Question

Case 14-6 Making Connections 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 2010. 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 Company’s remaining immaterial revenue was received from fees associated with the sale of virtual goods and services by third-party application developers using SKI’s various platforms. 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. 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. A new firm was selected and has performed each of the interim reviews in the current year. Kristine Drew, a senior auditor, is the in-charge accountant on the SKI audit. In addition to her supervisory and administrative responsibilities, Ms. Drew is responsible for auditing revenue. 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. 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 on 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. As part of its new corporate services program from the acquisition of CC, the Company earns revenues by providing corporate social network development and hosting services. For new customers, a contract will typically require an up-front fee to SKI for the development of the customer’s specific social media network; the contract will also include a separate multiyear hosting agreement. The customized social media networks only operate on the Company’s hosting platform, and customers do not have the option to take possession of the software used to run the networks. Revenues for the up-front fee associated with the development are recognized as the development is completed and the system is available to the customer. Hosting revenues are automatically recognized by the system based on the invoicing cycle outlined within the customer’s contract. According to Mr. Cook, this invoicing cycle is fairly uniform throughout the hosting period; therefore, from a materiality perspective, the Company will disclose that hosting fees are recognized ratably throughout the hosting contract period. , Ms. Drew was told that the corporate sales director had established a goal of increasing the length of the average hosting contract. Before SKI acquired CC, most of the multiyear hosting agreements were for three-year terms. In Q4, the corporate sales director implemented a strategy shift that would increase the contracted hosting period to five years. To accomplish this goal, the sales team was able to offer its customers three months of free service, to be added at the end of any new five-year agreement signed. In addition, the sales director offered an additional commission for converting existing contracts to five-year agreements. To accelerate the implementation of this plan, the sales commission is doubled if the contract modification occurs before the end of the fiscal year. Ms. Drew’s Concern Ms. Drew is concerned about several things she has learned regarding the appropriateness of management’s revenue recognition policies. Question: 1) Identify the potential revenue recognition issues related to each of the Company’s sources of revenue. 2)On the basis of the information Ms. Drew has learned, what fraud risk factors should she consider discussing with her team at the next fraud brainstorming meeting? 3)What potential audit procedures could the team consider to evaluate management’s revenue recognition policies and determine whether those policies are appropriately applied?

Answer 1

1)The majority of SKI’S revenue comes from advertising. They generate revenue from advertising by selling space on their website and helping the customers develop these ads. This is considered a multiple element arrangement. A multiple element arrangement is when a vendor delivers multiple products or services in one arrangement. According to ASC 605-25-25, the vendor should decide if the deliverables should be divided into separate units of accounting and determine how much should be allocated to each unit of accounting. The criteria for whether deliverables should be recorded as separate units of accounting are as follows: the delivered item could be sold on a standalone basis, and if the right of return exists for the delivered item, the vendor must have control of the undelivered item. Currently, SKI signs a contract with the client, develops the advertisement and the amount the customer pays is dependent on how many number of views and clicks the advertisement receives. The client is billed weekly and the revenue is recognized in the period that the views and clicks are made. By recognizing revenue this way, they are not separating their services into different accounting units even though the transaction meets the criteria.

In addition to advertising, SKI generates revenue from Corporate Social Network and Hosting. ASC 985-605-15-5 gives two criteria for hosting arrangements. The first is during the hosting period the customer must have the contractual right to take possession of the software without a significant penalty. The second criteria is the customer must be able to run the software on their own hardware or through a different vendor. The customized social media networks that SKI develops do not meet either of these criteria, therefore the revenue must be recognized as revenue from a service, not hosting.

2)According to the AS2110.65, fraud risk factors are events or conditions that indicate (1) an incentive or pressure to perpetrate fraud, (2) an opportunity to carry out the fraud, or (3) an attitude or rationalization that justifies the fraudulent action. SKI has experienced steep growth since the launch and went public five years later. Based on the stellar accomplishments in the past, the company might have experienced both external and internal pressure to strive for a continuing success. Moreover, by going public, SKI might have been pressured to maintain or increase the stock price to satisfy the public investors.

Most advertising revenue is generated directly through the advertising team, and extra commissions are paid to sales individuals who sign longer-term contracts that meet minimum revenue targets. Such extra commissions indicated an incentive to rate fraud. In addition, sales personnel responsible in securing contracts with customers shows an opportunity that sale staff can manipulate the terms of the contracts to carry out the fraud.

SKI uses an automatic revenue recognition system for hosting sales. Although the automatization is less likely to be subject to human error, it is critical that design and the implementation of internal control are in place. For instance, revenues are generated automatically based on the input information of the customer’s contract. It would be crucial to identify whether the roles of data entry, authorization, and the checking of accuracy and appropriateness are segregated. Additionally, based on Ms. Drew’s interview with the corporate sales director, it is notable that the company doubled the sales commissions to incentivize the employees to extend the duration of the existing contracts with the hosting clients. The employees might find the increased commissions as an opportunity to carry out the fraud.

3)According to AS2110.B1, the auditor should obtain an understanding of how the company uses information technology (“IT”)... including the IT general controls that are important to the effective operations of the automated controls, the advertising revenue is dependent on the number of views or on the number of user clicks, and is recorded in the period in which the views or clicks are made. Such revenue is highly relied on the ad delivery platform that captures all the relevant pricing information associated with the contract, and automatically tracks the advertising activity each day to bill customers, Therefore, the team could consider testing the ad delivery platform on a regular basis to ensure the platform processing accurate data, and no unauthorized changes to the contract with customers. The audit team should also review the current controls in place surrounding the sales team's ability to make adjustments to the current contracts without supervisory approval or review.

The audit team should focus on the controls created during the acquisition of CC as well as the design for merging the information of customers and contractual agreements into the system. If there is an establishment that the risk of a material misstatement within the revenue recognition process is higher or more likely to occur, there should be a stronger emphasis on those findings within the audit team’s reports as to their final decision on control effectiveness. Throughout the evaluation of management's revenue recognition policies, the auditors should continuously consider the risks to SKI’s internal controls over financial reporting resulting from IT. To emphasize, AS2110.B4 discusses IT risks such as reliance on systems or programs that are inaccurately processing data, processing inaccurate data, or both. As SKI relies heavily on their programs to apply the correct amount to the revenue accounts based on the invoicing cycle outlined within the customer’s contract, the internal controls over IT must be understood before their effectiveness is assessed.

Due to the increased incentives offered in Q4 by management to extend current contracts, there needs to be additional review around these hosting contracts extensions. As the revenue from these hosting services in recognized ratably throughout the contract period, it may not come to light that fraudulent activities have occurred until the next bill cycle. The audit team should review a percentage of the sales teams contracts that have been extended for policy and procedure implementation. When selecting the appropriate accounts and disclosures to analyse, the team should review the relevant risk factors stated in AS2110.60. These include,accounting and reporting complexities associated with the account or disclosure as well as susceptibility to misstatement due to error or fraud. As these hosting contracts were adopted by SKI from CC, there is additional precautions that must be taken around how customer agreements are updated and who has the authority to make these adjustments if the sales representatives are able to persuade customers into an extension from a three to five year contract.