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Auditing Fundamentals in A SA Context 2e
Auditing Fundamentals in A SA Context 2e
AUDITING FUNDAMENTALS
in a South African Context
AUDITING FUNDAMENTALS
in a South African Context
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First published 2014
Second edition published in 2018
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Auditing Fundamentals in a South African Context (second edition)
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eBook ISBN 978 0 19 075422 8
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Contents in brief
Chapter 1 Introduction
Chapter 2 Ethics
Chapter 3 Legal responsibilities of the auditor
Acknowledgements
Preface
List of authors
About the book
Ntsimbi Piping (Pty) Ltd Company Pro le
CHAPTER 1 Introduction
Learning outcomes
Reference list
1.1 Background
1.2 What is the purpose of and need for accounting records?
1.2.1 Purpose of accounting records
1.2.2 Examples of accounting records
1.3 What is the objective of and need for nancial
statements?
1.3.1 e objective of nancial statements
1.3.2 Responsibility for accounting records and
nancial statements
1.3.3 e assertions made by the preparers of the
nancial statements
Companies Act requirements for accounting
1.3.4 records and nancial statements
1.4 Why are external auditors needed and what is the
purpose of an external audit?
1.4.1 e need for external auditors
1.4.2 e history of auditing
1.4.3 e history of the external auditing profession in
South Africa
1.4.4 e purpose of an external ( nancial statement)
audit
1.4.5 Providing assurance
1.4.6 e de nition of an external audit
1.4.7 Auditing postulates
1.4.8 Types of auditors
1.5 What are examples of major corporate accounting
scandals in recent years?
1.5.1 International corporate accounting scandals
1.5.2 South African corporate accounting standards
1.6 What are the structures of the accounting and auditing
professions?
1.6.1 Professional bodies
1.6.2 International accounting bodies
1.6.3 Structure of the accounting and auditing
professions in South Africa
Assessment questions
CHAPTER 2 Ethics
Learning outcomes
Reference list
Assessment questions
3.1 Introduction
3.1.1 Legislation and regulations governing the audit
function
3.1.2 Legislation and regulations with which the
auditor has to be familiar
3.2 What are the statutory and regulatory requirements for
an audit?
3.2.1 Companies that have to be audited
3.2.2 What if a company does not have to be audited?
3.3 How does the statutory appointment, removal and
rotation of the auditor work and what are his or her
rights?
3.3.1 Requirements to be met by the auditor in order to
be appointed
3.3.2 Appointment of the auditor
3.3.3 Resignation of the auditor
3.3.4 Dismissal of the auditor
3.3.5 Appointment of a replacement auditor
3.3.6 Rotation of auditors
3.3.7 Statutory rights of the auditor
3.4 What are the statutory requirements to practise as an
auditor?
3.4.1 e requirements to become a Registered Auditor
3.4.2 Firms as Registered Auditors
3.4.3 Limitations on what an auditor may do
3.4.4 Statutory duties of auditors
3.4.5 Inspections of auditors
3.4.6 Liability of auditors for losses suffered by the
client and/or third parties
3.5 What does the auditor’s statutory responsibility to
identify and respond to Reportable Irregularities entail?
3.5.1 De nition of a Reportable Irregularity
3.5.2 e auditor’s reporting duties with regard to
Reportable Irregularities
3.5.3 e implications of a Reportable Irregularity for
the auditee
3.6 How is auditing in the public sector different from
auditing in the private sector?
3.6.1 Background to auditing in the public sector
3.6.2 Who performs public sector audits?
3.6.3 To what standards are these public sector audits
conducted?
3.7 What other legislation or regulations may impact on the
scope of the audit function?
3.7.1 e JSE Listings Requirements
3.7.2 What special quali cations are required to audit a
company listed on the JSE?
3.7.3 What are the speci c responsibilities of auditing
rms and individual auditors conducting audits
of companies listed on the JSE?
3.7.4 e Sarbanes–Oxley Act of 2002
3.8 What role can the auditor play to aid good corporate
governance?
3.8.1 e combined assurance model
3.8.2 e concept of combined assurance
3.8.3 e role of the audit committee with regard to the
external audit function
Assessment questions
Assessment questions
5.1 Introduction
5.2 How has information technology evolved?
5.3 How and why do companies have to govern their
computer information systems?
5.4 What is the impact of upgrading a manual accounting
system to an electronic accounting system?
5.5 What are the key components of a computer information
system?
5.6 How does a computerised accounting system operate?
5.7 How are computer controls classi ed?
5.8 How are general controls classi ed?
5.8.1 Organisational controls and personnel practices
5.8.2 System development and change controls
5.8.3 Access controls
5.8.4 Business continuity controls
5.8.5 Operating controls and system maintenance
controls
5.9 Which controls relate to the computerised processing of
business transactions?
5.9.1 Background
5.9.2 Manual versus computer controls
5.9.3 Overview of application controls
5.10 How are controls identi ed in advanced technologies?
5.10.1 Electronic commerce, electronic funds transfers
and other data communication
5.10.2 Service organisations, outsourcing and data
warehousing
Assessment questions
Appendix: Electronic funds transfer controls
Appendix: Accounting information systems
Assessment questions
Assessment questions
Assessment questions
Assessment questions
11.1 Introduction
11.2 What terminology is used by the auditor when
performing an audit?
11.3 What are the objectives of an audit?
11.4 What are the International Standards on Auditing
(ISAs)?
11.5 How is the audit and audit evidence documented?
11.5.1 Characteristics of audit evidence
11.6 What are the stages in the audit process?
11.6.1 What are pre-engagement activities?
11.6.2 What are planning activities?
11.6.3 Obtaining audit evidence
11.6.4 Evaluating, concluding and reporting
11.7 How do computerised environments impact on the audit
process?
11.8 Is there a link between the stages of the audit process
and the ISAs?
Assessment questions
CHAPTER 12 Pre-engagement and planning activities
Learning outcomes
Reference list
12.1 Introduction
12.1.1 e concepts of overall audit strategy, audit plan
and audit approach
12.2 How does the auditor perform pre-engagement
activities?
12.2.1 Requirements
12.2.2 Application in practice
12.3 How are the terms of the engagement documented?
12.3.1 Importance of documenting the terms
12.3.2 Contents of the engagement letter
12.4 How does the auditor obtain an understanding of the
entity?
12.4.1 Aspects of the entity to be understood
12.4.2 Method of obtaining the understanding
12.5 How does the auditor assess the risk of material
misstatement?
12.5.1 Conceptual aspects of risk assessment
12.5.2 e need to consider risk arising from going
concern issues
12.5.3 e need to consider risk arising of fraud
12.5.4 Identi cation of risks that require special audit
consideration (signi cant risks)
12.5.5 Risks for which substantive procedures alone do
not provide sufficient audit evidence
How can the auditor respond to identi ed risks of
12.6 material misstatement?
12.6.1 Responding to detection risk at the nancial
statement level
12.6.2 What options are available to the auditor to
achieve desired changes to the level of detection
risk at the nancial statement level?
12.6.3 Responding to detection risk at the account
balance/class of transactions/disclosure level
12.6.4 e implications of combined testing versus
substantive testing
12.6.5 Updating the audit approach and plan
throughout the audit 523
12.7 What is materiality and how is it calculated?
12.7.1 De nition
12.7.2 Calculating materiality
12.8 Attending to the logistics of the audit
Assessment questions
Assessment questions
Appendix
14.1 Introduction
14.2 How do we formulate the nature of further audit
procedures for speci c classes of transactions or account
balances?
14.2.1 Wages: Attendance of a wage payout
14.2.2 Cash and bank
14.2.3 Inventory: Attendance of inventory counts
14.2.4 Creditors reconciliations
14.3 What are the requirements of International Standards on
Auditing for dealing with speci c complexities that may
be encountered when performing audit procedures?
14.3.1 External con rmations
14.3.2 Management’s written representations
14.3.3 Accounting estimates
14.3.4 Use of other parties in the audit
14.4 What are computer-assisted audit techniques (CAATs)?
14.4.1 e basics of CAATs
14.4.2 e auditor’s use of computer software to assist in
the audit
14.4.3 Reasons for the use of CAATs in the audit process
14.4.4 Application of CAATs in the audit process
14.4.5 Steps in planning and performing CAATs
Assessment questions
Appendix: CAATs example
15.1 Introduction
15.2 What is the auditor’s responsibility regarding
subsequent events?
15.2.1 Introduction
15.2.2 Various periods pertaining to subsequent events
15.2.3 Auditor’s responsibility
15.3 What is the auditor’s responsibility regarding the going
concern basis of accounting?
15.3.1 Introduction
15.3.2 Management’s responsibility
15.3.3 Auditor’s responsibility
15.3.4 Business rescue and its impact on the audit
15.4 How does the auditor deal with uncorrected
misstatements in the nancial statements?
15.4.1 Misstatements identi ed during the audit
15.4.2 Final materiality
15.4.3 Evaluating the materiality of uncorrected
misstatements
15.4.4 Impact of uncorrected misstatements on the
nancial statements and auditor’s report
15.5 How does the auditor draft the auditor’s report?
15.5.1 Introduction
15.5.2 Contents of the auditor’s report
15.5.3 Types of audit opinions
15.5.4 Other sections in the auditor’s report
15.5.5 Impact of the auditee’s going concern ability on
the auditor’s report
Assessment questions
Assessment questions
Appendix: Examples of cycle documentation related to the
business cycles
Bibliography
Index
Acknowledgements
Frans Prinsloo
Pieter von Wielligh
July 2018
List of authors
Pieter von Wielligh (Editor) BAcc Honours (cum laude), MAcc, PhD
(Accounting) (Stellenbosch), CA(SA)
Henriëtte Scholtz BCom Honours (RAU), MCom & Adv tax cert
(UNISA), CA(SA)
Henriëtte Scholtz is a Senior Lecturer at Stellenbosch University and
lectures auditing at undergraduate and postgraduate levels. She worked
as a general manager in the internal auditing division of a big banking
group before joining academia. Henriëtte publishes articles and
presents papers at international conferences. Her areas of interest lie in
corporate governance and ethics. She is a member of the SAICA ethics
committee.
About the book
3. Company details
Ntsimbi Piping’s head office and manufacturing plant are on adjacent premises in Cape Town and the
company employs approximately 80 staff.
Ntsimbi Piping is one of a number of subsidiaries in the Ntsimbi Piping Investments Proprietary
Limited Group. Seventy per cent of the issued shares of Ntsimbi Piping is held by Ntsimbi Piping
Investments Proprietary Limited, and each of the three executive directors (refer to section 6 below)
holds 10% of the issued shares. In addition to providing equity funding to Ntsimbi Piping, the parent
also provides funding in the form of a shareholder loan.
Nolands Inc. has held the appointment as registered auditor of Ntsimbi Piping since the
incorporation of the company.
5. Company structure
Ntsimbi Piping has the following main operating divisions, all based at its premises in Cape Town:
1. Marketing and Sales;
2. Purchasing; and
3. Manufacturing.
e above-mentioned operating divisions are supported by the following support divisions, all based
at the head office:
1. Accounting and Finance;
2. Information technology; and
3. Human resources.
You will also be introduced to the following staff members of Ntsimbi Piping in this text:
Figure 2: Ntsimbi Piping organogram
Finished products are transferred from the manufacturing plant to the nished goods warehouse
located on the same property.
8. Accounting systems
All accounting processes (recording, processing and reporting of transactions) take place centrally at
Ntsimbi Piping’s head office.
Ntsimbi Piping has been using the PVCACC off-the-shelf accounting package since the company’s
incorporation. PVCACC was properly implemented and all teething problems that were experienced
shortly after implementation have been resolved. Users of PVCACC receive proper training in the use
of the system and any changes thereto.
Ntsimbi Piping uses, among other things, the following modules of the PVCACC system:
• General ledger;
• Sales, debtors and receipts (all sales take place on credit);
• Purchases, creditors and payments;
• Inventory (a process costing system is used for the costing of inventory);
• Payroll; and
• Fixed assets.
All computers in the head office and manufacturing plant are connected by means of a local area
network. As Ntsimbi Piping has no branch network, no off-site access to the accounting system is
required. e PVCACC package runs on a local server securely located in the head office building and
connected to the local area network.
Ntsimbi Piping pays its suppliers, other creditors and all staff by means of electronic funds
transfers. You will learn much more about the business cycles of Ntsimbi Piping, including the
embedded accounting processes and controls, when you read Chapters 6 to 10.
Figure 4: Ntsimbi Piping factory oor plan
9. Operational overview
9.1 e 20X1 nancial year
Sales volumes in the PVC consumables market, which are traditionally linked to demand in the
construction industry, continued to be under pressure. Nevertheless, Ntsimbi Piping managed to
achieve a 31% growth in sales during 20X1, resulting in sales revenue of R128 million – a record for
Ntsimbi Piping. is growth is backed not only by the demand arising from infrastructure and civil
construction, but also a regional population that is characterised by the rapid growth of a middle
class. is has created a demand for all products offered by Ntsimbi Piping.
However, notwithstanding the strong growth in sales revenue, both operating pro t and pro t
before tax only increased marginally from 20X0, primarily as a direct result of increased pressure on
cost prices, resulting in a reduced gross pro t margin.
Ntsimbi Piping continued its programme to invest in manufacturing plant modernisation,
additional capacity and efficiency enhancements and in 20X1 invested in plant and machinery assets
costing R7,2 million (20X0: R1,3 million).
In real terms, the 20X1 nancial year presented Ntsimbi Piping with major challenges arising from a
broad base of economic and operational conditions. At the foundation of these lay depressed global
and local economic conditions. ese challenges are the following:
• Growth prospects for the South African economy remain uncertain and sales volumes are therefore
likely to remain at their 20X1 levels for the foreseeable future;
• Increased competitor threats from new entrants into the market (although the market is still not
very competitive);
• Increasing demands from customers for improved customer service levels;
• Industrial action;
• Operating in ever-changing emerging markets; and
• Health and safety of the workforce (toxic by-products are unavoidably created and additives are
added in the PVC manufacturing process).
Management maintains a risk register in which all risks facing Ntsimbi Piping are described and
classi ed on the basis of their potential impact on the business. e register also indicates the policies,
procedures, controls and actions that management have in place to address each risk. An extract from
this register appears in Figure 4.1 of Chapter 4.
9.2 Outlook
Many of the internal factors that restrained growth during 20X1 have been resolved, clearing the way
for an incremental return to operational and nancial strength, barring unforeseen events. Continued
low economic growth, which impacts on manufacturing and civil construction spend in South Africa,
remains a real concern and, as a result, the directors’ outlook remains cautiously optimistic. e
directors are actively pursuing opportunities to expand into Africa and other international markets.
Directors’ Report
The following supplementary information does not form part of the annual nancial
statements and is unaudited:
Detailed Income Statement
The annual nancial statements for the year ended 31 December 20X1 have been
prepared under the supervision of Ms L Losper, the nancial director of the
company.
The annual nancial statements of Ntsimbi Piping Proprietary Limited have been
audited in compliance with S30 of the Companies Act.
Page 1
Opinion
We have audited the nancial statements of Ntsimbi Piping Proprietary Limited set
out on pages 7 to 24, which comprise the Statement of Financial Position as at 31
December 20X1, and the Statement of Comprehensive Income, Statement of
Changes in Equity and Statement of Cash Flows for the year then ended, and notes
to the nancial statements, including a summary of signi cant accounting policies.
In our opinion, the accompanying nancial statements present fairly, in all material
respects, the nancial position of Ntsimbi Piping Proprietary Limited as at 31
December 20X1, and its nancial performance and its cash ows for the year then
ended in accordance with International Financial Reporting Standards (IFRSs) and
the requirements of the Companies Act of South Africa.
Basis for Opinion
We conducted our audit in accordance with International Standards on Auditing
(ISAs). Our responsibilities under those standards are further described in the
Auditor’s Responsibilities for the Audit of the Financial Statements section of our
report. We are independent of the company in accordance with the Independent
Regulatory Board for Auditors Code of Professional Conduct for Registered Auditors
(IRBA Code), together with the ethical requirements that are relevant to our audit of
the nancial statements in South Africa. We have ful lled our other ethical
responsibilities in accordance with these requirements and the IRBA Code. The
IRBA Code is consistent with the International Ethics Standards Board for
Accountants Code of Ethics for Professional Accountants (Parts A and B). We
believe that the audit evidence we have obtained is suf cient and appropriate to
provide a basis for our opinion.
Other Information
The directors are responsible for the other information. The other information
comprises the Directors’ Responsibilities and Approval on page 4, the Directors’
Report as required by the Companies Act of South Africa on pages 5–6, and the
Detailed Income Statement on pages 25 to 26. The other information does not
include the nancial statements and our auditor’s report thereon.
Our opinion on the nancial statements does not cover the other information and
we do not express an audit opinion or any form of assurance conclusion thereon.
In connection with our audit of the nancial statements, our responsibility is to read
the other information and, in doing so, consider whether the other information is
materially inconsistent with the nancial statements or our knowledge obtained in
the audit or otherwise appears to be materially misstated. If, based on the work we
have performed, we conclude that there is a material misstatement of this other
information, we are required to report the fact. We have nothing to report in this
regard.
In preparing the nancial statements, the directors are responsible for assessing
the company’s ability to continue as a going concern, disclosing, as applicable,
matters related to going concern and using the going concern basis of accounting
unless the directors either intend to liquidate the company or to cease operations,
or have no realistic alternative but to do so.
Page 2
We communicate with the directors, among other matters, the planned scope and
timing of the audit and signi cant audit ndings, including any signi cant
de ciencies in internal control that we identify during our audit.
We also provide the directors with a statement that we have complied with relevant
ethical requirements regarding independence, and to communicate with them all
relationships and other matters that may reasonably be thought to bear on our
independence, and where applicable, related safeguards.
The engagement partner on the audit resulting in this independent auditor’s report
is Craig Stans eld.
Nolands Inc.
Practice number 900583e
Craig Stans eld CA(SA), RA Director
26 June 20X2 Cape Town
Page 3
The directors acknowledge that they are ultimately responsible for the system of
internal nancial control established by the company and place considerable
importance on maintaining a strong control environment. To enable the directors to
meet these responsibilities, the directors set standards for internal control aimed at
reducing the risk of error or loss in a cost-effective manner. Those standards include
the proper delegation of responsibilities within a clearly de ned framework, effective
accounting procedures and adequate segregation of duties to ensure an acceptable
level of risk. These controls are monitored throughout the company and all
employees are required to maintain the highest ethical standards in ensuring the
company’s business is conducted in a manner that in all reasonable circumstances
is above reproach. The focus of risk management in the company is on identifying,
assessing, managing and monitoring all known forms of risk across the company.
While operating risk cannot be fully eliminated, the company endeavours to
minimise it by ensuring that the appropriate infrastructure, controls, systems and
ethical behaviour are applied and managed within predetermined procedures and
constraints.
The directors are of the opinion, based on the information and explanations given by
management, that the system of internal control provides reasonable assurance
that the nancial records may be relied on for the preparation of the annual nancial
statements. However, any system of internal nancial control can provide only
reasonable, and not absolute, assurance against material misstatement or loss.
The external auditors are responsible for independently auditing and reporting on
the company’s annual nancial statements. The annual nancial statements have
been examined by the company’s external auditors and their report is presented on
pages 2 and 3.
The annual nancial statements set out on pages 5 to 24, which have been
prepared on the going concern basis, were approved by the directors and were
signed on their behalf by:
B Arnott
Managing Director
Cape Town
26 June 20X2
Page 4
DIRECTORS’ REPORT
The directors submit their report for the year ended 31 December 20X1.
2. Going concern
The annual nancial statements have been prepared on the basis of accounting
policies applicable to a going concern. This basis presumes that funds will be
available to nance future operations and that the realisation of assets and
settlement of liabilities, contingent obligations and commitments will occur in the
ordinary course of business.
5. Dividends
No dividends were declared or paid to the shareholders during the year.
6. Directors
The directors of the company during the year and at the date of this report are as
follows:
Name
B Arnott CA(SA) (executive)
M McDonald CA(SA)
K Khaudi
L Losper (executive)
S Mkhize (executive)
A Mehra
D Gcina
7. Auditors
Nolands Inc. will continue in of ce in accordance with section 90 of the Companies
Act.
8. Parent
The company’s parent is Ntsimbi Piping Investments Proprietary Limited, which is
incorporated in South Africa.
Page 5
Page 6
ASSETS
NON-CURRENT ASSETS
CURRENT ASSETS
EQUITY
LIABILITIES
NON-CURRENT LIABILITIES
CURRENT LIABILITIES
Page 7
Page 8
Page 9
Page 10
NOTES TO THE ANNUAL FINANCIAL STATEMENTS FOR THE YEAR ENDED 31 DECEMBER 20X1
Contingent liabilities
As detailed in note 23, a contingent liability exists at year-end. Uncertainty as to
whether a present obligation exists was taking into account in its accounting
treatment.
Page 11
Of ce equipment 5 years
The residual value, useful life and depreciation method of each asset are reviewed
at the end of each reporting period. If the expectations differ from previous
estimates, the change is accounted for as a change in accounting estimate.
The gain or loss arising from the derecognition of an item of property, plant and
equipment is included in pro t or loss when the item is derecognised. The gain or
loss arising from the derecognition of an item of property, plant and equipment is
determined as the difference between the net disposal proceeds, if any, and the
carrying amount of the item.
Page 12
1.6 Taxation
Current tax assets and liabilities
Current tax for current and prior periods is, to the extent unpaid, recognised as a
liability. If the amount already paid in respect of current and prior periods exceeds
the amount due for those periods, the excess is recognised as an asset.
Current tax liabilities and assets for the current and prior periods are measured
at the amount expected to be paid to or recovered from the tax authorities, using
the taxation rates that have been enacted or substantively enacted by the reporting
date.
Page 13
A deferred tax asset is recognised for all deductible temporary differences to the
extent that it is probable that taxable pro t will be available and against which the
deductible temporary difference can be used.
Deferred tax assets and liabilities are measured at the tax rates that are
expected to apply to the period when the asset is realised or the liability is settled,
based on tax rates that have been enacted or substantively enacted by the
reporting date.
Tax expenses
Current and deferred taxes are recognised as income or an expense and included in
pro t or loss for the period, except to the extent that the tax arises from:
• A transaction or event that is recognised in the same or different period from
other comprehensive income;
• A transaction or event that is recognised, in the same or a different period,
directly in equity; or
• A business combination.
1.7 Leases
A lease (in which the company is the lessee) is accounted for under the general
approach speci ed in IFRS 16. The right-of-use asset is capitalised with an
accompanying lease liability being recognised. The right-of-use asset is disclosed
and accounted for together with the class of property, plant and equipment to which
it pertains (refer note 1.3), while the lease liability is carried at amortised cost.
1.8 Inventories
Inventories are measured at the lower of average cost and net realisable value.
Net realisable value is the estimated selling price in the ordinary course of
business less the estimated costs of completion and the estimated costs
necessary to make the sale.
The cost of inventories comprises all costs of purchase, costs of conversion and
other costs incurred in bringing the inventories to their present location and
condition.
When inventories are sold, the carrying amount of those inventories is
recognised as an expense in the period in which the related revenue is recognised.
The amount of any write-down of inventories to net realisable value and all losses of
inventories are recognised as an expense in the period in which the write-down or
loss occurs.
Page 14
1.11 Revenue
Revenue from the sale of goods is recognised (under IFRS 15) when the
performance obligations relating to the sale (i.e. delivery and accompanying
transferral of control of the goods) have been satis ed. Revenue is measured at the
fair value of the consideration received or receivable and represents the amounts
receivable for goods and services provided in the normal course of business, net of
trade discounts and volume rebates, and value-added tax.
20X1 20X0
Page 15
3. Intangible assets
20X1 20X0
Cost Accumulated Carrying Cost Accumulated Carrying
amortisation value amortisation value
9,326,597 9,806,864
Page 16
17,241,701 14,862,673
Trade receivables
Movement in the allowance for credit losses: lifetime expected credit losses for
trade receivables without signi cant nancing components
Opening balance 408,800 253,359
Analysis of the credit rating grades of the trade receivables, showing their ageing
(based on gross carrying values)
20X1 Total Not yet due Between 0 Between 31 More than
and 30 and 90 90 days
days days overdue
overdue overdue
The loan is interest free and has no xed date of repayment. It is therefore
treated as repayable on demand. No allowance for credit losses was created.
Page 17
(4,000,757) 1,474,400
(4,000,757) 1,474,400
The banking facilities of the company are secured as follows:
• Limited letter of suretyship amounting to R4,500,000 by the parent.
• Cession of the company’s book debts.
• Cession of certain of the company’s debtor insurance policies.
Authorised
Issued
All the unissued shares are under the control of the directors until the
forthcoming annual general meeting. Each of the three executive directors
(Bongani Arnott, Lee-Ann Losper and Saul Mkhize) hold 10 of the issued ordinary
shares.
1,395,944 428,876
Maturity analysis of undiscounted cash ows due relating to the instalment sale
agreements
Payable within one year 2,112,225 1,885,621
Page 18
13,381,893 7,610,462
9,888,715 17,918,445
The loan is unsecured, bears interest at varying rates and has no xed date of
repayment (it is deemed to be repayable on demand). The current account is
interest free and is repayable on demand.
Operating pro t for the year is stated after accounting for the following:
Page 19
Interest received
214,580 16,358
505,737 509,033
Current
Local income tax - current period 200,508 –
Deferred
781,068 949,171
Reconciliation between applicable tax rate and average effective tax rate
Applicable statutory tax rate 28.00% 28.00%
141,650 190,250
19. Commitments
Page 20
Short-term bene ts
20X1
20X0
Further related party details are as follows: Amounts owing to parent – refer note
12. The only key management personnel are the executive directors. For their
directors’ emoluments – refer note 20.
The table on the following page analyses the company’s nancial liabilities into
relevant maturity groupings based on the remaining period at the reporting date to
the contractual maturity date. The trade and other payables, current tax payable as
well as bank overdraft are short-term and shown at their carrying amount, as the
impact of discounting is not material. The lease liabilities are shown at their
undiscounted (future cash ow) amounts. The amounts owing to parent are
repayable on demand, and therefore shown as short-term, and at their carrying
amount, as the impact of discounting is not material.
Page 21
There were no changes made in the objectives, policies or processes from the prior
year.
The company’s cash and cash equivalents are reviewed on a periodic basis to
ensure that the best possible return is being obtained.
If interest rates had been 1% lower/higher during the year under review, and all
other variables remained constant, the company’s pre-tax pro t for the year would
have been R32,351 (20X0: R78,301) lower/higher.
Foreign exchange risk
The company imports some of its raw materials, which are invoiced in Australian
dollar and New Zealand dollar. All purchases in foreign currency are settled
immediately to minimise exposure to changes in exchange rates. (All sales are
invoiced in South African Rands.) The company monitors the Rand/Dollar exchange
rates and hedges itself by taking out over-the-counter forward contracts if necessary.
No such contracts were entered into during the current or prior nancial year.
If exchange rates had been 10% lower/higher during the year under review, and all
other variables remained constant, the company’s pre-tax pro t for the year would
have been R182,351 (20X0: R201,301) lower/higher.
Credit risk
Credit risk is concentrated principally in trade receivables as well as cash and cash
equivalents.
Page 22
Trade receivables
Managing credit risk on trade receivables: Before accepting any new credit
customer, the company uses an external party to assess the potential customer’s
credit quality (only AA- and BB-rated clients are accepted) and de nes credit limits
for each customer. Limits are reviewed periodically in accordance with the
requirements of the National Credit Act and upon request by a customer. Overall
credit limits are approved by the board of directors. This process minimises the
exposure to credit losses and affects the calculation of expected credit losses.
Certain trade receivables are insured through an external party depending on the
level of exposure to the company. The maximum exposure in respect of trade
debtors is the balances (carrying amounts) disclosed in note 5.
17,294,723 17,294,723
16,443,209 16,443,209
Page 23
28,688,892 28,688,892
26,032,480 26,032,480
Page 24
Revenue
Cost of sales
(105,274,615) (76,863,054)
Other income
714,975 295,437
Page 25
Operating expenses
20,333,439 17,735,073
Page 26
ACCOUNT 20X1
Prepared by Reviewed by
IB CS
20X2/03/06 20X2/03/30
ACCOUNT 20X1
43,169,987.05
Prepared by Reviewed by
IB CS
20X2/03/06 20X2/03/30
ACCOUNT 20X1
2,144,373.07
Pro t and Loss on Disposal of Property, Plant and
Equipment Lead Schedule
NTSIMBI PIPING PROPRIETARY LIMITED
PROFIT AND LOSS ON DISPOSAL OF PROPERTY, PLANT AND EQUIPMENT LEAD SCHEDULE
Prepared by Reviewed by
IB CS
20X2/03/06 20X2/03/30
ACCOUNT 20X1
41,925.68
THE CONTEXT WITHIN PART
WHICH THE EXTERNAL A
AUDITOR OPERATES
CHAPTER 1 Introduction
CHAPTER 2 Ethics
CHAPTER 3 Legal responsibilities of the
auditor
Introduction CHAPTER 1
Henriëtte Scholtz
CHAPTER CONTENTS
Learning outcomes
Reference list
1.1 Background
1.2 What is the purpose of and need for accounting records?
1.3 What is the objective of and need for nancial statements?
1.4 Why are external auditors needed and what is the purpose of
an external audit?
1.5 What are examples of major corporate accounting scandals in
recent years?
1.6 What are the structures of the accounting and auditing
professions?
Assessment questions
LEARNING OUTCOMES
Describe the purpose of and requirements for accounting
1. records.
2. Describe the Companies Act requirements relating to accounting
records and nancial statements.
3. Describe the assertions contained in nancial statements.
4. Identify and formulate the assertions applicable to the account
balances, classes of transactions and disclosures contained in
nancial statements.
5. De ne an external audit.
6. Explain the need for an external audit.
7. Contrast the external auditor’s responsibility in relation to the
nancial statements with that of a company’s directors.
8. Provide an overview of the steps in the audit process.
9. Describe the inherent limitations of an audit.
10. Differentiate between the types of assurance and non-assurance
engagements and types of auditors.
11. Understand the history of auditing and major events in its history.
12. State and describe the postulates in auditing.
13. Brie y describe the structure of the auditing profession locally
and internationally.
REFERENCE LIST
1.1 Background
During the Industrial Revolution, businesses grew from entities owned
and managed by the same person into large corporations in which the
owners (shareholders) and management (executive directors) were
separate parties. As can be seen in Figure 1.1, the shareholders appoint
the directors of the company to manage their investment in the
company. is is known as the principal-agent theory, where the
shareholders are the principals and the directors are the agents.
e agency theory implies that if the principals do not trust the
agents to provide them with reliable and relevant information, they will
appoint external experts (called auditors), who are independent of the
agents, to review the credibility of the information presented to them.
Today this manifests as follows: e board of directors of a company
is responsible for, among other things, the preparation of nancial
statements (and other reports) for external users (including
shareholders) to account for their stewardship of the company. An
external audit of nancial statements is performed in order to enhance
the credibility of the nancial statements from the users’ perspective
and to reduce the risks that incorrect or misleading information is
conveyed in the nancial statements – as this may lead to incorrect
economic decision making by the users of the nancial statements.
What enhances the credibility of audited nancial statements is the
auditor’s report that accompanies the nancial statements (refer to
page 2 of Ntsimbi Piping’s nancial statements). is is prepared and
issued by the external auditor after the audit team has completed a
process known as the audit process (refer to section 1.4.5.3.1 of this
chapter and to Chapter 11 for more details). In this auditor’s report, the
auditor expresses a high level of assurance (comfort) on whether the
nancial statements fairly present the nancial position, performance
and cash ows of the company.3
CRITICAL THINKING
What can shareholders do if they are not satis ed with the way
in which directors are using the company’s assets and
resources in which their funds are invested?
Shareholders appoint the directors and they can vote at a
shareholders’ meeting to remove the directors.
CRITICAL THINKING
Why do sole proprietors need accounting records?
Sole proprietors need accounting records when they apply for
nance, for completing tax returns, and to enable a potential
buyer or investor to look at the records if a sole proprietor is
selling or expanding the business.
In South Africa, legislation requires companies keep proper accounting
records. Refer to section 1.3.4 of this chapter for the Companies Act 71
of 2008 requirements relating to accounting records.
CRITICAL THINKING
What documentation would be created for a purchases
transaction?
For a purchases transaction the following documentation would
be present:
• Purchase order
• Supplier delivery note
• Goods received note
• Supplier purchase invoice
• Purchases journal and creditors ledger
• Supplier statement
• General ledger
• Trial balance
• Financial statements
CRITICAL THINKING
Who is ultimately responsible for nancial statements?
According to the Conceptual Framework for the Financial
Statements, management (in South Africa for companies, this is
the board of directors as per the Companies Act) is ultimately
responsible for the preparation and presentation of nancial
statements.
1.3.3 e assertions made by the preparers of
the nancial statements
When issuing nancial statements, the preparers of these statements
(management/directors) are effectively making many representations
(statements) about, among other things, the nancial position, nancial
performance and cash ows of the entity. ese representations made
by management are called assertions (refer to the IAASB Glossary of
Terms).
ISA 315.A129 classi es the assertions as follows:
• Assertions relating to classes of transactions, events and related
disclosures; and
• Assertions relating to account balances and related disclosures.
Closing 16,584,187
balance
(31/12/20X1)
You will notice that the account consists of the following elements:
• An opening balance;
• Various types of debit and credit entries; and
• A closing balance.
Note the types of debit and credit entries that appear in the account,
such as credit sales entries on the debit side and sales returns entries on
the credit side. Each of these types of debit and credit entries represents
a class of transactions impacting the account. e closing balance is
the account balance, whereas the note to the nancial statements
where additional information about trade receivables is provided (note
5 on page 17 of the Ntsimbi Piping (Pty) Ltd nancial statements) is the
disclosure.
Now look at Table 1.1 that provides descriptions of the various
assertions and also indicates which assertions apply to which of the
three elements explained above.
CLASSES OF
ACCOUNT
TRANSACTIONS,
BALANCES AND
ASSERTIONS EVENTS AND
RELATED
RELATED
DISCLOSURES
DISCLOSURES
Existence:
Assets, liabilities
and equity that
appear in the
X
nancial statements
exist at the date of
the nancial
statements.
CLASSES OF
ACCOUNT
TRANSACTIONS,
BALANCES AND
ASSERTIONS EVENTS AND
RELATED
RELATED
DISCLOSURES
DISCLOSURES
Occurrence:
Transactions and
events that have
been recorded in the
nancial statements X
have actually
occurred during the
nancial period and
relate to the entity.
