After being in business for only two years, Your1040.com has quickly become a leading provider of online income tax preparation and filing services for individual taxpayers. Steven Chicago founded the company after a business idea came to him while shopping for individual tax preparation software. As he stared at all the software packages on the shelves at a local computer supply store, the following thought kept racing through his mind: "With all of the tax law changes from year to year, why should I shell out $50 for a CD that will be obsolete next year, not to mention the $20 I have to pay to file my taxes electronically over the Internet? Too bad a company doesn't exist that charges me a small membership fee to use continually updated tax preparation software. I'd sure pay for a service like that." Not long after his shopping experience, Chicago, an entrepreneur at heart, decided to create such a company. Just one year later, Your1040.com began operations in time for the next tax season.

Your1040.com is an entirely Internet-based tax preparation web site for preparing and filing federal and state individual income tax returns. Most of its revenues come from individuals seeking to avoid preparation of a paper-based tax return and who are willing to "rent" access to a popular tax preparation software package through Your1040.com. Other revenues come from individuals wanting to electronically file an already prepared paper-based return. For a minimal fee, Your1040.com provides an interface for individuals to electronically file their returns with the appropriate federal and state regulatory bodies. Typical users come from middle-class households wanting to simplify yearly tax return preparation tasks. These users are generally searching for an accurate, easy, and economic alternative to other professional tax services. Individuals can access these services through Your1040.com's web site. To log on, customers must first register for a user name and password. Once the customer logs on with the information, they are prompted to provide their full name, mailing address, Social Security number, birth date, phone number, email address, and a major credit card number. This registers the individual on Your1040.com's web site and initiates the credit card approval process. Once the credit card number is validated, customers select from one of three service packages: Silver, Gold, or Platinum.

The Silver package provides basic tax services, including electronic access to tax forms, schedules, and publications. Customers can enter tax return information directly onto the forms and schedules, and Your1040.com will file the completed materials electronically, which eliminates the need for mailing paper copies to tax agencies. The Silver package also provides a service that allows customers to apply electronically for a return extension. The Silver package, however, does not give subscribers access to the tax preparation software package.

In addition to the benefits of the Silver package, the Gold package grants customers online access to a commercially developed and continually maintained tax preparation software package. The package helps customers easily prepare tax returns ranging from the simple 1040-EZ to a complex return, such as one filed by a self-employed businessperson with nationwide real estate investments and actively traded securities. Both the Gold and the Silver packages provide access to services for one tax season only.

Premium services are offered through the Platinum package, which allows customers to sign up for Your1040.com membership ranging between two to five years. Through this multiple-year package service, customers receive year-round access to the tax preparation software provided to Gold customers, which allows them to continually track changes to their tax basis in securities and periodically evaluate tax implications of possible transactions. Furthermore, Platinum customers receive personalized attention and real-time tax support from qualified income tax specialists, who work on a contract basis, via an online instant messenger program.

Your1040.com experiences high seasonal demand for its services from early February to the filing deadline of April 15. Because Your1040.com allows customers to apply for filing extensions online, the company also experiences strong demand for its services just before extension deadlines. If the IRS finds a problem with a return submitted through Your 1040.com, Your1040.com does not correct the problem, but informs the customer of the problem so that the individual can correct the error and refile the return free of charge. The estimated frequency and cost of expected refilings are factored into the price of the service packages. Your1040.com does not handle tax refund or tax liability payments. If a customer is eligible for a refund, the IRS remits the payment directly to the taxpayer. If a customer is required to pay income taxes, the IRS simply charges the appropriate amount to the customer's credit card number that is electronically submitted with the income tax return. Your1040.com assumes no liability for inappropriately filed returns or the tax positions of its customers. All liability resides with the customer who prepared the return.

Your1040.com recognizes revenue differently for each product. The revenue for the first year of Platinum service is recognized immediately after the customer selects this option. The company assumes customers will use the package for an entire year without cancellation even though Your1040.com has a fairly simple cancellation policy. All revenues from subsequent years of Platinum service are recognized in like manner. For the Gold package, a portion of the revenue is recognized when the customer accesses the tax preparation software package via the Internet for the first time. The company recognizes the remaining revenue when the customer submits the return to the IRS. The company does not recognize revenue for the Silver package until the customer submits a return to the IRS. In addition to fees generated for its individual tax preparation services, Your1040.com engages in ad swapping with a number of major Internet companies. For example, Amazon.com swapped a significant amount of advertising with Your1040.com from January to April of this year. Amazon.com placed a banner ad on its web site reminding visitors to visit Your1040.com for all of their tax needs. In exchange for this ad, Your1040.com placed a similar ad directing its visitors to shop online at Amazon.com.

