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Solved by verified expert:There are three questions: The original document is attachedLearning Objectives: Learn how to determine the accuracy your client’s revenue recognition practices by applying your understanding of the FASB rules. Identify fraud risks and apply audit procedures that will help you to gain evidence about whether fraud has occurred and/or whether or not the organization has sound internal controls in place to deter fraud. #1: Identify at least 1 revenue recognition issue from the advertising source of revenue and 1 from the hosting revenue. Applicable guidance can be found in ASC 606 revenue recognition (make sure to use the new guidance in 606!) and ASC 985-605 software revenue recognition (for the hosting revenue). When answering this question, be sure to explain how the revenue should be recognized and offer your opinion based on your accounting research. #2: Using guidance from auditing standards AS2110, identify at least 1 fraud risk from the advertising source of revenue and 1 from the hosting revenue (in your own words). #3: Still referring to AS2110, identify at least 2 potential audit procedures for the advertising source of revenue and 2 for the hosting revenue that would address the fraud risks you identified in #2 (in your own words). Make sure your recommended audit procedures are specific to this case, for instance if you use “inquiry”, you must provide detail about what and whom the auditors are inquiring with related to the fraud risk you identified. 1
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Case 14-06
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 multi-year revenue contracts with its customers. In the current year, CC is
expected to produce approximately 20% of SKI’s consolidated revenue in the current
year.
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 indepth process flow documentation that will serve as the basis for the team’s risk
assessment.
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
Copyright 2013 Deloitte Development LLC
All Rights Reserved.
Case 14-06c: Making Connections
Page 2
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 website 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.
Corporate Social Network Development and Hosting Revenue
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 multi-year 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;
Copyright 2013 Deloitte Development LLC
All Rights Reserved.
Case 14-06c: Making Connections
Page 3
therefore, from a materiality perspective, the Company will disclose that hosting fees are
recognized ratably throughout the hosting contract period.
In Q4, during an interview with one of the new members of the corporate sales team, 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 multi-year
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.
Required:
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?
Copyright 2013 Deloitte Development LLC
All Rights Reserved.

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