Accuracy, valuation
and allocation:
Assets, liabilities
and equity are
included in the
nancial statements
at the correct
amounts and any
adjustments to the X
valuation or
allocation have been
appropriately
recorded and
disclosures have
been appropriately
measured and
described.
CLASSES OF
ACCOUNT
TRANSACTIONS,
BALANCES AND
ASSERTIONS EVENTS AND
RELATED
RELATED
DISCLOSURES
DISCLOSURES
Accuracy:
Amounts and other
data relating to
recorded
transactions have
been recorded
appropriately (e.g. in X
the correct amounts)
and appropriate
disclosures have
been appropriately
measured and
described.
Rights and
obligations:
The entity holds or
controls the rights to
the assets re ected
X
in the nancial
statements, and
liabilities re ected
are the obligations
of the company.
CLASSES OF
ACCOUNT
TRANSACTIONS,
BALANCES AND
ASSERTIONS EVENTS AND
RELATED
RELATED
DISCLOSURES
DISCLOSURES
Cut-off:
Transactions and
events have been
X
recorded in the
correct accounting
period.
Completeness:
All transactions,
events, assets,
liabilities, equity and
disclosures that
should have been X X
recorded and
included in the
nancial statements
have been recorded
and included.
Classi cation:
Assets, liabilities,
equity, transactions
X X
and events have
been recorded in the
proper accounts.
CLASSES OF
ACCOUNT
TRANSACTIONS,
BALANCES AND
ASSERTIONS EVENTS AND
RELATED
RELATED
DISCLOSURES
DISCLOSURES
Presentation:
Financial information
is appropriately
presented and X X
described, and
disclosures are
clearly expressed.
Ntsimbi Piping
Example: Property Plant and Equipment (PPE) with a carrying amount
of R43,169,987 in the Statement of Financial Position of Ntsimbi Piping
at 31 December 20X1
e directors of Ntsimbi Piping have made the following assertions by
re ecting the PPE balance on page 7 of the Statement of Financial
Position:
Existence: PPE of R43,169,987 actually exists at 31 December 20X1;
Accuracy, valuation and allocation: e PPE re ected in the
Statement of Financial Position at R43,169,987 is measured at the
appropriate carrying amount (meaning the assets were appropriately
measured at recognition; as well as continue to be appropriately
measured after recognition – i.e. taking into account adjustments for
impairments, depreciation, etc.) and disclosures have been
appropriately made (e.g. gross carrying amount and accumulated
depreciation at the beginning and end of the year);
Rights: Ntsimbi Piping holds the rights to the PPE of R43,169,987 at 31
December 20X1;
Completeness: All PPE assets of Ntsimbi Piping that should have been
recorded are recorded in the account balance re ected in the Statement
of Financial Position at 31 December 20X1;
Classi cation: All PPE assets of Ntsimbi Piping have been recorded in
the proper accounts (e.g. the PPE assets have been recorded as PPE and
not as intangible assets); and
Presentation: All PPE assets of Ntsimbi Piping have been appropriately
presented and disclosures are clearly expressed (e.g. the depreciation
method, depreciation rate and useful lives have been disclosed, as well
as reconciliation of carrying amount from beginning of the year to the
end of the year, showing additions to PPE, disposals of PPE,
revaluations of PPE, depreciation and any other movements).
CRITICAL THINKING
How should cryptocurrency be accounted for?7
There are no current existing accounting requirements to account
for cryptocurrency. Accounting at fair value with movements
re ected in pro t or loss would provide the most useful
information to investors.8
Now read through the auditor’s report on page 2 of the Ntsimbi Piping
nancial statements again. Note in particular the wording of the opinion
of the auditor.
CRITICAL THINKING
Can an auditor guarantee that the nancial statements are
100% accurate?
No, an audit can only provide reasonable assurance for reasons
listed in 1.4.5.2 above.
CRITICAL THINKING
What kind of engagement (assurance or non-assurance) is the
preparation of an income tax return by a practitioner?
And expressing an opinion on the fair presentation of a SARS
creditor balance in the Statement of Financial Position?
Preparation of the tax return is a non-assurance engagement,
whereas expressing an opinion on the fair presentation of the
SARS creditor balance is an assurance engagement.
WorldCom
Why is the WorldCom scandal important?
• WorldCom was the second-largest long-distance
telecommunications and data-services provider company in the
USA.
• WorldCom was once the fth most widely held company in the USA
and was rated rst for the best return to shareholders over a ten-year
period.
• Scott Sullivan, the CFO of WorldCom, was once the highest-paid
CFO in the USA and was well regarded by Wall Street. In the late
1990s, he received the CFO Excellence Award from the CFO
Magazine for work done in regard to mergers and acquisitions.
• WorldCom made corporate history when it acquired MCI, a
company three times its own size. e acquisition was nanced by
debt.
e WorldCom bankruptcy was the largest bankruptcy in the history
• of the USA at the time (21 July 2002). It was twice as large as Enron’s
record-setting bankruptcy led in December 2001.
Parmalat
Why is the Parmalat scandal important?
• In the wake of the Enron and WorldCom scandals, Europe’s CFOs
insisted that a nancial statement fraud of this magnitude could not
occur in Europe.
• Parmalat was the largest Italian food company and the fourth-largest
food company in Europe.
• When it occurred, Parmalat was the largest bankruptcy case in
European history, representing 1.5% of Italy’s gross national product
– proportionally larger than the ratio of the combined Enron and
WorldCom bankruptcies to the US gross national product.
It should be noted that at the time of writing, these allegations have not
yet been proven – as the forensic investigation (undertaken by PwC) is
still in progress. However, what is known is that there are material
misstatements in the 2015 and 2016 annual nancial statements, as the
company has publicly announced that these can ‘no longer be relied
upon’. 26
Assessment questions
For questions 1 to 4, select the correct answer:
1. e purpose of accounting records is/are: (More than one option is
possible.) (LO 1)
a) To ensure that records of transactions are kept
b) To ensure an effective nancial management system
c) To ensure that management has evidence of transactions and
balances
d) To ensure that nancial statements can be audited
13. Explain why an auditor can only provide reasonable assurance and
not absolute assurance. (LO 9)
17. Discuss one major event that affected the auditing profession (i)
locally and (ii) internationally and give a reason why you think it
affected the auditing profession. (LO 11)
19. List the four major stages in the audit process. (LO 8)
22. e auditor has to test all the transactions that occurred during a
reporting period of the auditee and thereby provide reasonable
assurance to users. (LO 5)
Henriëtte Scholtz
CHAPTER CONTENTS
Learning outcomes
Reference list
2.1 What is the nature of ethics?
2.2 Why do professions have codes of ethics?
2.3 What are the ethical codes and rules applicable to external auditors in South
Africa?
2.4 What constitutes prohibited actions for the external auditor?
2.5 How do the SAICA and IRBA disciplinary processes work?
2.6 What is the content of the SAICA and IRBA Codes of Professional Conduct?
2.7 How does ethics t into the audit process?
Assessment questions
LEARNING OUTCOMES
1. Explain what ethics are and why professions have codes of ethics.
2. Explain where in the audit process ethical requirements are considered.
3. Contrast the principles-based approach to ethics with a rules-based approach.
4. Explain which ethical codes and rules are applicable to Registered Auditors in South
Africa and what constitutes prohibited actions.
5. Brie y outline the disciplinary processes of the IRBA and SAICA.
6. Describe and apply the conceptual approach to ethics adopted in the
IFAC/SAICA/IRBA Codes of Professional Conduct.
7. Describe the guidance contained in the Codes of Professional Conduct and apply
this to practical situations.
8. Describe what constitutes improper conduct in terms of the IRBA’s Rules Regarding
Improper Conduct and apply these Rules to practical situations.
REFERENCE LIST
IN THE NEWS
EY ned $9m for improper auditor relationships
The U.S. Securities and Exchange Commission (SEC) said one member of the audit
team maintained an ‘improperly close’ friendship with the CFO of a New York-based
public company. The relationship between the audit member and the CEO
comprised personal emails, voice and text messages, sport events tickets and
gifts. On another audit, a member of the engagement team auditing the rm had a
romantic relationship with the chief accounting of cer of the company being
audited. The supervisor on the audit ‘became aware of facts suggesting the
improper relationship yet failed to perform a reasonable inquiry or raise concerns
internally.’ SEC rules forbid auditors from misrepresenting they are independent.
‘The individuals at the centre of these matters violated multiple EY policies, hid
their conduct and behaved in a way that was antithetical to EY’s Global Code of
Conduct, culture, values, policies, and training.’1
Registration of KPMG auditors at risk over Gupta audit
The KPMG partners, responsible for the audit of Gupta-owned Linkway Trading
(‘Linkway’) risk losing their designation as registered auditors if an investigation by
the profession’s regulator nds improper conduct on their part. The Independent
Regulatory Board for Auditors may, in terms of the Auditing Profession Act and
following a disciplinary hearing, impose a warning, or ne, or cancel an audit
practitioner’s registration where improper conduct is found. The board is now
investigating KPMG’s 2014 audit of Linkway, which paid for the R30m Gupta
wedding at Sun City in 2013, using money meant to develop Free State farmers.
The amaBhungane Centre for Investigative Journalism, reported that leaked Gupta
emails revealed how money from the Free State provincial government had owed
via the Estina company to the Gupta-owned company Accurate Investments in Dubai
and then on to Linkway.2 Linkway, supposedly a project management company in the
Gupta-owned Oakbay Group, used the money to pay for a Gupta family wedding. By
classifying it as a business expense, it paid no tax on the income. KPMG, which
resigned as Oakbay auditor in April 2016, said it was standard procedure for
entities such as Linkway to ‘receive and disburse funds against a speci c event’.
KPMG said it was not auditors of any offshore entities and therefore could not
comment on the ow of funds from the Free State dairy project. ‘We have acted with
integrity in our dealing with the Oakbay Group’, Moses Kgosana, previous CEO at
KPMG commented. Yet, during the time of the audit of Linkway he attended the
Gupta wedding and has since elected to withdraw as future chairman of Alexander
Forbes. Kgosana, who served on the company’s board for two years, was due to
become chairman of Alexander Forbes on 31 August 2017. He felt that time spent
dealing with these allegations would compromise what he was able to deliver as
chairman. The South African Institute of Chartered Accountants (SAICA) said it
would await the outcome of the audit regulator’s investigation before deciding
whether to take any disciplinary action in terms of its own code of conduct.2
Inside IRBA’s Deloitte disciplinary hearings
A lot is at stake for the Independent Regulatory Board for Auditors (IRBA), as the
audit regulator is leading the disciplinary hearing of Deloitte – the biggest case it
has handled since its 2006 inception. The disciplinary hearing could either entrench
perceptions that the IRBA has neither bark nor bite at a time when audit rms are
caught in accounting scandals, or prove sceptics wrong. The IRBA charge sheet
against two senior executives of Deloitte contains ten charges of misconduct. In
these hearings Deloitte have to explain why unquali ed auditor’s reports were
issued and why questions were not raised about the going concern status of African
Bank, and its then-parent company African Bank Investments Limited (Abil).
According to the IRBA, African Bank failed to comply with the international
accounting standards on the recognition of nancial instruments. The audited
nancial statements of African Bank for the year ended September 2014 showed a
restatement relating to differences between impairment models and the impairment
provisions recognised in the 2013 nancial statements. The impact of this
restatement on September 2013 was a R656 million downward adjustment of
African Bank’s income pre-tax. African bank’s management at the time identi ed
loan collection initiatives that could collect but Deloitte’s Jordan allegedly accepted
this without considering its validity. Jordan faces charges relating to African Bank’s
misstatement of loan impairments, which resulted in impairments that were
understated by R1.1 billion.3
Reserve Bank continues to meet with KPMG following VBS scandal
Since VBS was placed into curatorship and its nancial records investigated it has
emerged that some R900 million of its supposed deposits could not be traced.
There is seems to be extensive evidence that the VBS nancial statements –
signed off by its auditors – were in a terrible state, possibly a case of the auditors
not applying suf cient professional competence and due care while performing the
audit. It turned out that VBS had accidentally paid that money out ‘due to internal
control failures in a branch’. There had been ‘inept risk management functions and
practices’ the Reserve Bank said.4 The Reserve Bank says its interest in KPMG
stems from a public policy perspective arising from its mandate to ensure the
soundness and stability of South Africa’s nancial system. In a statement, the
Reserve Bank said: ‘Auditors play an important role in fostering market con dence
in the nancial statements of nancial institutions. The robustness and integrity of
audits depend to a large extent on the strength of governance and the depth of an
ethical culture within a nancial institution. These are issues that we monitor
constantly.’5
A code of ethics is important for a profession as it establishes the ethical expectations from
existing members for those joining the profession. A code of ethics is intended to be:
• A central guide and reference for members in support of day-to-day decision making;
• A tool to encourage discussions of ethics and to improve how members deal with the
ethical dilemmas, prejudices and grey areas that are encountered in everyday work; and
• Complementary to relevant standards, policies and rules – not a substitute for them.8
e difference between a code of ethics and a code of conduct is that a code of ethics
expresses fundamental principles that provide guidance in cases where no speci c rule is
in place or where matters are genuinely unclear. A well-drafted code of conduct will be
consistent with the primary code of ethics; however, it will provide much more speci c
guidance in dealing with ethical challenges. e SAICA and IRBA codes of conduct expand
the IFAC code somewhat by providing a local application of some sections of the code. An
example of this is the de nition of the fundamental principle of professional behaviour,
which, in the SAICA code of conduct, contains additional guidelines for multiple rms, and
signing convention for reports or certi cates.9
It is important to note that a code of conduct establishes the minimum ethical
requirements that are expected from the profession’s membership, and does not represent
an unattainable dream.
CRITICAL THINKING
To what risks and challenges would a profession be exposed without a code of
ethics?
The risks a profession could be faced with include, among other things:
• No communication of ethical expectations of the members of a profession would
exist. Ethical decision making by professionals would be dif cult which would
lead to varying standards of behaviour;
• It will be dif cult to hold the profession accountable for actions if no ethical
principles exist; and
• The public trust and the profession’s reputation could be damaged if members
act unethically and if no disciplinary process exists to correct the unethical
behaviour.
SMSF Auditors
Australia requires a registered auditor to conduct a nancial and compliance audit on self-
managed super funds, which is an annuity trust structure that provides bene ts to its
members on retirement. Several cases of breaches of independence of the code of ethics by
auditors were reported. In two of these cases, the auditors were found guilty of auditing
funds in which they and close family members were invested and of funds where they were
directors or trustees.11
Nkonki Inc
Sindi Zilwa, born Nkonki, was the second black woman in South Africa to qualify as a
Chartered Accountant (SA), in 1990. Two years later she started her own accounting rm, a
precursor to Nkonki Inc. In 1996, a merger took place to form Nkonki Sizwe Ntsaluba, the
rst national black accounting rm in South Africa. In 2013, Transnet outsourced its
internal audit function to three rms including Nkonki. Income from the transport utility
soon dwarfed that from Nkonki’s other clients. In 2015, Transnet accounted for 45% of
Nkonki’s R161m revenue internal records show, which could impose a self-interest threat
to independence. But in 2016, income from Transnet fell sharply. In the cash- ow crunch
that followed, millions of rands in employee tax deductions were not paid over to the South
African Revenue Service, exposing Nkonki to penalties and reputational risk. Mitesh Patel
offered a way out of Nkonki’s nancial troubles. Eric Wood, the CEO of Trillian Capital, a
Gupta-linked company, approached Patel with an offer to buy Nkonki on behalf of a black
CA. e deal was funded by a loan from Trillion Capital, which Patel claimed he did not
know about. After the buy-out, Nkonki instantly landed new work from Eskom, the state
utility whose board and executive were allegedly under Gupta in uence. Nkonki was
potentially also going to earn hundreds of millions in consulting fees from Eskom.19 Mitesh
Patel, the CEO of Nkonki, resigned in April 2018. e Auditor General terminated its
contract with Nkonki, due to concerns about the independence and adequacy of risk
management practices of Nkonki and also whether all shareholders were registered
auditors. ‘One of the key elements of independence for auditors is embedded in the
Auditor Professions Act, which stipulates that the only rms that may be registered
auditors are partnerships where all individuals are registered auditors, sole proprietorship
where the owner is a registered auditor, or companies which are registered by the
Independent Regulatory Board of Auditors (IRBA)’ Auditor General Kimi Makwetu said.20 A
week after the Auditor General announced the termination of public auditing contracts
with KMPG and Nkonki Inc., the latter rm announced it has taken the ‘very painful and
difficult’ decision to be placed in voluntary liquidation.21
Masterbond
In the early 1990s, following the liquidation of the group of companies, the name
‘Masterbond’ was associated in South Africa with pensioners who invested in the group
struggling for survival on dog food and the kindness of others after losing their life savings.
e Nel Commission’s report on its investigation of the Masterbond case provided proof of
auditor dishonesty, collusion of auditors with management, and lack of auditor
independence because of non-audit services provided to auditees.
e then-Public Accountants and Auditors Board (the predecessor of the IRBA) found
the auditor involved guilty of improper conduct (as discussed in section 2.4.1 of this
chapter). e auditor was sanctioned by a ne of R10 000 (being the maximum ne at the
time) and suspension from practice for two years, suspended for three years on condition
that the accused was not found guilty of contravening the Disciplinary Rules (the
predecessor of the Rules Regarding Improper Conduct) during that period.22
EXAMPLE
Manufacture Limited, a client of the rm of registered auditors, Nel and Associates
(Nel), wants to take over another business and requires a loan from the bank to
nance the takeover. The bank requires a pro t forecast in order to approve the
loan. Manufacture Limited completes the pro t forecast and engages Nel and
Associates, the company’s external auditors for the past year, to review and sign
the pro t forecast as being ‘correct’. Mr Nel, the partner in charge of the audit of
Manufacture Limited, signs the pro t forecast.
By signing the pro t forecast, Mr Nel, has contravened the Rules Regarding
Improper Conduct by allowing his name to be used in connection with an estimate
of earnings that is dependent on future transactions. It may be perceived by the
bank that he vouches for the accuracy of the pro t forecast.
EXAMPLE
Remind yourself of the facts regarding the example involving Mr Nel in section
2.4.1. Now assuming Mr Nel is also a Chartered Accountant (SA). Can he be
found guilty of a punishable offence by SAICA?
In by-law 34 of SAICA, there is no equivalent to Rule 2.9 of IRBA. However, given
that one cannot guarantee the reasonableness of a pro t forecast, Mr Nel clearly
also acted without professional competence. Accordingly, he can be found guilty by
SAICA of a punishable offence in terms of the following by-laws: by-law 34.1; 34.2;
34.3; and/or 34.10 (as professional competence and due care is a fundamental
principle of the SAICA Code).
Figure 2.2: Summary of the IRBA Rules Regarding Improper Conduct applicable to RAs
Figure 2.3: Summary of SAICA punishable offences (by-law 34)
EXAMPLE
Outcome of SAICA disciplinary process
An Associate General Accountant (registered as an AGA with SAICA) was found
guilty as he sent out a misleading letter to a client pretending to be an RA. He
failed to respond to correspondence and did not attend the hearing. He was
permanently excluded from associate membership, a previous suspended ne of
R25 000 became payable and he had to contribute to the legal costs of R20
000.25
Outcome of IRBA disciplinary process
The respondents’ audit rm prepared the annual nancial statements or performed
accounting services for clients where the respondents were the audit engagement
partners. In so doing, the respondents contravened section 90(2) of the
Companies Act. The respondents were each sentenced to a ne of R80 000, of
which R40 000 has been suspended for three years (on condition that the
respondents are not found guilty of unprofessional conduct committed during the
period of suspension), a cost order of R5 000, and publication by the IRBA of the
details of the case in general terms.26
Outcome of IRBA disciplinary process
The respondent was appointed as executor of a deceased estate. Despite the
client making numerous requests for various copies of documentation, the
respondent failed to provide the client with the documentation. The respondent
was sentenced to a ne of R50 000, of which R20 000 was suspended for three
years (on condition that the respondent is not found guilty of unprofessional
conduct committed during the period of suspension), no costs order and
publication of the details of the case by the IRBA in general terms.27
Outcome of IRBA disciplinary process
An audit team member was a bene ciary in a trust that held a signi cant interest
in an audit client. The respondent failed to identify and respond to this
independence threat for which no safeguards exist. The respondent was
sentenced to a ne of R80 000, of which R40 000 has been suspended for three
years (on condition that the respondent is not found guilty of unprofessional
conduct committed during the period of suspension), no costs order and
publication by the IRBA of the details of the case in general terms.28
IN THE NEWS
Auditor ethics
Enron, Parmalat, WorldCom and Steinhoff – these corporate reporting and
accounting scandals have shaken the foundations of investor con dence in the
transparency, integrity and accountability of corporations and capital markets. There
has also been public disquiet about the role professional auditors and auditing
rms have played in these corporate scandals.
For the audit profession, these highlighted the gaps between public expectations
and the reality of the role of the auditor. The biggest challenges for auditors ahead
is to identify how ethical behaviour can be – and be seen to be – restored, as it is
this that will be the basis for the reconstruction of public trust in the profession and
in the practice of auditing.
The revised IFAC International Code of Ethics for Professional Accountants,
issued in 2018, strengthened independence provisions contained in the Code to
raise public trust in the accounting profession.29
2.6 What is the content of the SAICA and IRBA
Codes of Professional Conduct?
2.6.1 Background to the SAICA and IRBA Codes of
Professional Conduct
Global corporate nancial reporting scandals, such as those involving Enron, WorldCom
and Steinhoff, negatively affected the standing of the auditing profession and questions
arose about auditor ethics (e.g. auditors not avoiding situations where their independence
is compromised).
Due to the nature of the work carried out by auditors, ethics are of the utmost
importance – auditors should be ethical at all times and in all circumstances. Various
stakeholders rely on the outcome of the work performed by the auditor as conveyed in the
opinion section of the auditor’s report. Owing to the nature of the auditor’s report, it is very
difficult to gauge the exact nature of the work performed by the auditor. Hence the
stakeholder has to rely on the auditor to do a proper job. Any de ciency in the auditor’s
professional conduct or any improper conduct in their personal life places the integrity of
the auditor in question, and may raise doubts about the reliability of the auditor’s report
(and speci cally the audit opinion). e adoption and application of a code of ethics for
auditors promotes stakeholders’ trust and con dence in auditors and their work.30
As discussed in Chapter 1, IFAC is responsible for the establishment and promotion of
standards, including ethical codes. IFAC’s International Ethics Standards Board for
Accountants (IESBA) maintains the International Code of Ethics for Professional
Accountants to serve as a model for all codes of ethics developed and used by national
accountancy organisations (including SAICA). In 2001, IFAC for the rst time adopted a
conceptual framework approach for a section of the code of ethics dealing with
independence. In 2003, the IFAC ethics committee issued a revised code of ethics in order
to restore the standing of the auditing profession after the global corporate collapses. is
2003 code contained a conceptual framework for the entire code whereby threats to the
fundamental principles had to be identi ed, their signi cance evaluated and safeguards
implemented. Most recently in 2018, the IESBA completed a restructuring of its code of
professional ethics to make the code more understandable and easier to use, but also to be
more robust with substantial improvements in many areas, including auditor
independence.
SAICA formally adopted the 2003 version of the IFAC International Code of Ethics for
Professional Accountants with effect from 30 June 2006, but added an additional part
(called Part D or section 400), which speci cally focused on professional accountants in
South Africa. e adoption of the IFAC Code was done to improve con dence in the local
accounting profession. From November 2010, the Board of SAICA resolved to accept the
IFAC Code issued on 1 April 2006 in its entirety, but added limited additional guidance in
Part A to assist with the local application of certain requirements applicable to all
professional accountants in SA. Part D (or section 400) of the SAICA Code was removed in
the 2010 version of the SAICA Code. At the time of writing, all indications are that the IFAC
restructured code issued in 2018 will also be accepted by SAICA, with certain South African
amendments, and will be applicable from 15 June 2019. A South African work group is
adapting the IFAC Code for South African circumstances.
After careful consideration and a mapping exercise between the IRBA Code of
Professional Conduct in issue at the time and the IFAC International Code of Ethics for
Professional Accountants, the IRBA decided to adopt Parts A and B of the IFAC
International Code of Ethics for Professional Accountants (issued 1 April 2006). e then-
IRBA Code of Professional Conduct was repealed and replaced by a new IRBA Code of
Professional Conduct based on the IFAC International Code of Ethics for Professional
Accountants with effect from 1 January 2011. At the time of writing, all indications are that
the IFAC restructured code issued in 2018 will also be accepted by IRBA, with some South
African amendments, which will be effective from 15 June 2019.
Table 2.1: Differences between the IFAC International Code of Ethics for Professional
Accountants, the IRBA Code of Professional Conduct and the SAICA Code of
Professional Conduct
IFAC IRBA31 SAICA32
Section 330 Fees and Section 330 provides additional guidance regarding the
other types of charging of contingent fees when preparing tax returns.
remuneration Additional safeguards, i.e. obtaining advance agreement
upfront and in writing from the client for commission or
referral arrangements, were also added.
Section 350: Custody of Section 350: Custody of client assets was expanded to
client assets include additional guidance for the local application of
the code.
The following additional matters were included:
• Section 350.4a SA: Guidance on what to do when it
is believed that money was received from illegal
activities.
• Section 350.6 SA: Speci c instructions regarding
what to do with client monies received.
• Section 350.7a SA: Speci c instructions regarding
what to do with client assets other than monies
received.
• Section 350.8A1 SA: Speci c instructions regarding
possible measures of protection (of client assets).
• Section 350.9 SA: Speci c instructions regarding
custody of client assets for audit or other assurance
clients.
Section 400.8: Public Section 400.8 was updated to expand the de nition of
interest entities public interest entities in a South African context.
Section 540.5: Long Section 540.5a SA was added to include guidance that
association the professional accountant might need to consider
threats relating to non-assurance services when
considering the association with clients.
A professional accountant may not knowingly be associated with any statement, account or
return that:
• Contains a materially false or misleading statement;
• Is issued recklessly; or
• Omits or obscures information.
EXAMPLE
Susan Smith, a registered auditor, is the audit partner assigned to the audit of
Seagull Limited, a listed company. Susan advises her friend to purchase shares
in Seagull as the company will take over another company after the release of its
nancial results and it is expected that the share price will increase
substantially. Did Susan Smith act unethically?
Yes, con dential information may not be used for personal advantage or advantage
of third parties. (Note: Susan Smith is also likely to be guilty of an insider trading
offence in terms of the Financial Markets Act 19 of 2012 – and as such in breach
of the principle of professional behaviour).
WHAT What if a member of the audit team becomes aware of fraud in which
the directors of an auditee are involved? Can this be disclosed?
IF? This fraud can (and has to) be disclosed to the IRBA if the requirements
of section 45 of the Auditing Profession Act are met – as the auditor will
have a professional duty to report this information (refer to Chapter 3 for
a detailed discussion of the relevant requirements of this Act). If the fraud
has an impact on the fair presentation of the nancial statements, this
will also be disclosed in the auditor’s report.
e professional accountant shall consider the context in which the issue has arisen.
2.6.4.4.2.1 Independence
e professional accountant in public practice is required by International Independence
Standards to be independent when conducting these engagements. Independence is
linked to fundamental principles of objectivity and integrity, and includes independence
in mind and in appearance.
e IAASB Glossary of Terms de nes these terms as follows (SAICA Handbook Vol 2):
• Independence in mind: A state of mind that permits the provision of an opinion without
being affected by in uences that compromise professional judgement, allowing an
individual to act with integrity and exercise objectivity and professional scepticism.
• Independence in appearance: e avoidance of facts and circumstances that are so
signi cant that a reasonable informed third party, having knowledge of all relevant
information, including safeguards applied, would reasonably conclude that a rm’s or a
member of the assurance team’s integrity, objectivity or professional scepticism has
been compromised.
A professional accountant who intends to rely on the work of others (whether internal or
external from the employer) shall take steps to ensure that he or she complies with the
requirements of preparation and presentation of information and consider:
• e reputation, expertise and resources available to the other individual; and
• Whether the other individual is subject to professional and ethical standards.
When a professional accountant knows or has reason to believe that the information that
the professional accountant is associated with is misleading, the professional accountant
shall take appropriate actions such as:
• Discussing these concerns with a superior, management or those charged with
governance of the employer and request that appropriate action is taken such as:
• Having the information corrected;
• Informing users and correcting information if already disclosed to users; and
• Consulting the policies and procedures within the employer (such as ethics and
whistle-blowing policies).
If appropriate actions have not been taken by the employer, and the professional
accountant believes that the information is misleading, the professional accountant, while
remaining cognisant of the principle of con dentiality, might consider:
• Consulting with a relevant professional body;
• Consulting with the internal and external auditor;
• Legal counsel;
• Determining whether any requirements exist to communicate with:
• ird parties including users;
• Regulatory or oversight bodies; and
• If after exhausting all feasible options, the professional accountant shall refuse to be
associated with the information in which case it might be appropriate to resign.
EXAMPLE
Viwe Khumalo CA(SA) is the nancial manager of Furniture Limited (‘Furniture’).
She is responsible for the preparation of the nancial statements of Furniture.
The chief executive of cer (CEO) of Furniture expects Viwe to not consolidate
all subsidiaries and only include those that are pro t-making (and not those that
are loss-making) – in order to make earnings appear better than they actually
are.
Discuss this with reference to the CPC.
If Viwe only includes pro t-making subsidiaries, and not those that are loss-
making, self-interest and intimidation threats to integrity, objectivity, professional
competence and due care, and professional behaviour will be created.
The threats will be signi cant, as she is expected to act contrary to the
Companies Act and IFRS by fraudulently misrepresenting information and not
consolidating subsidiaries fully.
Safeguards include the following:
• Refuse to selectively consolidate the subsidiaries nancial information, and
explain the reasons why she cannot do so. If the CEO still insists that this be
done, she should obtain advice from the audit committee or independent
directors of Furniture (if any), or seek advice from an independent professional
or SAICA;
• Use the formal dispute resolution process or whistle-blowing process in
operation in Furniture (if applicable); and/or
• Seek legal advice.
If these safeguards fail to yield a satisfactory outcome, she should resign and
provide her reasons to the board of directors of Furniture.
A self-interest threat to professional competence and due care could be created when the
professional accountant has:
• Insufficient time for performing or completing tasks;
• Incomplete, restricted or inadequate information when performing duties;
• Insufficient expertise, training or education; or
• Inadequate resources for performance of duties.
Factors that are relevant in evaluating the level of such a threat will depend on the:
• Extent of working with others (e.g. whether there are superiors or peers available to ask
advice or help);
• Seniority of the individual; and
• Level of supervision and review.
A self-interest threat to professional competence and due care could arise if Isak
Tenene accepts this appointment.
The threat will be signi cant, as Isak has never been employed in the nancial
services industry before and thus has no knowledge of the laws and regulations,
nancial management practices, and nancial reporting standards applicable to
this industry.
EXAMPLE
Karin Booth CA(SA), the nancial manager of Zeelight Limited (‘Zeelight’), is
responsible for the preparation of the nancial statements of Zeelight. She will
receive an incentive bonus based on the company’s reported pro t after tax for
the 20X1 nancial year. She therefore wants to present the best possible
nancial results for Zeelight.
Discuss this matter with reference to the CPC.
If Karin Booth receives a performance-related bonus, it will create a self-interest
threat for objectivity.
The threat will be signi cant as the incentive bonus is based on the pro t after
tax gure.
Safeguards that could be implemented are internal and external audit
procedures on the appropriateness of the pro t after tax gure for the 20X1
nancial year and the awarding of bonuses.
Figure 2.8: Factors to consider when determining whether there is an actual or perceived intent to in uence
behaviour
Figure 2.9: Examples of actions that might be safeguards
Inducements made with no intent to improperly in uence behaviour can still create threats
to the fundamental principles. Self-interest threats can be created where the professional
accountant is offered part-time employment by a vendor. Familiarity threats may be
created if a professional accountant regularly takes a vendor or a supplier to sporting
events. Intimidation threats may be created if the professional accountant accepts
hospitality which could be perceived to be inappropriate were it to be publicly disclosed.
If the inducement is trivial and inconsequential the threats will be at an acceptable
level.
EXAMPLE
Mr Ricardo is a professional accountant working as an internal auditor at Nala
Limited (‘Nala’). During the performance of an internal audit of the sales division
of Nala, he detected fraud committed by the sales clerk. The sales clerk offered
to pay a substantial amount into Mr Ricardo’s bank account in return for not
disclosing this fraud.
Discuss this matter with reference to the CPC.
A self-interest threat and an intimidation threat to integrity, objectivity and
professional behaviour will be created if the amount is accepted.
The threat will be signi cant, as it is an amount offered not to disclose fraud,
which is an illegal act.
Non-compliance might result in nes, litigation or other consequences for the employing
organisation, potentially materially affecting its nancial statements, and may have wider
public interest implications of potential harm to investors, creditors, employees or the
general public (e.g. breaches of environmental laws and regulations endangering health
and safety of employees or the public). NOCLAR can be committed by the employing
organisation, those charged with governance, management or other individuals working
for or under the direction of the employing organisation.
If a professional accountant becomes aware of NOCLAR in the course of carrying out
professional activities, a self-interest or intimidation threat is created to integrity and
professional behaviour. Refer to Figure 2.11 for examples of laws and regulations that could
be transgressed which will trigger NOCLAR responsibilities for the professional
accountant. Refer to Figure 2.12 for actions required. In exceptional circumstances,
immediate disclosure to the appropriate authority may be required.
A distinguishing mark of the accounting profession is the acceptance of the
responsibility to act in the public interest. When responding to NOCLAR the objectives of
the professional accountant are:
• To comply with the principles of integrity and professional behaviour;
• By alerting management or those charged with governance to seek to:
• Enable them to rectify, remediate or mitigate the consequences of NOCLAR; or
• Deter the NOCLAR if it has not yet occurred.
• To take such further action as appropriate in the public interest.
Figure 2.11: Examples of laws and regulations that could be transgressed for NOCLAR
Figure 2.12: Actions required for NOCLAR
EXAMPLE
Ricardo January is a CA(SA) working as the head of internal audit at Siesa
Proprietary Limited (‘Siesa’), a waste water management facility. During the
performance of an internal audit, Ricardo detected that Siesa released polluted
water into the Vaal River which exceeded the permitted pollution levels by 50
times.
Discuss whether there are any actions that Ricardo January should take with
reference to the CPC.
• If a NOCLAR exists, a self-interest or intimidation threat is created to integrity
and professional behaviour.
• Ricardo January must consider whether the pollution constitutes a possible
NOCLAR:
• It is an action;
• By the management of Siesa; and
• It is contradictory with Health and Safety Acts (e.g. Waste Act 59 of 2008).
