Part III: (2,000 word minimum, due on Monday, April 29th) 4. Finally, prepare a substantive audit program to address the risks identified in requirement 3. The substantive audit program should be thorough and detailed, clearly expressing the audit steps that should be performed. It should be written in enough detail that a staff auditor or intern could read your instructions and know how the test should be performed. For instance, if you are proposing that sampling be utilized, you need to state how you will select the sample./n WWE Preliminary Risk Assessment for Revenues & Receivables Year Ended 4/30/2006 I. Gain Sufficient Understanding to Plan the Audit Multiple sources are possible. For class we'll keep it simple: Read the 10K. In order of importance: (1) Financial statements, pp. F2-F23; (2) Management Discussion and Analysis, pp. 15-29; (3) Company Business Risk Factors, pp. 9-12. II. Preliminary Risk Assessment We want to achieve overall LOW audit risk. For the case, we're going to ignore Control Risk, because we haven't yet learned how to assess it. Hence, we're setting that to MAXIMUM. Using our audit risk model with those constraints, we have: = AR (Low) IR x Maximum CR (100%) x DR Thus, when IR is high, we will need to set DR to low. When IR is moderate, we will set DR to moderate. When IR is low, we can set DR to high. Our next task is to assess IR, but first we have to determine what will be material to the financial statements as well as to the accounts we're examining for this case (Revenues & Receivables). Then we need to perform our preliminary risk assessment procedures. These consist primarily of Preliminary Analytical Procedures, and consideration of Specific Inherent Risk Factors (those factors are listed in the headings of section II.C.). II.A1. Set Overall Planning Materiality for the Audit Profile of Potential Materiality Bases: 2006 2005 2004 Revenues Operating Income $ 400,051 $ 366,431 $ 374,909 70,540 50,293 Net Income 47,047 39,147 73,580 48,192 Total Assets 479,390 441,405 Net Assets 396,181 375,534 The company has reported somewhat fluctuating revenues for the past three years, with an uptick in 2006. Operating income is consistent in 2006 and 2004, with a downward spike in 2005, and net income has followed a similar pattern. Total and net assets have experienced steady growth. Total debt is minor relative to equity: in 2006 reported long term debt is $6,381, and in 2005 is $7,198. With the relative importance of equity over debt, the primary emphasis of the financial statement users is likely to be on income. We will base our planning materiality for the audit of the 2006 financial statements on 5% of operating income for 2006. Reported Operating Income, 2006 5% Threshold Planning Materiality (rounded) 70,540 5% 3,600 II.A2. Set Performance Materiality for Accounts in the Case (Revenues and Receivables) Revenue recognition at the company is extremely complex, and requires a number of significant judgments. Normally we would allow some flexibility in accounts requiring significant judgment, because honest and informed individuals may have slightly different ideas as to what the best estimate is for the account. However, it also is an extremely large component of the financial statements, so we will consider misstatements in the account that exceed 1/2% of the account balance as being likely influence a user's judgment, and hence material. Receivables are smaller and less complex but subject to even greater judgment regarding collectability, so we will apply a looser threshold of 2.5% of the account balance. In all cases, the materiality applied to any specific account can never exceed overall planning materiality for the financial statements (II.A.1). To be more conservative, for this case we'll restrict that threshold even further, and allow no account to exceed 75% of overall planning materiality. Hence, our performance materiality for each account will be the lesser of a percentage of the account balance, or 75% of overall planning materiality: Balance, 4/30/2006 Threshold Percentage Threshold (rounded) 75% of Planning Materiality Performance Materiality: Revenues Receivables 400,051 67,775 1/2% 2.5% 2,000 1,694 2,700 2,700 2,000 1,694 II.B. Preliminary Analytical Procedures - Revenue & Receivable Accounts II.B.1. Revenues (by Segment): Product Line 2006 2005 2004 Live and televised entertainment 290 299 308 change -3% -3% Consumer products 86 53 54 change 62% -2% Digital media 22 13 11 change 69% 18% Films 0 Analysis of Revenue Components in Live Televised Entertainment: 2006 2005 Change Live events Venue Merchandise Pay-per-view Advertising Television rights fees Other $75.0 $78.7 -5% 14.7 12.8 15% 94.8 85.5 11% 22.6 43.7 -48% 81.5 78 4% 2.2 0.8 175% $290.8 $299.5 -3% Analysis of Revenue Components in Consumer Products: 2006 2005 Change Licensing 32.2 20.9 54% Magazine publishing 11.1 12.2 -9% Home video 42.6 20.1 112% Other 0.5 0.7 -29% $86.4 $53.9 60% While total revenues increased substantially in 2006, that increase is driven by Consumer Products. The revenues in Televised Entertainment declined, even with a portion of merchandise sales (labeled "Venue Merchandise" above) having been reclassified into the segment. Even with the reclassification, live entertainment revenues declined to 73% of total revenues in 2006, compared to 82% in 2005. Since the company considers the televised entertainment to be the driver of demand for the other product lines, this decline requires investigation. The revenues for live televised events declined primarily due to offering fewer of those events: 248 in 2006, compared to 276 in 2005. Average ticket prices declined 3% in 2006, but were more than offset by attendance growth of 17%. The decline in advertising revenues is the primary determinant of the decrease in live revenues. This decline is due to a new contractual arrangement with cable providers, where WWE is no longer allowed to directly sell advertising except in Canada. Pay-per-view revenues increased significantly, which could signal continued strong interest in the company's products. The net effect of these factors is a decline in live event revenues. Since the company considers this the main driver for its products, the decline creates upward pressure to maintain those revenues at a high level. Hence, we