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Unformatted text preview: 546 APPENDIX A: AUDITING AND A TTES TA TION SIMULATIONS SIMULATION 1 (60 to 70 minutes) Topics—Planning, Internal Control, and Evidence DietWeb Inc. (hereafter DietWeb) was incorporated and began business in March of 20X 1, seven years ago. You are
working on the 20X8 audit—your CPA ﬁrrn’s fifth audit of DietWeb. The company’s mission is to provide solutions that help individuals to realize their full potential through better eating hab-
its and lifestyles. Much of 20X1 and 20X2 was spent in developing a unique software platform that facilitates the production of
individualized meal plans and shopping lists using a speciﬁc mathematical algorithm, which considers the user’s physical con—
dition, proclivity to exercise, food preferences, cooking preferences, desire to use prepackaged meals or dine out, among others.
DietWeb sold its ﬁrst online diet program in 20X2 and has continued to market memberships through increasing online adver—
tising arrangements through the years. The company has continued to develop this program throughout the years and finally
became proﬁtable in 20X6. DietWeb is executing a strategy to be a leading online provider of services, information and products related to nutrition,
fitness and motivation. In 20X8, the company derived approximately 86% of its total revenues from the sale of approximately
203,000 personalized subscription-based online nutrition plans related to weight management, to dietary regimens such as
vegetarianism and to specific medical conditions such as Type 2 diabetes. Given the personal nature of dieting, DietWeb assures
customers of complete privacy of the information they provide. To this point DietWeb’s management is proud of its success in
assuring the privacy of information supplied by its customers—this is a constant battle given the variety of intrusion attempts by
various Internet hackers. DietWeb nutrition plans are paid in advance by customers and offered in increments of thirteen weeks with the customers
having the ability to cancel and receive a refund of the unused portion of the subscription—this results in a significant level of
“deferred revenue” each period. Although some DietWeb members are billed through use of the postal system, most DietWeb
members currently purchase programs and products using credit cards, with renewals billed automatically, until cancellation.
One week of a basic DietWeb membership costs less than one-half the cost of a weekly visit to the leading classroom-based diet
program. The president, Mr. William Readings, suggests that in addition to its superior cost-effectiveness, the DietWeb online
diet program is successful relative to classroom-based programs due to its customization, ease of use, expert support, privacy,
constant availability, and breadth of choice. The basic DietWeb membership includes ‘ Customized meal plans and workout schedules and related tools such as shopping lists, journals, and weight and exercise
tracking. - Interactive online support and education including approximately 100 message boards on various topics of interest to
members and a library of dozens of multimedia educational segments presented by experts including psychologists,
mental health counselors, dietitians, fitness trainers, a spiritual advisor and a physician. - 24/7/365 telephone support from a staff of approximately 30 customer service representatives, nutritionists and ﬁtness
personnel. Throughout its nine-year history, Mr. William Readings has served as chief executive officer. The other three founders of
the company are also ofﬁcers. A ﬁfth individual, Willingsley Williamson, also a founder, served as Chief Financial Officer
until mid-20X8 when he left the company due to a difference of opinion with Mr. Readings. The four founders purchased Mr.
Williamson’s stock and invested an additional approximately $1.2 million in common stock during 20X8 so as to limit the use
of long-term debt. The company’s board of directors is currently composed of the four individuals who remain active in the company; these
four individuals also serve as the company’s audit committee; Mr. Readings chairs both the board and the audit committee.
