Netflix Audit Research Project

Candra Williams
ACCT 6334.OW1
Chris Linsteadt
November 3, 2015

Table of Contents
Introduction
Chapter 1: The client acceptance/continuation process, including establishing an
understanding with the client.
Chapter 2: Obtaining an understanding of the entity and its environment, including
internal control.
Chapter 3: Preliminary Engagement Activities.
Chapter 4: Assess Risks and Establish Materiality
Chapter 5: Consider Internal Control
Chapter 6: Plan the Audit
Chapter 7: Complete the Audit
Chapter 8: Evaluate results and issue an audit report

Introduction
Netflix is an on demand online media streaming company. The company was founded in
1997, initially offering online movie rentals. Throughout the past 18 years, Netflix has refined
and differentiated its services by giving users unlimited access to content at a low monthly
subscription cost. The companys content evolution to a more digital instantaneous delivery
content facilitated global expansion, increased market share and secured Netflix a position as
the worlds leading internet subscription service. I chose Netflix because I have noticed a
decline in traditional television cable subscriptions in younger generations, myself included, as
more users switch over to online base media content. I thought it would be interesting to gain
some insight into the growing industry by evaluating one of its top contenders.
Chapter 1: The client acceptance/continuation process.
In an effort to minimize our business risk, we have evaluated Netflix using our new client
acceptance procedures. The procedures included gaining approval from Netflix to make contact
with the predecessor auditor, Ernst & Young, reviewing Netflixs annual reports, interim
statements, Form 10-Ks and reports to regulatory agencies, obtaining criminal background
reports on senior management, and making inquiry of Netflixs reputation with their bank and
legal counsel. The results of our evaluation of Netflix supports the integrity of management, the
integrity of accounting procedures, financial soundness and profitability, which leads us to
conclude that taking on this engagement would not bring on any unusual risk to the accounting
firm.

Chapter 1: Establishing an understanding with the client.

The Engagement letter documents the understanding of the requirements and
expectations between Netflix and our firm. The Engagement letter includes the objective,
managements responsibilities, the auditors responsibilities and any limitations. The established
objective is to audit the Netflix financial statements at year end for the purpose of stating an
opinion. Netflixs management team has the responsibilities of the financial statements, internal
controls, complying with regulations, making financial records available to the audit team and
adjusting material misstatements within financial statements. Our responsibilities as auditors is to
conduct the audit of Netflix financial statements and internal controls in accordance to the
PCAOB standards. These standards require our firm to plan and perform an audit to offer
reasonable assurance that Netflix financial statements are free of material misstatements. The
limitations of the engagement include the inability of internal controls to prevent and detect all
misstatements.
Chapter 2: Obtaining Understanding of the entity, its environment, including internal
controls
Industry and Regulation
Netflix is a part of the internet video streaming industry. Companies within the industry purchase
content license or develop original content that is delivered to consumers instantaneously via the
internet. Over recent years there has been tremendous growth in this industry as many
subscribers transition from traditional cable providers. (Business insider).Within the United
States, Netflix and other video streaming companies must comply with the Federal

Communications Commision(FCC) regulation on net neutrality, internet traffic exchange and

open internet rules.(CNN).
Chapter 2: Nature, Objectives, Strategies, and Business Risk
The nature of Netflix is a centralized, debt funded international company that operational
revenue is earned by offering streaming content and DVD rental services via an online format. In
Netflixs 2014 10k report, the company stated their objective was to attract and retain members
by consistently providing members with compelling content choices, and quality experiences for
selecting and viewing TV shows and movies.(Netflix) The strategy to execute the companys
objective is focused on differential service offerings to enhance the Netflix Brand. Netflix is
focused on [devoting] more resources toward the development, production, marketing and
distribution of original programming, TV series and movies.(Netflix). Some of the business risk
that may affect the companys objective is the loss of customers to competition, the inability to
satisfy existing customers with content offering, and adverse view of how the company chooses
to market services.
Chapter 2: Financial Performance
Netflix financial performance has steadily increased over the past 3 years. In 2012, Netflix had a
net income of 17.15 million; in 2013, net income for Netflix was 112.4 million and in 2014,
Netflix had a net income of 266.8 million.(Marketwatch) Netflix has experienced a 1,456%
increase in net income since 2012. In addition to net income, Earnings per share increase from .
04 in 2012 to .63 in 2014 accounting for a 1475% increase in EPS. This large percentage of
growth in income over such a short period of time is in indicator of the growing profitability of
Netflix and the rapid growth of popularity in the video streaming industry.

