Audit of Finance Transactions: Internet Business. City Search Inc. (CSI) is a technology company providing local search engine services in the Greater Toronto Area (GTA). CSI combines online search capability with a print directory (City Pages) focusing specifically on GTA websites. Consumers use the search engine and print directory to locate local businesses. Businesses use the search engine and print directory to attract potential customers to their places of business through paid advertisements. CSI began operations in March 20X3 and launched its first sales campaign for print and online search advertisements in June 20X3. Since that time, over 600,000 copies of the City Pages have been distributed to businesses and residences.

The original financing to start CSI came from several wealthy investors who purchased common shares. Additional common shares were issued to the public in late 20X4. These shares initially sold for $2.40, but, during 20X5, the share price fell to less than $1.00. The decline in price is mainly because two of the original investors sold large blocks of shares for whatever they could get as the business was not proving to be as successful as they expected. In early 20X5, the CSI board of directors hired a new president, Bill Dorado, to aggressively promote the CSI directory as a superior directory for local shopping and entertainment searches, and to find innovative ways to increase revenues and CSI’s share price.

Businesses that are clients of CSI pay an advertising fee for print and online directory listings that include the business name, address, phone number, type of products/services offered, and website link. CSI will also create a website for clients for a one-time fee that varies depending on the number of pages, links, and type of content the client wants.

CSI clients also can purchase banner advertising that pops up when users browse through the online directory. Clients sign a contract for the ad frequency they require, and are billed monthly. Clients can also purchase additional advertising features, such as moving graphics, audio, and a special patented “bull’s-eye target” (BT) feature, which concentrates the client’s ads in directory locations they choose. For example, a home decorating service can sign up for BT service that will cause their ads to be shown whenever users are searching for home products businesses.

In February 20X6, CSI entered into an agreement with Flogg Investments Inc. (FII) in which FII agreed to sell newly issued common shares of the company for total gross proceeds of up to $8 million. The proceeds raised from the new common shares will be used by CSI to support its growth initiatives and for working capital and general corporate purposes, including repayment of loans from shareholders that amounted to approximately $4 million as of December 31, 20X5.

Your firm was recently engaged to audit CSI’s 20X5 financial statements. The previous auditors that reported on the 20X3 and 20X4 financial statements have resigned. In communicating with the predecessor auditors, you find out that they resigned due to a change in circumstances that lead to their firm’s partners not being independent of CSI. To date, CSI has provided the audit partner of your firm, who is in charge of the audit, with preliminary financial statements (prior to audit) for its most recent year end, December 31, 20X5. You are assigned to plan the audit. From reviewing these preliminary financial statements and talking to Bill

Dorado you have learned the following:

1. CSI recognizes revenue on a straight-line basis as each service is provided over the terms of its individual client contracts. The contracts range in length from three months to four years, with the majority lasting for two years. Revenues from contracts ranging from one to four years are deferred and amortized as each service is provided. Upfront direct costs associated with these revenues, including the production costs and selling commissions, are deferred and amortized over the life of each client contract on a straight-line basis. Adjustments are made to deferred revenue and deferred production costs for cancellations at the time they are made. Cancellations are permitted if clients relocate outside the GTA or close their business. CSI management estimates the future value of contracts in progress and compares this value with deferred production costs to ensure these costs are fully recoverable.

2. CSI’s revenue is generated mainly through the sale of advertising to local businesses, many of which are small- and medium-sized enterprises (up to 50 employees). In the ordinary course of operations, CSI may extend credit to these advertisers for advertising purchases on a case-by-case basis, a practice that is common in the industry. CSI management evaluates the collectability of its trade receivables from its clients, based upon a combination of factors, including aging of receivables, on a periodic basis, and records a general allowance for doubtful accounts and bad debt expense. When management becomes aware of a client’s inability to meet its financial obligations to CSI (such as in the case of bankruptcy or significant deterioration in the client’s financial position and payment experience), a specific bad debt provision is recorded to reduce the client’s related trade receivable to its estimated net realizable value.

3. CSI is a registered member of three barter networks serving the Greater Toronto Area GTA) marketplace. CSI sells its services and purchases goods and services through these networks. The full market value of a contract sale settled through a barter network is recorded in accounts receivable and deferred revenue at the time of the sale. Revenues are recognized in income on a straight-line basis over the term of the contract. Receivables are reduced when a good or service purchased through a barter network has been received. The president believes this bartering arrangement was an astute business move that “saves us tons of cash and increases revenues at the same time.”

4. CSI has signed contracts with two well-known, local retail chains that want to start direct online retailing, and have paid CSI $13.5 million to develop all their online shopping systems, including customer relation management and payment processing. CSI has never completed this type of system before, but has the technical expertise from developing its own systems. CSI expects the contract to be completed by the end of 20X6. CSI recorded $6.5 million of the $13.5 million as revenues in 20X5, deferring the rest to be reported when the work is completed.

5. The president and several top CSI executives have received options to purchase common shares at a fixed price of $1 per share. None of the options have been exercised yet.

6. The BT technology was patented by CSI in early 20X4. In late 20X4, the BT patent was sold for $7 million to LivePatents Inc., which is owned by one of the original CSI investors, who is also a board member of CSI. CSI repurchased the patent in early 20X5 for $10 million, by paying $7 million in cash and issuing a loan payable to LivePatents Inc. for the remainder. The patent is shown on CSI balance sheet at its cost of $10 million, and is being amortized over 17 years.

7. Internal search engine development costs are recorded at cost. The company provides for amortization of these costs at the following annual rates:

• Directory, research and design costs—30% declining-balance basis

• Internal directory design costs—30% declining-balance basis

Required:

Prepare a detailed and complete audit plan that addresses the accounting and other information items noted in this case. Also, suggest any other information that you would want to obtain for planning the audit.