Reference no: EM13490326

A few years ago Mr Charles Byte identified a significant demand among cell phone users in South Africa for high quality cell phone ring tones, wallpapers and games (referred to as 'content'). Accordingly, Mr Byte incorporated a company, Mobile Creations (Pty) Ltd ('Mobile Creations'), to develop such content or to acquire the rights to it from the owners of the intellectual property in order to make the items available to South African cell phone users at reasonable prices.
Mobile Creations has three shareholders:

Mr Charles Byte 10 000 shares
Mr Donald Keys 5 000 shares
Ms Esmé Mouse 5 000 shares

The board of directors of Mobile Creations comprises Mr Charles Byte, the managing director, and Mr Ben Mazibuko, the financial director.

You are an audit senior at ABC & Associates, a firm of registered auditors, and you are currently planning the audit of Mobile Creations for the year ending 30 June 2008. Whilst obtaining an understanding of the entity and its environment, you documented the following points:

1 Customers can purchase an item of content by sending a unique content code to a five digit number via SMS.

2 In order to focus on the core business of developing or acquiring high quality content, Mr Byte intends to outsource the following functions to WASP Innovations CC ('WASP'):

• Maintaining the website that markets the Mobile Creations content to South African cell phone users;
• Distributing content on receipt of a customer SMS;
• Maintaining logs with full particulars of all content distributed; and
• Invoicing the price of the content purchased by cell phone users to the cell phone network companies. The cell phone network companies recover the invoiced amount for content purchased by a charge to the relevant customer's cell phone account. The cell phone network companies deduct an agreed commission from the gross amount due by the cell phone customer to Mobile Creations, before payment is made to Mobile Creations.

3 The agreement between Mobile Creations and WASP includes the following terms:

• Neither Mobile Creations nor its auditors has access rights to the hardware and software of WASP;
• Mobile Creations has the right to receive quarterly reports from WASP's independent auditors. The scope of the reports (i.e. the control areas to be covered) is specified in the agreement; and

• Mobile Creations may request additional reports from WASP's independent auditors, provided that Mobile Creations bears the related costs and gives sufficient notice.

4 In terms of the accounting policy of Mobile Creations, revenue is recognised when the content is distributed to the cell phone customer and is measured at the amount that the customer has to pay for the content, in other words the price advertised on the website, less Value-added Tax (VAT).

5 The revenue system of Mobile Creations has been documented by one of the trainee accountants in work paper C1 (attached).
During a lunch meeting with Mr Byte, he informed you that Mobile Creations was considering the acquisition of the issued share capital of a competitor, Cell Inventions (Pty) Ltd ('Cell Inventions'). Before finalising the external audit, he wants your audit team to -
• undertake a due diligence of Cell Inventions; and
• determine a fair price for its shares.

DEF & Daughters are the current external auditors of Cell Inventions. Mobile Creations intends to retain DEF & Daughters as auditors of Cell Inventions after the acquisition. Mr Byte wants you to find out whether the partners and staff of ABC & Associates would like to acquire up to 25% of the shares in Cell Inventions. (Mobile Creations will then acquire the balance.)

Mr Byte added that he intended to list Mobile Creations on the JSE Ltd within the next two to three years, and therefore wants to commence a process to improve the company's governance structures. He wants to implement the following plans in the short term:
• Appointment of the senior partner of ABC & Associates, Mr AB Cohen, as the chairman of the board of directors of Mobile Creations.
• Granting a loan to Mr Mazibuko to enable him to acquire up to 5 000 shares in Mobile Creations from Mr Byte so as to improve the company's black economic empowerment credentials.

Work paper prepared on the revenue system of Mobile Creations:
Entity name: Mobile Creations (Pty) Ltd
Year end: 30 June 2008
Prepared by: E Nkosi
Date: 10 March 2008
Subject: Systems description of revenue

C1
1 In order to load the content (e.g. ring tone) on their cell phones, customers have to SMS the relevant content code to the five digit number provided on the Mobile Creations website.

2 All SMS data sent to this number are logged by WASP on receipt. In terms of the agreement with WASP, Mobile Creations has read only access to these logs.

3 On receipt of the SMS, the computer system of WASP automatically -
• sends the content requested to the cell phone that initiated the SMS;
• computes the amount due by the customer; and
• records the pertinent details of the transaction onto its accounting system.

4 Based on the data recorded in the accounting system, WASP generates a log of cell phone numbers and total amounts due from each customer on a monthly basis. Each customer also receives a breakdown of his or her transactions with Mobile Creations and the total amount due. The cell phone network companies deduct an agreed commission from the gross amount due by the customer to Mobile Creations. Accordingly the logs reflect the price of the item, as advertised on the website, as well as the cell phone network companies' charges, based on the agreed-upon percentages. The logs are used as the basis for invoicing the cell phone network companies. Mobile Creations also downloads electronic copies of the logs on a monthly basis via an Electronic Data Interchange (EDI) link to update its general ledger, with the gross amount being credited to revenue in terms of its accounting policy on revenue.

5 WASP collects the amounts owing to Mobile Creations on their behalf from the cell phone network companies, 60 days after invoice. After deducting their fees and charges in terms of the agreement, WASP pays over the balance electronically to Mobile Creations' bank account. A breakdown of how this amount was computed is e-mailed to Mobile Creations.

6 Mobile Creations is required to pay royalties to the providers of intellectual property in terms of agreements entered into with them. The payments are based on a monthly report produced by WASP which summarises the quantities of each content item sold. A more detailed report identifying the specific transactions is available from WASP upon request.

7 Mobile Creations uses content amendment application software to capture the following data amendments to the content catalogue:
• The nature of the request (add / delete / modify the available content);
• The file containing the content (in electronic format) (for additions / modifications); and
• The price to be charged for the content (for additions / modifications).
Once captured, these data are sent to WASP via the EDI link for uploading to the website.

REQUIRED

Marks
(a)
Using a tabular format -
(i) identify and explain the risks to Mobile Creations (Pty) Ltd that will arise from the outsourcing arrangement with WASP Innovations CC. In your explanation you should include a description of the potential consequences of each risk (in your answer you should not deal with any risks related to the introduction and use of the EDI link); and

(ii) describe the specific steps that Mobile Creations (Pty) Ltd should have implemented to reduce each of the risks identified in (i) to a low level. In cases where the mitigating step is to modify the proposed agreement with WASP Innovations CC, clearly describe the specific requirements that should be incorporated into the agreement to manage the risk.

(b) Describe the audit procedures (both manual and computerised) that should be performed to obtain sufficient appropriate audit evidence about the occurrence, accuracy and completeness of the revenue of Mobile Creations (Pty) Ltd.
Assume that you are satisfied with the client's accounting policy for revenue recognition and that appropriate mitigating steps have been implemented as identified in (a)(ii) above when the arrangement was entered into with WASP Innovations CC.

(c) Describe any ethical (with reference only to the SAICA Code of Professional Conduct), professional, statutory and / or corporate governance concerns that may arise from your lunch meeting with Mr Byte.