Part 3 of the CPC contains examples of situations that may create threats to ethical
behaviour for the professional accountant in public practice – refer to Figure 2.13 and to
Table 2.3. Note that the examples are not intended to be a complete list of all circumstances
that may arise for the professional accountant in public practice.
In order to reduce these threats to an acceptable level, the professional accountant can
apply certain safeguards – refer to Figure 2.14 for factors which may in uence the
evaluation of threats, and to Figure 2.15 for safeguards that can be applied. To determine if
safeguards are still appropriate consideration should be given to changes at the client
(expansion of scope of professional service or if the client becomes a listed entity) or new
information that comes to the attention of the professional accountant.
Some of the safeguards are incorporated into the quality control system implemented
in the professional services (auditing) rm. For example, International Standard on Quality
Control 1 (ISQC 1) paragraph 20 requires the rm to abide by ethical principles for all
professional services it renders to the public, including the external audit. In order to
ensure that this is achieved, the rm will have to establish policies and procedures to
ensure that the rm and its staff adhere to the fundamental principles contained in the
Codes of Professional Conduct. Such policies and procedures (e.g. requiring staff training
to ensure that they know the requirements of, say, the SAICA/IRBA CPC and implementing
structures to monitor staff’s adherence to the fundamental ethical principles) will create an
environment in which these principles are adhered to, thereby mitigating the signi cance
of threats.
e level of the threats should be evaluated. Relevant factors include measures in place to
prevent unauthorised disclosure of con dential information such as:
• Separate practice areas within a professional services rm;
• Implementing procedures to prevent one engagement team from gaining access to the
working papers of the other engagement team in the rm;
• Entering into con dentiality agreements with the engagement teams; and
• Separation of con dential information physically (e.g. by keeping client les separate).
A professional accountant should evaluate whether it is necessary to disclose the con ict of
interest, and obtain explicit consent in order to address the resulting threat. Factors such as
the circumstances creating the con ict, the parties involved and the nature of the con ict
of interest should be evaluated.
When making disclosures for obtaining speci c consent from the client and this would
breach the fundamental principle of con dentiality, and such consent cannot be obtained,
the rm shall only accept or continue the engagement if:
• e rm does not act in an advocacy role for one client against another client in the
same matter;
• Speci c measures are in place to prevent disclosure of information between
engagement teams of two clients; and
• e rm applies the reasonable and informed third-party test, and concludes that it is
appropriate to accept or continue with the engagement.
e professional accountant should document the nature of the con ict of interest, the
safeguards applied, consent obtained, speci c measures in place to prevent disclosure of
information, if applicable, and why it is appropriate to accept the engagement.
EXAMPLE
Books Limited, a publishing company, is a major external audit client of Henn
and Associates. Publish Limited, another publishing company, also approached
Henn and Associates with the request to act as its external auditors.
Can Henn and Associates accept the external audit of Publish Limited?
A self-interest threat for objectivity and con dentiality could be created if Henn and
Associates acts as external auditors for Books Limited and Publish Limited.
The threat will be signi cant, as important con dential information could ‘leak’
between the audit teams of Books Limited and Publish Limited, both of which are
in the same industry.
Additional steps that Henn and Associates could implement to mitigate these
threats are:
• Preventing access to information of the two companies through, for example,
physical separation of teams and secure ling of client information;
• Providing policies and procedures to members of the engagement teams about
security and con dentiality;
• Entering into con dentiality agreements with the engagement team members;
• Notifying Books Limited that Henn and Associates has been approached by
Publish Limited to act as its external auditor;
• Notifying Publish Limited that Henn and Associates already acts as external
auditor of Books Limited;
• Notifying Books Limited and Publish Limited that a professional accountant
cannot act exclusively for one client;
• Obtaining consent from Books Limited and Publish Limited;
• Using separate engagement teams to conduct the audits of the two companies
in the same sector; and
• Reviewing the key judgements and conclusions to ensure that they are
appropriate by a senior individual not involved in the engagement.
Unless the threat can be eliminated or reduced suf ciently, Henn and Associates
should not accept the engagement of performing the external audit for Publish
Limited.
Note: In all the examples in section 2.6.6, it is assumed that the persons rendering external
audit services are not only RAs, but also professional accountants. As such, the SAICA Code
of Professional Conduct will apply to them (in addition to the IRBA Code of Professional
Conduct).
2.6.6.2 Professional appointment: Client and engagement acceptance
(section 320, paragraphs 320.3A1–320. 3A5)
In addition to carefully evaluating whether a new client can be accepted (i.e. whether this
creates threats to the fundamental principles), existing clients should be reviewed at least
annually to determine whether the relationship should be continued. Whether a client or
potential client is involved in, for example, illegal activities, dishonesty or questionable
reporting practices (identi ed by a professional accountant during a client evaluation), this
could create threats with the professional accountant’s compliance with the fundamental
principles of professional behaviour and integrity.
EXAMPLE
Coffee Limited (‘Coffee’) contacted Temba and Associates (‘Temba’) with a
request to act as its external auditors. As part of the pre-engagement activities,
Temba obtained the following information about Coffee:
• The Competition Tribunal is currently investigating a price- xing charge in
relation to one of the divisions of Coffee. The charge has to do with the
application of a pricing formula and the exchange of information relating to
the pricing of a product with a competitor.
• Coffee is currently involved in court cases with the SA Revenue Service.
• In addition, there are allegations that Coffee is involved in illegal activities.
Having accepted the client, a self-interest threat to professional competence and due care
could arise when a professional accountant is not competent or experienced enough to
provide the service contracted or does not have enough time or resources to complete the
engagement timeously.
Safeguards that can be implemented to bring the threat to an acceptable level are:
• Inform Media Proprietary Limited that Sandiswa does not have knowledge to
perform the engagement and decline the engagement;
• Use an expert from outside of the rm who has the knowledge of how to
conduct review engagements; and
• Assign one or more staff time to gain an understanding of the requirements for
a review engagement.
EXAMPLE
Health Limited (‘Health’) had a disagreement with its current external auditors,
Stan and Associates, over the accounting treatment relating to the purchase of
a new subsidiary. Health asked Sisulu and Associates to take over the audit of
Health and not to contact Stan and Associates.
Can Sisulu and Associates accept the engagement?
A self-interest threat to professional competence and due care may be created if
Stan and Associates are not contacted.
The threat will be signi cant, as Health asked Sisulu and Associates not to
contact Stan and Associates and it will therefore be impossible to obtain all the
important information needed to make the decision about accepting the
engagement.
If the professional accountant who is to provide the second opinion is not granted
permission by the client to contact the current professional accountant, the possibility of
providing the second opinion should the carefully considered.
EXAMPLE
Furnishings Group Limited (‘FG’) approached Kunene and Associates to provide a
second opinion on whether a material subsidiary should be consolidated or not.
The current external auditors of FG are of the opinion that the subsidiary should
be consolidated, whereas FG feels that consolidation is not necessary. May
Kunene and Associates accept this engagement and are there any steps they
can implement if they decide to accept the engagement?
The provision of a second opinion about the need to consolidate the subsidiary
can create a self-interest threat to professional competence and due care if it is
not based on the same facts as available to the current auditor in arriving at his or
her opinion.
The threat will be signi cant since a second opinion on the consolidation of a
material subsidiary is requested, which could possibly not be based on the same
facts as the rst opinion. This could result in the second opinion being factually
incorrect.
Examples of actions that might be safeguards to address the self-interest threat include:
• Adjusting the level of the fees or scope of the engagement; and
• Having an appropriate reviewer to review the work performed.
EXAMPLE
The auditing rm, Anton and Associates, was recently founded. In order to
obtain audit clients, Anton and Associates quotes fees that are 50% lower than
those charged by other auditing rms. Is this permissible and, if not, can any
steps be taken to ensure the permissibility?
A self-interest threat for professional competence and due care will be created if
the quote is so low that it will be dif cult to perform the audit according to the
requirements of the International Standards on Auditing.
The threat will be signi cant, as a fee that is 50% lower than other auditing
rm’s fees is markedly lower, which may make it dif cult to perform the audit in
accordance with auditing standards.
Factors relevant in evaluating the level of the threats may depend on:
• e nature of the engagement;
• e range of possible fee amounts;
• e basis for determining fees;
• Disclosure to intended users of the work performed by the professional accountant and
basis of remuneration;
• Quality control procedures;
• Whether the outcome of the transaction is to be reviewed by an independent third
party; and
• Whether the level of the fee is set by an independent third party.
Under no circumstances may contingent fees be charged for the preparation of an original
or amended tax return, owing to the unacceptable self-interest threat to objectivity that
arise in such situations.
EXAMPLE
Alwyn and Associates, a rm of professional accountants, provides a wide range
of services to its clients. Auditing services are provided to ve clients. The audit
fees are calculated as 5% of the clients’ pro t before tax for the year.
This basis is applicable to all clients.
Is the basis on which these fees are determined allowed?
• This type of fee is not allowed for assurance clients as it creates a self-interest
threat to objectivity.
• The threat will be signi cant, since the contingent fees are levied for assurance
engagements (audits).
• The threat is so signi cant that no safeguards will reduce the threat to an
acceptable level.
• The fee that is levied for the audit services must be calculated taking into
account, among other things, the time and experience of the persons working
on the audit.
Examples of actions that might be safeguards to address such self-interest threat include:
• Obtaining prior agreement in writing from the client for the commission arrangements;
and
• Disclosing any referral fees or commission arrangements paid to or received from
another professional accountant or third party to the client and obtaining written
approval in advance.
EXAMPLE
Gumede and Associates (‘Gumede’) does not provide taxation services. Gumede
refers its clients requiring taxation services to Tiaan and Associates (‘Tiaan’).
For this referral, Tiaan pays 7.5% commission of the total fees charged for
taxation services provided for Gumede’s clients to Gumede.
Is this allowed according to the CPC?
The payment of commission to Gumede for taxation services provided creates a
self-interest threat to objectivity, professional competence and due care.
The threat will be signi cant, as it is a signi cant amount of remuneration
(commission) that will be received for the work referred.
EXAMPLE
The nancial director of KL Limited (‘KL’) invited the lead engagement partner
on the external audit of KL and his wife to his exclusive game farm in Botswana
for a week-long stay. The nancial director also mentioned that the audit partner
would be allowed to hunt free of charge on the farm.
May the lead engagement partner accept this offer?
As part of client engagement acceptance procedures to take custody of a client’s assets the
professional accountant shall:
• Make inquiries into the source of the assets; and
• Consider related legal and regulatory requirements such as the Financial Intelligence
Centre Act 38 of 2001 (FICA), which may require the client to provide proof of residence
and identi cation before client assets are accepted into custody of the rm.
For all client monies which the professional accountant controls or is liable to account for:
• e professional accountant shall not refer to such monies as being ‘in trust’ or in a
‘trust account’ as this could be misleading;
• Separate bank accounts have to be opened at an institution that is registered in terms of
the Banks Act 74 of 1990;
• e accounts have to be appropriately named to distinguish them from the rm’s
normal business accounts or a speci c account named and operated per relevant client
(e.g. ABC’s Client Account or John Smith account);
• e client’s monies have to be deposited into the appropriate bank account without
delay;
• e professional accountant shall maintain such records to ensure that the money can
be readily identi ed as the property of the client (e.g. detailed bookkeeping to supply
client with analysis of the account);
• e professional accountant shall perform a reconciliation between the designated
bank account and the client’s monies ledger accounts; and
• Client monies should not be held inde nitely unless speci cally allowed by regulations.
For property other than money in his or her custody the professional accountant should:
• Not refer to such assets as being ‘in trust’ or in a ‘trust account’ as this could be
misleading.
• Maintain such records to ensure that the client’s assets can be readily identi ed as the
property of the client; and
• For documents of title, the professional accountant should make arrangements to
safeguard the documents against unauthorised use.
For audit or assurance clients, a professional accountant may not accept custody of these
client’s assets, unless the threat to independence can be eliminated or reduced to an
acceptable level.
EXAMPLE
Opera Limited (‘Opera’) handed a cheque in the amount of R500 000 to Xolani
and Associates (‘Xolani’), a rm of professional accountants, to purchase a
property on Opera’s behalf. Xolani deposited the money into Xolani’s money-
market account.
Is the way the money was treated acceptable according to the CPC? If not, list
any steps that could be taken to make it appropriate.
EXAMPLE
Riaan Ernst is a professional accountant (SA) working as a tax practitioner. He
was approached by Fil Proprietary Limited (‘Fil’) to help to get their tax affairs in
order. While performing his duties, he noted that certain of the tax returns led
with the SA Revenue Service (SARS) were incorrectly completed (resulting in an
understatement of the company’s tax liabilities). This resulted in Fil still owing
SARS more than R2 million (additional to the taxes already paid).
Discuss whether there are any actions that Riaan Ernst should take with
reference to the CPC.
• Riaan Ernst must consider whether the inaccurate tax returns constitute a
possible NOCLAR.
• It is an action
• By the management of Fil
• It is contradictory with the Income Tax Act 58 of 1962
• It does constitute a possible NOCLAR.
• Riaan Ernst must investigate the matter further to obtain a better
understanding of the matter.
• Riaan Ernst must discuss the matter with management and those charged with
governance of Fil.
• If the tax act transgressions have taken place, Riaan Ernst must inform
management that it constitutes a NOCLAR and that the matter should be
recti ed and reported.
• If a NOCLAR exists, a self-interest or intimidation threat is created to integrity
and professional behaviour.
• If tax act transgressions have taken place and management does not do
anything about it:
• Riaan Ernst should discuss the matter with the audit rm’s engagement
partner;
• Riaan Ernst could consider getting legal advice;
• Riaan Ernst should consider reporting the matter to the relevant authority (in
this case the SA Revenue Service); and
• Riaan Ernst could consider resigning.
• Riaan Ernst must document the following:
• The NOCLAR matter;
• Signi cant judgement and conclusions made;
• Discussions with management and how they reacted; and
• Further actions to consider and decisions made by Riaan Ernst.
2.6.7.1 Independence
e section on independence in the CPC is divided into two areas:
• Section 4A: Independence – Audit and Review Engagements; and
• Section 4B: Independence: Other Assurance Engagements.
Both independence sections are divided into various subsections and there are certain
considerations that the professional accountant has to take into account when determining
the signi cance of threats.
Note that this text includes only selected examples from section 4A of the CPC. Readers are
encouraged to read these thoroughly themselves to gain an understanding of the whole
range of examples included in the CPC.
e CPC also imposes additional requirements for audit clients that are public interest
entities (e.g. listed companies), which result in even stricter independence requirements
for the audits of such entities. is approach is followed in the CPC because the audited
nancial statements of public interest entities have a greater public interest, and because of
the greater adverse repercussions if the audit opinion expressed on a public interest entity’s
nancial statements is inappropriate. For more on this, read paragraphs 400.8 of the CPC,
as well as all those paragraphs in section 4A headed by ‘Audit Clients that are Public
Interest Entities’.
EXAMPLE
Mnunu Auditors (‘Mnunu’) is a medium-sized auditing rm. The audit fee of one
of the rm’s clients, Loophole Proprietary Limited (‘Loophole’), constitutes a
large portion of the current year’s fees generated by one of the partners of
Mnunu.
Discuss the resulting threats in terms of the CPC.
If the audit fee of one of the audit clients constitutes a material part of the audit
fees earned by one partner, it will create a self-interest and intimidation threat to
independence (paragraph 410.3A4).
The threat will be signi cant as the partner could be over-reliant on the fees of
that client.
Factors that are relevant in evaluating the level of such threat include:
• e materiality of the litigation; and
• Whether the litigation relates to a prior audit engagement.
An example of an action that might be a safeguard is having a quality control review on the
audit work performed.
When determining the level of the threats, the professional accountant should consider:
• e role of the person holding the interest;
• Whether it is a direct or indirect interest; and
• e materiality of the interest.
EXAMPLE
Ria Limited (‘Ria’) appointed Funeka and Associates as its external auditor. The
audit engagement partner assigned is Ms Funeka. She has a material
shareholding in Ria Limited. Is it appropriate that Ms Funeka is the audit
engagement partner?
The direct nancial interest in Ria creates a self-interest threat to independence.
The threat is signi cant, as the holding is material.
Actions that could be taken to eliminate the threat are the following:
• Ms Funeka will only be allowed to be the audit engagement partner if she sells
her shareholding in Ria; or
• Ms Funeka must be removed from the audit of Ria and another engagement
partner appointed.
EXAMPLE
Best Bank (‘Best’) is an external audit client of Sarah and Associates. Mrs
Sarah, the engagement partner assigned to the audit of Best, obtained a home
loan from Best under the normal lending terms offered to all of the bank’s
clients.
Will the loan provided create a threat to Mrs Sarah’s independence?
No threat will be created as the loan is made under the normal lending terms
offered to all clients of Best, which is a nancial institution.
EXAMPLE
Marketing Limited (‘Marketing’) is an external audit client of Jonono and
Associates (‘Jonono’). Jonono agreed to provide a sizeable loan to Marketing to
nance the company’s expansion. Interest at market-related rates will be
charged on this loan.
Is Jonono allowed to provide this loan?
Jonono cannot provide this loan, as it will create a self-interest threat to the rm’s
independence. The threat will be signi cant, because the auditing rm is providing
a material loan to an audit client. The threat will be so signi cant that no
safeguards will reduce the threat to an acceptable level.
The way forward: The loan should not be provided to Marketing, or Jonono
should resign as Marketing’s external auditors.
2.6.7.9 Business relationships with clients (section 520)
Unless a business relationship is insigni cant to the rm and the client, the self-interest
and intimidation threats to independence created will be signi cant. e relationship
should not be entered into or should be reduced to an insigni cant level. If this cannot be
achieved, it should be terminated or the audit team member involved should be removed
from the audit team.
EXAMPLE
Mr Peter is an audit partner at Peter & Smit and Associates (‘Peter & Smit’). Mr
Peter wants to start marketing the accounting software package developed by
Up Proprietary Limited, one of the rm’s audit clients, to the rm’s other clients
in exchange for a fee.
Will Mr Peter be allowed to start to market the accounting software?
No, Mr Peter will not be allowed to market the accounting software to other clients.
If Mr Peter markets the products of the audit client of Peter & Smit, a signi cant
self-interest threat to independence will be created.
The threat will be so signi cant that no safeguard will reduce the threat to an
acceptable level. Therefore, this marketing initiative should not be undertaken.
EXAMPLE
Darnell and Associates (‘Darnell’) is the external auditor of Malik Proprietary
Limited (‘Malik’). Mr Tyron is a rst-year trainee accountant at Darnell. Mr
Tyron’s father is the nancial director of Malik.
Can Mr Tyron be assigned as a member of the external audit team of Malik?
No, Mr Tyron cannot be on the external audit team of Malik. If he is on the audit
team, it will create self-interest and familiarity threats to independence. The
threats will be signi cant, as Malik is an audit client of Darnell and Mr Tyron’s
father is the client’s nancial director responsible for the preparation of the
nancial statements subject to audit by the audit team.
When determining the signi cance of the threat, the following should be considered:
• e position that the person held at the client;
• e length of time that has elapsed since the person left the employ of the client; and
• e role of the person in the audit team.
EXAMPLE
Ms Lindelwa joined the auditing rm Natasha and Associates (‘Natasha’) four
months ago. Natasha wants to assign Ms Lindelwa as the audit engagement
partner of Reya Limited (‘Reya’). Ms Lindelwa is highly competent and very
knowledgeable of Reya’s affairs, as she was the nancial manager at Reya
before joining Natasha.
Discuss whether the assignment of Ms Lindelwa will be in accordance with the
CPC.
Self-interest, self-review and familiarity threats to independence will arise if Ms
Lindelwa is allowed to be the engagement partner on Natasha’s audit.
The threat will be signi cant, as she was the nancial manager at Natasha
previously (until joining Natasha four months ago) and will now be the engagement
partner on the audit of Natasha, in which position she may have to review
information that she prepared as nancial manager.
A safeguard that could be implemented is to not assign Ms Lindelwa as the
engagement partner responsible for the audit of Natasha.
When determining the signi cance of the threats, the following factors should be
considered:
• e position of the former audit rm employee at the client;
• e former position of the employee on the audit team;
• e involvement of the former audit rm employee with the audit team; and
• e length of time that has elapsed since the former audit rm employee left the employ
of the rm.
EXAMPLE
Maurice and Associates (‘Maurice’) is the external auditor of Xavier Limited
(‘Xavier’). Mrs Alexus, previously a partner of Maurice, accepted a position as
nancial director of Xavier six months ago.
Will Maurice be still be allowed to be the external auditor of Xavier?
If Maurice were to continue as the external auditor of Xavier, it would create
familiarity and possible intimidation threats to independence.
The threats will be signi cant, as a former partner of Maurice is the nancial
director at Xavier and will be involved in the audit process of Xavier. It has only
been six months since she joined Xavier.
Safeguards that can be implemented are having an engagement quality control
review performed on the audit and assigning individuals to the team with suf cient
expertise. Moreover, Mrs Alexus should also no longer be involved with any
activities of Maurice.
An audit team member enters into employment negotiations with audit client
A self-interest threat to independence could be created if a member of the audit team
participates in the audit engagement while knowing that he or she might join the client in
the foreseeable future. Firm policies should be implemented that require the member of
the audit team to notify the rm when he or she enters into employment negotiations with
an audit client.
An action that might be a safeguard is removing the individual from the audit team.
EXAMPLE
Ms Jasmin is a third-year trainee accountant working at the auditing rm of
Allison and Associates (‘Allison’). She is currently assigned to the audit of
Precious Proprietary Limited (‘Precious’). Precious approached Ms Jasmin to
become the nancial manager at Precious after completion of the audit.
What steps must Ms Jasmin and Allison take?
A self-interest threat to independence would be created. The threat will be
signi cant, as Ms Jasmin, a member of the audit team, is being offered a position
as the nancial manager at Precious and would therefore be under pressure not to
act in a way that could jeopardise the offer.
Ms Jasmin should inform Allison when entering serious employment
negotiations.
Allison, upon being noti ed of this, should remove Ms Jasmin from the audit
team.
EXAMPLE
Mr Scott is a third-year trainee accountant at Bradley and Associates
(‘Bradley’). He assisted George Proprietary Limited (‘George’), an external audit
client of Bradley, for one month of the current nancial year by standing in for
the nancial manager while she was in hospital.
Can Mr Scott be assigned to the team to audit George? What safeguards must
be implemented by Bradley while Mr Scott is seconded to George?
No, Mr Scott cannot be on the audit team of George. This will create self-review,
familiarity and possible advocacy threats to independence. Additional safeguards
will be that Mr Scott during his assignment cannot be involved in any management
activities and must not take any management decisions at George.
e factors that are relevant in evaluating the level of the threats include:
• e length of time that the individual has been on the team;
• e role of the individual on the team;
• e extent to which the individual’s work is directed, reviewed or supervised;
• e extent to which the individual can in uence the outcome of the audit;
• e closeness and nature, frequency and extent of the personal relationship with senior
management;
• e nature of complexity of the client’s accounting and nancial reporting issues; and
• Any recent changes in senior management or structure at the client.
For audits of public interest entities an individual may not act in the following roles for
more than seven cumulative years:
• Engagement partner;
• Individual responsible for quality control on the engagement; and
• Any other key audit partner role.
EXAMPLE
Mr Eon has worked as an audit partner at Ananas and Associates, a small
auditing rm, for the past 20 years. He has been the lead engagement partner
on the audits of some of his clients for more than 10 years.
Discuss this in terms of the CPC.
Since Mr Eon has been the lead engagement partner on the audits of some clients
for a signi cant period of time (longer than 10 years), the threat would be
signi cant. A familiarity threat to independence may result in Mr Eon being loath to
engage with the management of clients about issues identi ed during their audit
for fear of jeopardising the friendships that have developed over the years.
Moreover, he may have become too close to the clients to be able to view
misstatements in the nancial statements objectively (i.e. with an open-minded
perspective).
e factors that are relevant to assessing the level of the threats created include:
• Type of client (whether it is an audit client or not and whether the client is a public
interest entity);
• Type of non-assurance service to be provided to the client (e.g. taxation services);
• Who provides the non-assurance service (whether the person is on the audit team or
not);
• e extent to which the non-assurance service impacts on the accounting system,
internal control system or nancial statements (e.g. valuation services will have a direct
in uence on the gures re ected in the nancial statements); and
• e level of expertise of the client’s employees with respect to the service provided (e.g.
the client’s staff may have no expertise in relation to IT systems and IT consulting
services are provided).
REFLECTION
After reading section 90(2) of the Companies Act, answer the following question:
Are any other non-assurance services prohibited for statutory audit clients?
is means that even though it may be legal to provide a particular non-assurance service
to a client, and the auditor does not identify any unacceptable threats to independence, the
rendering of this service may still be disallowed by the audit committee as the independent
directors serving on this committee believe that it will jeopardise the independence of the
auditor in fact or in appearance.
EXAMPLE
Small auditing rms are often in the situation where they provide a
comprehensive range of accounting and auditing services to sole proprietors and
partnerships. Are they allowed to render these services?
Rendering a comprehensive range of accounting and auditing services to these
audit clients will create a self-review and threat, threat to independence (section
601).
Rendering accounting services to these audit clients will create a signi cant
threat, as accounting information that is vital to the audit is being prepared by the
rm auditing this information.
Since the audit clients are not companies, safeguards can be implemented to
reduce the threats to an acceptable level. (Had they been companies, section
90(2)(b) of the Companies Act would prohibit the rendering of the accounting
service concurrently with the audit – unless the audits were undertaken voluntarily,
i.e. undertaken in terms of a resolution of the shareholders or directors.)
Safeguards include:
• Staff members who render the accounting services must not be assigned to the
audit team;
• Having policies and procedures in the rm that prohibit such staff members
from making management decisions on behalf of the client; and
• The client should approve journal entries or any changes made to the nancial
statements by the auditing rm staff.
Assessment questions
1. De ne and explain the concept of ethics. (LO 1)
2. State where in the audit process the ethical requirements have to be considered. (LO 2)
3. Explain why professions have codes of ethics. (LO 1)
5. What ethical codes and rules are applicable to external auditors in South Africa? (LO 4)
6. Which actions constitute prohibited actions for an external auditor in South Africa?
(LO 4)
7. Brie y describe the disciplinary processes of the IRBA and SAICA. (LO 5)
8. Identify and describe the steps to be followed in the conceptual framework approach
to ethics. (LO 6)
9. List the ve fundamental principles of the SAICA Code of Professional Conduct that
should be adhered to by professional accountants. (LO 6)
11. Below are three columns that contain information regarding situations the
professional accountant may encounter. e situations are listed in column A. e
threats that these situations may cause are listed in column B. e fundamental
principles that could be threatened are listed in column C. Link the three columns
with each other by writing for each situation in column A, the letter of the
corresponding threat from column B and the number of the relevant fundamental
principle from column C. (LO 6 & 7)
14. Which of the following will create a familiarity threat? (Only one option is possible.)
(LO 7)
a) Owning shares in the audit client
b) Receiving sporting event tickets from a client
c) Having a family member working at the client
d) Performing auditing and accounting work for a client
17. Mr Wilson is the audit manager in charge of the audit of Tuscany Limited and his wife
is a material shareholder of Tuscany Limited. Mr Wilson will be allowed to be the audit
manager on Tuscany Limited if his wife sells her shares in Tuscany Limited. (LO 7)
CHAPTER CONTENTS
Learning outcomes
Reference list
3.1 Introduction
3.2 What are the statutory and regulatory requirements for an
audit?
3.3 How does the statutory appointment, removal and rotation of
the auditor work and what are his or her rights?
3.4 What are the statutory requirements to practise as an auditor?
3.5 What does the auditor’s statutory responsibility to identify and
respond to Reportable Irregularities entail?
3.6 How is auditing in the public sector different from auditing in
the private sector?
3.7 What other legislation and regulations may impact on the
scope of the audit function?
3.8 What role can the auditor play to aid good corporate
governance?
Assessment questions
LEARNING OUTCOMES
REFERENCE LIST
IN THE NEWS
2001 Accounting scandal
In 2001, after a series of revelations involving irregular
accounting procedures bordering on fraud perpetrated throughout
the 1990s involving Enron and its accounting rm Arthur
Andersen, Enron suffered the largest Chapter 11 bankruptcy in
history (since surpassed by those of WorldCom in 2002 and
Lehman Brothers in 2008).
As the scandal unravelled, Enron shares dropped from over
$90.00 in the summer of 2000 to just cents. Enron had been
considered a blue chip stock, so this was an unprecedented
event in the nancial world. Enron’s plunge occurred after the
revelation that much of its pro t and revenue were the result of
deals with special purpose entities (limited partnerships which it
controlled). This meant that many of Enron’s debts and the
losses that it suffered were not reported in its nancial
statements. Enron led for bankruptcy on 2 December 2001.
In addition, the scandal caused the dissolution of Arthur
Andersen, which at the time was one of the world’s top
accounting rms. The rm was found guilty of obstruction of
justice in 2002 for destroying documents related to the Enron
audit. Since the Securities and Exchange Commission (SEC) is
not allowed to accept audits from convicted felons, Andersen was
forced to stop auditing public companies. Although the conviction
was thrown out in 2005 by the Supreme Court, the damage to
the Andersen name prevented it from returning as a viable
business even on a limited scale.
Oakbay/SARS scandals
KPMG (one of the ‘big four’ audit rms in South Africa – along
with Deloitte, Ernst & Young and PwC) has a heritage in South
Africa dating back to 1895, and the rm has been part of the
international KPMG organisation since its formation in 1979.
During 2017, KPMG South Africa became embroiled in scandals
involving the notorious Gupta family, which has led to the closure
of several of its of ces and resulting (at the time of writing) in
considerable uncertainty about its continued operations in South
Africa.
In June 2017, the amaBhungane Centre for Investigative
Journalism revealed some fascinating correspondence between
KPMG and Oakbay Resources and Energy (a Gupta-owned entity
in the mining sector). KPMG had been the auditors of the Oakbay
group for 15 years prior to the revelations of corruption and
collusion, at which point KPMG then resigned. One of the more
controversial transactions to emerge was the nancing of a
R30m wedding for one of the Gupta daughters, allegedly using
funding earmarked by the Free State government to a dairy farm.
It appears that funds were redirected from this project via related
party entities (Linkway Trading and Accurate Investments) to
nance the wedding. KPMG’s chief executive and KPMG’s lead
engagement partner for the audit of Oakbay were both guests at
the wedding.
To make matters even worse for KPMG, they also issued a
controversial report in 2015 implicating former Finance Minister
Pravin Gordhan in the creation of an illegal rogue intelligence
gathering unit of the South African Revenue Service (SARS). This
report was seen by many to be part of a wider Gupta-linked state
capture conspiracy, with the aim of forcing Gordhan out of his
post. The report was withdrawn by KPMG in September 2017
creating large-scale public backlash.
These scandals ultimately resulted in the resignation of
several partners within KPMG’s senior leadership in South Africa,
including its chairman, its chief executive of cer and its chief
operating of cer.
Numerous large South African companies dismissed KPMG as
their auditors in the immediate aftermath of the scandal,
including the Auditor General of South Africa and ABSA Group
Limited. Many of their other clients will no-doubt be seriously re-
considering their continued relationship with KPMG.
At the time of writing, KPMG is still under investigation by the
IRBA in relation to their conduct.
3.1 Introduction
Given the vital role that auditors play in providing assurance to people
and organisations that rely on nancial statement information to make
economic decisions, it is not surprising to see the signi cant extent to
which the profession is regulated.
e Enron and KPMG scandals referred to in the newspaper articles
above paint a clear picture of what can happen when auditors do not
ful l their responsibilities properly or are perceived not to have done so.
Despite their knowledge of the serious aws in the nancial statements
of Enron, the auditors (Arthur Andersen) continued to issue an
unmodi ed (or ‘clean’) opinion on the nancial statements. is
resulted ultimately in both investors and lenders suffering huge losses,
and led to a lawsuit against the auditor from which it could not recover.
It is worth noting from the Enron article that the SEC (to an extent
the equivalent of South Africa’s JSE) has a regulation prohibiting
auditing rms that have been found guilty of performing audits in
contravention of legislation from continuing to audit publicly listed
companies. e loss of credibility associated with a conviction of this
nature would no doubt have a large impact on the level of assurance
third parties can take from an audit opinion issued by the convicted
auditor.
is event (along with several others around the same time) led to a
widespread loss of public con dence in the opinions being expressed
by auditors on nancial statements.
CRITICAL THINKING
Just how prevalent are scandals that involve auditing rms?
Do an internet search for ‘scandals involving audit rms’ and see
what comes up …
In order for the public to retain high levels of con dence in the opinions
expressed by auditors on nancial statements, it is vital that the
auditing profession be properly monitored and regulated. In South
Africa, the Independent Regulatory Board for Auditors (IRBA) was
created in 2005 to do just that. (Note that its predecessor was the Public
Accountants and Auditors Board – refer to Chapter 1 for the history of
the auditing profession.)
Given the technical nature of this chapter and the ease with which one
can become disoriented, it is appropriate to start with a high-level
overview of this chapter’s overall structure and ow:
• We start with an introduction in section 3.1 of this chapter to the two
pieces of legislation that form the basis for the bulk of the content of
this chapter – the Companies Act 71 of 2008 and the Auditing
Profession Act 26 of 2005.
• In section 3.2, we turn our attention to the statutory requirements for
an audit as established by the Companies Act. Not all companies
need to be audited. Consequently, before considering the legislation
governing the auditor, you need rst to be clear as to when auditors
are required. Section 3.2 also explains what happens if a company
does not have to be audited.
• Having established when the need for an audit arises, section 3.3
then considers the requirements that need to be met by companies
when appointing their auditor and what they need to do should they
wish to reappoint, or even remove, the auditor.
• Section 3.4 considers who is able to act as an auditor, as well as the
regulations that govern the scope, duties and conduct of the auditor.
• Section 3.5 discusses Reportable Irregularities, including what they
are and what the auditor’s responsibilities are with regard to them.
• Sections 3.6 and 3.7 contain a brief look at some of the other
environments in which audits might take place and the related
additional requirements that may arise. ese environments include
auditing in the public sector, auditing companies listed on the JSE,
and auditing South African subsidiaries of American holding
companies.
• e nal section considers the impact of good corporate governance
on the audit function. (Corporate governance is covered in detail in
Chapter 4.)
SPECIFIC ASPECTS
LEGISLATION RELATING TO THE
GOVERNING AUDIT FUNCTION SECTION/REGULATION
THE AUDIT THAT ARE REFERENCE
FUNCTION GOVERNED BY THIS
LEGISLATION
EXAMPLE
Pro t company (section 1)
A company incorporated for the purpose of nancial gain for its
shareholders.