Protecting unauthorized access to customer information is a high priority at Your1040.com. The company houses its web server and microcomputers, which run critical applications, in a key-coded room accessible only to the programmer and Chicago, the CEO. The web server is also protected by a proxy-server firewall to prevent outside hackers from attacking the database. In addition to these security measures, all customers are required to create alphanumeric passwords that are at least six characters in length, to prevent unauthorized access to customer accounts. Your1040.com does not maintain a "bricks and mortar" storefront or interact face-to-face with customers. The company engages in all transactions electronically and stores all purchase orders, sales invoices, and advertising contracts in electronic form. The company backs up data daily, but the backup data are not readily available at all times. After six months of soft storage on the company's server network, backup files are removed from the network to free up the limited storage capacity. The files are downloaded to compact discs for storage and future retrieval. A significant upgrade of Your 1040.com's limited information system is in the planning stages.

Two of Chicago's nephews-Nathan Randall and Matthew Gilbert-oversee the maintenance of the company's information system. Both employees will graduate with degrees in Information Systems at the end of the semester from a local university and will begin working full time for the company after graduation. The accounting system is maintained by Chicago's niece, Emily Parkin, who is a Master's student studying accounting. She has been with the company since the beginning and is responsible for the preparation of all internal financial statements.

Given the growth in the number of individuals using Your1040.com's services, several marketing executives have recently begun to offer Chicago large sums of money for purchasing Your1040.com's customer lists. Although Chicago has yet to formally draft an official privacy statement for his company, he feels responsible for the privacy of his customers' information and is unsure if he should sell the lists. The cash offers have been tempting, however, given that the money would allow him to move ahead with planned information system upgrades. In the meantime, Chicago arranged a line of credit with a local bank to fund the upgrades. As part of that financing transaction, the bank has required an audit of Your1040.com's annual financial statements.

REQUIREMENTS 

1. You are an audit senior with Gooch & Brown CPA, LLP, a local accounting firm specializing in audits of information systems and financial statements. Your1040.com engaged your firm to perform its financial statement audit. You have been asked by the partner to perform the following tasks:

a. Describe to Steven Chicago why it is important for your firm to have an understanding of Your 1040.com's business model.

b. Identify Your1040.com's major business risks and describe how those risks may increase the likelihood of material misstatements in Your1040.com's financial statements.

c. What should Your1040.com do to improve its internal control?

d. What audit implications arise if you decide that the controls over electronic records at Your1040.com are inadequate to ensure that records have not been altered?

e. Authoritative literature provides guidelines for proper revenue recognition policies for transactions such as those discussed in the case. Analyze Your1040.com's revenue recognition policies for the three package services. Provide appropriate citations to authoritative literature.

f. How can you obtain evidence that ad swapping actually occurred between the Your1040.com and Amazon.com? Describe accounting issues that arise when Internet-based companies swap ad services and identify relevant authoritative literature. g. Address a memo to Steven Chicago detailing the appropriate contents for a customer privacy policy. (You may want to visit other company web sites, such as www.cpamoneywatch.com, to see an example of a privacy policy.) Why is it important for Your1040.com to have an explicit privacy policy? How might the lack of a policy affect Your1040.com's financial statements in the future? 2. Statement on Auditing Standard No. 31, Evidential Matter, provides guidance for auditors when evaluating electronic evidence. What are the implications for an auditor when a client's accounting system produces and stores transaction evidence only electronically? 3. Your1040.com's main business strategy involves the delivery of services via the Internet. What are some threats to the viability of Your1040.com's business strategy? 4. When customers register for the Platinum package, they have online access to tax professionals who are paid on a contract basis. If you were in Steven Chicago's shoes, how would you compensate those professionals for their services? What controls could Your1040.com implement to ensure that the company does not overpay for those professional services?