In the late 1990s, the investing public’s fascination with Internet-based companies prompted the cyberspace equivalent of the Oklahoma Land Rush, according to one prominent Wall Street analyst. “In a land rush, you suspend rules because your perception is that time is of the essence.”1 That perception caused many anxious investors who feared missing out on a once-in-a-lifetime investment opportunity to bid the prices of Internet stocks to ever-higher levels. Those investors readily discounted the fact that most Internet companies were reporting minimal revenues and sizable, if not staggering, operating losses. Over a 15-month stretch between late 1998 and March 2000, the dot-com-laced NASDAQ stock exchange rose by more than 150 percent. By comparison, over the same time frame, the largely “Old Economy” Dow Jones Industrial Average managed a much less impressive 15 percent gain. 

Dot-com fever caused many investment services and publications to create new stock indices dedicated strictly to Internet companies. On June 30, 1999, USA Today launched the Internet 100 to track the stock prices of 100 high-profile companies whose primary lines of business were directly or exclusively related to the Internet. 

Within a few months, the collective value of that index had risen by more than 60 percent. Other Internet stock indices realized similar increases. By early March 2000, the 300 companies included in the Forbes Internet Index had a collective market value of $1.2 trillion, which was approximately equal to the total value of all publicly traded U.S. stocks a little more than one decade earlier. 

The public’s feeding frenzy on Internet stocks produced numerous paper billionaires among dot-com bigwigs. Dot-com billionaires making appearances in the Forbes 400, a list of the 400 “richest people in America,” included, among several others, Jeff Bezos (Amazon), Stephen Case (AOL), Mark Cuban (Broadcast.com), Andrew McKelvey (Monster.com), Pierre Omidyar (eBay), Jay Walker ( Priceline), David Wetherell (CMGI), and Jerry Yang and David Filo (Yahoo!). As you might expect, the surging prices of Internet stocks added an even larger number of new members to the millionaires’ club. By early 2000, one publication reported that in northern California’s Silicon Valley alone, the Internet revolution was creating 64 new millionaires each day. Among these millionaires were Jeremy and Molly Lent, a husband-and-wife team that founded the Internet-based NextCard, Inc., in 1997. 

Jeremy Lent served as the chief financial officer (CFO) of Providian Financial Corporation during the early 1990s. At the time, Providian ranked among the largest financial services companies in the United States. Experts in the financial services industry attributed Providian’s success to the direct-mail marketing methods the company used to identify and then recruit as customers, individuals who made extensive use of credit cards. In the late 1990s, Lent decided that the marketing tactics used by Providian could be easily adapted to the Internet, which prompted him and his wife to create NextCard, an online company that would offer Internet users the opportunity to obtain a credit card in a matter of moments. Because of his tenure at Providian, Lent realized that a key metric in the credit card industry is the acquisition cost of a new customer. Lent was convinced that he could use the Internet to undercut the average acquisition cost of a new customer incurred by brick-and-mortar credit card companies, such as Providian. Likewise, Lent believed that his company would have significantly lower bad debt losses than conventional credit card issuers. Marketing research had found that Internet users were generally more affluent and, thus, better credit risks, than individuals drawn from the general population of consumers.

One of Lent’s first major strategic initiatives was hiring dozens of marketing researchers to analyze a large database of “clickstream data” that documented the “surfing” habits of Internet users. After analyzing these data, the company’s marketing team developed Internet-based advertising campaigns targeting Internet users who made frequent use of, and maintained large balances on, their credit cards. 

NextCard’s online ads encouraged such individuals to apply for a credit card with NextBank, a virtual bank that was NextCard’s largest operating unit, and to transfer their existing credit card balances to this new card. The key inducement used by Lent to convince potential customers to apply for a NextBank credit card was a lower interest rate than that charged by conventional credit card issuers. Lent also promised those potential customers that a decision regarding their online credit card application would be made within 30 seconds of their submitting that application.

Initially, Lent’s business model for NextCard appeared to be a huge success as the company quickly became recognized as one of the leaders of the Internet Revolution that made the term e-commerce the hottest buzzword among Wall Street analysts and individual investors. The company’s website was regularly named one of the top 50 financial websites by Money magazine and by 2000 had more daily “hits” or visits than any other website in the financial services industry. More importantly, for several consecutive years, NextCard issued more credit cards online than any other credit card issuer, including such large and well-established firms as American Express, Bank of America, Citibank, and MBNA. Lent used NextCard’s prominent position in the Internet industry to create a network of 60,000 online “affiliates” that referred potential credit card customers to NextCard. Several of these affiliates, including Amazon.com, purchased significant ownership interests in NextCard......  

Questions 

1. Should auditors evaluate the soundness of a client’s business model? Defend your answer.

2. Identify and briefl y describe the specifi c fraud risk factors present during the 2000 NextCard audit. How should these factors have affected the planning and execution of that engagement?

3. What are the primary objectives an audit team hopes to accomplish by preparing a proper set of audit workpapers?

4. Identify the generally accepted auditing standards violated by the E&Y auditors in this case. Briefl y explain how each standard was violated.

5. When he became a member of the NextCard audit engagement team, Oliver Flanagan hoped that Robert Trauger would serve as his mentor. What responsibility, if any, do senior audit personnel have to serve as mentors for their subordinates?

6. Assume the role of Oliver Flanagan in this case. What would you have done when Robert Trauger asked you to help him alter the 2000 NextCard audit workpapers? In answering this question, identify the alternative courses of action available to you. Also identify the individuals who may be affected by your decision and briefl y describe how they may be affected.