State-owned company (section 1)
An enterprise that is registered in terms of the Companies Act
as a company and is either listed as a public entity in the Public
Finance Management Act 1 of 1999 (PFMA), or is owned by a
municipality (as contemplated in the Local Government:
Municipal Systems Act 32 of 2000) and is otherwise similar to
the enterprises listed in the PFMA.
Private company (sections 1 and 8)
A pro t company that is not a state-owned company and in
terms of its Memorandum of Incorporation is prohibited from
offering any of its securities to the public and is restricted when
it comes to the transferability of its securities.
Personal liability company (sections 1 and 8)
A private company where its Memorandum of Incorporation
speci cally states that it is a personal liability company. Section
19 then provides that where a company is a personal liability
company, the directors and past directors are jointly and
severally liable, together with the company, for any debts and
liabilities of the company.
CRITICAL THINKING
Think of examples of companies that might fall into this third
category.
1. Estate agent companies that hold deposits in trust.
2. Investment companies that hold investor funds in trust.
3. Incorporated attorney practices that via their trust accounts
hold client monies.
4. Non-pro t companies:
a) Incorporated directly or indirectly by the State, an
international entity, a foreign state entity, or a foreign
company;
b) Incorporated primarily to perform a statutory or regulatory
function in terms of any legislation;
c) Incorporated to carry out a public function at the direct or
indirect initiation or direction of the State, an international
entity, a foreign state entity, or a foreign company; and
d) Incorporated for a purpose ancillary to items b) or c) above.
CRITICAL THINKING
Does the IRBA need to be audited?
Yes it does. It is incorporated primarily to perform a regulatory
function in terms of the Auditing Profession Act of 2005.
Any other company (pro t or non-pro t) whose public interest
5.
score in that nancial year:
a) Is equal to, or exceeds, 350; or
b) Falls in the range of 100 to 349 if its annual nancial
statements were internally compiled (i.e. compiled by staff of
the company without the use of an independent professional
accountant).
COMPONENT OF CALCULATION
PUBLIC INTEREST
EXAMPLE
A practical example of the calculation of a company’s public
interest score
Consider the following information about Stratus (Pty) Ltd, a
pro t company with a June nancial year-end that is involved in
the manufacture and retail of designer gumboots:
• 51% of the shares in Stratus are held by another company,
Big Brother (Pty) Ltd; 25% are held by Mr Smith, and the
remaining 24% are held by Mrs Doe.
• Big Brother has 12 shareholders, all of whom are individuals.
• Mr Smith and Mrs Doe are both directors of Stratus (Pty) Ltd.
• The company’s annual turnover for the current nancial year
is R37,439,021.
• Liabilities as at year-end comprised the following amounts
owing:
• Trade Payables (to non-related companies) – R 2,367,210
• Loan owing to Mr Smith – R1,239,000
• Loan owing to Big Brother (Pty) Ltd – R 4,367,996
• The company had 15 salaried employees and 36 wage-
earning employees on its payroll at the end of their nancial
year. During the year, four new wage-earning employees were
appointed. There were no resignations or dismissals.
• The company prepares its own annual nancial statements.
CRITICAL THINKING
Do the nancial statements of Ntsimbi Piping have to be
audited?
Given that Ntsimbi Piping prepares its own nancial statements,
like Stratus (Pty) Ltd in the example above, it would need a PIS
of greater than 100 for it to have to be audited.
Given that Ntsimbi Piping employs approximately 80 staff and
its revenue for the current year is R128,3 million, its PIS already
exceeds 200 before even considering the other public interest
components. Therefore, its nancial statements will have to be
audited.
CRITICAL THINKING
Who is a prescribed of cer?
In terms of regulation 38 of the Companies Regulations, a
prescribed of cer is de ned as being a person who, despite not
being a director, nonetheless exercises, or regularly participates
to a material degree in the exercising of, general executive
control over the management of the business.
A person cannot therefore avoid statutory responsibilities just
by not being a director in a formal capacity.
CRITICAL THINKING
Can a person who has been the company secretary of a
company be appointed as their auditor?
Strictly speaking, point 4 above refers only to directors, of cers
or employees of a person appointed as company secretary and
not the actual person themselves.
Now have a look at the next prohibition!
CRITICAL THINKING
Why is it necessary to include point number 6?
If you are, for example, a current director (or employee, of cer,
etc.) of a company, then you could have resigned from that
position and immediately become its auditor were it not for point
number 6. This section now sets a time period (a ‘cooling off
period’, if you like) during which you must not have been
engaged in any of the capacities referred to in the previous four
points should you wish to be considered for appointment as that
company’s auditor. This ensures that the auditor will be
suf ciently independent.
CRITICAL THINKING
Why might an auditor choose to resign from an audit
appointment?
1. The auditor no longer has the required knowledge, skills or
capacity to audit the company.
2. The auditor no longer wants to be associated with the
company or with the individuals who manage or own the
company.
3. The audit is not economically viable (the audit fee does not
recover the amount of time required for performing the audit).
4. An ethical con ict has arisen that creates a situation where
the auditor can no longer maintain the required level of
objectivity.
REFLECTION
Did you notice the following point?
Auditors of the holding company do not have immediate right of
access to the subsidiary’s accounting records and need to direct
any information requirements through the directors or prescribed
of cers of the holding company or subsidiary.
CRITICAL THINKING
Are there any services (other than the audit) that an auditor is
not permitted to perform for the auditee in terms of the
Companies Act?
We have already seen that in terms of section 90(2) the auditors
may not also act as bookkeeper, accountant or company
secretary to the company.
CRITICAL THINKING
Why does the IRBA have to be satis ed regarding an auditor’s
eligibility to practise? Why not simply let companies evaluate
the auditors they wish to appoint?
Companies do not always have the resources or ability to
evaluate for themselves the credibility or competence of a
potential auditor.
Having a regulatory board consider the suitability of an
auditor establishes a common benchmark for the evaluation of
all auditors in terms of suitable criteria.
It is the role of the IRBA to protect the public interest in
nancial statements of companies. This must necessitate a
quality check on the auditors who are expressing opinions on the
nancial information on which the public is then placing their
reliance.
e IRBA must be satis ed as to the following before they will register
an applicant:
1. e applicant must have complied with the prescribed education,
training and competency requirements for RAs (i.e. he or she
should possess the requisite competence to practise as an auditor).
CRITICAL THINKING
What are the prescribed education, training and competency
requirements?
Currently, the only professional quali cation that meets the IRBA
education, training and competency requirements is the
Chartered Accountant (SA). So, generally, you cannot become an
RA unless you have met the requirements to be a CA(SA).
Note that this does not mean you have to be a member of
SAICA but only that you must have met their requirements for
quali cation, in other words that you are eligible to become a
CA(SA).
In addition to the requirement to be a CA(SA), the IRBA
introduced an additional requirement from 1 January 2015 that
quali ed CAs will also need to complete at least an 18-month
post-quali cation period of ‘apprenticeship’ – known as the
‘Audit Development Programme’ (ADP) – under the guidance and
supervision of an RA, who will serve as their mentor. During this
‘apprenticeship’, a prescribed number of hours on audit-related
matters will have to be completed at a level more senior than
that experienced during the three-year SAICA training contract. In
so doing, the CA(SA) will effectively become a specialist in
auditing.
CRITICAL THINKING
What about unrehabilitated insolvents?
Section 37(5) directs that the IRBA may (not must, like the four
points before) decline to register an individual who:
• Is an unrehabilitated insolvent;
• Has entered into a compromise arrangement with their
creditors; or
• Has been provisionally sequestrated.
In terms of section 46(2), no loss will be suffered by the auditor (i.e. they
cannot be held liable for any loss suffered by clients or by third parties)
unless it is proved that the opinion was expressed:
• Maliciously (done with the intent to cause harm);
• Fraudulently (done with the intent to deceive); or
• Negligently (done unintentionally through human error or oversight,
but nonetheless arising as a result of not having exercised due care in
performing the audit).
ere are some additional aspects that have to be considered that are
speci c to the auditor’s liability toward their client and toward third
parties (who rely on the opinion expressed by the auditor about their
client’s nancial statements).
CRITICAL THINKING
How can it be proved that an auditor was negligent?
Audits are required to be conducted in terms of the ISAs. These
standards prescribe how auditors must conduct their audits and
will be the rst things that are looked at to establish negligence.
‘Did the auditors conduct the audit in terms of the
requirements laid out in the ISAs?’ If not, the auditors are likely
to be found to have been negligent in the performance of their
duties.
FURTHER READING
FURTHER READING
Step 2:
Within three days of sending the report to the IRBA, the auditor must
notify the members of the management board of the entity, in writing,
of the fact that the report has been submitted.
is notice should include a copy of the report and must make
reference to section 45 of the APA and the auditor’s resultant duties in
respect of the reporting of possible Reportable Irregularities to the
IRBA.
Step 3:
As soon as is reasonably possible (but no later than 30 days from the
date that the report was sent to the IRBA), the auditor must take all
reasonable measures to discuss the report with management, including
providing management with an opportunity to make their own
representations regarding the contents of the report.
e purpose of this third step is to afford management an
opportunity to put across their perspective of the Reportable
Irregularity and thus potentially provide the auditors with further
information or evidence regarding the irregularity.
As a result of these discussions and any further information
provided by management, the auditor will then need to reach one of
three possible conclusions regarding the matter that has already been
reported to the IRBA:
1. No Reportable Irregularity had taken place or is taking place (i.e.
the auditor was wrong to have thought that the matter was a
Reportable Irregularity); or
2. e suspected Reportable Irregularity is no longer taking place and
management have taken adequate steps to prevent any further loss
and/or recover any possible loss that may have arisen from the
matter, if relevant (i.e. the auditor was correct to have reported the
matter but, having discussed it with management, management
saw where they were wrong and have taken adequate steps to
remedy the situation); or
3. e suspected Reportable Irregularity is continuing (i.e. the auditor
was correct to have reported the matter and, having discussed it
with management, management have done nothing, or have taken
inadequate steps, to remedy the situation).
Step 4:
Having discussed the report with management, the auditor will now
send a second report to the IRBA advising it of the results of the
discussion and the status of the Reportable Irregularity (i.e. which of the
three possibilities mentioned previously represents the current
position).
e auditors will provide the IRBA with any additional supporting
information to back up their statement regarding the current status of
the Reportable Irregularity.
On receipt of this second report, the IRBA will consider the evidence
presented by the auditor and, in the event that the matter was in fact a
Reportable Irregularity, will take any action that it believes may be
necessary in terms of advising (in writing) the appropriate regulator of
the Act that has been contravened, as well as providing full particulars
of the matter.
CRITICAL THINKING
What happens if the auditor does not detect a Reportable
Irregularity that did actually exist?
There is no requirement that auditors design speci c procedures
to identify possible Reportable Irregularities. Rather, should the
auditor become aware of them or have reason to believe that
they exist, the duty to report them arises.
Having said that, if an auditor does not detect a Reportable
Irregularity that they should have become aware of through the
normal course of their audit procedures, section 46(7) of the
APA holds that auditor potentially liable to any party suffering
loss as a result of the auditor’s non-reporting of the irregularity.
Should an auditor be found guilty of improper conduct in this
respect, in addition to the settlement of any loss incurred by a
party arising from the auditor’s failure to detect and report the
irregularity (through a civil claim against the auditor), the IRBA
might also take the following action in terms of section 51 of the
APA:
1. Issue a caution or reprimand to the auditing rm; and/or
2. Fine the auditor an amount not exceeding the equivalent of a
ve-year jail term; and/or
3. Suspend the right of that auditor to practise for a speci ed
period of time; and/or
4. Cancel the registration of that auditor, which would prevent
the auditor from conducting audits.
FURTHER READING
The Auditor-General in collaboration with the IRBA issued a guide
in 2012 entitled ‘Guidance for auditing in the public sector’. This
guide provides an overview of the public sector environment
within which public sector audits are conducted, and is essential
reading for anyone wishing to gain insights into the nature of
auditing in the public sector. The guide can be accessed on the
website of the IRBA as follows:
https://www.irba.co.za/guidance-to-ras/technical-guidance-for-
auditors/public-sector
In addition to this, the IRBA published two further guidelines in
August 2015 that may also be of interest. They can also be
found at the link above.
Assessment questions
For questions 1 to 6, indicate whether the statement is true or false:
1. e Companies Act 71 of 2008, together with the Auditing
Profession Act 26 of 2005, prescribes and governs the appointment
of an external auditor for a public company. (LO 1)
2. A person who was the prescribed officer of the company four years
ago cannot be appointed as the auditor of that company. (LO 4)
For questions 7 to 14, select the correct answer/s. More than one
answer is possible:
7. Which of the following statements is/are true for a company that
does not have a statutory requirement to be audited? (LO 3)
a) ey might have to be independently reviewed as a statutory
requirement.
b) eir directors might voluntarily choose to have the company
audited even if it does not need to be.
c) e company’s Memorandum of Incorporation might require
it to be audited even if it does not need to be.
d) e company might not even have to be independently
reviewed.
10. Which of the following conditions are not likely to result in a matter
being regarded as a Reportable Irregularity? (LO 8)
a) An unlawful omission has taken place (i.e. the directors have
neglected to do something that they should have done in
terms of a statutory requirement).
b) An unlawful act was committed by a sales representative of the
company.
c) An unlawful act is only likely to cause potential loss (i.e. no
actual loss suffered yet).
d) An unlawful act amounts to theft but is an immaterial amount.
e) An unlawful act that constitutes a breach of duciary duty
through a relatively minor single infringement of the
Companies Act.
11. Which of the following options might be communicated by an
auditor to the IRBA in their second (follow-up) report? (LO 8)
a) e matter has been discussed with management and no
Reportable Irregularity has actually taken place.
b) e matter has not yet been discussed with management
despite reasonable attempts on the part of the auditor to do
so.
c) e matter has been discussed with management who have
subsequently taken steps to recover any loss and/or prevent
any further or future loss.
d) Although the matter has been discussed with management,
they have not yet taken steps to address the matter.
12. Which of the following statements is/are false? (LO 9, 10 & 11)
a) e audits of municipalities are regulated by the Public Audit
Act 25 of 2004 and not by the Auditing Profession Act 26 of
2005.
b) e Auditor-General is required to audit entities listed in the
Public Finance Management Act (such as Eskom or the SABC,
for example).
c) e Auditor-General is accountable to the IRBA and is subject
to the same IRBA disciplinary process as any registered
auditing rm.
d) Mandatory audits conducted by the Auditor-General in terms
of the Public Audit Act may only be carried out by staff who
are registered with the IRBA as Registered Auditors.
e) South African subsidiaries of American publicly listed
companies need to comply with the requirements of the
Sarbanes-Oxley Act, even though these subsidiaries are not
registered in the USA.
f) e JSE Listings Requirements create additional
responsibilities for auditors of companies listed on the JSE.
15. Why is it acceptable that a pro t company (that does not hold
assets in a duciary capacity for third parties) with a public interest
score of less than 100 is not required to be audited? (LO 2)
16. What does a company need to do if it wants to replace its auditors?
(LO 5)
CHAPTER CONTENTS
Learning outcomes
Reference list
4.1 What is governance?
4.2 What is the relationship between governance and internal
control?
4.3 What is internal control?
4.4 How does one design a system of internal control?
Assessment questions
LEARNING OUTCOMES
REFLECTION
When would an entity regard a particular risk as ‘unacceptable’?
One could therefore say that internal controls can have three types of
objectives, namely, nancial reporting objectives, operational
objectives and compliance objectives. As the nancial reporting
objectives and the controls necessary to ensure reliable nancial
reporting are the responsibility of the accounting department and
the nancial director, and are closely related to the audit process,
this constitutes the focus of this text.
• e system of internal control can only provide reasonable
assurance that the numerous risks that threaten the entity’s
objectives are addressed. is is due to the inherent limitations of
any system of internal control. ese limitations are discussed in
section 4.3.3 of this chapter.
REFLECTION
Does this mean that the same system of internal control will be
appropriate and adequate for different entities?
e way in which the system of internal control is designed,
implemented and maintained varies with the size and complexity of the
entity concerned, as well as with the risks faced by the particular entity.
In addition, computers may form part of a system of internal control to
varying degrees, depending on the nature and extent of
computerisation of the entity’s nancial system. Computer controls are
discussed in Chapter 5.
REFLECTION
How will the use of a computerised system by an entity in uence
the above-mentioned stages that a transaction goes through?
i) Document design
Documents used in the accounting system for the recording and
processing of transactions (such as orders, goods received notes and
invoices) should be preprinted and designed in a way to assist in the
process of using them and to minimise the chances of making mistakes
in the completion and use thereof. In this manner, the design of the
documents will assist in ensuring the accurate and complete recording
of the relevant information relating to the transaction.
c) Segregation of duties
Transactions go through various stages in the accounting process, each
with its own activities and procedures that employees must perform.
Certain transactions are more susceptible to fraud and error when one
employee is responsible for handling the particular transaction from
beginning to end. If this were allowed to happen, it would be possible
for an employee to make mistakes and/or conceal errors or
irregularities without anybody detecting them.
Incompatible duties are regarded as those duties that would put a
person in a position to commit fraud or make mistakes without
anybody noticing. In such instances, it is necessary to have more than
one employee involved in the execution of the transaction, where each
employee is responsible only for certain duties associated with the
transaction. Having two or more employees performing these
incompatible duties is referred to as segregation of duties.
d) Access control
Where assets such as inventory and cash are involved in the execution
of a transaction, it is necessary to control access to the assets properly.
However, properly protecting assets involves more than merely
restricting physical access to assets. Proper access control includes
controls to protect the entity’s assets, stationery (documents and
records, including the entity’s nancial records) and information that
might be sensitive against, among other things, loss, damage, theft and
unauthorised access or use.
Keeping these assets behind locked doors (e.g. keeping inventory in
a warehouse), locking assets (such as cash) away in a safe and using
security guards to control access to and protect the assets are examples
of access controls. e issue and use of documentation and records can
be controlled through the use of a stationery register.
Additional computerised controls can be used to facilitate proper
access control in a computerised environment – refer to Chapter 5
section 5.8.3.
REFLECTION
Think of the risks associated with a credit sales transaction. If
you struggle to identify risks, ask yourself: What could go wrong?
REFLECTION
List the risks (things that could go wrong) when an entity orders
goods from suppliers, receives the goods and pays for the goods
received.
GENERIC DEFINITION OR
CONTROL OBJECTIVE
MEANING
REFLECTION
Are all the control objectives equally important for every
transaction, or are certain control objectives more important for
certain classes of transactions?
e control objectives are the objectives to be achieved in order to
address the risks associated with a particular class of transactions.
However, not all classes of transactions are susceptible to the same
risks. erefore, it follows that although all the control objectives are
relevant and should be achieved for every class of transaction, certain
control objectives are of greater (or lesser) signi cance when there is a
higher (or lower) intrinsic risk associated with that particular class of
transactions.
For example, purchasing transactions are more susceptible to
unauthorised purchases and purchases made by employees for private
use. As a result, the validity control objective would be more important
for purchases transactions than, say, for cash sales transactions.
However, when dealing with a credit sales transaction, validity would, in
fact, also be an important objective as it would be essential to ensure
that credit sales are made only to customers who are creditworthy,
therefore preventing irrecoverable debts and losses to the entity.
In order to ensure that these control objectives are met for every
class of transactions that ows through the entity’s accounting system,
management must design, implement and maintain a suitable system
of internal control.
Table 4.2: Risks and control objectives for the credit sales
transaction
The goods leaving the premises To ensure that all goods that
do not actually reach (are not leave the premises are delivered
delivered to) the customer (theft to the customer (no theft of
of goods on the way to the goods) (completeness and
customer), resulting in nancial validity).
losses to the entity and
dissatis ed customers.
It is clear from the formulation of the control objectives in the table that
a control objective (what management wants to achieve or ensure) is
simply a different formulation of the risk (things that could go wrong).
It is also important to note that a particular control objective may be
relevant to more than one risk. In the example above the validity control
objective (identi ed in column 2) related to more than one of the risks
(identi ed in column 1). In the table, the validity control objective
relates to the risks of selling to customers who are not creditworthy,
goods leaving the premises and being delivered when no order was
placed, goods being stolen and as a result not reaching the customer,
the customer being invoiced although no goods were delivered, and the
customer denying placing an order/receiving goods.
REFLECTION
List management’s control objectives for goods ordered from
suppliers, received and paid for by the company.
When formulating control objectives, ask yourself: What does
management want the system to achieve/ensure in respect of
the particular class of transactions?
REFLECTION
Which assertion will be affected if controls to ensure that
calculations on invoices are correct, are not in place?
REFLECTION
Identify which of the control activities in section 4.3.2.4 have
been utilised to design the internal controls to respond to the
risk identi ed.
REFLECTION
Consider whether the internal controls listed in Table 4.3 to
address the risk of selling to new customers who are not
creditworthy are preventative, or detective and corrective
controls.
REFLECTION
What is the relationship between control objectives, key controls
and assertions?
REFLECTION
Can you think of internal controls that would generally not be
regarded as key controls?
In addition to the key controls that entities implement to ensure that the
nancial statements are free from material misstatements (these
controls have nancial reporting objectives), they also implement
internal controls that have operational objectives. ese operational
controls control the operations of the entity, such as the efficiency of
the cleaning of its office space, the effectiveness of the production
process in the factory (to ensure good quality, saleable products), but
have no direct impact on the nancial statements. erefore,
operational controls would never be regarded as key controls – they do
not prevent, or detect and correct, material misstatements in the
nancial statements.
Certain nancial controls that are not regarded as the key controls to
address a speci c control objective, but nonetheless still mitigate risk to
some extent, are known as compensating controls. ese controls
must be considered where a key control that should otherwise have
been implemented to address the risk is not cost-effective, or where the
key control, for whatever reason, did not function for a period of time.
Although compensating controls are less desirable than key
controls, there are instances where, owing to, for example, a lack of the
necessary resources, entities are unable to implement the proper key
control to address a particular risk. In such instances, entities are forced
to implement control measures to compensate for the lack of the key
control. For example, where an entity does not have a sufficient number
of employees to ensure adequate segregation of duties, its management
may implement other control measures to compensate for the risk
involved. Controls to compensate for the lack of segregation of duties
may involve periodic independent checks of the work performed by the
employee with incompatible functions to ensure that no fraud or error
has occurred.
Compensating controls are less desirable than the key control (in
this example segregation of duties) because they generally occur after
the transaction is complete. Also, it takes more resources to investigate
and correct errors and to recover losses than it does to prevent the
errors in the rst place.
However, in some circumstances, entities do not have the staff
resources to establish adequate segregation of duties. In these
instances, it is important for management to implement internal
controls that compensate for the increased risk.
Refer to Chapters 6 to 10 for internal controls in each of the business
cycles.
Assessment questions
Questions 1 to 5 are multiple-choice questions. Select the
appropriate answer(s). (More than one answer is possible):
1. e system that documents the procedures and records that a
transaction follows from where it is initiated to where it is included
in the nancial statements is known as the: (LO 3)
a) Internal control system
b) Corporate governance system
c) Accounting system
d) Risk management system
e) Control environment
8. List and brie y explain the risk response options that management
has available to address appropriately the risks they identi ed. (LO
5)
Column A Column B
12. Describe the three steps that an entity should follow in order to
design a suitable system of internal control. (LO 10)
Explain why a system of internal control can only provide
13. reasonable assurance that the entity’s control objectives are
achieved. (LO 7)
CHAPTER CONTENTS
Learning outcomes
5.1 Introduction
5.2 How has information technology evolved?
5.3 How and why do companies have to govern their computer
information systems?
5.4 What is the impact of upgrading a manual accounting system
to an electronic accounting system?
5.5 What are the key components of a computer information
system?
5.6 How does a computerised accounting system operate?
5.7 How are computer controls classi ed?
5.8 How are general controls classi ed?
5.9 Which controls relate to the computerised processing of
business transactions?
5.10 How are controls identi ed in advanced technologies?
Assessment questions
Appendix: Electronic funds transfer controls
Appendix: Accounting information systems
LEARNING OUTCOMES
5.1 Introduction
Information and communication technology (ICT) has become an
integral part of modern business. Hardly any business enterprise
operates in the modern business world without using at least some
elements of information technology (IT) and communication
technology (CT). IT is no longer seen as simply a mechanism for
processing information, but rather as a strategic resource. It impacts on
how companies do business, how they interact with clients, and how
businesses control their operations and nancial reporting processes, to
list but a few examples. It also has an impact on various aspects of the
audit process that was brie y introduced in Chapter 1. e IT
infrastructure may take many forms, from a desktop connected to a
cash register to an integrated enterprise resource planning (ERP)
system, and it changes with the needs of a business.
Irrespective of the nature of the system, the general risks, related
internal controls and principles outlined in this chapter remain
applicable and must be implemented by all companies that use IT. e
following sections provide a basic background to IT and the key aspects
underlying IT used in a nancial information system. IT is a specialist
subject area. erefore, this chapter focuses only on entry-level
technology and the principles that every manager and owner should be
aware of. e application of these controls is illustrated using the
business cycles of Ntsimbi Piping in Chapters 6 to 10.
To make the most of the topics covered in this chapter, you should
rst revise a couple of key concepts from your Information Systems
courses or from a detailed text that explains basic IT concepts. ese
concepts are highlighted in bold print and discussed in the paragraphs
that follow.
FURTHER READING
Google the terms and technologies in this chapter that are
unknown to you or visit the following website:
www.howstuffworks.com.
Two or more computers can be connected to form a network in either
one location or multiple locations. When computers are connected in
one location, they form a local area network (LAN). ey can also be
connected between different geographical locations to form a wide
area network (WAN). Networks are formed by means of, for example,
cabling, wireless connections, or over the internet. A virtual private
network, which uses telecommunication infrastructure to form a
network between various locations, can be set up.
Each computer in the network consists of hardware and software.
ere are two types of software: system software and application
software. Software is the program that gives the computer the
instruction to perform tasks. Microsoft Windows and Linux are
examples of system software (i.e. operating systems) that run the
computer, whereas Pastel Accounting and Microsoft Office (including
MS Word, Outlook and Excel) are application software. System software
runs in the background of the computer and is designed to give the
hardware instructions on how to run a speci c application. Application
software performs speci c functions required by the users. e user is
not aware of the activities and operations that the system software
performs.
Accounting packages, as an example, are application software that
maintains data, les and transaction details in databases. A database
can consist of transaction details or cumulative balances stored in
transaction les or master les respectively.
Master les are used to store permanent information or standing
data such as a customer’s full name and contact details and inventory
descriptions. Master les are also used to store the information and
cumulative totals or balances of all transactions that were entered into
and processed by the system from transaction les. Transaction les
are used to record the transaction details of each individual transaction
in both real time and batch processing systems.
In a real-time system, the master le is updated with the
cumulative totals or balances of all transactions recorded as and when
the transactions occur. In contrast, in a batch processing system, the
details of each individual transaction are stored in a transaction le
until such time as the system processes the data, at which time the
information in the transaction le is used to update the master le.
Batch processing and real-time systems are discussed in section 5.6.
Each le is made up of rows and columns of data. Data stored
electronically is represented by elds, records and les stored in a
database. When data is captured, it is stored in a eld (e.g. amount,
price, quantity or date). Multiple elds that relate to a particular
transaction are stored in a record (e.g. all the elds relating to a debtor
or transaction). e records of all related transactions (e.g. debtors) are
saved in a le. A collection of les or data that relate to a similar class of
transactions or balance makes up a database. is database can be
used and shared among multiple applications. Figure 5.1 presents the
relationship between elds, records, les and databases using Ntsimbi
Piping’s debtors as an example. A more detailed discussion is contained
in an appendix to this chapter.
REFLECTION
What can go wrong (i.e. which risks arise) should management
not implement controls to address each of the control objectives
of validity, accuracy and completeness?
As we noted above, once these risks have been identi ed, management
must evaluate the likelihood of occurrence and the impact thereof.
Introducing a computerised system into a business environment has
various bene ts, but also introduces risks that do not exist in a manual
environment, as well as risks that are unique to each type of computer
system. Some general bene ts and risks are contained in International
Standard on Auditing (ISA) ISA 315.A62–A63. Since computers are
programmed to follow prede ned coding derived from rules and set
parameters, they perform all calculations and processes in a consistent
and uniform manner. is uniform processing of information,
irrespective of form, ensures that timely and accurate information is
available as and when needed. Advance analytics built into computers
facilitate analysis of larger volumes of data than ever before. Availability
of timely and accurate information enhances the users’ ability to
monitor the performance of the entity’s activities and its policies and
procedures, which in turn reduces the risk that controls are breached.
e introduction of computers into a cycle gave rise to new
preventative, corrective and detective controls in a system. It also
enhanced the efficacy of traditional manual controls. For example,
since computers can be con gured in various forms and network
structures, which enables effective segregation of duties by
implementing security and other controls. is reduces the risk that
controls can be circumvented by users.
Due to the complexity of computers and the low level of
understanding required by users of computers, IT has also introduced
new risks. e overreliance by users on systems or programs that
potentially could incorrectly process data due to a aw in their
programming or process data captured inaccurately.
e ease of access to data by unauthorised users may result in
destruction or manipulation (completeness, validity and accuracy) of
data, as well as the recording of unauthorised or ctitious (valid)
transactions. Unintentional amendments to data can also occur by
accident. Unauthorised changes are not only limited to changes to data;
computers have made it easier for unauthorised changes to les,
systems or programs to go unnoticed. Authorised users also now pose a
risk, with IT personnel gaining access to data and systems beyond what
is necessary to perform their work. is could also result in loss of
privacy, with private information being access. IT personnel might also
fail to make necessary changes to systems or programs.
e most common user error occurs during the input and the
processing of transactions, with either erroneous or incomplete
information being captured and processed. Users may have
inappropriate manual intervention or override automated and other
controls.
A lack of understanding of how computers process information (i.e.
loss of data while data is being processed or transmitted) and how they
produce output may result in duplicate or incomplete information
being produced by a computer and user in decision making. is
overreliance on IT could result in incorrect decision making and the
inability to continue operating a business during an IT failure.
If these risks are not properly managed, they could have severe
consequences and have, among other things, nancial and reputational
risk implications, as has been demonstrated by cyber attacks, such as
the 2017 WannaCry ransomware attack and the recent hacking of some
social media platforms.
REFLECTION
What other bene ts and disadvantages do you think can be
derived from the introduction of computer processing facilities
into a manual system?
IN THE NEWS
Hacking in the news
WannaCry was a 2017 ransomware attack that took over infected
computers and encrypted the contents of the users’ hard drives
and demanded a payment in Bitcoin from the user in order to
decrypt the content on the computer to allow the user access to
his or her data. The malware had a severe impact on facilities
run by the United Kingdom’s National Health Services. The
nancial impact included the cost of paying the ransom, loss of
productive time during the attack, as well as, in instances where
the data was backed up, the loss of time reperforming work since
the last back-up was made.
Money is also at risk, am amount of $39,4 million in Ether, a
cryptocurrency, was stolen from the Ethereum app platform in
two instances in 2017.
At the height of the social media era, the media reported
various instances of hacking of high-pro le companies. The rst
was LinkedIn, a social media networking site that connects
business professionals. A Russian user claimed in a public news
forum to have downloaded 6.5 million LinkedIn user passwords.
Another highly published hacking incident occurred when
Facebook founder Mark Zuckerberg fell victim to a hacking attack
on his personal Facebook page. The attack highlighted the
vulnerability of many websites that use only a login and password
over HTTP connections to protect accounts. Zuckerberg was not
the only high-pro le Facebook user that was hacked. Former
French president Nicolas Sarkozy’s Facebook page displayed a
message with poor grammar stating that he would not run for re-
election in 2012. The post was later removed.
REFLECTION
How would the characteristics of an accounting system of a
business change with the introduction of computer processing
facilities into the manual system currently in use?
At each stage of the transaction, errors can occur and fraud can be
committed. As discussed in Chapter 4, management implements
controls over the accounting system to address risks (i.e. to achieve
control objectives) in both manual and IT environments. ey must
implement controls to respond to the risks (i.e. to achieve control
objectives) in both environments. It follows that when formulating the
controls, management has the same control objectives (introduced in
Chapter 4) in mind in both environments. In light of the fact that the
two environments are different, the control measures in a manual
environment will differ from those in an IT environment.
e following sections introduce controls in IT environments in
general terms.
ese policies, as well as all job functions and descriptions, and levels
of authority of IT staff should be documented. In developing these
policies, the principles of segregation of duties, security, continuity of
operations, overreliance on staff and staff development should be kept
in mind. For more information about acceptable personnel practices,
refer to Chapter 9.
REFLECTION
What are the risks for a business (things that could go wrong)
should each of the controls listed in sections 5.8.1.1 to 5.8.1.4
not be present?
REFLECTION
How is this process of system development similiar to and
different from that of building a house?
IN THE NEWS
10 years of expenditure yielding no results
The National Treasury initiated the Integrated Financial
Management System (IFMS) project and spent R1 billion on the
rst phase. Another R1,2 billion was spent during the second
phase of the project. IFMS was never implemented. IFMS was
supposed to modernise the government’s IT system across
departments. The failure was due to the internal controls of
National Treasury not identifying problems in the project. Project
costing was prepared informally, with consultants monitoring
themselves and ineffective internal monitoring controls.
SYSTEM CLOSE-OFF
SYSTEM POST-CONVERSION
AND DATA CLEAN
CONVERSION REVIEW
UP
IN THE NEWS
eNaTIS and Aarto fail to impress
A good example of project failure is the Electronic National
Administration Traf c Information System (eNaTIS), South Africa’s
upgraded transport information system, used, among other
things, to issue and manage drivers’ licences. The system, which
cost R408 million, was doomed to failure before it was
introduced.
The Auditor-General stated in the nal report that he was 80%
sure that the system was going to fail. The Auditor-General’s
investigation examined 24 aspects of eNaTIS and found 19 of
them to be ‘high risk’. But despite this warning, the government
still went ahead with the implementation of the system.
There were also many errors in the Aarto driving licence
system. Prior to the launch of the system, assessment reports of
two pilot projects highlighted the nightmare it proved to be for
drivers and municipalities. The report shows that the driver
demerit system led to various problems in training traf c police in
how to implement the system, but more importantly it was found
that 60% of the addresses of motorists stored on eNaTIS were
incorrect. eNaTIS is the register for all vehicles, driving licences,
contraventions and accident data. This meant that drivers could
be unaware of the fact that they might have incurred demerit
points because the noti cation of offences would be sent to an
incorrect mailing address. Companies employing drivers
complained they would have to incur costs in monitoring the
status of their drivers. Should a driver lose his or her licence, it
would have labour law implications for a company. Municipalities
received a lot of correspondence and complaints from drivers
and incurred high costs due to the incorrect addressing of letters
of offence, as all letters had to be sent by registered mail.