Chapter 2: Internal Controls

Some of Netflix internal controls require separation of duties of negotiating contracts and
approving invoices for the contracts. Netflix is a web based company so it is important to have
internal controls in place to securely transmit customer payment and billing information over the
internet as well as internal controls that restrict access of unauthorized employees to customer
credit card information.
Chapter 3: Preliminary Engagement Activities
The firms audit team requirements to perform the Netflix Audit include the audit
engagement partner, audit manager, IT audit specialist, tax partner, quality assurance partner and
audit staff.
Our firm has met the principle responsibility of being independent in fact, which allows
us to give a unbiased opinion on the financial statements as well as being independent in
appearance by not having any financial stakes or managerial relationships within Netflix.
Chapter 4: Assess Risk and Establish Materiality
We will use the Audit Risk Model to assess the probability of misstatement while completing the
Netflix audit. The audit risk model format is Audit Risk= Inherent Risk *Control Risk*Detection
Risk. Audit risk is the probability that our auditors will give an incorrect audit opinion on the
financial statements. Our audit team set a desired low level of audit risk at .04. Inherent risk is
the possibility that material errors could enter the accounting system. The current content library
on Netflix balance sheet will be audited. Our team feels that there is high inherent risk of
valuation of this account, we will assign Inherent risk at .80. Control risk is the probability that

Netflixs internal controls will fail to recognize material misstatements should the current content
library inventory be valuated incorrectly. The audit team assessment of Netflixs internal control
to recognize this risk is moderately effective, we assigned the control risk at .50. The detection
risk is probability that our audit teams procedures will fail to detect material misstatements
about the Netflix current content library. We have assigned the detection risk at .10, this is the
amount of risk that our team can allow and still meet the audit level risk of .04. Netflix states in
the investor questions section of the website that some content is amortized using straight-line
over license period, some content has accelerated amortization and that the amortization
schedule is adjusted based off of viewing patterns. Our audit team feels that the nature of the
valuation of the current content library is highly dependent on viewer hour estimates and can
produce complicated transactions and calculations that are subject to error. The audit risk for the
financial statements and the content library is the risk of making material misstatements of
amounts over $50,000 overstating or understating account balances by incorrectly using the
wrong amortization techniques.
Chapter 5: Consider Internal Controls
Internal Controls is a process created by an entitys board of directors, management and
personnel to help provide reasonable assurance regarding reliability of financial reporting,
effectiveness and efficiency of operations and compliance with applicable laws and regulation.
The Netflix internal controls that the audit team has identified as relevant to the audit is the
separation of the departments/ people that record the content library contracts and the
departments/people that perform periodic reconciliations of existing amounts to recorded
amounts. The components of internal controls are the control environments, risk assessment,
control activities, monitoring information and communication. The Netflix board of directors and

