determining the risk assessment for the audit.

Ms. Drew has read the Company’s disclosed accounting policies and is interviewing the revenue controller, Bill Cook, and various sales personnel to develop in-depth process flow documentation that will serve as the basis for the team’s risk assessment.

Required:

1. What would you set Audit risk, Control Risk, Inherent Risk, and Detection risk? (Very low, low, medium, or high)
2. Are there are significant or fraud risks that you have identified? (If any why are they fraud or significant risks?)
3. What other information do you need to plan your audit approach? Where would you get this information from? For each piece of information indicate where you might receive it from and how? (ex: who else is on the board of directors- obtained through inquiry.)
4. What benchmark would you use to calculate materiality? Why? (ex: revenue, EBITDA, Equity, Assets, etc)
5. Using the benchmark and guidance in the book calculate “overall materiality” for your audit? (ex: 8% of Equity ($60m)= $2.4m).
6. For Revenue what assertions are the most important for you to test?
7. For Revenue what are your concerns with each of those assertions based on the information above?
8. What are the things about testing revenue that you are concerned about (specifically what parts of the company’s process if any concern you)? (Example: An employee could steal money from the bank account, or revenue could be modified in the accounting software by an employee.) (Focus on the actual real process for the company described above to make this determination.)
9. For your audit approach would you choose to test controls or primarily perform substantive procedures? If so what would be your mix of control testing to substantive testing? (ex: 50% controls, and 50% substantive)
10. Would you accept this audit? If not why not?

Answer 1

Audit of Social Konnections Inc.

1. The Audit risk, Control Risk, Inherent Risk, and Detection risk are to be set at very high level as there are frequent changes in the systems as the business is technology driven. The frequent changes in technology requires the auditor to be updated with the latest technology and have a good internal control system so that the audit risk can be controlled. The inherent risks cannot be ignored,however steps can be taken to prevant the inherent risk.

2. The Employee Code of Ethics were drafted in 2005 when the company was founded. It should be reviewed every year.

There are significant risks involved in the ad services as well. The is given a commission for sales leads generated by them. The contract is again given to the sales manager for checking its accuracy. There are high chances of manipulation as the sales manager can manipulate the sales data for the commission.

It violates the basic internal control system principal - Maker should never be the Checker.

3. The auditor should observe the business processses and conduct inquiry for necessary queries. The auditor will also require the documents prepared by the management for reporting to the top management like the CFO reports to the CEO on a quarterly basis. The documentary eveidence about what actions has been taken for remedial measures etc should be answered by the document. In absence of such information, the auditor should obtain conclusive evidence from the management regarding the same. This information can be obtained from employee also who are a part of this reporting.

4. The benchmark should be the revenue as in Year 1 it showed a revenue of $30 Million and in another year,Year 2, the reduction in revenue was by $12 Million, i.e. a revenue of $18 Million.

5. Overall materiality can be determined by the Asset Turnover Ratio. An asset turnover ratio determines the ability of the assets to generate revenue.

6. The sales revenue will be the most important assertion.

7. The revenue has decreased significantly. The reasons for the decrease in sales revenue should be determined.

8. The manipulation by the sales manager for earning more commission through manipulation of sales revenue is the biggest concern.

9. There shall be a higher level of control testing involved along with substantive testing. A proportion of 60:40 is a rational mix for performing audit.

10. The top management has been noticed leaving the company and no replacement could be found for a straight period of 4 months. It reflects a shady image about the company. For the same reason, the audit should not be accepted.