REFLECTION
Go to the computer laboratory that you use at your university. As
you walk to and enter the laboratory, what physical access
controls to the premises can you identify?
Access to computer terminals
It is not always possible to limit computer terminals to a speci c
location in the company. erefore, it is important to implement
controls around terminals. In order to limit access to terminals, a
company can use the following physical access controls:
• e computer terminal should preferably be located in an office or
dedicated, lockable room with only one secure access point, or
otherwise in a highly visible area away from general access. It is also
important that all staff members should have a way of identifying
themselves as being authorised to have access to computer
resources or to move around the IT department (such as a photo
identity staff card). Levels of authorisation and access could also be
displayed.
• If practically possible, a member of management should supervise
the activities on the computers.
• Access to computers should be limited to office hours, either
physically, by locking the premises after hours, or electronically, by
means of the job scheduling function in a computer package, which
only allows an application to be opened during speci c hours of the
day. Any work performed after office hours should be authorised.
• Access to the computer can be limited using either a terminal lock or
a biometric thumbprint scanner.
• e computer or any hardware should be securely fastened to the
table or desk so that it cannot be stolen or removed. is can be done
either by a cable (such as a Kensington lock) or by encasing it in a
metal box mounted to the wall or oor.
• Logs or activity registers should be maintained of all work performed
on the computer. ese should be reviewed on a frequent basis and
any unusual activity should be investigated.
Authentication
For the above-mentioned identi cation mechanisms to work
effectively, they should be linked to some mechanisms to authenticate
(i.e. verify the identity of ) the user or electronic resource or device
requesting access to the system.
is is done by an access table which links each username or device
identi cation number to some method of authentication, such as:
• A unique password (for sensitive transactions such as payments in
excess of a particular amount, multiple passwords could be
required);
• A speci c question as de ned by the user to which only that user
would know the answer, such as the user’s favourite primary school
teacher’s name or his or her pet’s birthday;
• An electronic key, magnetic card or USB device (called a dongle) that
contains authentication-related information unique to the user;
• A physical attribute unique to the user such as a ngerprint or face
scan; and
• An additional password sent to the user’s cellphone or email account
to be entered once the account has activated to gain nal access.
If the username and the authentication provided do not match, the user
is not granted access to the system. e most common form of
authentication is a password. For a password to be effective, it must
meet the following minimum criteria and controls:
1. It must be unique to each user and should not be obvious or easy
to guess.
2. It should remain con dential.
3. It should have a minimum length, for example, at least ve
characters.
4. e password should consist of a combination of letters, gures
and symbols (%$#*&) and contain both upper and lower case
letters.
5. New users should change their initial password the rst time they
log on to the system.
6. Passwords should be changed frequently, for example, once every
three months, and may not be reused.
7. e password should not be displayed on the screen, printed in a
report or maintained in a transaction log, and should rather be
re ected as: ‘*****’. Users should also be prohibited from disclosing
or sharing passwords.
8. Usernames and passwords should be disabled if someone resigns
or moves to another department.
9. Electronic les in which passwords are stored by the system should
be encrypted to prevent unauthorised access to password details.
10. e system should maintain an activity register that records the
time when staff log on and off and the nature of the activities
performed.
11. If a password is unsuccessfully entered, say three times, the user’s
access should be blocked and only reinstated by management after
a detailed investigation.
12. If the system is inactive for a predetermined period of time, the
system should either log off the user or initiate a screensaver
password.
13. If the system detects a breach in security, the system should
automatically shut down and only be reactivated once the IT
managers have investigated the breach.
REFLECTION
Have you changed your password for your Facebook or Twitter
account recently? If so, what password controls were present?
Authorisation
Once the user or device is authenticated, access to the system (or parts
thereof ) and data les, as well as the functionality (read, write, delete or
change) that the user has access to must be limited to those computer
resources that are required for the user to perform his or her work. A
package can use an access table to de ne the access rights of each staff
level at both a systems level (general control) and to a particular
application program (application control). Access rights are set up once
a new user is added onto the system. Users could be granted general
authorisation rights given to, for example, a category of staff relating to a
category of transactions or functions. A user might also require speci c
authorisation for higher risk transactions, which would require, for
example, a second staff member to authorise a transaction.
IN THE NEWS
Increase in cyber attacks
South Africa’s formal business sector and much of society are
already highly dependent on digital platforms, with a strong
emphasis on mobile technology, as is common in developing
economies.
According to computer forensics company Cyanre, the US
Federal Bureau of Investigation (FBI) has ranked South Africa
sixth and seventh on the cybercrime predator list in 2017, which
means that there is an increasing incidence of fraud being
perpetrated from the country. South Africa was the twenty-third
highest attacked country in terms of hacking and cybercrime. The
year 2017 was characterised by four main cyber-crime trends:
massive malware attacks, attacks against crypto-currency
exchanges, major data breaches and widespread use of hacking
tools. There have been a number of well-published cyber attacks.
One example is phishing attacks. It is estimated that one out
of 14 emails sent in South Africa is a scam, with 79% of all
online phishing victims losing money. The estimated loss per
incident in South Africa amounts to, on average, $476. While
calculating the direct cost of a breach is dif cult enough, it can
also have indirect costs.
Other examples include the WannaCry ransomware attack
that affected at least 200 000 organisations globally, and
NotPetya and Bad Rabbit. In these attacks, users access to their
own data was restricted.
Major data breaches also occurred in 2017. LinkedIn,
Dropbox and Yahoo were global victims. Locally, the personal
records of around half the South African population were found
on the Dark Web thanks to a hack of the Deeds Of ce and, in
September, the South African branch of web hosting company
Hetzner was hacked, compromising client data.
Cyber attacks, although illegal, can also facilitate social
reform. Internationally, the Panama Papers leaked emails
identi ed corrupt practices in the private and public sector,
implicating well-known public gures. In South Africa, the Gupta
email leaks disclosed public sector corruption and untoward
personal relationships between public gures.
5.8.4.2.1 Backups
A business should maintain suitable backups of all source documents
and records. Backups can take many forms, including having backup
staff, using redundant or duplicate systems as backup processing
facilities, saving data in multiple locations and making backup copies of
data and programs. Backup copies of data and programs should be
made frequently using the following guidelines:
• A formalised backup policy that states when and how backups are to
be made must be in place.
• e policy should state which les should be backed up and it
should include all operating and nancial information necessary for
a business to recommence operations should a disaster occur.
• Regular backups must be scheduled and made. At least three
generations of backups should be maintained. is includes weekly
backups of all data, monthly backups of all operational and nancial
les and quarterly backups of the entire system (including all
devices).
• Backups should be stored in a secure location off-site, preferably in a
reproof facility. e viability of cloud services should also be
considered.
• e backup copies must be tested frequently.
Once the transaction has been input into the application, the
application will process the transaction to ensure that the individual
components of the transaction are recorded correctly into various les
and databases, including the accounting records. Processing also
includes calculations being performed on the transaction (e.g. where a
transaction that includes VAT is processed, the processing could
include automatically calculating the VAT). Processing therefore
includes a number of functions performed automatically by the
application based on preset commands. e complexity of the
processing that occurs behind the scenes will depend on the company’s
speci c requirements, as well as the programming of the application
being used. Once a transaction has been processed, the raw data is
converted into information that the company can use.
e output of information is the nal form in which data is used.
e output of information can occur in numerous formats, depending
on the purpose or use of the information. If the information is to be
printed, this hard-copy document will be an output. However, the
information could simply be viewed on the screen by a speci c user –
this on-screen viewing is also a form of output.
Where data of a semi-permanent nature (e.g. a debtor’s address or
sales prices of inventory items) on the system is changed, master le
changes are made.
MANUAL COMPUTERISED
ENVIRONMENT ENVIRONMENT
If authorisation is
dependent on other
documents or details
from another part of
the transaction, the
program can perform
matching between
the data on, for
example, the details
stored in memory
relating to the
captured goods
received note with
MANUAL COMPUTERISED
ENVIRONMENT ENVIRONMENT
data captured from
an invoice before
allowing the invoice
to be processed.
Segregation of duties
Incompatible The access rights an
functions are employee has are
assigned to different
controlled and the
personnel at each functions limited that
stage of the he or she can
transaction ow. perform on the
application according
Employees only have
access to to the employee’s
documentation responsibilities.
necessary for them Access controls
to perform their should be applied to
jobs. the data underlying a
transaction on a
Staff could also be
segregated using least-privilege basis
physical barriers. Isolation of
Isolation of responsibility is
responsibility is achieved by giving
achieved by making each employee a
unique username or
a speci c employee
responsible for a magnetic card that
speci c task or identi es the
function and, after employee. Logs,
having completed records or audit trails
of the tasks or
the task or function,
having the employee functions performed
sign a document by employees are
maintained of all
MANUAL COMPUTERISED
ENVIRONMENT ENVIRONMENT
indicating that the employee activities,
task has been together with the
completed. related usernames.
This is extracted and
reviewed and any
unusual activities
that are not within
normal
responsibilities of
employees are
investigated.
Reconciliations and
Staff members The computer
independent review
perform automatically
comparisons performs
between multiple comparisons (or
sets of data, matching) between
records, documents different elds of
and physical assets. data sets contained
in different master
Individual manual
records are les and/or
compared with transaction les. Any
physical assets. exceptions are
recorded in a log,
which is reviewed
and investigated by
senior management.
(Performing
reconciliations is
made easier in a
computerised
environment because
of the availability and
increased
accessibility of
nancial and non-
nancial data in
electronic format.)
Reports of balances
per the computerised
system are compared
with physical assets.
5.9.3.1.1 Recording of data
When recording data onto a computer (inputting), controls should be
applied to the following:
• e person capturing the document or data and, if applicable, the
hard-copy document that is captured onto the system;
• e computer screen that aids the person capturing the document
(known as screen aids);
• Checking the validity, accuracy and completeness of the data that
was captured by means of controls programmed into the software
(known as logical programmed controls); and
• Management review of the data that was captured in order to identify
and correct any errors timeously.
CONTROLS
Documentation
In order to reduce the possibility of
misstatements, it is necessary to
ensure that the manual
documentation complies with
acceptable document standards and
is well designed and easy to
understand. Controls should also be
in place over the custody over the
documents (refer to Chapter 4,
section 4.3.2.4). (Note that the
validity, accuracy and completeness
of the data on the hard-copy
documents used as the basis for the
input into the computer system is a
prerequisite for the validity, accuracy
and completeness of the input.)
CONTROLS
Input
Once the class of transactions has been recorded on
controls hard-copy documents for a period of time (e.g. a day),
a staff member should place the documents into
manageable batches or bundles. Each batch must
receive a unique bundle number. The staff member
should review the sequential numbers of the
documents and calculate various control totals
(discussed below) before creating a batch.
Thereafter, the batch can be captured, during which
the input controls as discussed in Table 5.4 remain
relevant.
Batch control Once the batch has been prepared and control totals
sheets calculated, a batch control sheet, attached to the
batch, is prepared. It should contain at a minimum
the following data:
• A unique batch number;
• All calculated control totals; and
• A description of the transaction and related
details.
The batch control sheet should also comply with the
acceptable document standards contained in Chapter
4, section 4.3.2.4.
A second staff member should review the batch and
recalculate the totals and sign the batch control
sheet as proof that the controls have been
performed. He or she should also review the batch to
ensure that it contains transactions for only the
period speci ed on the batch control sheet.
After capturing of the batch, the computer should
print a batch control report as proof that the totals
have been compared. This is led with the batch
control sheet.
CONTROLS
REFLECTION
Can you think of the types of controls that should address these
risks?
CONTROLS
Controls
Various controls should be programmed into the
during
computer program. These program controls should
processing detect any missing transactions or data by
performing:
A le sequence investigation, where the program
investigates whether the rst transaction’s
reference number in the current transaction le
•
follows on the last transaction’s reference number
in the previous transaction le; and
• A completeness test during the processing of data
to identify missing reference numbers.
Other programmed validation tests must be
performed by the system to detect data errors (for
example sequence tests, matching tests and record
comparison tests) and processing errors (for
example, validation tests, mathematical accuracy
tests or reasonableness tests) and exception reports
generated and investigated.
REFLECTION
Can you list the controls that should be in place to secure a
memory stick with con dential information?
5.9.3.4 Master le change controls
As mentioned earlier in this chapter, a master le contains standing
data that is frequently used by the accounting package, but need not be
changed frequently. Master le changes are where the master le or
standing data is changed, updated or added to the system. For example,
a debtors master le has to be updated when a client updates his or her
home address or telephone number, and the price master le is
changed when the new authorised price list is loaded onto the
computer system. In general terms, master le amendments are
initiated by a user or the instruction arises from an external source. is
is distinct from processing, where the computer updates the data from
transaction les to a master le, which is subject to processing controls
(discussed in section 5.9.3.2), but not to master le change controls.
Master le changes tend to happen less frequently, tend to be high risk
because the data being changed may be re-used in various calculations,
and do not occur during the normal business operating cycles.
Master le data (such as debtors’ details and price lists) is often
captured once into a program and then re-used by various programs
and applications when transactions are captured or being processed.
For example, when a program calculates the total cost of an inventory
item being purchased, it multiplies the quantity captured by the user
with the selling price from the price list master le. As a consequence, a
data error in the master le could have a signi cant impact on an
accounting system, because one error will in uence all transactions
that rely on that master le. erefore, controls over approving master
le amendments and the review performed after an amendment has
been processed are paramount. Controls over master le amendments
also rely heavily on input controls. If the master le amendment process
is not managed effectively or if the controls are not implemented
effectively, it could result in:
• Unauthorised amendments;
• Not all authorised amendments being updated on master les;
• Errors in capturing amendments, which result in all nancial
information that is dependent on the master le being processed
incorrectly; and
• Errors contained in the master le data going undetected.
CONTROLS
CONTROLS
e majority, if not all, of the key controls can be identi ed using this
process. is is shown below by way of two examples.
REFLECTION
Can you identify the controls required should ‘Dropbox’ be used
by an entity to store data?
Assessment questions
For questions 1 to 5, indicate whether the statement is true or false:
1. e board of directors can fully delegate their responsibility for
implementing internal controls to the chief information system
officer. (LO 1)
17. Describe the key input controls you would implement around a
computerised cash register. (LO 7)
18. Describe how you would protect yourself against having your
identity stolen in situations where your personal data may be
accessible via the internet. (LO 7)
• User-friendly
screen design;
• On-screen
instructions
and prompting,
as well as
COMPONENTS RISKS CONTROL CONTROLS
OBJECTIVES
compulsory
elds;
• Minimum input
required by
means of drop-
down menus
and tick boxes;
• Bene ciary
details loaded
upfront and
recalled from
the bank’s
database as
needed (data
echo test);
• Validation tests
must be in
place, such as
a limit test,
which limits the
daily allowable
transfer
amount; and
• On-screen data
is visually
veri ed against
the supporting
documentation.
Transaction
report/payment
vouchers should
COMPONENTS RISKS CONTROL CONTROLS
OBJECTIVES
be printed (from
the data captured
onto the system)
and compared
with supporting
documentation
before being
signed and
captured onto the
EFT system.
• Limit the
physical
access to the
terminal that
contains the
EFT software.
COMPONENTS RISKS CONTROL CONTROLS
OBJECTIVES
Limit number
of terminals
and authorised
• users that can
make EFT
payments.
• Rely on least-
privilege rights
of users to the
various
functionalities
in the EFT
system.
The following
controls could be
used to
authenticate
users of the EFT
system:
• Physical
authentication
could be
established by
means of a
dongle inserted
into the
computer USB
port or by using
a random
number
generator
COMPONENTS RISKS CONTROL CONTROLS
OBJECTIVES
device. Normal
physical
access (i.e.
custody)
controls around
these devices
apply.
• Authenticate
users to the
service by
using a
username
linked to a
password.
• Password must
comply with the
normal
password
controls.
• Processing of
transactions
requires the
user to capture
the bank pin
before gaining
access to the
system.
• High-value
payments
require multiple
user
authorisations
COMPONENTS RISKS CONTROL CONTROLS
OBJECTIVES
by means of
usernames and
passwords.
• Bank
statements;
• Daily
transaction
listings; and
• Access
violation logs.
Bank
reconciliations
(refer to section
4.3.2.4 of
Chapter 4 and to
Chapter 10) are
performed on a
monthly basis.
COMPONENTS RISKS CONTROL CONTROLS
OBJECTIVES
Note: Table 5.8 contains only the controls over making EFT payments. It
does not address all controls to ensure that the payment is valid, accurate
and complete (e.g. in a salaries and wages application that the amount
of net wages computed for employees is valid, accurate and complete).
ese are addressed in Chapters 7 and 9 in relation to payments to
creditors and salary-related payments.
Step 6: Evaluate the impact of the existing controls and the risks
identi ed on the business
Step 7: Select suitable controls to mitigate the remaining risks to an
acceptable level
An evaluation must be performed of the manual controls and the
computerised controls in order to make a risk assessment. Based on the
combination of risk assessment and proposed controls, management
must decide which controls would mitigate their risk to an acceptable
level.
Appendix: Accounting
Information Systems
Costs are not limited to quantitative measures: Matters such as the need
for regulatory compliance, non-compliance with industry best-
practices, as well as opportunity costs of not having the relevant
information, must also be taken into account.
1 Each computer application must also have its own application-speci c access controls that
restrict access to data, les, functions and features. However, as these access controls relate
only to a particular application, they are classi ed as application controls and not as general
controls.
2 e user-related controls include controls that were discussed in the section on general
controls. e reason they are included in this section on application controls is that they
contribute directly to the validity, accuracy and completeness of the recording of a particular
type of transaction in a speci c application.
3 Refer to section 5.1 for an explanation of the difference between the two types of les.
4 e user-related controls include controls that were discussed in the section on general
controls. e reason they are included in this section on application controls is that they
contribute directly to the validity, accuracy and completeness of the recording of a particular
type of transaction in a speci c application.
5 e user-related controls include controls that were discussed in the section on general
controls. e reason they are included in this section on application controls is that they
contribute directly to the validity, accuracy and completeness of the recording of a particular
type of transaction in a speci c application.
6 e user-related controls include controls that were discussed in the section on general
controls. e reason they are included in this section on application controls, is that they
contribute to the validity, accuracy and completeness of master le changes in a speci c
application.
Revenue and receipts cycle CHAPTER 6
Gerrit Penning
CHAPTER CONTENTS
Learning outcomes
Reference list
6.1 What are the nature, purpose and accounting implications of the cycle?
6.2 What functional areas occur in the cycle?
6.3 What information system is used in the cycle?
6.4 What could go wrong (risks) in the cycle?
6.5 What computer technologies are used in the cycle?
6.6 What are the control objectives in the cycle?
6.7 What are the controls in the cycle (manual and computerised)?
6.8 Cycle illustration: e revenue and receipts cycle at Ntsimbi Piping
Assessment questions
LEARNING OUTCOMES
REFERENCE LIST
International Financial Reporting Standard (IFRS) 15 – Revenue from Contracts with Customers
IN THE NEWS
SEC charges energy services company and executives with accounting fraud1
Washington D.C., Oct. 17, 2016
The Securities and Exchange Commission today charged an energy services provider and four
executives for their roles in an accounting fraud in which the company recognised revenue earlier
than allowed in order to meet internal targets.
Lime Energy Co. agreed to pay $1 million to settle the charges, and its four now-former
executives also agreed to settlements.
The SEC’s complaint alleges that Lime Energy improperly recognised $20 million in revenue from
at least 2010 to 2012. Two then-executives in the company’s utilities division vice president of
operations Joaquin Alberto Dos Santos Almeida and director of operations Karan Raina developed
procedures to enable the company to recognise revenue on newly signed contracts based on
documentation received before year-end 2010. But when documentation did not arrive in time, they
allegedly went ahead and booked the revenue anyway.
According to the SEC’s complaint, Almeida and Raina became even more aggressive in 2011 and
2012 as they further recognised revenue earlier than allowed by accounting principles as they faced
increasing pressure to produce results. They eventually went so far as to direct internal accountants
to book revenue on jobs that didn’t exist. The SEC further alleges that Lime Energy’s then-corporate
controller Julianne M. Chandler accepted new accounting entries to book millions of dollars in
additional 2011 revenue well after the year-end close. And in February 2012 when Lime Energy still
needed $500,000 to meet its 2011 revenue target, the company’s then-executive vice president
James G. Smith suddenly sent Chandler new entries that provided the company with even more
additional revenue to improperly recognise.
‘Lime Energy and its then-executives engaged in a wide array of wrongdoing, including the
improper reporting of a signi cant amount of fake revenue,’ said Scott W. Friestad, Associate Director
of the SEC’s Division of Enforcement. ‘The desire to meet earnings or revenue targets cannot
override corporate of cers’ responsibilities to public shareholders to assure that the company’s
accounting re ects nancial reality.’
CRITICAL THINKING
Can you think of reasons for an entity to want to overstate or understate its reported revenue? In
addition, what personal interest do you think a director of an entity may have in manipulating
revenue?
Such incentives to misstate revenues may give rise to risks relating to the company’s nancial
information not being fairly presented.
6.1 What are the nature, purpose and accounting implications
of the cycle?
6.1.1 e nature and purpose of the cycle
e revenue and receipts cycle relates to an entity’s activities of selling goods or rendering services and
receiving cash from customers in exchange. Without sufficient revenue from sales or services, an entity may
not be a viable going concern. Failure to collect cash from customers for sales or services will place
signi cant strain on an entity’s cash ow. is may lead to eventual bankruptcy if an entity cannot pay its
debts as they become due.
However, the cycle is not just about the business function of making sales and receiving cash. It is also
about the accounting function where transactions associated with those sales and receipts are accounted for
(recorded) in an entity’s accounting records.
In terms of the accounting function, sales and services rendered are recorded as revenue in an entity’s
accounting records. It is imperative that all sales and services transactions are recorded, otherwise the
nancial reports will re ect a distorted view of the true nancial position and performance of the entity.
REFLECTION
What are the implications for the owners and employees of an entity and for the tax authorities
should an entity not record all its sales or services transactions?
When an entity manipulates its revenue, it is important to consider the negative consequences to
the entity’s stakeholders – not only from an economic perspective, but also from an ethical
perspective. Shareholders might make wrong investment decisions based on incorrect accounting
information, employees might be told that they have to forfeit the salary increase they could
otherwise have been awarded, and the tax authorities could be defrauded if the entity does not
declare all of its taxable income.
Sales made or services rendered to customers can be either on credit or for cash. If for cash, the entity will
immediately receive cash physically in banknotes and coins or through an electronic credit or debit card
transaction, or through an electronic funds transfer (EFT). If sales are on credit, the goods are provided (or
the service rendered) to the customer, but the customer is allowed to pay the outstanding amount at a later
date (i.e. the customer buys ‘on account’).
WHY? Why would an entity allow its customers to buy from it on credit given the possibility
that they will not settle their debts to the entity? What are the bene ts and what are
the risks?
By allowing credit facilities, including favourable credit terms, an entity can encourage
customers to purchase goods or services from it. Remember that some customers might
not be able to pay for the goods or services immediately (e.g. in the context of a
wholesaler, its customers may not have cash until they have resold the products). The
major risk, however, is that customers might not settle their accounts in time or not settle
it at all, causing nancial losses to the entity that provided the credit facilities.
A business has to implement proper internal controls in its revenue and receipts cycle to enable the
proper handling and recording of its sales/services and the subsequent collection of the amount due
from customers.
No matter the type of a business entity or the nature of its revenue, if a product is sold or a service is rendered
to a customer, revenue will ow to the entity and cash should subsequently be received.
REFLECTION
How would the risks for a company whose customers all pay in cash at its business premises
when buying goods differ from those for a business whose customers pay by means of EFT only?
The answer relates to the risks due to theft from the holding of physical cash versus the risks of
unauthorised access being obtained to the entity’s bank account.
When selling goods and rendering services to consumers, remember the Consumer Protection Act.
The Consumer Protection Act applies to the majority of businesses in South Africa that sell goods
and render services to the public. The Act mainly aims to protect the end-consumer against abuse
and malpractices by businesses. If the Act applies to a business or particular transaction, the seller
should comply with the requirements of the Act, or the seller might face nes and penalties.
Accordingly, a business’s information system, including internal controls, should make provision
for ensuring compliance with the Act.
As soon as one of the above triggers occurs, the revenue and receipts cycle will ‘go into action’ and the
internal controls in the cycle will need to be applied.
CRITICAL THINKING
How is a sales or service transaction recorded in the accounting records?
A sales or service transaction is ordinarily documented on an invoice and recorded in the sales or
service journal, the total of which is periodically posted to the revenue account in the general ledger.
If the sales or service transaction is on credit, it is also recorded in the customer’s account in the
debtors ledger. In a manual system, these activities would generally be separate actions (writing out
an invoice and posting the sale to the accounting records). In a computerised system, the
generation of an electronic invoice and the processing of a sale to the accounting records (sales
transaction le, general ledger accounts and debtors master le) may happen at the same time
without any manual intervention.
WHAT What if an entity neglects to follow up on a customer order it has received? What will
the consequences for the entity be? Are there any implications on the fair presentation
IF? of the nancial statements?
The entity might lose a sale and forgo any resulting pro ts that could have been earned
from the transaction. It might also lose the customer to a competitor, should the customer
deem the entity’s level of service to be unacceptable. However, there is no impact on the
fair presentation of the nancial statements as no sales transaction would have taken
place and therefore there is no misstatement in the revenue line item in the Statement of
Comprehensive Income.
CRITICAL THINKING
Keep in mind that, even though the transactions might happen at the same time, the recording of a
sale as revenue is a separate transaction from the recording of cash received as a receipt. Each is
subject to nancial reporting risks, while cash (as an asset) received is also at risk of
misappropriation. Revenue should be recorded when goods are sold or services are rendered and a
receipt should be recorded when the cash for these goods/services is received.
REFLECTION
Which accounts in the accounting records of an entity will be affected should a debtor fail to pay
its debt?
The debtors balance (an asset) will be affected, either due to the debtor’s balance having to be
written off or being included in an allowance for credit losses. These entries will also affect expense
accounts such as ‘bad debts’ and ‘increase/decrease in allowance for credit losses’.
Note that, despite the fact that the entity never receives any money for the goods sold or services
rendered, the revenue that was recorded would not be reversed. It remains revenue in the accounting
records and is reported as such. The bank account is not affected as no cash is received.
Although some forms of income, such as those listed below, are generally categorised under other cycles
(such as the investment and nancing cycle (refer to Chapter 10)), they may be subject to similar risks and
controls as identi ed in the revenue and receipts cycle (e.g. when the amounts from these forms of income
are physically received in cash or deposited into an entity’s bank account):
• Dividend income;
• Rental income;
• Interest income;
• Royalty income;
• Commission income; and
• Income from the disposal of assets.
IFRS 15 stipulates that an entity should recognise revenue as and when control over the goods/services
transfers from the entity to the customer, either over time or at a particular point in time depending on the
nature of the contract with the customer. It would therefore not be appropriate for an entity to recognise
revenue upfront in cases where the goods or service are provided to the customer over a period of time. For
extended periods, the entity will need to determine the appropriate method of allocating the transaction
amount over the period of the provision of the goods or rendering of the service to the customer.
Should an entity not comply with the requirements of IFRS 15, it runs the risk of having material
misstatements in its nancial statements, which will result in a modi ed opinion in the auditor’s report and
possibly adverse consequences for the entity.
Other accounting standards that may be applicable to the revenue and receipts cycle (but fall outside the
scope of this text) include:
• IFRS 16, Leases (i.e. speci cally relating to entities that are lessors); and
• IAS 20, Accounting for Government Grants and Disclosure of Government Assistance.
WHAT What if the management of an entity were to misinterpret the requirements of IFRS 15
or decide to deliberately misapply the principles?
IF? Consider the following example involving the inappropriate timing for recognising revenue:
A security rm was contracted by another entity to render security services to it for a 24-
month period. Instead of recognising the revenue over the course of the performance of
the service (i.e. evenly over the 24 months), the security rm inappropriately recognises
the total of all revenue it expects to receive at the end of the rst month.
What are the implications on fair presentation of the nancial statements because of
such accounting treatment?
For a typical wholesaler selling on credit to customers (debtors), the cycle can be divided into the following
functional areas:
1. Credit management;
2. Receiving orders from customers;
3. Authorisation of sales orders;
4. Picking of goods from warehouse;
5. Despatch and delivery of goods to customers;
6. Invoicing;
7. Recording of sales in the accounting records;
8. Receipt of cash from customers;
9. Recording of receipts in the accounting records; and
10. Processing and recording of returns and other sales adjustments.
A brief summary of each functional area in a wholesaler that sells goods to customers on credit follows.
1. Credit management
Purpose: To grant credit to creditworthy customers who do not immediately pay cash when receiving goods.
Main activities: Receiving credit application from customer; setting credit limits in terms of customer’s
creditworthiness; ongoing review of customer’s creditworthiness; handling account queries from customers;
collecting outstanding debts; handing over uncollectable debts to attorneys; recommending to management
debtor balances that should be written off as uncollectable.
Persons involved in this area: Credit controller, nancial accountant/ nancial manager.
WHY? Why is the responsibility for approving new customers and setting credit limits assigned
to a credit controller and not to the sales order clerk who receives orders from the
customers?
Consider the importance of segregation of duties when answering this question and the
risks that arise should these duties be carried out by the same person. For example, what
do you think the consequence might be if a sales order clerk were to receive a sales order
from a friend who is not able to pay for the goods ordered, but the clerk was able to set
the credit limit on the friend’s account? The clerk could supply the goods to the friend
without any problems, but the entity would probably never receive any payment for the
goods.
WHAT What if the customer is not granted the opportunity to place goods on backorder?
What might the nancial implications for the entity be?
IF? Customers might choose to rather make use of the entity’s competitors in the event of the
unavailability of goods. Its clientele might even be lost permanently, translating into lost
sales for the entity and therefore lower pro ts.
If the entity is a wholesaler, its customers might be business entities themselves, with
a responsibility to promptly satisfy the demands of their own customers’ needs for goods
or services!
WHY? Why are the warehouse and despatch staff responsible for the picking of goods from the
stores and despatch thereof (respectively), and not the sales order clerk?
If there is a lack of segregation of duties, the sales order clerk could create a fake order
and take the goods for himself or herself, or have a friend’s sales order ‘disappear’ after
the goods were delivered. The risk is even greater if the sales order clerk can also create
customer accounts.
REFLECTION
What purpose (from a revenue recognition perspective) is served by having a customer sign a
copy of the delivery note as proof of receiving the goods?
In order to record a sale in the accounting records, there must be proof that a transaction occurred
between the entity and another party, (i.e. that goods were sold or a service was rendered). The
customer’s signature serves as evidence that another party acknowledged its willing participation in
the transaction and that it took control of the goods/services.
6. Invoicing
Purpose: To create and issue an invoice to customers notifying them of their obligation to pay for goods
received.
Main activities: Creating a customer invoice and sending it to the customer.
Persons involved in this area: Invoicing clerk.
REFLECTION
What are the consequences for an entity should a sale take place and goods are delivered to a
customer, but an invoice is never created nor sent to the customer? Consider both the accounting
implications of such a mistake as well as the implications for the entity’s cash ows.
From an accounting perspective, as sales are typically recorded in the entity’s accounting records
from the delivery note and the invoice that is created, revenue might be understated. From a cash
ow perspective, the invoice serves as documentary proof of the amount that the customer has to
pay for the goods or services. Failure to create an invoice may result in the entity/customer
‘forgetting’ that the amount due still has to be paid, resulting in the cash never being received at all
or not received in a timely manner.
WHY? Why should the accounts receivable bookkeeper, responsible for creating invoices and
posting the invoices to the debtors ledger, not also receive cash from debtors or record
receipts in the cashbook?
Under conditions of weak segregation of duties, the accounts receivable bookkeeper could
decide not to post the invoice to the debtor’s account, but still send the invoice to the
debtor. When the debtor pays the accounts receivable bookkeeper, he or she can take the
money for himself or herself without posting a receipt to the debtors account.
Alternatively, and under certain conditions, the bookkeeper might even be able to post
a credit note to the account in order to ‘cancel’ the debt, making it appear as if the debtor
did not have to pay, thereby concealing his or her misappropriation of the cash received.
Be sure to distinguish between operational activities and nancial recording activities (bookkeeping).
Many actions in the cycle are not performed by accounting/bookkeeping staff. A business is primarily
about selling goods or rendering services, and not about the accounting behind it. However, the
accounting function is crucial as it evidences the history of the transaction from its origin all the way
through to when it is recorded in the accounting records (to eventually form part of the entity’s
nancial statements).
WHY? Why should the same staff member not be allowed to create a general journal and
approve it? Consider the role of segregation of duties in answering this question.
The person who initiates or executes the transaction (i.e. the general journal entry) must
not also be able to approve it. This is to prevent a person creating a ctitious or erroneous
transaction without the knowledge of anyone else. The segregation of duties achieved by a
second person reviewing the journal entry will facilitate the detection of the fraud or error.
6. Picking slip
e picking slip is created from the internal sales order. It serves as an instruction for the goods to be picked
from the store or warehouse for eventual delivery to the customer. Sales prices are usually not displayed on
the picking slip, but rather only item codes, descriptions, quantities and store location of goods to be picked.
e picking slip is sometimes referred to as the stores requisition.
Example: Refer to document 1C (internal sales order which also serves as the picking slip) in the appendix at
the end of the book.
7. Delivery note
e delivery note is created from the actual goods being packed for despatch to the customer and should
agree with the items being despatched. Prices are usually not displayed on the delivery note: only item
codes, descriptions and quantities.
Example: Refer to document 1E in the appendix at the end of the book.
WHY? Why are item prices not usually displayed on a delivery note?
The entity would not want its despatch or delivery staff to see the value of the goods that
were purchased by the customer. This is in order to reduce the chance of those staff
stealing goods that are seen to be of particularly high value. It also assists in preventing
the delivery note from being confused with other documents that do contain prices.
8. Sales invoice
e sales invoice is prepared for those goods or services that have been accepted by the customer and for
which the customer is liable to pay. It contains, among other things, proper descriptions and quantities of
the goods sold or services rendered, the prices of all items, and the total amount due.
Example: Refer to document 1F in the appendix at the end of the book.
In many computerised systems it is not necessary for a computer user to input product quantities
and prices for the purpose of generating an electronic sales invoice: item codes, descriptions and
quantities can be programmatically retrieved (i.e. by the computer) from the delivery note previously
generated in the warehouse and prices can be obtained from the sales order already stored on the
computer system (if the sales order contained prices, or alternatively it can be automatically
retrieved from price list master le). The sales invoice is therefore ‘generated’ using data that
already exists on the system, thereby avoiding data capturing errors.