will emphasize heightened scrutiny on the increase in pay-per-view revenues. In addition, in 2006 the company introduced a fourth segment for WWE films, which as of the end of the year had not yet released its first film, hence generating no revenue. In conjunction with this new product line, the company reclassified its prior segments, moving a portion of the growing merchandise sales into the live entertainment segment. Since the growth in merchandise sales has a natural effect of increasing live event revenues with this reclassification, we will investigate the business rationale for the reclassification, as well as the transactions involved making the reclassification. The significant increase in revenues from consumer products is due to increased sales in two areas. The increase in licensing revenues is the result of video game sales. The home video sales revenue more than doubled, due to the company's strategy of marketing videos of its pay-per-view events, as well as its large library of "classic" footage. For both categories, revenues are recognized when products are shipped from the distributor to wholesale and retail vendors. Given the significance of the increases, we will place high emphasis on verifying the validity of these transactions, particularly around the end of the year. II.B.2. Accounts Receivable: Net Revenues 2006 400,051 2005 Net Receivables 366,431 67,775 61,901 2004 374,909 374,264 62,703 49,729 2003 2002 409,622 2001 438,139 63,762 72,337 Receivables as % of Revenues 0.17 0.17 0.17 0.13 0.16 0.17 Allowance Account 3,740 3,278 2,612 5,284 2,890 1,868 % of A/R 0.06 0.05 0.04 0.11 0.05 0.03 Accounts receivable consist primarily of amounts due from (a) pay-per-view providers and television networks for live events; (b) advertisers; and (c) distributors for sales of videos and magazines. The receivables have been very stable relative to revenues for the past several years, which is consistent with the characteristics of the customer base. II.C. Consideration of Specific Inherent Risk Factors for Revenues II.C.1. Factors Related to Accidental Misstatements (Errors) - Nature of the Company, Industry (in this case, specifically its Revenue Sources); - Complexity of Accounting; - Degree of Judgment; - Significant Estimates Revenue recognition is extremely difficult at WWE due to the various types of revenues. Those difficulties arise both from the complexity of the accounting treatment, and from the significance of the estimates, as follows: Revenues are recognized for pay-per-view events on the date the event is aired. However, the precise information on the number of purchases of the event is available only to the pay-per-view distributors. On the event date, the company records revenues based on the estimated number of total purchases using preliminary information provided by the distributors. A final reconciliation to the actual number of buys takes place within one year, and subsequent adjustments are made on a cash basis. These judgments result in uncertainty about how many • • • • viewings were sold during the period. Conceivably this could lead to either an overstatement risk or understatement risk, but the risk of understatement in revenues is usually considered low. This company has no incentive for understatement of revenues, but rather a very high incentive to ensure that all revenues are recorded. Hence, the net effect of these estimates creates a significant risk for either the existence assertion (if we view each pay per view as a sale to an end consumer), or the valuation assertion (if we view each pay per view event as a single economic event). Revenues from television advertising are related to the Canadian market. Those revenues are recorded when the commercial airs (Cutoff risk), based on terms in the contract with the advertiser. In cases where the contract calls for reaching a specific number of viewers, the revenue will have to be adjusted if it is later determined that those benchmarks were not achieved. This creates a risk to the valuation assertion. Revenues from sponsorships are recognized as various deliverables within the sponsorship are achieved, with the portion of revenues recognized being based on the relative fair values of each of those deliverables. Since early or late recognition of the associated revenues can occur easily with incorrect estimation, this creates a risk for the valuation assertion and the cutoff assertion. Revenues from home videos, video games, and books are recognized when shipped from the distributor. Those revenues are recorded net of estimated returns. In addition, when the estimated net revenues from a video or book are less than the allocated costs (i.e., a net loss on the video), the full amount of the loss is recognized in the period (note that this is more of a misstatement risk for inventory and expenses rather than revenues and receivables). The shipment of products around the end of the year creates a risk for the existence, and/or cutoff, assertion, while the need to estimate returns and potential losses creates a risk to the valuation assertion. Revenues from magazine publishing are recognized when shipped by the distributor, net of estimated returns. Much like the video revenues, the nature of this arrangement creates risks for the existence and/or cutoff assertions, and the valuation assertion. Revenues from feature films have not yet been recorded, since no films have been released as of the balance sheet date.¹ When the films are released, the new revenue stream will be at very high risk for valuation. In particular, estimated revenues will be based on the revenues from the film during the period relative to total lifetime expected revenues on the film. Since the company has no history in this area, they may lack the internal expertise to reliably make those estimates. Further, there is no baseline against which to judge the success of the company's films, since it is a completely new product line for them. For next year, this will likely create a need for us to involve firm specialists on the film industry. 1 Of course this was as of April 2006 -- now the films have been released. But since I'm pretending to audit the 2006 financial statements for purposes of this illustration, I'm also pretending that they've not yet been released.

Fig: 1