management team represent integrity and ethical values which sets a sound control environment
for the company. Netflixs management team identifies several business risk in their 2014 10k.
These risk include service level and content offerings of competitors, ability satisfy customers
with current content offerings, and long-term fixed cost of content commitments. Control
activities are actions taken to help ensure that managements directions are carried out. Netflix
control activity for recording the new content license contracts is matching sales invoices to
content contract details. Information and communication is related to the information systems
that relate to the business processes of the company. Understanding Netflix use of Teradata
Cloud as a data backup and recovery system is important in relating how this information system
supports the accounting process. (Teredata) The elements involved in understanding the control
risk of Netflix include identifying entity level controls, transaction level controls, evaluating
control design effectiveness, performing a walkthrough by inquiring with personnel and
observation, assess operation effectiveness by reperforming critical controls. The audit teams
assessment of the control risk determine that the controls in place to separate the duties of the
personnel that negotiate the content library contracts, issue payment on the contracts, record the
contract transactions in the ledger and amortizes the content correctly over the correct licensing
period are strong. Its the responsibility of Netflix management team to establish and maintain
effective internal controls over financial reporting. It is our firms responsibility to provide and
opinion on the effectiveness of the internal controls over financial reporting.(SEC)
Chapter 6: Plan the Audit
While making a plan for the Netflix audit, the audit team determined that the business process
needed to amortize the video content library according to viewer hours is indicative to the online
media streaming industry. In response to this business process it was determined that it is more

efficient to bring on an auditor specialist in the area of valuating content libraries based on the
varying levels of views by customers. The possibility for illegal acts to occur is highly likely
when the motivation, the opportunity, and the rationalization to commit fraud. The strong control
environment at Netflix minimizes the possibility for illegal acts to be committed. Related parties
are individuals that can influence or be influenced by decisions of the company through family
and investment relationships. No related-party transactions were found during the planning
process.
The preliminary analytical procedures require the auditing team to perform five steps. Develop
an expectation, define a significant difference, compare expectation with the recorded amount
and investigate significant differences. The expectations developed for Netflix were based on the
comparison of current year account balances to December 2014 account balances. The
significant difference from the expectation that can still be considered reasonable is $20,000. Our
auditors used comparative financial statements to calculate changes from year to year in the
financial statements. No significant differences were found.
Chapter 6: Audit Program
The account to be audited is the current content library. Managements assertions about the
current content library is that they have been accurately valuated at $2,695,184. The risk related
to the account involve incorrect amortization methods which could result in overstatement or
understatement of account balances. The procedure used to gather evidence about the assertion is
to retrieve copies of sales contracts from vendors, ensure content libraries have been labeled
properly and match content library sales contracts to the appropriate amortization schedules and
check that the accounts have been valuated properly. For this account, our audit team will rely

less on the internal controls which will call for external evidence, testing performed at year end,
and a larger sample size of the content library.
Chapter 7: Complete the Audit
Our responsibilities as auditors during the completion stage of the Netflix audit is to review the
evidence found during the audit to communicate all misstatement to the company for correction
before issuing an opinion of reasonable assurance of the financial statements.(accaglobal)

Independent Auditors' Report

To the Board of Directors and Shareholders
Netflix, Inc.
100 Winchester Circle
Los Gatos, California 95032

We have audited the accompanying balance sheets of Netflix, Inc. as of December 31, 2015 and
the related financial statements for the year end. These financial statements are the responsibility
of the Netflixs management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United
States of America. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement.
An audit includes examining, on test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of Netflix, Inc. as of December 31, 2015 and the results of its operations
and cash flow conform with accounting principles generally accepted in the United States of
America.
Candra Williams
November 22, 2015

References
1. http://www.businessinsider.com/the-future-of-the-video-streaming-industry-20114
Regulations
2. http://money.cnn.com/2014/06/13/technology/fcc-netflix-verizon/index.html

3. http://files.shareholder.com/downloads/NFLX/856809844x0x826035/b69e6840a84e-425e-9ea3-a0ff4c507e58/SEC-NFLX-1065280-15-6.pdf pg 3
4. http://www.marketwatch.com/investing/stock/NFLX/financials

5. IR.netflix .com
Internal control.
6. http://www.teradata.com/News-Releases/2013/Netflix-Selects-Teradata-Cloud-forHigh-Performance-Analytics/

7. http://www.sec.gov/rules/final/33-8238.htm

8. http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/saoct11-complete-audit.pdf