9. Debtors statement
e debtors statement represents a summary of all the transactions (invoices, receipts and adjustments)
relating to a debtor, usually over a period of a month. At the end of a month, a debtors clerk (manual system)
or a computer (computerised system) prepares a statement from each debtor’s account in the debtors ledger
to indicate clearly to the customer what the customer still owes (i.e. what the customer’s outstanding debt
is). e outstanding balance per the debtors statement should agree with the outstanding balance per the
debtor’s account in the debtors ledger.
EXAMPLE
Source documents in the cycle serve as a transaction trail. They are also used to create other
source documents as a transaction ows through the cycle. For example, a customer order will be
used to create an internal sales order (and backorder note if applicable).
Further examples:
6.3.2.2 Journals and ledgers
REFLECTION
What is the sales journal called in a computerised system?
In a computerised system, the sales journal may also be referred to as the ‘sales transaction le’.
4. General journal
e general journal contains a record of all non-routine transactions and events not posted to the sales, sales
adjustments or cash receipts journals, such as the write-off of bad debts or when management creates an
allowance for credit losses.
5. Debtors ledger
e debtors ledger contains a detailed record of all transactions (invoices, receipts, returns and adjustments)
applicable to all debtors. Each debtor has its own account in the debtors ledger. e closing balance of each
debtor in the debtors ledger constitutes the outstanding debt payable by the debtor to the entity.
6. General ledger
e general ledger contains accounts drawn from all journals to serve as a collection point for all
transactions that occurred in the various business cycles of an entity. e general ledger facilitates the
compilation of a trial balance and the nancial statements. It further enables a double-entry bookkeeping
function that ‘controls’ the recording of transactions in an accounting system. For example, a credit to the
sales account will always be matched to a debit to the debtors control account.
REFLECTION
What type of transactions might a person who attempts to fraudulently reduce a debtor’s
outstanding balance post to a debtor’s account in the subsidiary ledger?
Such transactions could include ctitious credit notes (for returns) or receipts for amounts that were
never in fact received. It could also involve any ctitious sales adjustments that would decrease the
debtors’ outstanding balance.
DEB007 AJS Trading (Pty) 22 Green Avenue, 023 123 R15,610 R20,000
Ltd Westville 4567
3. Inventory master le
Manual system equivalent: Inventory list
e inventory master le is a database containing, among other things, the inventory codes, the description
of each item, together with the cost per unit, the unit selling price, and the quantities of goods available for
sale for each item of inventory.
6.3.4 Reports
1. Debtors listing (summary list of all debtors) (computerised systems only)
In a computerised system, the debtors listing is printed from the debtors master le. A computer application
typically allows a user to choose which information (data elds) to include in the list, for example debtor’s
code, debtor’s name, credit limit and balance due. e total outstanding balances when adding all individual
debtors’ balances on the list should agree with the total balance according to the debtors master le.
6.3.5 Reconciliations
1. Debtors reconciliation
A debtors reconciliation takes place between the total of all the individual debtor accounts in the debtors
ledger and the total balance per the debtors control account in the general ledger at a speci c point in time
(for example, at month end). In this way, an accountant can identify posting errors, such as where a receipt
from a debtor was recorded in the debtor’s account (debtors ledger), but was not recorded in the debtors
control account in the general ledger.
2. Bank reconciliation
A bank reconciliation is performed between the bank balance as per the bank statement (external balance
per the entity’s bankers) and the balance as per the cashbook (internal balance as per the entity’s accounting
records) at a speci c point in time (for example, at month end). If these two balances are not the same,
reconciling items will exist.
Such reconciling items may include, for example, deposits (or payments) that have been recorded in the
entity’s cash book, but which have not yet been processed by the entity’s banker and would therefore not yet
appear on the bank statement (or vice versa where the transaction has been processed by the banker, but not
yet recorded in the entity’s cash book).
REFLECTION
How does the presence of a high volume of cash sales in an entity affect the risk of fraud in terms
of revenue recognition?
Keep in mind that in a cash sales system, cash is received at the same time as when the goods are
delivered (think of a grocery store) or the service is rendered. Because the timing of revenue
recognition and recording of the cash receipt is the same, the risk of fraud resulting from the
manipulation of timing differences is reduced. However, there is a risk that cash is received from
customers, but that neither the receipt nor the revenue is recorded (in order to, for instance, evade
the entity’s income tax obligations).
CASE STUDY
A South African corporate collapse2
What if an entity were to immediately recognise the full revenue from the rendering of a service that
is worth say R9 600 per customer, but the service to the customer is provided over a period of two
years (24 x R400 per month)?
Ignoring the time value of money for this example, IFRS 15 requires that the R9 600 should not
be recognised as revenue in the accounting records immediately, even if the customer signed a two-
year contract on day one promising to pay R400 per month for a period of two years. As the entity
will incur expenses each month for as long as the contract is in operation, the recognition of the
revenue should be ‘spread’ over the period over which expenses will be incurred.
The practice of recognising revenue in advance, instead of deferring it, will signi cantly distort
the true nature of the entity’s ability to cover its future expenses. Should the full revenue from such
a long-term contract be recorded all at once (‘upfront’), the entity may be inclined to pay out the
revenue as dividends soon thereafter, leaving little to cover future expenses that the entity is
obliged to incur as it continues to render the service over the period of the contract.
The inappropriate recognition of revenue in advance contributed to one of the largest corporate
collapses in South African history. The case involved Leisurenet Ltd, a company that was listed on
the JSE. Leisurenet operated a chain of gyms and offered, among other things, long-term gym
memberships to customers. The company did not in all instances recognise revenue from
membership fees over the duration of the membership contracts, but instead did so upfront when a
contract was signed.
In 1999, Leisurenet’s revenue recognition policies included a statement reading as follows:
Revenue from long-term membership fees is spread over the period of the contract based on the
estimated usage of the facilities by members. A statistical analysis is performed so as to establish the
average percentages of users and non-users and the trends established are used in the calculation of
the income deferred.3
Deferring gym membership fees only for those members who regularly utilised Leisurenet’s gym
facilities and not also for the large percentage of members who did not regularly attend gym,
resulted in a distorted view of the actual nancial performance of Leisurenet. The distortion was
evidenced by the restatements to the nancial statements that were required when the company
implemented its new (‘correct’) accounting policy for revenue recognition. It came to light that much
of the revenue that was recorded for many years up to that point was in fact ctitious. As a result,
an annual pro t of R109,5 million turned into a loss of R46,8 million and shareholders’ funds of
R610 million were reduced to about R157 million.
The collapse and ultimate demise of the company nally happened in October 2000 when the
company was liquidated. This was followed by many years of litigation against the directors of
Leisurenet and even against the company’s auditor.
HOW? How does an understanding of the appropriate accounting treatment for revenue assist
an auditor?
The auditor will be able to identify and assess more comprehensively the risks relating to
material misstatements in the annual nancial statements, both in terms of errors and
fraud.
EXAMPLE
Consider two entities A (Pty) Ltd and B (Pty) Ltd in the same group of companies utilising different
banks, but they each have the ability to request transfers from the other company’s bank accounts
using their online banking platforms. Before kiting was applied, the cash positions of the two
entities re ected the following:
A (Pty) Ltd bank balance at 31 December 20X1: R8 million
B (Pty) Ltd bank balance at 31 December 20X1: R3 million
Group’s total cash position: R11 million
Assuming a transfer request of R2 million was made by B (Pty) Ltd from the bank account of A (Pty)
Ltd and assuming the group engages in the practice of kiting, the cash position of the entities in
their respective general ledgers and the group’s net position will appear as follows:
A (Pty) Ltd bank balance at 31 December 20X1: R8 million (out ow of funds not yet recorded)
B (Pty) Ltd bank balance at 31 December 20X1: R5 million (in ow of funds has been recorded)
Group’s total cash position: R13 million (overstated by R2 million)
The recipient of the transfer, B (Pty) Ltd, records the R2 million received in its nancial records as a
deposit (as soon as the funds are requested) and this deposit will actually show on the bank
statement before year-end as such. The entity which has to settle the transfer, A (Pty) Ltd, however,
refrains from making any accounting entry relating to the disbursement until after year-end. In other
words, A (Pty) Ltd does not record an out ow, due to the funds still ‘appearing’ in its bank account.
Accordingly, A (Pty) Ltd abuses the time it takes for A (Pty) Ltd’s bank to process the transfer,
leading to a situation where both A (Pty) Ltd and B (Pty) Ltd account for the very same funds (i.e.
overall, the group double-counts for the funds).
To address the risk of kiting, auditors prepare transfer schedules whereby they list all the transfers that
occurred (usually close to year-end and shortly thereafter) in bank account 1 as well as those in bank
account 2. ey then reconcile the amounts to ensure that for every deposit recorded in the nancial records
prior to year-end, a corresponding disbursement has also been recorded in the same nancial period.
EXAMPLE
Debtor A pays the cashier R1 000 to settle his account. The cashier misappropriates the money by
taking it without the debtor knowing. Even though a receipt might have been issued to the debtor,
the money is not banked. The cash-up results for the day would appear as follows:
Total cash received (per receipt issued): R1 000
Total cash banked: R0
Shortfall: R1 000 (cash misappropriated by cashier)
If the cashier does not engage in cash lapping by rolling the misappropriated funds, Debtor A will
become suspicious at the end of the month (on receiving a debtors statement) when his or her
balance still shows an outstanding amount of R1 000. (Note: The receipt would not have been
recorded to the debtors account/cash book, as no money was deposited in the bank in order to justify
the recording thereof.) In order to avoid scrutiny from Debtor A, the cashier will have to apply a
subsequent debtor’s cash/cheque receipt (e.g. Debtor B’s) or part thereof (i.e. at least R1 000) to
Debtor A’s outstanding account balance in order to make it appear as if the money had been
received from Debtor A:
Total cash received (receipt): R2 000 (received from Debtor B)
Total cash banked: R2 000 (of which R 1 000 is allocated to Debtor A’s account and R1 000 is
allocated to Debtor’s B account)
Shortfall: R0 (the original shortfall of R1 000 is being lapped)
On the last day of the month, by which time Debtor C’s money might be lapped to make up for the
shortfall in Debtor B’s account, it is practical for the cashier simply to tell Debtor C (on enquiry and
if the cashier handles debtor queries) that the reason for Debtor C’s statement showing a balance
of R1 000 (instead of R0) is due to ‘an error on the part of the entity, which will be corrected by the
next statement date’ (or some similar excuse). The theft of the original R1 000 cash, however, has
been concealed using lapping. Note that Debtor C’s account will show R1 000 as outstanding at the
end of the month despite Debtor C having paid, because an amount of R1 000 from Debtor A was
misappropriated by the cashier and subsequently lapped.
A system of lapping can continue into perpetuity if not detected by management. Besides being
caught out, the perpetrator involved can also end the lapping by returning the shortfall from his or
her ‘personal’ funds before debtors or management become suspicious. This will restore all
balances to the correct amounts. A lapping ‘system’ can become highly complex and dif cult to
detect. For this reason, it is imperative that cashiers should:
• Not deal with the bookkeeping function (they should especially not be allowed to post credit
adjustments to debtors’ accounts, otherwise they might easily conceal theft);
• Not handle debtor queries/complaints; and
• Be compelled to go on leave for extended periods of time during which lapping systems may
become exposed if the cashier is not present to cover-up and manage his or her system of cash
lapping.
6.6.1.2 Consequences if the control objectives in the cycle are not achieved
Table 6.2 summarises the consequences if the control objectives for revenue (sales/services transactions) are
not achieved.
Table 6.2: Consequences if control objectives are not achieved for revenue (sales/services) transactions
Example: If ctitious sales transactions are recorded in the nancial records, the control objective of validity,
which should have prevented such transactions from being recorded, would not have been achieved.
Revenue would thus be overstated in the Statement of Comprehensive Income.
Table 6.3 summarises the consequences if the control objectives for revenue adjustment (e.g. sales
returns) transactions are not achieved.
Table 6.3: Consequences if control objectives are not achieved for revenue adjustment (e.g. sales
returns) transactions
Example: If all transactions relating to sales returns are not included in the nancial records, the control
objective of completeness of nancial information would not have been achieved. is would lead to an
overstatement of revenue, since sales returns would decrease sales in the Statement of Comprehensive
Income.
Table 6.4 summarises the consequences if the control objectives for cash receipt transactions from
debtors (as opposed to those relating to cash sales) are not achieved.
Table 6.4: Consequences if control objectives are not achieved for cash receipt transactions from
debtors (as opposed to those relating to cash sales)
Details of control objectives and controls in the cycle appear in section 6.7 of this chapter.
6.6.3 Link between the control objectives in the cycle and
management’s assertions
Transactions that are not valid, accurate and complete (caused by the control objectives not having been
achieved) will result in revenue and receipts (and related account balances) being misstated in the
accounting records, which will in turn result in the nancial statements being misstated.
e process of recording a transaction in the nancial records and thus for it to be included in the
nancial statements, is as follows:
During a transaction’s ow through an entity’s information system, it will be subject to numerous internal
controls that help ensure that the control objectives are achieved. e transaction will only reach its end
point appropriately if it ends up in the nancial statements in a manner that achieves the control objectives.
us, if management wishes to ensure proper nancial recording (and fairly presented nancial statements),
they need to implement and maintain a proper information system, including an accounting system and
related internal controls. In this way, the control objectives contribute to the appropriateness of the
assertions made by management in the nancial statements and will indirectly result in the latter being free
from material misstatement.
e assertions for revenue (including sales adjustments) and accounts receivable are linked to the control
objectives in the cycle as shown in Table 6.5.
MANAGEMENT ASSERTIONS
Note: Controls that achieve the control objectives of validity, accuracy and completeness collectively contribute
to management being able to properly present both classes of transactions and events and the related
disclosures, and account balances and the related disclosures in the nancial statements. Consequently, the
Presentation assertion is not included explicitly in Table 6.5 above.
e assertions for cash receipts are linked to the control objectives in the cycle as shown in Table 6.6.
MANAGEMENT ASSERTIONS
Refer to Chapter 4, section 4.3.2.4 for details of the above-mentioned types of controls.
Typical duties that should be segregated and performed by different persons in the revenue and receipts
cycle include those shown in Figure 6.4 below. Each block represents an activity performed by a person and
should be segregated from the functions performed in any other block. In this table, blocks are grouped
together in terms of the functional areas.
Figure 6.4: Overview of segregation of duties in the revenue and receipts cycle
Reconciliations are usually performed by a clerk and must be reviewed by a senior staff member. In the event
that the person who is responsible for recording transactions in the accounting records also performs a
reconciliation on recorded information (typically of smaller entities), strong and thorough review controls
should be in place over the reconciliation.
1 CREDIT MANAGEMENT
| CREDIT DEPARTMENT |
1.4 Credit Debtors Company D All cash that N/A: 1.4D Cre
Management controller master le fails to can be Assuming the controlle
evaluates the Financial (debtors collect received from debts were recomme
collectability of accountant/ ledger) outstanding defaulting written off, nancial
1 CREDIT MANAGEMENT
| CREDIT DEPARTMENT |
outstanding Financial Debtors age debt from debtors is then no accounta
debt (some may manager analysis defaulting collected. further for appro
require inclusion (compiled or debtors as (Operational accounting overdue
in an allowance generated collection control) implications collected
for credit from debtors procedures (assertions submits
losses). ledger) not followed therefore not debtors
Credit controller General promptly. affected). or credit
attempts to journal agency i
collect overdue manner.
amounts from
debtors who
have not settled
their
outstanding
accounts
timeously.
Activity Responsible Documents and What could go Control Account/ Manual contro
party records; master wrong/risks objective assertion
les affected
2.1 An Sales order Customer order Order is A All orders N/A: 2.1A A prepr
order for clerk Internal sales received from accepted are Operational sequentially
goods is customer, but processed measure internal sale
Manual order (ISO)
received system not acted on timeously. without (ISO) on whic
from a Picking slip (or not acted (Operational accounting details of cu
only:
customer. Supervisory on control) implications: order are rec
timeously), Should an order made out by
staff
member in leading to not lead to a order clerk.
lost sales or sale, it would
sales order When goods
department unfavourable be picked in wa
inappropriate to
warehouse s
2 RECEIVING ORDERS FROM CUSTOMERS
| SALES DEPARTMENT |
customer record a a copy of the
relations. transaction in slip to the sa
the nancial department
records. 4.1) for matc
the ISO. This
indicate that
customer ord
been proces
despatch.
ISO le is ch
supervisor in
order depart
Long-outstan
orders (i.e. I
without a ma
picking slip),
followed up w
warehouse a
reason for de
picking;
Sequential n
to ensure all
accounted fo
are obtained
cancelled IS
sequence if
unclear or un
2 RECEIVING
ORDERS FROM
Backorder note Order is
CUSTOMERS B Items and N/A: 2.1B Sales o
| SALES DEPARTMENT | Inventory accepted quantities Operational requests wa
without there ordered are measure perform inve
listing/Inventory
being in stock, or without availability a
master le
suf cient are promptly accounting check, or co
inventory in put on implications. inventory list
stock to backorder if Accuracy of which clerk h
despatch to not available, revenue: The access.
customer, which will undercharging If items are
leading to thus not of customers stock, clerk
delays in unnecessarily would lead to with custome
delivery and delay the an goods can b
possible processing of understatement backorder an
negative the in revenue if a backorder
customer customer’s error not customer ag
relations. order. detected before
nal invoicing. (Note: Copy o
backorder no
3.1 Approval of Sales order Customer Order is A All orders Accuracy, 3.1A Order
customer: clerk order accepted received are valuation clerk accepts
from a non- from and order only
A Credit Debtors
person/business controller master approved approved allocation of from a
customer, customers trade customer who
places a sales (authorisation le
order with the and approval) (Debtors leading to only. debtors. is able to
possible (Validity) provide an
entity. ledger) Existence of
uncollectable trade account
debt in number and
debtors.
future and who is on the
nancial authorised
losses for customer list
entity.
If the
customer is
not on the
customer list
the customer
is referred to
the credit
controller to
commence
credit
application
process (see
activity 1.1).
Sales order
clerk
requests
customer to
provide
pertinent
details (such
as ID number
address,
contact
details etc.)
to con rm
customer is
genuine (i.e.
the person
requesting
the order is
3 AUTHORISATION OF SALES ORDERS
| CREDIT AND SALES ORDER DEPARTMENT |
the actual
customer
associated
with the
customer
number).
Management
to review
debtors
ledger for
evidence of
possible
ctitious
debtor
accounts as
sales order
clerk is not
allowed to
create
accounts.
3.2 Approval of Sales order Internal An order is B Credit Accuracy, 3.2B All ISOs
sales clerk sales accepted sales are valuation are submitted
transaction: Credit order from an only made and to the credit
(ISO) approved to debtors allocation of controller for
A sales order is controller
received from an (authorisation Debtors customer who are trade approval (with
who will creditworthy, debtors attached
approved and approval) master
customer. le exceed his i.e. who will picking slip –
(Computerised credit limit still be refer to 3.3C
system: (debtors
ledger) should the within their below). Order
programmatic sale be credit limits only approved
authorisation accepted, after the (by the credit
of sale in which may sale is controller
terms of pre- give rise to accepted. signing the
authorised irrecoverable (Validity) ISO) if the
credit limit set debts. customer is
by credit still within his
controller.) or her credit
limit, with
reference to
the
preapproved
credit limit on
the
authorised
customer list
3 AUTHORISATION OF SALES ORDERS
| CREDIT AND SALES ORDER DEPARTMENT |
(list compiled
from debtors
ledger).
Only credit
controller is
allowed to
increase
credit limit of
customer (i.e
override the
limit) should
order exceed
credit limit,
and after
investigating
the client’s
current
nancial
position.
3 AUTHORISATION OF SALES ORDERS
| CREDIT AND SALES ORDER DEPARTMENT |
3.3 Instruction Sales order Picking Unauthorised C Only valid Accuracy, 3.3C Picking
to pick (select) clerk slip pickings picking slips valuation slips are pre-
goods from slips are are created and printed and
Credit
warehouse is controller or created, based on allocation of cross-
created. leading to approved trade referenced to
second
administrative goods being ISOs. debtors. the
removed (Validity) corresponding
clerk
from the ISO and
warehouse attached to
for despatch the ISO for
to a submission
customer for approval
who signs for of order as
the goods per 3.2B
(takes above.
custody
thereof) but
who will not
be able to
settle his or
her debt.
3 AUTHORISATION OF SALES ORDERS
| CREDIT AND SALES ORDER DEPARTMENT |
4.1 Goods Storeman Picking Goods are A Goods N/A: 4.1A 4.1A
are picked Warehouse slip erroneously are picked Operational Supervisory Computer
from the picked from from measure staff system
supervisor
warehouse warehouse warehouse without member in does not
with that have in terms of accounting warehouse allow
reference not been the implications checks the warehouse
to an ordered by authorised (customers goods staff to
authorised the ISO and are only picked back create
picking customer, picking slip. charged for to the picking
slip. i.e. are not (Operational what they picking slip slips or
in terms of control) sign for on to con rm make
an delivery of all goods additions o
approved goods). correctly changes to
ISO, picked by on-screen
leading to picker picking
short or before slips (i.e.
over- goods are they have
deliveries sent to read-only
and the despatch access to
resultant and signs picking
negative the picking slips based
customer slip as on the
relations. evidence of access
the check. tables that
grant
access to
the system
on a least
privilege
basis).
4 PICKING OF GOODS FROM WAREHOUSE
| WAREHOUSE |
5.2 Goods Despatch Delivery Goods leaving B All goods Completeness 5.2B
are loaded clerk and note premises are loaded into the of revenue. (If Despatch
onto other not recorded on delivery truck ordered goods clerk crea
delivery despatch staff a supporting for despatch are not numerical
vehicle, document, have been recorded on sequence
Gate security
which then guard leading to recorded on a delivery note, it delivery
exits delivery without delivery note. might not be notes for
business Driver charge to the (Completeness) invoiced to goods bei
premises. customer (where customer despatche
goods are not despite Driver
returned) or to customer taking
checks
theft of the custody thereof
goods
goods before or if the goods
loaded on
reaching the are trucks bac
customer. misappropriated
to delivery
en route.)
note and
Existence of signs as
inventory. evidence
taking
custody o
goods.
To ensure
goods
leaving
premises
have been
recorded o
a delivery
note,
security
5 DESPATCH AND DELIVERY OF GOODS TO CUSTOMERS
| WAREHOUSE |
guard at e
gate
inspects
delivery n
and
performs:
• Check
numbe
boxes
truck; a
• Spot
checks
conten
where
possib
by
agreein
boxes
and/or
conten
back to
deliver
note,
depend
on the
nature
the goo
sold.
6 INVOICING
| ACCOUNTING DEPARTMENT |
Activity Responsible party Documents What could go Control objective Account/ Manual co
and records; wrong/risks assertion
master les affected
6 INVOICING
| ACCOUNTING DEPARTMENT |
6.1 Invoicing clerk Customer Goods are A All deliveries Completeness 6.1A A co
Customer- (invoicing) invoice delivered to give rise to a of revenue. the custo
signed copy Senior/supervisory Sales customer, corresponding signed de
of delivery but invoice. note (refe
debtors clerk journal
note is customer is (Completeness) 5.3C) is r
(recording) (Sales
received by never from driv
transaction
accounting le) invoiced for returning
department, those delivery a
initiating Debtors goods. in a pend
the creation ledger in seque
of a (Debtors order by t
customer master invoicing
invoice. le)
For each
Price list note rece
(Price list the invoic
master clerk pre
le) sequenti
numbere
invoice a
copy is
the
correspo
delivery n
(Note: int
sales ord
received
sales ord
departme
would als
led with
delivery n
invoice.)
6 INVOICING
| ACCOUNTING DEPARTMENT |
Supervis
member
bookkeep
of ce rev
pending
delivery n
identify:
• Any m
delive
(gaps
seque
follow
the de
bay on
delive
not ye
place;
• Delive
for wh
invoice
yet be
record
the sa
journa
6 INVOICING
| ACCOUNTING DEPARTMENT |
Activity Responsible party Documents What could Control objective Account/ Manual contro
and records; go assertion
master les wrong/risks affected
7.1 Sales Accounts Sales Posting to A Only valid Occurrence, 7.1A Second
invoice is receivable journal the sales invoices are accuracy and bookkeeping
posted to clerk/Bookkeeper journal, posted to the completeness checks the
(Sales
the sales Financial transaction debtors sales journal, of revenue. recorded invo
journal and ledger and debtors ledger in the sales
manager/ le) Existence,
debtors control and general journal by
accuracy,
account in Financial Debtors account ledger. agreeing the
valuation and
the accountant ledger and (Validity) entries to th
allocation
debtors (Debtors revenue supporting
master le) account in B Details of and
ledger. invoices to
sales completeness
General the general con rm that
Sales are transactions of trade
posted ledger: ledger may are correctly receivables. valid invoice
be exists for ea
from the Revenue posted from
incomplete, recorded sal
sales and trade the invoice to
inaccurate transaction.
journal to receivables or invalid. the sales
the trade journal, (Occurrence)
control Invoices wer
receivables accounts debtors ledger
accurately po
control and general
Debtors by agreeing
account in ledger.
the general statement (Accuracy) amounts
(Accuracy); a
ledger. C All sales
All invoices w
invoices are
posted by
posted to the
checking the
sales journal,
debtors ledger numerical
sequence of
and general
entries.
ledger.
(Completene
(Completeness)
7.1BC Secon
bookkeeping
also checks
posting of
invoices from
invoice to the
sales journa
the debtors
ledger to con
7.1ABC Debt
reconciliation
performed by
supervisor in
bookkeeping
7 RECORDING OF SALES IN THE ACCOUNTING RECORDS
| ACCOUNTING DEPARTMENT |
section to
reconcile the
of all accoun
the debtors
ledger to the
balance as p
the trade
receivables
control acco
the general
ledger.
Financial
manager/ n
accountant
reviews the
debtors
reconciliation
follows up on
reconciling it
before mont
statements a
prepared for
mailing to
debtors.
A person
independent
the recording
receipt of ca
functions fol
up on all deb
queries, e.g.
where debto
complain abo
errors on the
invoices.
Activity Responsible Documents What could go Control objective Account/ Manual controls
party and wrong/risks assertion
records; affected
master
les
8.1 Receipt Mail Mail For money A All cash Completeness 8.1A For mon
of cash from opening register received by post received is of bank and received in th
staff and in person: deposited in post:
Cashier
8 RECEIPT OF CASH FROM Receipt
CUSTOMERS Money is
| ACCOUNTING Chief
DEPARTMENT | received from
Cashing-
customer,
customers cashier up sheet entity’s bank cash At least tw
• but is not
by: Security Bank deposited account. balances. persons, o
• Postal company deposit into entity’s (Completeness) which at le
mail guards slip bank • one
(cheques); account. independe
• In person of the bank
Instances where
at depositing
cash can be
cashiers and record
misappropriated
(cash or functions,
between receipt
cheques). open mail.
from customer
and banking of • Mail regist
cash include: is maintain
in which da
• Theft of
of receipt,
monies in
debtor nam
mail-opening
and amoun
stage where
received is
cheques are
recorded.
received in
the post and • Both staff
stolen by members s
mail register
openers. (isolation o
responsibi
• Theft of
When mon
monies paid
and mail
in person by
register is
recipient
transferred
preparing
cashiers,
ctitious
cashiers
receipt or no
count mon
receipt at all
received in
(theft cannot
the presen
be picked up
of mail
timeously as
openers an
no record of
sign regist
receipt
as proof of
exists). (Risk
accepting
also applies
custody of
to
cash.
unauthorised
or fake hand- For monies
written received by
receipts used cashiers
in a (cheques from
computerised mail openers
environment cash/cheques
to unaware from walk-in
customer.) customers):
• Adequate
security
arrangeme
8 RECEIPT OF CASH FROM CUSTOMERS
| ACCOUNTING DEPARTMENT |
to be made
(e.g.
appointme
of security
company;
installation
and
monitoring
cash regist
by CCTV).
• Notice stat
that custom
should ins
on a receip
from cashi
• Cashier
creates a
numerically
sequenced
multicopied
receipt for
money
received.
Activity Responsible Documents What could go Control objective Account/ Manual controls
party and records; wrong/risks assertion
master les affected
9 RECORDING RECEIPTS IN THE ACCOUNTING RECORDS
| ACCOUNTING DEPARTMENT |
9.1 Cash book Cash book Fictitious A Cash receipts Occurrence of 9.1ABC Debtors
Receipt clerk (cash cash recorded relate to cash reconciliation is
from Financial receipts receipts are actual cash receipts. performed on a
debtor journal) recorded in received, i.e. each monthly basis to
manager/ Completeness
is cash book entry in cash book ensure correct
Debtors and accuracy,
posted Financial and in is supported by posting of
ledger valuation and
to the accountant customer’s cash receipts to the
(debtors allocation of
cash account in deposited/received debtors ledger
master le) trade
book debtors in bank account. and general
receivables.
(cash General ledger. (Validity) ledger control
receipts ledger: account (refer to
journal) Bank and functional area 7
and the cash above for detaile
debtor’s control controls).
account accounts
in the and
debtors debtors
ledger. control
account
Bank
statement
List/report
of
unidenti ed
deposits.
9 RECORDING RECEIPTS IN THE ACCOUNTING RECORDS
| ACCOUNTING DEPARTMENT |
Table 6.16: Processing and recording of returns and other sales adjustments
j
10 PROCESSING AND RECORDING OF RETURNS AND OTHER SALES ADJUSTMENTS
| WAREHOUSE, SALES AND ACCOUNTING DEPARTMENT |
j
10 PROCESSING AND RECORDING OF RETURNS AND OTHER SALES ADJUSTMENTS
| WAREHOUSE, SALES AND ACCOUNTING DEPARTMENT |
Mike submits the credit application with supporting documentation to an external service provider,
DebtACheck (Pty) Ltd, who assesses the customer’s credit quality by performing a credit background check
on the customer as follows:
• Following up with the customer’s trade references (to con rm whether the customer is in good standing
with its suppliers and other business associates);
• Querying credit bureaus to con rm the customer has a favourable credit history (i.e. the customer’s credit
rating is not impaired); and
• Analysing the nancial information provided by the customer (such as audited nancial statements) to
con rm customer has a healthy cash and liquidity position.
e check usually takes one day to complete. Only customers who are rated as ‘AA’ or ‘BB’ quality by
DebtACheck (Pty) Ltd are advanced credit by Ntsimbi Piping. Should the credit assessment be successful
(i.e. for AA and BB-rated customers) DebtACheck (Pty) Ltd recommends a credit limit for the customer’s
account by indicating the limit on the customer’s application form. Credit limits may only be recommended
within the overall parameters previously approved by Ntsimbi Piping’s board of directors. Unsuccessful
applicants are indicated on the application form as such.
When the nalised application form with supporting documentation is received back from DebtACheck
(Pty) Ltd, Mike Milton rst reviews and approves the credit limits recommended by DebtACheck (Pty) Ltd.
His review involves ensuring that proper supporting documentation (such as evidence of the credit
background check) is attached and that the credit limit is reasonable given the information obtained by
DebtACheck (Pty) Ltd in making its decision on the customer’s credit limit. e three copies of the
application form are distributed as follows:
• e original is retained by Mike and led in numerical sequence;
• e rst copy is given to the customer for the customer’s records; and
• e nal copy is sent to Janice Fourie, the data capture clerk, for capturing onto the computer system, in a
batch together with a master le amendment form.
To initiate capturing, Janice Fourie accesses the customer master le module on the company’s
computerised accounting application (PVCACC) with her unique username and password and selects the
‘Amend debtor details’ function. Working her way down the master le amendment form, she enters all the
particulars of the new customers as they appear on the attached application forms. e system automatically
allocates a unique sequential account number (customer code) to each new customer account as Janice
captures the information. PVCACC does not allow Janice to choose or furnish an account number herself for
new customers.
He also reviews the log for any unusual modi cations such as possible duplications or exorbitant credit
limits captured. Any exceptions are followed up with Janice or Mike and resolved. James signs the log as
evidence of having performed the review.
WHY? Why are telephone orders not checked for accuracy by the second staff member?
Recall that Curtis captured the order directly from his conversation with the customer,
leaving no paper trail for a second person to check. However, Curtis did read back the
details on the on-screen ISO to the customer, which in effect served as the accuracy
check.
6.8.2.3 Backorders
Should there not be sufficient quantities of an item on hand at the time of the order, Curtis informs the
customer accordingly and, should the customer wish to proceed, Curtis ags the item on the ISO for transfer
by the computer to the backorder system. e computer sends an electronic backorder note to Ntsimbi
Piping’s purchasing division for acquisition from suppliers. Curtis regularly reviews the list of backorders on
the computer for long-outstanding backorders and follows up with the purchasing division about delays.
6.8.6 Invoicing
• Function performed by the bookkeeping office (a section in the accounting and nance division).
• Persons involved in function:
• Mary Carlson (the invoicing clerk and bookkeeper responsible for accounts receivable)
• Jason Naidoo (senior bookkeeper in the bookkeeping office).
Mary Carlson is responsible for creating and emailing invoices to customers. As and when a customer-signed
delivery note is received from the driver (see distribution of delivery notes in 6.8.5.3 above), Mary les it
sequentially in a ‘pending invoice le’.
Customers pay their outstanding debtors balances mostly by making EFTs (using their internet banking
facility) directly into Ntsimbi Piping’s bank account. A minority of customers pay in cash at the company’s
head office where the cashier is located, or they make direct deposits into the company’s bank account by
depositing money in person at a branch of Ntsimbi Piping’s bank.
6.8.8.3 Cashing up
At the end of each day, Tracy prints a ‘daily cash-up report’ from PVCACC, which shows the total receipts
recorded by the computer for the day. She counts the physical cash received and reconciles it to the total of
the daily cash-up report. Although it rarely occurs that there is a surplus or shortage of cash takings, she has
to inform Jason Naidoo (senior bookkeeper) of any discrepancy should it arise.
Tracy proceeds to complete a bank deposit slip in triplicate, indicating the total cash that should be
banked for the day. is is ordinarily equal to the total of the daily cash-up report.
6.8.9.1 Posting of receipts to cash book and debtors master le (computer system activity)
When Tracy Lee issues a receipt to a customer, the receipt is automatically posted to the cash receipts
transaction le (cash book) and general ledger by the computerised accounting application. In addition, the
receipt is also automatically posted to the applicable debtor’s account in the debtors master le, crediting the
debtor’s account. It is not possible for a user to make changes to the cash receipts transaction le, debtors
master le or general ledger other than by following the steps described above.
6.8.9.2 Allocating deposits other than cash receipts by the cashier to debtor accounts
On a daily basis, Sibongile Mathlabe posts receipts that were received by EFTs and direct bank deposit to the
accounting records. Customers are required to quote their customer account number as banking reference
when effecting an EFT or making a direct deposit. is practice enables Sibongile to identify which deposit
belongs to which debtor. He is able to download the company’s bank statements electronically using Ntsimbi
Piping’s online banking facility.