Previously, Mr. Readings had also served on the board and the audit committee. With Mr. Williamson’s departure, Ms. Jane
Jennings, another of the founders, became the company’s CFO. The nutrition and diet industry in many ways thrives because individuals are becoming more aware of the negative health
and financial consequences of being overweight, and consider important both weight loss and healthy weight maintenance. A
study by two respected researchers concluded that obesity was linked to higher rates of chronic illness than living in poverty,
than smoking, or than drinking. In addition, the American Cancer Society reported that as many as 14% of cancer deaths in men
and 20% of cancer deaths in women could be related to being overweight. The financial costs of excess weight are also high. A 20X8 study based on data from a major automobile manufacturer’s
health care plan showed that an overweight adult has annual health care costs that are 7.3% higher than a person in a healthy
weight range, while obese individuals have annual health care costs that are 69% higher than a person of a healthy weight. With APPENDIX A: AUDITING AND ATTESTATION SIMULATIONS 547 health care cost inﬂation running in the double digits in the United States since 20X4, supporters of the industry believe that the
implementation of effective weight management tools will attract more attention from insurers, employers, consumers, and the
government. As of January 20x9 ﬁve nutrition- or ﬁtness-related bills were being considered in Congress, and several states
had enacted or were considering enacting legislation relating to the sale of “junk” food in public schools. In addition, the US
Food and Drug Administration, Department of Health and Human Services, and Federal Trade Commission are contemplating
new labeling requirements for packaged food and restaurant food, new educational and motivational programs related to healthy
eating and exercise, and increased regulation of advertising claims for food. In response to consumers’ growing demand for more healthful eating options, quick—service and full-service restaurants
have introduced new offerings including salads, sandwiches, burgers, and other food items designed for the weight-conscious
person. At the retail level, sales of natural and organic foods have been growing more rapidly than the overall food and over-
the-counter drug market for the last several years. Nutritional supplement sales in the US, for instance, are estimated to have
grown 34% between 20X4 and 20X8, while natural and organic foods are estimated to be growing at a rate of approximately
15% annually. Also, the industry has a tendency to change quickly as “dieting fads” regularly are introduced; some remain
popular for years, some for only months. Approximately 60% of the US adult population, or 120 million adults, are overweight and, of those, the Calorie Control
Council estimates only about 50 million are dieting in a given year. About 15% of these dieters are using a commercial weight
loss center, generating revenues of approximately $1.5 billion annually. DietWeb targets dieters who are online, which repre-
sents about two-thirds of the total universe at current Internet penetration rates, or 34 million adults, about 5 million of whom
are spending approximately $1 billion at weight loss centers. At the same time, the online dieting segment of the market is growing rapidly. The online diet industry in the US generated
in excess of $100 million in 20X8, compared to revenues of approximately $75 million in 20x2. The industry includes other
online nutrition and diet-oriented Web sites. Another group of competitors to DietWeb are commercial weight loss centers, an industry that has shown marked decline
in the last decade. According to Market Analysis Enterprises, the number of commercial weight loss centers in the US declined
approximately 50% between 20X2 and 20X8, from over 8,600 to approximately 4,400. DietWeb competes against this segment
on the basis of lower price, superior value, convenience, availability, the ability to personalize a meal plan on an ongoing basis,
its extensive support capabilities, and the breadth of its meal plan options. DietWeb, Inc.
December 31, 20X8 and 20X7
(in thousands) M13 M Assets
Current assets Cash and cash equivalents $3,032 $1,072 Trade receivables 485 450 Prepaid advertising expenses ' 59 609 Prepaid expenses and other current assets #5 ﬂ
Total current assets 3,751 2,361
Fixed assets, net m 1%
Total assets TEM 35%
Liabilities and shareholders’ equity
Current liabilities Accounts payable $1,070 $ 909 Current maturities of notes payable 42 316 Deferred revenue 1,973 1,396 Other current liabilities i1 12
Total current liabilities 3,256 2,633
Long-term debt, less current maturity 34 176
Accrued liabilities 792 690
Deferred tax liability J ﬂ
Total liabilities M M
Shareholders” equity Common stock ' 6,040 4,854 Retained earnings 13,065) (2,211)
Total shareholders’ equity m m Total liabilities plus shareholders’ equity $1072 $6.281 548 APPENDIX A: AUDITING AND AT TESTAT ION SIMULATIONS DietWeb, Inc.
Two Years Ended December 31, 20X8 and 20X 7
(in thousands) 20X8 20X 7 Revenue $19,166 $14,814
Costs and expenses
Cost of revenue 2,326 1,528
Product development 725 653
Sales and marketing ‘ 13,903 8,710
General and administrative 2,531 2,575
Depreciation and amortization 629 661
Impairment of intangible assets 35 - Total costs and expenses 20,149 14,127
Net income before taxes (983) 687
Income tax beneﬁt m m
Net income (loss) aw) $812 DietWeb, Inc.