In order to allocate deposits to debtor accounts, Sibongile rst accesses the ‘Record receipts’ function on
PVCACC with his unique username and password. He also accesses the online banking facility using read-
only access and prints a hard copy of the bank statement. He then ticks off each deposit that appears on the
bank statement as he posts it to a debtor’s account in the computer application. e crediting of the debtor’s
account in the debtors master le takes place automatically at the same time that a receipt is posted by
Sibongile to the cash receipts transaction le. is automated posting is possible as Sibongile has entered the
debtor’s account number before posting the deposit, enabling the system to identify the account to which the
receipt should be allocated.
It occasionally happens that customers are justi ably not satis ed with goods delivered or that goods are
damaged in transit. In such cases, a customer sends the goods back to Ntsimbi Piping for a credit to his or
her account.
Strict controls are in place over the issue of sales credits due to the high risk of fraud in this area.
Note: Where credit being granted to a customer is not based on returned goods, but is related to other
adjustments, such as account corrections, Leanne Ford must rst authorise the adjustment. Mary Carlson
would generate a preliminary credit note on the accounting application (e.g. to correct a debtor account that
was overcharged) and submit any documentation supporting the adjustment to Leanne. Such documentation
may, for instance, consist of a debit note from the debtor and a print-out of the erroneous invoice. Leanne
authorises the credit note on-screen after con rming that a valid reason exists for the adjustment with reference
to the supporting documentation.
Upon on-screen approval, the credit note is processed automatically to the sales adjustments transaction le
and debtors master le without further action by Mary.
Leanne Ford prints a monthly report of all credit notes generated by the system for review. She
scrutinises this report for any unusual credit transactions or large transaction amounts and performs a
month-to-month comparison of total credit granted to investigate months with unexpectedly large totals.
Assessment questions
For questions 1 to 3, select the most appropriate answer(s) from the options provided:
1. A sale to a customer can ordinarily be recognised in the accounting records as revenue once: (LO 3 & 5)
a) A sales order has been received from the customer
b) e sales order received from the customer has been approved
c) Ordered goods have been delivered to the customer
d) An invoice has been sent to the customer to demand payment
2. A reason for making out an internal sales order (ISO) despite the fact that a written customer order has
been received is that: (LO 6)
a) e entity requires customer orders to be sequentially numbered, while those received from
various customers are not in sequential number order
b) e entity requires an ISO in order to prove the validity of the future sales transaction, without
which a sale cannot be recorded as revenue
c) An internal sales order is necessary for the proper approval of an order
d) An internal sales order is necessary to create a picking slip
3. A customer is required to sign the entity’s delivery note on delivery of goods or rendering of a service
because the signature: (LO 8)
a) Proves that the correct sales prices were originally quoted to the customer
b) Serves as an indication that a sales transaction can be recorded in the accounting records
c) Removes the possibility that delivery staff might misappropriate goods en route to the customer
d) Prevents collusion between the customer and delivery staff
For questions 4 to 9, indicate whether the statement is true or false and explain your answer:
4. A picking slip is an essential document needed for a sale to be recorded in the accounting records and
for an invoice to be created. (LO 5 & 6)
5. If an entity renders a service to a customer over a 24-month period, but the customer paid all 24 months’
fees up front (i.e. on the day the contract was signed), the entity can record the total contract value (24
months’ worth of services) in the initial nancial year if the customer agrees to this. (LO 3)
6. Only staff members at managerial level (and accordingly, not clerks) should be allowed to perform
reconciliations, such as a bank and debtors reconciliation. (LO 10)
7. For proper segregation of duties to occur, the staff member who receives and processes customer orders
should not be allowed also to post sales transactions to debtors’ accounts in the accounting records. (LO
10)
8. It is possible for a computer program to approve a credit note without any manual intervention from a
staff member. (LO 10)
9. A point-of-sales system is linked to the inventory master le in the company’s computer system to
enable it to retrieve the selling prices of items being sold. (LO 8)
10. Brie y explain the purpose of the revenue and receipts cycle. (LO 1)
11. State the major general ledger accounts that are affected by the revenue and receipts cycle. Provide your
answer in terms of the double-entry bookkeeping system, i.e. also state the contra-accounts affected.
(LO 4)
12. State the general ledger accounts most likely affected when the following activities occur: (LO 4)
a) An order is received from a customer.
b) An invoice is made out to a credit customer.
c) Money is received from a credit customer to settle his or her account.
d) A customer returns faulty goods to an entity and a credit note is approved.
13. Brie y explain the main purpose of each of the following functional areas present in the revenue and
receipts cycle: (LO 4)
a) Credit management
b) Invoicing
c) Recording of sales in the accounting records
d) Processing and recording of returns and other sales adjustments
14. Describe the purpose of each of the following documents/accounting records used in the revenue and
receipts cycle: (LO 6)
a) Internal sales order
b) Delivery note
c) Invoice
d) Credit note
e) Sales journal
f) Cash receipts journal
g) Debtors master le
15. State the source documents used in order to record the following in the cash receipts journal (cash
book): (LO 5 & 6)
a) A deposit is received from a customer via an electronic funds transfer.
b) A deposit is received from a customer via a direct deposit made at a branch of the company’s bank.
c) Physical cash is received from a debtor who settled his or her account.
d) A cheque is received from a customer through postal mail.
16. For each of the following risks, state whether the risk will result in an overstatement or an
understatement of revenue in the nancial statements and also state the revenue-related assertion
affected by each risk: (LO 7)
a) Fictitious sales are recorded in the sales journal.
b) A clerk incorrectly used a sales price of R22 for a particular item and not the official price of R30
when preparing an invoice for a customer.
c) A customer order is accepted and processed from a customer who has exceeded their credit limit,
without management approval.
d) Sales invoices were destroyed in a re and could not be recorded in the sales journal.
e) Sales transactions are deliberately omitted from the accounting records in order fraudulently to
reduce an entity’s tax liability.
17. For each of the following risks, state whether the risk results in an overstatement or an understatement
in the accounts receivable account balance and also state the accounts receivable-related assertion
affected by each risk: (LO 7)
a) Trade debtors become uncollectable, but are carried at their original (gross) values in the nancial
statements.
b) An entity delivers goods to a customer, but neglects to record a sale or create an account for the
debtor in the debtors master le.
c) e entity sold its debtors to a debt collection agency, but still shows the debtors in its nancial
statements.
d) A ctitious sale is recorded in the sales journal.
18. Formulate the control objectives of validity, accuracy and completeness in the context of a sales
transaction. (LO 10)
Assume that physical products are sold and that no computerisation applies:
a) An invoice is recorded as a sale in the sales journal without the goods relating to the sale having
been delivered to the customer.
b) Not all sales transactions (invoices) are recorded in the nancial records.
c) A credit note is issued to a debtor who has not requested an adjustment to his or her account.
d) A sales transaction is incorrectly posted to a debtor’s account in the debtors ledger from the sales
journal through a transposition error (e.g. incorrectly as R1 240 and not correctly as R1 420). e
general ledger entries are, however, correct.
e) A cashier receives money from a debtor, but misappropriates the money for personal gain and
writes off the customer’s debt in the debtors ledger to conceal the theft.
1 Source: US Securities and Exchange Commission news release. [Online]. Available: https://www.sec.gov/news/pressrelease/2016-218.html
2 Based on information found at: http://www.accountancysa.org.za/resources/ShowItemArticle.asp?ArticleId=625&Issue=449.
3 Information obtained and prepared from: ‘Non-audit services: How it affects the independence of the auditor’; Deon Basson, 2004. [Online].
Available: http://reference.sabinet.co.za/webx/access/journal_archive/10289003/28.pdf Reprinted by permission of e Southern African
Institute of Government Auditors (SAIGA).
Purchases and payments cycle CHAPTER 7
Gerrit Penning
CHAPTER CONTENTS
Learning outcomes
7.1 What are the nature, purpose and accounting implications of the cycle?
7.2 What functional areas occur in the cycle?
7.3 What information system is used in the cycle?
7.4 What could go wrong (risks) in the cycle?
7.5 What computer technologies are used in the cycle?
7.6 What are the control objectives in the cycle?
7.7 What are the controls in the cycle (manual and computerised)?
7.8 Cycle illustration: e purchase and payments cycle at Ntsimbi Piping
Assessment questions
LEARNING OUTCOMES
IN THE NEWS
SEC charges Bankrate and former executives with accounting fraud1
Extract from a securities2 fraud3 complaint submitted to the Securities and Exchange Commission,
United States of America
8 September 2015
The Securities and Exchange Commission today announced that Bankrate Inc. has agreed to pay
$15 million to settle accounting fraud charges. Three former executives are charged in the case that
involves fraudulent manipulation of the company’s nancial results to meet analyst expectations.4
The SEC alleges that Bankrate’s then-CFO Edward DiMaria, then-director of accounting Matthew
Gamsey, and then-vice president of nance Hyunjin Lerner, engaged in a scheme to fabricate
revenues and avoid booking certain expenses to meet analyst estimates for a key nancial metric:
adjusted earnings before interest, taxes, depreciation, and amortisation (EBITDA). Bankrate
consequently overstated its second quarter 2012 net income. Bankrate’s [securities] rose when the
company announced the in ated nancial results, and DiMaria allegedly proceeded to sell more than
$2 million in company [securities].
Lerner agreed to pay more than $180,000 to settle the SEC’s charges. The litigation continues
against DiMaria and Gamsey.
‘We allege that at the highest levels of its accounting department, Bankrate improperly in ated
its nancial performance to avoid falling short of Wall Street’s expectations,’ said Andrew J.
Ceresney, Director of the SEC’s Division of Enforcement. ‘Bankrate manipulated its nancial results
through numerous small accounting entries in order to meet analyst estimates on a key metric.’
According to the SEC’s complaint led in federal court in Manhattan: [extract of some complaints
only]
• After learning that Bankrate’s preliminary nancial results for the second quarter of 2012 fell
short of analyst estimates, DiMaria arbitrarily decided to increase the company’s revenue after the
end of the quarter.
• In addition to booking improper revenue, Bankrate, through the accounting executives, improperly
reduced certain expenses or failed to book them at all in order to meet analyst estimates.
• One of the expense accounts and related accrual account manipulated by Bankrate had been
used as a ‘cushion’5 account to manipulate the company’s nancial results for at least a year.
• DiMaria, Gamsey, and Lerner lied to the company’s auditor regarding the improper accounting
entries.
Lerner also agreed to be barred from serving as an of cer or director at a public company for ve
years and from public company accounting for at least ve years.
REFLECTION
What incentives do you think an entity might have to fraudulently overstate its pro ts by arti cially
understating its expenditure? Which of the entity’s stakeholders would you say could be affected by
such fraudulent manipulation of the nancial information?
On the other hand, do you think an entity might have an incentive to overstate its expenses in
order to understate its pro ts? Which stakeholders would be affected if this were the case?
7.1 What are the nature, purpose and accounting implications
of the cycle?
7.1.1 e nature and purpose of the cycle
e purchases and payments cycle relates to an entity’s acquisition of goods and services from suppliers,
and payment to the suppliers in exchange. It is also sometimes referred to as the ‘acquisitions and payments’
or ‘requisitions to cheque’ cycle. e cycle does not deal with the purchase of capital assets (such as
investments, property, plant and equipment), which is dealt with separately in the investment and nancing
cycle in Chapter 10.
An entity needs to acquire goods and services from other entities in order to enable sales to its own
customers. Failure to acquire goods on time, or failure to acquire goods at all, may render an entity unable to
engage in further business activities. Similarly, an inability to pay suppliers in a timely manner may lead to
suppliers withdrawing their commercial ties with the entity.
WHAT What if an entity fails to provide goods to its customers within a reasonable time due to a
failure to acquire goods in time or if it fails to provide goods at all? What could the
IF? economic implications be for the entity?
Establishing good business relations with suppliers is an important component of an entity’s ability to
remain competitive. Not only can it result in reduced purchase costs, but will also contribute to an
uninterrupted supply chain of goods and services from the supplier to the entity and on towards the entity’s
customers. To maintain favourable supplier relations, an entity should, among other things, strictly adhere to
the payment terms as negotiated with suppliers, for example payment of all purchases within 30 days from
date of receiving the supplier’s invoice, in order to qualify for a purchase discount.
A supply chain is the process whereby products or services are transferred from a supplier to a customer.
Ensuring a continuous, unbroken supply chain may add to an entity’s ability to remain a viable business
concern.
It is typical of a successful business always to attempt to increase the ef ciency, effectiveness and
economy of its supply chain activities. A business may seek to automate (computerise) the bulk of
its purchases and payments cycle in order to gain further supply chain ef ciencies and maintain
control over increasing volumes of business information and transaction data.
A transaction in the cycle will come to an end once the goods or services purchased have been received or
rendered respectively, payment to the supplier has been made, and the purchase and payment transaction
has been appropriately recorded in the nancial records.
e cycle will repeat itself each time a purchase or payment transaction is initiated.
In some computerised systems it is possible to programme the computer to identify low inventory
levels. The software would trigger an alert or send a noti cation to the appropriate staff member in
the entity when a particular item of inventory has fallen to a certain minimum theoretical quantity.
Such automation may allow for faster identi cation of low-running inventory and can optimise the
purchase process accordingly. Automation however, does not change the need for an internal
requisition: it should still be generated in order to document the need for the item.
REFLECTION
By referring to the nancial statements of Ntsimbi Piping, can you determine the type of the inventory
system operated by the company?
In both the above-mentioned systems, accounts payable in the form of trade creditors are raised on
acquiring inventory on credit.
e journal entries will comprise the following:
Account Dr Cr Account Dr Cr
R R R R
i. Buy 1 000 items of inventory from supplier costing R2 000 in total (R2 per item)
ii. Sell 750 items to customer for a total of R2 250 (R3 per item)
Purchases 2
000
(Remaining 250 inventory items already up-to- (Remaining inventory items recorded as inventory
date in inventory records due to perpetual balance, reversing purchases and recognising the
recording after each transaction.) difference as cost of sales.)
REFLECTION
Refer to document 2E (supplier statement) in the appendix at the end of the book. Can you
determine the date on which the balance on the statement is due for payment?
7.1.7.3 Accruals
Accruals is a form of liability recorded in the statement of nancial position at the year-end. It relates to
existing liabilities that have not yet been paid at year-end and which have not yet been included in accounts
payable. Accruals may, for example, relate to water and electricity services received from the municipality,
but which have not been paid for at the year-end, as no invoice has yet been received from the municipality.
An accrual will be raised at year-end to record an outstanding liability payable to the municipality. In the
subsequent period, the accrual is reversed against the relevant expense account. Refer to Figure 7.2 for a
municipal bill that was subsequently received and which will reverse the accrual previously created for the
bill.
Other expenses that may result in the need to accrue for liabilities include:
• Telephone accounts for which invoices are only received in the period following the month in which the
calls were made (refer to Figure 7.3 for an example of a telephone account);
• Contractual expenses paid only in the period subsequent to the month in which the goods were received
or a service was rendered to the entity; and
• Salaries and wages or any other expenses incurred before year-end, but which are only paid after year-
end and are not normally included in trade creditors or other liability accounts.
WHAT What if an entity has received goods from a supplier before the nancial year-end, but the
supplier has not invoiced the entity yet. Will accruals be affected? What would the effect
IF? on net pro t for the nancial year be if the entity neglects to accrue for the outstanding
invoice?
What if an entity were to purchase consumables for its of ce (such as cleaning materials,
WHAT small kitchen utensils and stationary) and instead of expensing it, the entity capitalises
IF? the items as assets. What would the effect on the entity’s total assets in the nancial
statements be? And on its net pro t? Which accounts will be over or understated as a
result?
Refer to the ‘Detailed Income Statement’ in the supplementary information to Ntsimbi Piping’s nancial
statements (page 25) for examples of speci c transactions and events relating to types of expenditure other than
purchases and cost of sales.
7.1.7.6 Acquisitions from foreign suppliers
e nancial record keeping for acquisitions from foreign suppliers is complex and falls mostly outside the
scope of this text. Only the conversion of transactions and balances between local and foreign currency is
explained here.
1. Purchase requisition
Purpose: To ensure that an entity’s operational and sales requirements are met timeously.
Main activities: Determining anticipated sales levels using sales forecasts and budgets; identifying inventory
that is at low levels and needs replenishment, or services that are required; preparing a requisition and
obtaining authorisation therefor; requesting the procurement department to obtain goods (including raw
materials for the production process – refer to Chapter 8) from suppliers.
Persons involved: Depends on department in the entity that initiates the requisition, such as the sales
department, warehouse or factory.
CRITICAL THINKING
Why do you think the ordering and the receiving of goods and services are two separate functions?
What are the risks involved in relation to the possible misappropriation of the purchased goods or
services should the staff member ordering the goods or services also receive them and take
custody of them?
4. Recording of purchases
Purpose: To ensure that all valid purchases made are accurately accounted for in the entity’s nancial
records, and in a timely manner.
Main activities: Recording purchases, cost of sales and other expenses and related creditors (liabilities) in
the nancial records; performing creditors reconciliations.
Persons involved: Accounts payable clerk and senior bookkeeping clerk (accounting department).
5. Payment preparation
Purpose: To prepare payment timeously for purchases that are payable to suppliers.
Main activities: Performing reconciliations of the supplier’s account in the entity’s records to the supplier’s
statement; preparing payment documentation based on valid supporting documents.
Persons involved: Accounts payable clerk and senior accounting staff (accounting department).
CRITICAL THINKING
Why do you think senior staff members, usually at management level, are responsible for the
payment of suppliers, rather than the clerks responsible for the recording of purchases? Consider
for instance the risk that exists from a bookkeeping clerk creating a creditor account and posting a
purchase invoice to the account and subsequently paying that creditor a certain amount to settle the
apparent debt.
7. Recording payments
Purpose: To record properly all payments made to suppliers in the entity’s accounting records.
Main activities: Recording of payments in the books of primary entry and posting the payment to the
subsidiary and general ledgers.
Persons involved: Cash book clerk (accounting department).
1. The requisition of goods and services will originate from various departments in the entity, where
approval for the purchase will also be granted usually by the departmental/warehouse manager.
7.3.1.1 Routine transactions and the use of speci c journals in the cycle
e documents shown in Figure 7.4 will ordinarily be used to enter routine purchases (and related returns)
and payment transactions into speci c books of primary entry (journals) in the accounting system, should
goods be purchased from suppliers on credit.
Figure 7.4: Documents in the purchases and payments cycle
7.3.1.2 Non-routine transactions and the use of general journals in the cycle
On occasion, a non-routine transaction or event, including adjusting entries, may occur. ese will not be
recorded on standard documentation or in a speci c journal. In such instances, a general journal voucher
will be used to record the transaction or event in the general journal. An example of non-routine
transactions in the cycle is the raising of accruals (refer to section 7.1.7.3).
WHAT What if an entity was to allow its buying department to order goods or services from any
supplier without obtaining quotations? Consider the possible nancial consequences for
IF? the entity and the effect that this leniency may have on the business relationships between
the entity and its customers.
4. Purchase order
A purchase order is an internally created, sequentially numbered document that is sent to the supplier
indicating the goods or services needed by the entity. It contains the quantity, description and, in some
cases, the price of the items required. A purchase order will typically be based on the approved internal
requisition and will be referenced to a quotation if a quotation was received from the supplier. e purchase
order will further stipulate the delivery address where the supplier must deliver the ordered goods or
services to.
Example: Refer to document 2A in the appendix at the end of the book.
5. Supplier delivery note
e supplier delivery note (prepared by the supplier) is a document that speci es the details of the goods
delivered to the entity. When a supplier delivers goods to the entity, the supplier will provide the entity with a
copy of the delivery note, which the receiving staff member signs as proof of acceptance of the delivery. is
external document serves as proof that goods have been delivered by the supplier and that the goods have
been accepted by the entity. It contains the quantities and descriptions of items delivered, but may not
contain item prices. Similarly, for services rendered, a delivery note (or appropriately named equivalent
document such as a job card) will be provided to the entity by a supplier to serve as proof of the service
having been rendered.
What if a GRN is not created for goods received and only the supplier’s delivery note is
WHAT signed and used as evidence of the goods having been received? What could the potential
IF? effect be on an entity’s inventory records and accounts payable records as a result of this
shortcoming in its purchases cycle?
7. Supplier invoice
An invoice is a supplier’s documented instruction to the entity that the entity owes it compensation for goods
delivered or services rendered. e invoice contains the quantity and description of goods delivered/service
rendered, as well as the amounts charged for the goods/services. e invoice may further indicate payment
terms and conditions (e.g. the payment due date or discount eligibility, if applicable). In most instances, a
separate invoice will be generated for each purchase transaction.
Example: Refer to document 2D in the appendix at the end of the book.
CRITICAL THINKING
Can you think of possible nancial consequences for an entity if it was to pay a supplier upon receipt
of an invoice for goods sold by the supplier, without rst ensuring that a goods received note has
been created by the warehouse staff who took custody of the goods?
8. Supplier statement
A supplier statement is received from a supplier at periodic intervals (e.g. once a month). It indicates the
entity’s outstanding balance with the supplier, made up as follows:
• Balance carried forward from the previous period’s statement (if unpaid);
• All amounts invoiced since the previous statement date;
• Any subsequent adjustments made to the entity’s account by the supplier (such as credit notes granted for
goods returned);
• Payments received from the entity since the previous statement date;
• Any payment discounts for which the entity quali ed; and
• e ageing of the entity’s outstanding balance (current, 30 days, 60 days, etc.).
Example: Refer to document 2E in the appendix at the end of the book.
9. Remittance advice and proof of payment
A remittance advice is sent by the entity to the supplier to accompany a payment and indicates which
invoice(s) the payment relates to.
In addition, a proof of payment document may be sent to the supplier after payment has been made to
inform the supplier of the payment having been made. With EFT systems, such as through internet payment
facilities, the entity can request via the EFT system that the bank automatically notify the supplier of the
payment made, whether through fax, SMS or email.
Example: Refer to document 2F and document 2G in the appendix at the end of the book.
10. Goods returned to supplier voucher
A goods returned to supplier voucher (GRSV) is a document indicating the quantities and descriptions of
goods that are returned to a supplier. Several reasons may result in an entity returning goods previously
purchased, for example unsatisfactory or defective goods received from the supplier and broken/damaged
goods sent back by customers (which should be returned to the supplier if they are still under warranty).
Example: Refer to document 2I in the appendix at the end of the book.
11. Debit note
A debit note is a documentary request to a supplier to debit the entity’s account, in other words to reduce the
outstanding debt owing by the entity to the supplier. A debit note may, for instance, be created due to a
purchase return (see goods returned to supplier voucher above). e debit note indicates the quantity and
description of goods being returned and the amount of the debit requested (usually equal to the price of the
goods involved as per the supplier’s invoice). e entity records a debit entry in its creditors ledger, reducing
the outstanding balance it owes to the supplier, after recording a debit note in the purchase returns (or credit
adjustments) journal.
Example: Refer to document 2J in the appendix at the end of the book.
7.3.2.2 Journals and ledgers
1. Purchase journal
e purchase journal is a book of primary entry in which routine purchase transactions are recorded. Cash
purchases are not recorded in the purchase journals, only credit purchases. (Cash purchases are posted to
the purchases account in the general ledger from the cash book.) Purchase transactions are commonly
recorded in the number sequence of GRNs. Daily purchase totals are posted from the purchase journal to the
purchases account and the creditors control account in the general ledger.
Example: Refer to document 2K in the appendix at the end of the book.
In order to record a purchase in the purchase journal (and, resultantly, a trade creditor in the
creditors ledger), a bookkeeper will require the following documents (for the purpose noted in
brackets):
• Purchase order (proof of authorisation of the purchase);
• Supplier delivery note (supplier name and proof that goods were delivered);
• GRN (further proof that goods were delivered and actual quantity of goods accepted from supplier
and classi cation of the expense); and
• Supplier invoice (supplier name and prices invoiced).
Once these documents are matched, it makes sense to record purchases in the purchases journal in
GRN number sequence, as this will facilitate the identi cation of goods received (for which the entity
is liable to pay the supplier), but which have not been recorded (i.e. ensuring the completeness of
recording of purchases).
WHY? Why would purchase transactions be recorded in GRN number sequence in the purchase
journal and not in the sequence in which or on the date when supplier invoices are
received? Consider the timing difference between the receipt of goods and the receipt of
invoices from suppliers and the risk involved for proper cut-off of the purchase transaction:
a supplier might not necessarily supply an invoice with the delivered goods. And goods
could be received a few days before the entity’s nancial year-end, while the invoice from
the supplier is only received several days after year-end.
WHAT What would the purchase journal look like if the entity uses a computerised system?
The purchase journal may be referred to as the ‘purchases transaction le’. If one could
IF? download the purchases transaction le from the computer system and open it on a
computer screen, it would resemble a spreadsheet or set of data, consisting of the same
columns one would nd in a typical purchase journal (called ‘data elds’ in the
computerised system) and numerous rows (‘records’ of individual purchase transactions).
In order to record a purchase return in the purchase returns journal, the following will be needed:
• Original supplier invoice to which the return relates (description and price of goods returned);
• Goods return voucher (GRV) (authorisation for the return; contains the description and quantity of
goods returned and supplier name); and
• Debit note (approval for the recording of the return; contains description, price and quantity of
goods returned to supplier).
4. General journal
e general journal, also a book of primary entry, contains a record of all non-routine transactions and
events and adjusting entries not allocated to the above specialised books of primary entry.
Example: Refer to document 2L in the appendix at the end of the book.
5. Creditors ledger (a subsidiary ledger to the general ledger)
e creditors ledger contains a detailed record of all transactions (invoices, payments, purchase returns and
adjustments) applicable to creditors. Each creditor has its own account in the creditors ledger. e closing
balance per the creditors ledger should represent the outstanding debt payable by the entity to the supplier
according to the entity’s records and should be the same as the balance on the creditors control account in
the general ledger, unless reconciling items exist (refer to section 7.3.5 below).
6. General ledger
e general ledger contains accounts drawn from all books of primary entry affected by the cycle to serve as
a collection point for transactions that occurred in the cycle. e general ledger facilitates the preparation of
a trial balance and the nancial statements. e use of a creditors control account in the general ledger
further facilitates the validity, accuracy and completeness of the accounting records, as the balance on this
control account can be compared to the total of the subsidiary ledger (creditors ledger) on a monthly basis.
2. Inventory master le
Manual system equivalent: Inventory listing or Inventory register
e inventory master le is a database containing the quantities of inventory on hand, together with
standing data pertaining to the inventory, for example inventory code, description and location.
7.3.4 Reports
1. Creditors list
A creditors list is printed from the creditors master le (computerised systems), or can be manually prepared
using the balances due to each supplier in the creditors ledger (manual systems). A computer application
will commonly allow a user to choose which information (data elds) to include in the list, for example
creditor’s code, name and balance due. e total outstanding balances when adding all individual creditor’s
balances should agree with the grand total due to all creditors according to the creditors ledger (as well as
the creditors control account in the general ledger).
7.3.5 Reconciliations
1. Supplier statement reconciliation
A supplier statement reconciliation is made between the outstanding balance owing to a creditor as per the
creditors (subsidiary) ledger (internal accounting information) and the balance owing as re ected on the
statement received from the creditor/supplier (external information). It is an internal reconciliation
performed by the entity’s staff.
e reconciliation re ects all reconciling items that cause the balances not to agree. A reconciling item
may exist due to the entity having recorded a transaction with the supplier, but which the supplier has not yet
recorded in its nancial records, or vice versa.
Reconciling items may also exist due to disputes with suppliers (e.g. when one party records an amount
which is different from the other party’s amount). It is important that the reconciling items not include
amounts that are in fact errors in the entity’s own records – these should be corrected by way of an
appropriate adjustment to the entity’s records.
A supplier statement reconciliation is a critical accounting function, particularly where payments to
suppliers are based on the supplier statements and not on supplier invoices.
Example: Refer to document 2N in the appendix at the end of the book.
What if an entity does not perform a supplier statement reconciliation before it pays a
WHAT supplier ‘on statement’ – what are the risks associated with the disbursement? In
IF? considering this matter, ask yourself whether the supplier could have made a mistake on
its statement. Do you think the entity’s accounts payable staff could perhaps have made a
mistake in the entity’s internal records? How would a reconciliation bene t the accounting
process in such a case?
These risks apply especially to entities where controls over payments are weak, such as where
supporting documentation is not properly kept or reviewed before payment, or where supporting
documentation is not cancelled after payment and can therefore be resubmitted for a future
payment. The risks are lower where an invoice received is matched to both a purchase order and
GRN before payment to reduce the likelihood of an invalid payment being made.
Paying on statement implies the payment of an amount determined with reference to the
outstanding balance re ected on a supplier’s statement, which is usually received on a monthly
basis. Paying on statement requires that a supplier statement reconciliation be prepared before
payment is made, ensuring that the amount to be paid reconciles with the outstanding supplier
balance in the entity’s creditors ledger. Although paying on statement will require more detailed
record keeping of transactions with suppliers, it can assist in avoiding invalid, double or
overpayments, as the entity will not pay an outstanding balance if not adequately supported by
detailed purchase transactions in its own accounting records.
2. Creditors reconciliation
A creditors reconciliation reconciles the creditors control account in the general ledger with the creditors
(subsidiary) ledger. When adding all creditors’ balances in the subledger, the total outstanding balance
owing to all creditors should agree with the outstanding balance per the creditors control account.
Such a reconciliation will identify purchase, payment or purchase return transactions recorded in the
primary journals and posted to the general ledger, but which have not been posted to the subsidiary ledger. It
can also identify double or other inaccurate postings to the subsidiary ledger.
Note that the theft of inventory does not create an under or overstatement risk for purchases or
accounts payable. (It does, however, create an overstatement risk for inventory.) In most cases, as
soon as there is evidence of the entity having taken control of the goods, usually evidenced by
acknowledgement of receipt through the signing of a delivery note (or sometimes through the
realisation of a condition in an agreement), a purchase transaction occurs and the entity becomes
liable for payment to the supplier. Should goods be stolen before being received by the entity’s staff
(i.e. in transit to the entity), there is no misstatement risk for the entity as control over the goods
has not yet transferred from the supplier. The goods remain the property (and risk) of the supplier
until the entity has taken control of the goods (or as per the conditions of an agreement, if
applicable).
• Purchases or other expense transactions are not recorded accurately, leading to expenditure and
accounts payable or accruals balances being either under- or overstated. Such misstatements might occur
where a purchase transaction, for instance, is inaccurately recorded in the purchase journal from the
supplier invoice by recording an incorrect price. For example, the supplier charged R230 for item A on its
invoice, but the entity’s bookkeeper erroneously recorded an amount of R320 in the purchase journal. e
result is an overstatement of purchases (or inventory in a perpetual system) and an overstatement of the
trade creditor liability.
• Purchase or other expense transactions are not recorded in the nancial period to which they pertain.
Such incorrect cut-off of purchase transactions may result in either:
• An overstatement of expenditure/accounts payable if the transaction took place in a different nancial
period than the one in which the transaction was recorded; or
• An understatement of expenditure/accounts payable if the transaction took place in the nancial
period under consideration, but was recorded in a preceding or subsequent period.
• Purchase or other expense transactions are not classi ed in the appropriate account in the nancial
records, leading to either an over or understatement of expenditure and possibly accounts payable should
the transaction relate to a credit purchase.
CRITICAL THINKING
Can you identify from the above the risk(s) which may apply in the following cases?
• A director of an entity fraudulently records a personal expense incurred by the director in his/her
private capacity, as a business expense of the entity.
• Goods are received by the warehouse and taken custody of, but because of circumstance, the
warehouse staff neglect to ever create a goods received note.
• Goods are received by the warehouse on the last day of the nancial year, but due to the
computerised system having gone off-line, the warehouse staff could only create the necessary
goods received notes on the computer system several days later.
• On the last day of the nancial year, a bookkeeper responsible for expense accounts enquired
from the municipality as to when the invoice relating to the water and electricity account for the
last month of the entity’s nancial year would be received. The municipality couldn’t provide the
bookkeeper with an answer. Accordingly, the bookkeeper decided not to take any further action in
relation to the accounting records for the particular nancial year.
In order to reduce or eliminate the above-mentioned nancial reporting and misappropriation risks,
management will implement and maintain a system of internal controls to achieve the control objectives of
validity, accuracy and completeness of nancial information related to purchases (and related returns) and
payments transactions.
An entity’s supply chain activities are a prime target for theft and fraud, as they involve:
• Obtaining assets (which can be misappropriated through theft or unauthorised use); and
• Payment of money to outside parties (which can be misappropriated through overpayments or
unauthorised payments).
The above unauthorised actions may also lead to invalid nancial information being recorded in the
nancial records.
To ensure that the recorded purchases and payments transactions are valid, these transactions should:
• Have been authorised in terms of management’s policy;
• Relate only to genuine transactions that occurred (i.e. are not ctitious);
• Have been recorded in the year to which they pertain; and
• Be supported by sufficient documentation.
To ensure that purchase and payment transactions are accurate, they should be recorded at the appropriate
amount. ‘Appropriate’ implies that all amounts were calculated correctly (in terms of quantity and price in
respect of goods purchased and in terms of price where services have been rendered). Accuracy further
entails that internal controls ensure these transactions are correctly classi ed in terms of their nature and
recorded in the appropriate accounts.
To ensure that purchase and payment transactions are complete, all purchase and payment transactions
that occurred in a given period should have been recorded in the accounting records and recorded in a
timely manner. No purchase or payment transaction that occurred should thus be omitted from the entity’s
accounting records.
7.6.1.2 Consequences if the control objectives in the cycle are not achieved
Table 7.2 summarises the consequences if the control objectives are not achieved.
7.6.2 Achievement of the control objectives in the cycle
e control objectives in the cycle are achieved through the proper implementation and operation of an
information system, including an accounting system and related internal controls, in an entity. Note that the
control objectives can be achieved either manually (a person performs the internal control) or by automated
means (a computer performs the control).
e following examples illustrate in broad terms several ways in which the control objectives can be
achieved in the cycle. Note that it is not a re ection of the detailed control activities required to achieve the
control objectives.
Details of control objectives and controls in the cycle appear in section 7.7 of this chapter.
e assertions for purchases and accounts payable are linked to the control objectives in the cycle as shown
in Table 7.3.
Table 7.3: The link between the assertions for purchases/accounts payable and the control objectives
MANAGEMENT ASSERTIONS
Note: Controls that achieve the control objectives of validity, accuracy and completeness collectively contribute
to management being able to properly present both classes of transactions and events and the related
disclosures, and account balances and the related disclosures in the nancial statements. Consequently, the
Presentation assertion is not included explicitly in the table above.
e assertions for payments are linked to the control objectives in the cycle as shown in Table 7.4.