STATEMENT OF CASH FLOWS
Year Ended December 31, 20X8 m M
Cash ﬂows from operations
Net income (loss) I $(854) 812
Adjustments to net income
Depreciation 629 660
Increase in receivables (35) (47)
Decrease (Increase) in prepaid advertising ' 550 (650)
Decrease in other current assets 55 74
Increase (Decrease) in accounts payable 161 (540)
Increase in accrued liabilities 102 43
Increase (Decrease) in deferred revenue . 432 (665)
Increase in common stock issued 1,186 -
Increase in other current liabilities _1ﬂ ﬂ
Net cash provided (used) by operations 2,385 (270)
Cash ﬂows from investing activities
Purchase of property and equipment (320) 2,016
Cash ﬂows from ﬁnancing activities
New debt 613 40
Debt payments w) (918)
Net cash provided (used) by ﬁnancing activities (1%) (87—8)
Net increase in cash and cash equivalents $1,960 868
Cash and equivalents at beginning of year $1,072 204
Cash and equivalents at end of year ' $3,032 1,072 (A) (B) (C) (D) 1. Of the following, which is likely to be one of DietWeb’s major risks of doing business on the O O O 0
Internet in the future? A. Maintaining privacy of customer information. B. Maintaining the ability to pay Federal Communication Commission Internet use fees.
C. Inability to provide 24/7/365 support. D. Inability to reach customers beyond the United States. APPENDIX A: AUDITING AND AT TESTATION SIMULATIONS 549 , (A) (B) (C) (D)
2. Which of the following is likely to be the most signiﬁcant business risk for DietWeb? O O O O A. Internal control limitations due to the small size of the company. B. Inability of the Internet to provide adequate support for such a business due to its instability.
,C. Entrance of new competitors onto the Internet. D. Misstatements of revenues due to difficulties in determining appropriate year-end cutoffs. (A) (B) (C) (D)
1. The most likely misstatement in the ﬁnancial statements is O O O O A. The increase in cash in 20X8. B. Treatment of impaired intangible assets as an expense in 20X8. C. Treatment of common stock issued as an adjustment to net income. D. An income tax beneﬁt on the income statement as contrasted to income tax expense. (A) (B) (C) (D) 2. Which of the following is the most unexpected change on the balance sheet, if one assumes the O O O O
revenue increase in 20X8 is correct? A. Decrease in prepaid advertising expenses.
B. Increase in accounts payable. C. Decrease in deferred revenues. D. Increase in common stock. The auditor determines that each of the following objectives will be part of DietWeb’s audit. For each audit objective, se-
lect a substantive procedure that would help to achieve that objective. Each of the procedures may be used once, more than
once, or not at all. Substantive procedure A. Trace opening balances in the summary schedules to the prior year’s audit working papers.
B. Review the provision for deprecation expense and determine that depreciable lives and methods used in the current
year are consistent with those used in the prior year.
C. Determine that responsibility for maintaining the property and equipment records is segregated from the responsibil-
ity for custody of property and equipment.
D. Examine deeds and title insurance certificates.
E. Perform cutoff test to verify that property and equipment additions are recorded in the proper period.
F. Determine that property and equipment is adequately insured.
G. Physically examine all recorded major property and equipment additions.
(A) (B) (C) (D) (E) (F) (G)
l. DietWeb has legal rights to property and equipment acquired during 0 O O O O O
2. DietWeb recorded property and equipment acquired during the year 0 O O O O O O that did not actually exist at the balance sheet date. This is your ﬁrm’s sixth audit of DietWeb. In a memorandum to the audit team (below) summarize your view of the audit
committee’s strengths, weaknesses, and any changes that have occurred relating to the audit committee this year. Remember: Your response will be graded for both technical relevance and writing skills. For writing skills you should demon-
strate an ability to develop your ideas, organize them, and express them clearly. Do not convey information in the form of a ta-
ble, bullet point list, or other abbreviated presentation. ...
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This note was uploaded on 08/06/2008 for the course ECON 132A taught by Professor Anderson during the Spring '08 term at UCSB.
- Spring '08