Typical duties that should be segregated and performed by different persons in the purchases and payments
cycle include those shown in Figure 7.6. (Each block represents one or more persons performing the same
function that should be segregated from the functions performed by a person(s) in the other blocks.)
Figure 7.6: Segregation of duties for the purchases and payments cycle
In a computerised system, segregation of duties can be achieved through the implementation of user pro les
whereby an employee is only granted access to the part of the accounting system that is necessary for the
performance of the employee’s duties.
Reconciliations will usually be performed by a clerk and must be reviewed by a senior staff member. In the
event that the person who is responsible for recording transactions in the accounting records also performs a
reconciliation on recorded information (typically of smaller entities), strong and thorough review controls
should be in place over the reconciliation.
1 PURCHASE REQUISITION
| ORIGINATES FROM DEPARTMENT WHERE THE NEED FOR RAW MATERIALS/GOODS IS IDENTIFIED |
1 PURCHASE REQUISITION
| ORIGINATES FROM DEPARTMENT WHERE THE NEED FOR RAW MATERIALS/GOODS IS IDENTIFIED |
Activity Responsible Documents What could go wrong/risks Control objective Account/assertion Manu
party and affected
records;
master les
2 ORDERING RAW MATERIALS/GOODS FROM SUPPLIERS
| PROCUREMENT DEPARTMENT |
Activity Responsible party Documents What could go Control objective Account/ assertion
and wrong/risks affected
records;
master
les
3 RECEIVING RAW MATERIALS/GOODS FROM SUPPLIERS
| RECEIVING BAY IN WAREHOUSE |
3.1 Goods receiving Supplier Items that have A All inventory Occurrence of
Supplier clerk in delivery not been received has been expenditure.
delivers factory/warehouse note ordered (i.e. ordered in terms of
ordered Goods unauthorised an approved
items to received items) are purchase order.
entity. note accepted and (Validity)
(GRN) recorded as
inventory.
3 RECEIVING RAW MATERIALS/GOODS FROM SUPPLIERS
| RECEIVING BAY IN WAREHOUSE |
4 RECORDING OF PURCHASES
| ACCOUNTING DEPARTMENT |
Activity Responsible Documents What could Control objective Account/ Manual controls
party and records; go assertion
master les wrong/risks affected
4 RECORDING OF PURCHASES
| ACCOUNTING DEPARTMENT |
4.1 Invoice Accounts Standard Fictitious A All purchase Occurrence of 4.1A Senior
is received payable chart of purchases transactions expenditure. bookkeeping cle
from clerk accounts are that are Existence and reviews purchase
supplier Senior Purchase recorded in recorded in the obligation of journal (and cred
and bookkeeping journal the accounting accounts ledger) to ensure
purchase clerk (Purchases accounting records pertain payable. each recorded
is transaction records. to actual purchase is supp
Financial
recorded. le) This may purchase by a GRN, suppl
manager
occur where transactions delivery note and
Goods
a purchase that took place authorised purch
received
is recorded with bona de order.
note (GRN)
for items suppliers and
Supplier that were are only
invoice never recorded if an
Supplier ordered order was
statement and/or for approved and
Creditors items that items have
subsidiary were never been delivered.
ledger received. (Validity)
General Purchases
ledger are
creditors erroneously
control duplicated
account in the
accounting
records.
4 RECORDING OF PURCHASES
| ACCOUNTING DEPARTMENT |
Unmatched GRN
4 RECORDING OF PURCHASES
| ACCOUNTING DEPARTMENT |
year-end accruals
For all GRNs with
corresponding
supplier invoice
year-end, a liabil
accrued at year-e
means of a gene
journal entry. The
amount of the jo
is determined wi
reference to pric
the correspondin
purchase orders
other supporting
document conta
item prices.
Performing credi
reconciliations
Accounts payabl
clerk performs a
reconciliation be
the creditors con
account in the ge
ledger and the g
total of all credit
accounts in the
creditors ledger
identify postings
were made from
purchase journa
the GL without b
posted to credito
accounts in cred
ledger or vice ve
Financial manag
reviews reconcili
Note: Reconciliat
may also identify
inaccurate or inv
postings.
Accounts payabl
clerk performs a
supplier stateme
reconciliation to
identify any amo
on supplier
statements that
not recorded as
purchases/trade
creditors in the
4 RECORDING OF PURCHASES
| ACCOUNTING DEPARTMENT |
accounting recor
(see also contro
under 5A).
5 PAYMENT PREPARATION
| ACCOUNTING DEPARTMENT |
Activity Responsible Documents and What could go Control Account/ Manual controls Alter
party records; master wrong/risks objective assertion addi
les affected cont
comp
envir
Activity Responsible party Documents What could go Control Account/ Manual controls
and records; wrong/risks objective assertion
master les affected
6.1 Payment/cheque Signed Payments are not A Only Occurrence 6.1AB For
Entity signatories cheque made in terms of supplier of payments by
pays (manual the payment invoices payments. cheque
supplier system) documentation authorised At least two
for Proof of prepared during for senior manage
goods payment payment payment staff members
received. (EFT system) preparation. are paid. authorise
Bank Suppliers/parties (Validity) payments on t
statement that are not on signing of
Bank the payment cheques.
reconciliation schedule are The cheque
paid. signatories rev
the payment
documentation
before signing
cheques and
ensure the
following:
• Payment
schedule ha
been signed
by senior
bookkeepin
clerk during
payment
preparation
• Each payme
due as per
payment
schedule is
supported b
cheque
requisition,
cheque,
supplier
statement,
remittance
advice, all
supplier
invoices, GR
and purcha
orders relat
6 PAYING THE SUPPLIER
| ACCOUNTING DEPARTMENT |
to items be
paid;
• Amounts ag
between the
cheque and
supporting
payment
documentat
and
• Cheques ar
crossed ‘no
transferrab
and contain
alterations.
Amounts paid do B Accuracy The cheque
not agree with Payments of signatories ca
the amounts are made payments. all supporting
prepared for in documentation
payment. accordance (including
with the payment
amounts schedule) by
that should stamping it as
be paid. ‘Paid’ to avoid
(Accuracy) being presente
for payment ag
in the future.
Cheques are
mailed to
suppliers or di
deposits are
made into
suppliers’ ban
accounts by a
person who wa
not involved in
payment
preparation.
7 RECORDING OF PAYMENTS
| ACCOUNTING DEPARTMENT |
Activity Responsible Documents What could Control objective Account/ Manual Altern
party and records; go assertion controls addit
master les wrong/risks affected contr
comp
enviro
7 RECORDING OF PAYMENTS
| ACCOUNTING DEPARTMENT |
7.1 After Cash book Receipt (for Fictitious A All recorded Occurrence of 7.1ABC All 7.1A
payment, clerk cash payments payments payments. control Com
payment payments) (payments relate to actual objectives to syste
details Bank- that never payments be addressed perfo
are stamped took made. (Validity) through the auto
recorded returned place) are performance bank
in the cheque or recorded. of a bank reco
nancial approved reconciliation, shou
records. cheque which state
requisition reconciles bala
(for cheque the cash avail
payments) book balance elect
Proof of (general for
payment/EFT ledger control com
voucher (for account) with with
EFT the balance com
payments) as per the cash
bank book
Bank
statement. ledge
statement
In this way, bala
Bank Man
payments can
reconciliation revie
be identi ed
which: requ
• Never took follow
place but any u
were reco
recorded; item
error
• Were
reco
recorded
at
incorrect
amounts;
and/or
• Took place
but were
not
recorded.
7 RECORDING OF PAYMENTS
| ACCOUNTING DEPARTMENT |
Activity Responsible Documents What could Control objective Account/ Manual controls Alte
party and go assertion add
records; wrong/risks affected con
master com
les env
8 RETURNING GOODS AND RECORDING OF A PURCHASE ADJUSTMENT
| ACCOUNTING DEPARTMENT |
8.1 Warehouse Goods Recorded A All purchase Occurrence 8.1A Debit 8.1
Purchase staff who returned purchase returns and cut-off of notes are Co
return is receive to returns are recorded relate purchase created only if sys
recorded returned supplier not to actual and returns. supported by: the
in the goods and voucher genuine. authorised • An of
accounting initiate the (GRSV) goods returned authorised not
records. return Debit during the year. GRSV as to
transaction. note (Validity) well as a ret
Accounts GRN if a
payable evidencing cor
clerk that the GR
Managerial goods is s
staff being the
member in returned if it
approval have ret
capacity originally fou
been GR
purchased; dat
and the
• A supplier sys
invoice on
which the
goods
originally
appeared.
Financial
manager
approves
all debit
notes after
con rming
that all the
above
supporting
documents
exist and
are
attached to
the debit
note.
8 RETURNING GOODS AND RECORDING OF A PURCHASE ADJUSTMENT
| ACCOUNTING DEPARTMENT |
e raw materials warehouse, which serves as a warehouse where raw materials are kept until they are
transferred to the production line, is the originating division for a potential purchase transaction at Ntsimbi
Piping.
After completion of the scanning of all containers/items delivered, the hand-held device sends an
instruction to the PVCACC inventory application, which prints the following two documents:
1. A GRN which lists all items scanned as received; and
2. A variance report, which lists items short- or over-delivered in comparison with the quantities and items
on the purchase order stored in the computer’s database.
Over-deliveries must be authorised by Raymond Harris (the production manager) before acceptance,
through an override function on the computer requiring his username and password. If not authorised, the
items are sent back with the supplier’s delivery truck. Short deliveries are indicated on the supplier’s delivery
note and marked off on the variance report for the purchasing division to follow up with the supplier.
Abdul signs the supplier’s delivery note and receives a carbon copy of the document from the supplier’s
delivery personnel.
Should there be no discrepancies, Vuyo clicks on the ‘Post’ button next to the particular GRN on the list. is
instructs the computer to post the transaction to the purchase journal and update the creditors subledger.
e computer multiplies the item quantities on the GRN with the prices stored on the electronic, approved
purchase order (see 7.8.2.2) stored in its database.
Source documents (GRN, delivery note and variance report) are led in number sequence of the GRN for
record keeping and future query purposes.
Note: It is not necessary for Vuyo to ensure that a purchase order exists for each GRN, as the computer
system required Abdul Paruk in the warehouse to furnish a purchase order number before a GRN could be
created. A GRN can thus not be generated if an approved purchase order is not found on the computer’s
database. e system also does not allow the reuse of a purchase order number. It is therefore assumed that all
GRNs relate to an approved purchase order. However, Vuyo does have read-only access to all purchase orders,
which he can call up on-screen should he have a query as to the approval status associated with a purchase.
Vuyo does not have logical access to change any of the details of inventory items on the inventory system
and cannot change details on the on-screen GRN list or GRNs themselves. e computer also prevents him
(and anyone else in the company) from posting a transaction to the purchases journal if there is not a
pending purchase (GRN) listed on the GRN list.
Recall that purchases are recorded from GRNs and not from supplier invoices. The amount on a
supplier’s invoice might differ from the purchase amount recorded in the purchase journal, leading to
reconciling items between the records of Ntsimbi Piping and a supplier. A supplier statement
reconciliation should detect such discrepancies.
If no supplier statement has been received from a supplier, the balance as per the creditors ledger is settled
nevertheless and included in the payment schedule (refer to 7.8.5.3 below).
Before each payment run takes place, James Khumalo (the nancial manager) reviews the printed supplier
statement reconciliations with reference to the supporting supplier statement and the creditors ledger and
follows up with Vuyo or Jason on any queries he may have about reconciling items. He signs each
reconciliation as evidence of the review.
To avoid instances where a supplier’s balance is due for payment, but has not been included on the month’s
payment schedule, Jason requests PVCACC print an age analysis of outstanding creditor balances. He
reconciles the outstanding balances on the analysis with the balances on the payment schedule to ensure all
outstanding creditor balances have been included for payment. Balances not included (and those which are
over 30 days old and the most likely not to qualify for discount) are discussed with the nancial manager,
James Khumalo, for further investigation.
After performing the above checks and if he is satis ed with all payment information, Jason accesses the
‘Supplier payments module’ on PVCACC with his username and supervisor password and ags the
electronic version of the payment schedule as ‘Ready for payment’.
Payment to suppliers takes place on the last business day of each month by means of a monthly payment
run, using an EFT payment facility.
If the above review indicates no discrepancies, James accesses the EFT application by entering his unique
username and password. James rst instructs the computer to transfer automatically the information on the
electronic version of the payment schedule (as prepared by Vuyo Mthethwa in 7.8.5.3 above) to the EFT
application. e EFT application has been set up in such a way that it can interface with the payments
schedule on the accounting system. is decreases the risks of inaccurate payment details being furnished to
the EFT application, suppliers being inappropriately added to the payment run and suppliers being omitted
from the payment run. As an added control after the transfer of the payment data to the EFT facility, the
computer automatically reconciles the data transferred onto the EFT application with the data on the
payment schedule to ensure all payment data has been transferred to the EFT facility (this is done prior to
the nal approval for the payments to be made).
If James and Lee-Ann are both satis ed with the payment information, they approve the payments on the
EFT application by selecting ‘Process payment’. (Any discrepancies would have been referred back to Vuyo or
Jason for correction prior to payment).
A ‘con rmation of payment’ report is printed from the EFT application indicating the nal amounts paid
to each supplier. Should the report indicate that a payment could not be processed (e.g. supplier has closed
its bank account or incorrect bank account details have been identi ed), the payment documentation is
handed to Jason Naidoo for resolution and resubmission.
After performing a successful payment run, the payment signatories stamp the payment schedule and all
supporting documentation in the purchase packs as ‘Paid’ to avoid the documents from being resubmitted
for payment in the future.
e payment schedule with supporting documentation is handed to Sibongile Mathlabe to process the
payments to the payments cash book and to send an individual remittance advice/proof of payment to each
supplier, which shows the details of the payment made.
If he is satis ed with the validity and accuracy of the debit requests, James clicks on the ‘Approve’ button,
which posts the debit notes to the nancial records (purchase returns journal and general ledger accounts)
and updates the physical inventory records.
Jason Naidoo, the senior bookkeeper, reviews the physical copies of sequentially led GRSVs on a regular
basis to follow up on missing GRSVs and to con rm that for each GRSV a corresponding approved debit note
exists on the nancial application (posted to the purchase returns journal and general ledger accounts). He
prints a log from the computer system showing any missing GRSV numbers in the purchase returns journal
for follow-up. While performing the above review, he also accesses the pending purchase returns le to
ensure it has been cleared.
Vuyo submits an electronic copy of the debit note to the supplier by email.
Assessment questions
For questions 1 to 3, select the correct answer(s):
1. Which of the following duties should be performed by different staff members in the purchases and
payments cycle in order to achieve proper segregation of duties? (More than one answer is possible.)
(LO 7)
a) Performing a quantity check on goods received and signing as acknowledgement of acceptance of
the goods
b) Ordering goods from suppliers and recording purchases in the accounting records
c) Receiving invoices from suppliers and performing supplier statement reconciliations
d) Obtaining quotations from suppliers and preparing a purchase order
e) Approving new suppliers and preparing a purchase order
2. When should an entity record a purchase in its accounting records? Generally when: (Only one answer
is possible.) (LO 3)
a) e purchase order is sent to a supplier
b) Goods are taken custody of on delivery from a supplier
c) An invoice is received from a supplier
d) A supplier con rms receipt of payment for goods previously purchased on credit
e) At any of the above times
3. A purchase transaction is initiated in the purchases component of the cycle when: (Only one answer is
possible.) (LO 5)
a) A purchase order is approved by the chief buyer
b) A purchase is recorded in the purchase journal
c) A need for goods or services is identi ed and a purchase requisition is completed by the relevant
department
d) A supplier statement is received from a creditor demanding payment of an outstanding balance
For questions 4 to 6, indicate whether the statement is true or false:
4. From an accounting perspective, the purpose of the purchases and payments cycle of a retailer is to
ensure that an entity procures the necessary goods for resale from trusted suppliers, in order to operate
an efficient and pro table business. (LO 1)
5. Internal controls implemented for the purpose of achieving the control objective of validity aim to
ensure that all purchase transactions that were entered into during a period are recorded in the nancial
records. (LO 9)
6. e control objective of accuracy aims to ensure that all purchase transactions in the nancial records
have been correctly recorded in terms of their amount and account classi cation. (LO 9)
8. List the functional areas in a typical purchases and payments cycle for a wholesale entity selling goods to
retail customers on credit and provide a brief description of the purpose of each functional area. (LO 4)
9. Complete the following table by linking the relevant assertion(s) to each control objective for purchase
transactions: (LO 10)
Validity
Accuracy
Completeness
10. Brie y describe the purpose of the following supporting documentation in the purchases and payments
cycle: (LO 6)
a) Goods return voucher
b) Debit note
c) Supplier statement
d) Purchase requisition
e) Goods received note
f) Remittance advice
11. For each of the items below, identify at least two reasons that an entity may fraudulently want to: (LO 7)
a) Overstate its expenditure.
b) Understate its accounts payable balance.
12. Identify and explain the effect of each of the following risks on an entity’s ‘net pro t for the year’ (if any):
(LO 7)
a) e risk that not all purchases that took place during the year were recorded in the accounting
records
b) e risk that the entity recorded invalid purchase returns during the nancial year
c) e risk that not all payments made to suppliers was recorded in the entity’s accounting records
13. Explain the term ‘accrual’ in the context of trade creditors and provide an example of why such accruals
may be required. (LO 3)
14. List the major classes of transactions and account balances affected by the purchases and payments
cycle. (LO 2)
15. Brie y describe the following computer technologies typically found in the cycle: (LO 8)
a) Electronic funds transfer (EFT)
b) Electronic data interchange (EDI)
16. Explain why the following internal control achieves the control objective of ‘completeness’ of recorded
purchase transactions: (LO 9)
‘On a weekly basis, the nancial manager scrutinises the purchase entries in the purchase journal to
detect any missing goods received note numbers (GRNs) and follows up with the accounts payable clerk
on reasons that a GRN has not yet been recorded as a purchase.’
17. Consider the following scenarios relating to Car Sound (Pty) Ltd, which manufactures a broad range of
vehicle audio equipment (including standard car radios on contract for a major vehicle manufacturer):
i) e company’s factory manager discusses the availability of inventory items used in the
manufacturing process with his factory foreman on a weekly basis in order to identify raw material
levels that are running low. e computer software that previously monitored inventory levels
stopped working the preceding month and has not yet been reprogrammed.
ii) When goods are received in the receiving bay of Car Sound (Pty) Ltd’s raw materials store, the
goods receiving clerk phones the senior bookkeeper to inform the accounting department of the
quantity of goods delivered and from which supplier the goods were received. e senior
bookkeeper then records the purchases in the purchase journal after having written down the items
on a blank piece of paper.
iii) Car Sound (Pty) Ltd maintains a list of approved suppliers, who are the only suppliers from which
purchases are allowed to be made. Due to staff shortages in the buying department, the company’s
bookkeeper has been tasked with the temporary responsibility of approving any new suppliers.
18. For scenario (ii) of the previous question (question 17), brie y describe the internal controls that should
be implemented to achieve the control objective concerned. Also state the number of copies of the
goods received note that should be prepared and to which persons/departments each copy should be
distributed. (LO 12)
Rolien Kunz
CHAPTER CONTENTS
Learning outcomes
Reference list
8.1 What are the nature, purpose and accounting implications of the cycle?
8.2 What functional areas occur in the cycle?
8.3 What information system is used in the cycle?
8.4 What could go wrong (risks) in the cycle?
8.5 What computer technologies are used in the cycle?
8.6 What are the control objectives in the cycle?
8.7 What are the controls in the cycle (manual and computerised)?
8.8 Cycle illustration: e inventory and production cycle at Ntsimbi Piping
Assessment questions
LEARNING OUTCOMES
REFERENCE LIST
IN THE NEWS
Employee inventory theft – a reality
An employee from a cellular phone store in the United States was charged with the theft of 22
cellular phones with a value of $18 901.38, from the store where he worked. The employee
disguised the theft of the 22 iPhone 8s by adjusting the inventory records. He did this by writing the
phones off as damaged inventory. This was detected by the store’s operations manager when the
operations manager went to look for the damaged phones on the pallet of write-off phones in the
warehouse, and determined that the phones were not there. The operations manager reported the
matter and the necessary actions were taken by the store.
REFLECTION
Which assertion(s) will be affected if proper internal controls regarding the safeguarding of
inventory are not implemented by an entity?
• Another word for safeguarding is protecting. An entity should protect its inventory from theft as
well as damage.
• If inventory is not safeguarded by an entity, it might be stolen which will lead to inventory that
does not exist being included in the nancial statements, therefore the existence assertion will be
affected.
• If inventory is damaged due to a lack of safeguarding, the inventory’s net realisable value may be
below cost – which in turn will affect the accuracy, valuation and classi cation assertion.
REFLECTION
Will the inventory and production cycle be relevant to all entities, irrespective of the type of
entity?
• This cycle is only applicable to entities selling goods (e.g. trading or manufacturing entities) and
not to those entities only rendering services.
e inventory balance (originating from this cycle) will have a material effect on both the Statement of
Comprehensive Income and the Statement of Financial Position of entities manufacturing and/or selling
goods.
Failure to safeguard inventory by a trading or manufacturing entity may lead to theft of and damage to
inventory and will put signi cant strain on the entity’s cash ow, which may lead to eventual bankruptcy.
Failure to control the production process effectively may result in the products produced not being saleable,
obsolete inventory for which there is low demand and claims against the entity for damages suffered by
those purchasing the products, which will also cause considerable damage to the entity’s reputation.
However, the cycle is not just about the operational functions of safeguarding of inventory and controlling
the production process. It is also about the accounting function where transactions associated with the
production process are costed and accounted for (recorded) in an entity’s accounting records.
From an accounting perspective, raw materials, work-in-progress and nished goods are recorded as
inventory. It is imperative that only inventory that exists and to which the entity has the rights of ownership
are recorded, that all inventory items are recorded and that inventory is recorded at the appropriate
amounts, otherwise the misstatements in the inventory account balance included in an entity’s nancial
statements will re ect an incorrect picture of the nancial performance and nancial position of the entity.
For this reason, it is also important that the movement of the inventory as it progresses through the
production process from raw materials to work-in-progress to nished goods, and the costs relating to the
transformation, are appropriately recorded.
is chapter focuses on the nancial internal controls that will ensure that inventory is safeguarded, costed
and accounted for correctly. e focus is not on the operational controls that might also be necessary in the
cycle to control the production process.
REFLECTION
Consider the following: What are the implications for the nancial statements should an entity
not correctly record (i) all the movements of the inventory through the production process from
raw materials to work-in-progress to nished goods, and/or (ii) all the costs relating to this
transformation of raw materials into nished goods?
• If it is not correctly recorded, inventory (and the related costs) will be misstated in the accounting
records and consequently in the entity’s nancial statements.
• Speci cally, the assertions for the inventory account balance and related disclosures such as
classi cation and accuracy, valuation and allocation will be affected – the speci cs of the fact set
will determine the speci c assertion(s) that are misstated.
REFLECTION
Can you think of reasons why the management of an entity would want to overstate or understate
its inventory? These incentives may give rise to risks relating to the entity’s nancial statements
containing material misstatements.
• Overstating inventory will translate to assets and pro ts being overstated (as cost of sales will be
understated) leading to the entity appearing to be more pro table/ nancially sound than it
actually is. By arti cially improving the appearance of an entity’s nancial performance and
position, this will facilitate the entity’s ability to raise funds from banks or shareholders.
• On the other hand, the understatement of inventory will lead to an understatement of the entity’s
pro ts and ultimately to an understatement of its taxable income. This, in turn, will reduce the
entity’s tax liability.
Irrespective of the type of entity, its inventory will have to be safeguarded against theft and damage.
Figure 8.1: PVC pipes in the nished goods warehouse, ready for despatch
Source: Bigstock.
For details of how an inventory transaction is recorded in the accounting records, refer to section 7.1.7 of
Chapter 7.
In a manufacturing entity, a transaction will commence as soon as a job order has been received from a
customer or as soon as internal production orders have been prepared and authorised. e goods ordered
and received will represent raw materials and consumables that will be transformed into nished goods. In
addition to the actions described above for a retail entity, namely the preparation of a GRN for the raw
materials received, the transfer of the goods to the warehouse and the safeguarding of the inventory against
theft and damage until the inventory is sold to a customer, the process will have to incorporate the following
in a manufacturing entity – all of which form part of the inventory and production cycle:
• e control of the movement of the raw materials from the raw materials warehouse to the factory (where
it will become part of the work-in-progress) and from there to the nished goods warehouse;
• e control of the costs allocated during the production process; and
• e control of the operation of the production process itself.
Inventories shall be measured at the lower of cost and net realisable value, the latter being the estimated
selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs
necessary to make the sale (IAS 2 paragraph 28). e cost of inventories shall comprise all costs of purchase,
costs of conversion and other costs incurred in bringing the inventories to their present location and
condition (IAS 2 paragraph 10).
When inventories are sold, the carrying amount of such inventories shall be recognised as an expense in
the period in which the related revenue is recognised. e amount of any write-down of inventory to net
realisable value and all losses of inventories shall be recognised as an expense in the period in which the
write-down or loss occurs.
Should an entity not comply with the requirements of IAS 2, it runs the risk of having material
misstatements in its nancial statements, which will result in a modi ed opinion in the auditor’s report and
possibly adverse consequences for the entity.
REFLECTION
How can management use inventory to manipulate the nancial statements?
• The pro t gure in an entity’s nancial statements can be misstated by manipulating the inventory
gure in the nancial statements.
• Overstating inventory will provide an arti cially ‘better’ picture of an entity’s nancial position and
performance compared to when inventory is not overstated. The entity’s assets and as a
consequence its pro ts will be overstated (as cost of sales will be understated) leading to the
entity looking more solvent and pro table than it actually is.
• On the other hand, the understatement of inventory will go hand in hand with the understatement
of pro ts and taxable income.
For a typical manufacturing entity, the cycle can be split into the following functional areas:
1. Storage of raw materials;
2. Production planning;
3. Transfer of raw materials to production;
4. Production;
5. Transfer of nished goods to nished goods warehouse;
6. Storage of nished goods;
7. Cost allocation and updating of inventory records; and
8. Maintenance of inventory records.
REFLECTION
Can you think of examples of how inventory can be protected from theft?
• Implement access control to the warehouse (e.g. locked, with restricted entry, and minimal
entry/exit points to the warehouse and/or factory); and
• Employ security guards to patrol and monitor the area, who can be supported by installing and
monitoring surveillance cameras.
REFLECTION
Can you think of possible circumstances which may result in damaged inventory, and identify
examples of how inventory can be protected from damage?
• There are a number of general circumstances which might result in damaged inventory, such as
leaking roofs and untidy warehouses. Therefore solid-structure, well-maintained buildings and
neatly packed warehouses are examples of how inventory can be protected from being damaged.
• Another point to consider in answering this question is the type of inventory being discussed.
• For example, consider frozen meals compared to text books. The frozen meals could be
damaged if not kept below a certain minimum temperature, whilst the temperature at which
text books are stored will have no effect on them.
• Therefore, the examples identi ed for protecting speci c types of inventory from damage need to
take the inventory’s speci c characteristics into account.
2. Production planning
Purpose: To plan the production process.
Main activities: Determine production needs, determine raw materials needed and request raw materials.
Persons involved in this area: Marketing manager, production manager, factory manager.
REFLECTION
What will happen if an entity does not determine its production needs properly?
• The entity might manufacture too much inventory, for which there is no demand, resulting in
obsolete inventory; or
• The entity might not manufacture suf cient inventory to meet the demands of customers,
resulting in unhappy customers; or
• The production process may be disorganised (e.g. production commencing without all the raw
materials being available), resulting in the entity’s resources such as labour and material being
wasted.
REFLECTION
Why are personnel from both the raw materials warehouse and the factory involved in this
functional area?
• Raw materials warehouse personnel will be involved in the selection, preparation and transfer of
the raw material from the raw materials warehouse and the factory personnel will have to receive
the raw materials transferred to the factory.
4. Production
Purpose: To control the production process.
Main activities: Comparison and reconciliation of raw materials received and nished goods manufactured,
inspection of the quality of nished goods.
Persons involved in this area: Factory personnel.
REFLECTION
Why is it necessary to inspect the quality of the nished goods?
• The manufactured goods might not meet the entity’s quality standards and if it is not detected
the sub-standards goods will be sold and delivered to the entity’s customers. This will result in
dissatis ed customers and reputational damage to the entity – and nancial losses that have to
be incurred in order to replace the inferior products.
REFLECTION
Will the controls implemented for this function be similar to the controls implemented for the rst
function (storage of raw materials)?
• Yes, the controls will be similar but there might be slight differences regarding the controls to
prevent damage.
• As explained earlier, the type of inventory might have an effect on the controls required – for
example, while the raw materials might have to be protected from getting wet (e.g. PVC resin in
powder form as raw material), this will not apply to the manufactured PVC pipes ( nished goods).
There are different costing methods to account for the cost of goods sold, of which the following are
examples: rst in, rst out (FIFO); last in, rst out (LIFO); and weighted average.
When using the FIFO method, the oldest costs are assigned to the inventory items sold,
regardless of whether the sold items were actually purchased at that cost. Once the number of
inventory items purchased at the oldest cost has been sold, the next oldest cost is assigned to
sales. For example, for costing purposes, if an entity buys 100 pencils at R2 each, then buys 100
more at R2.50 each, the entity would assign the R2 cost to the rst 100 pencils sold and thereafter
begin to assign the R2.50 cost.
The LIFO method is the exact opposite of the FIFO method, assigning the most recent inventory
costs to items sold. Using the example above, for costing purposes under the LIFO method, an entity
would assign the latest cost of R2.50 to the rst 100 pencils sold, then move on to the R2 cost,
assuming it had not made another purchase in the meantime.
The weighted average cost method assigns inventory costs by calculating a moving average of all
inventory purchase costs. With the same example as above, using the weighted average method for
costing purposes, the entity would assign an average cost of R2.25 (weighted average of 100 at
R2.50 and 100 at R2) to all 200 pencils sold.
It should be noted that according to IAS 2 on Inventories, speci cally paragraph 25, the cost of
inventories shall be assigned using the FIFO or weighted average cost methods, and not the LIFO
method.
Be sure to distinguish between operational activities and nancial recording (bookkeeping). Many
actions in the cycle are not performed by accounting/bookkeeping staff. An entity is primarily about
manufacturing and/or selling goods or rendering services, and not about the accounting behind it.
However, the accounting function is crucial as it evidences the history of the transactions from their
origin all the way through to when they were recorded in the accounting records (to eventually form
part of the entity’s nancial statements).
For a retail entity, only functions 6, 7 and 8 above are applicable, as no manufacturing (dealt with in
functions 1 to 5 above) takes place.
Process costing is a method of costing used mainly in manufacturing where units are continuously
mass-produced through one or more processes. Examples of this include the manufacturing of
pencils, clothing and cars. In process costing, the process is costed, unlike job costing where each
job is costed separately.
EXAMPLE
Source documents in a cycle facilitate the creation of other source documents as a transaction
ows through the cycle. For example, a production plan will be used to create a production
schedule.
Further examples:
8.3.4 Reports
1. Inventory listing (summary list of all inventory: computerised systems only) (manufacturing,
wholesale and retail entities)
e inventory listing is generated from the inventory master le. A computer application will typically allow a
user to choose which information (data elds) to include on the list, such as inventory code, inventory
description, quantity on hand and cost price. e total cost of inventory per this listing, when adding
together all the individual inventory cost amounts, should agree with the balance of the inventory account(s)
in the general ledger.
8.3.5 Reconciliations
1. Inventory reconciliation (manufacturing, wholesale and retail entities)
Inventory reconciliations take place during inventory counts between the quantities recorded on the
inventory sheets (actual inventory) and the quantities on the inventory list (theoretical inventory). In this
way, an accountant can detect inventory shortages/surpluses, which may be the result of theft, inventory
items which were never recorded, as well as damaged inventory items. e adjustments required as a result
of this process will be recorded on the inventory adjustment form.
8.6.1.2 Consequences if the control objectives in the cycle are not achieved
Table 8.2 explains the consequences if the control objectives are not achieved.
Details of control objectives and controls in the cycle appear in section 8.7 of this chapter.
As a transaction is processed through an entity’s information system, it will be subject to numerous internal
controls that help it along the way to ensure that the control objectives are achieved. e transaction will
only reach its destination appropriately if it ends up in the nancial statements in a manner that achieves the
control objectives. us, if management wishes to ensure proper nancial recording (and fairly presented
nancial statements), they need to implement and maintain a proper information system, including an
accounting system and related internal controls. In this way, the control objectives contribute to the
appropriateness of the assertions made by management in the nancial statements and will indirectly result
in the latter being free from material misstatement.
e assertions for inventory and cost of sales/purchases are linked to the control objectives in the cycle as
shown in Table 8.3.
Table 8.3: The link between the assertions for inventory and cost of sales/purchases, and the control
objectives
MANAGEMENT ASSERTIONS
Note: Controls that achieve the control objectives of validity, accuracy and completeness collectively contribute
to management being able to properly present both classes of transactions and events and the related
disclosures, and account balances and the related disclosures in the nancial statements. Consequently the
Presentation assertion is not included explicitly in Table 8.3 above.
8.7.1.2 Authorisation and approval
One of the most effective ways to ensure that the validity control objective is met in the cycle is to have the
transaction authorised.
Let’s apply this principle to a typical transaction in this cycle. As soon as a retail entity’s inventory items
reach a certain predetermined minimum level, the inventory will be ordered (after being authorised) from a
supplier, and this will be the commencement of a transaction. On receipt of the goods from the supplier, the
entity will prepare a GRN and the goods will be transferred to the warehouse. e entity then needs to
safeguard the inventory against theft and damage until the inventory is sold to a customer. e customer may
phone or email the entity to place an order for goods. is order will once again have to be authorised before
being processed. If the goods are available in the warehouse, the sales order department will instruct the
warehouse to pick the goods and pack them for despatch. Despatch will deliver the goods to the customer
(after being authorised), who is then invoiced by the accounting department.
Note that in a computerised environment, the authorisation of a transaction may in some cases take
place programmatically without intervention by a senior staff member for each transaction. e purchase
order and/or the internal sales order in the preceding paragraph may be automatically authorised by a
computer program after the program has performed the necessary tests to ensure that, for example, the
predetermined minimum inventory level has been reached or that the customer is still within its credit limit.
e following are examples of duties in the inventory and production cycle that should be performed by
different staff members/departments:
• Requesting the transfer of raw materials to production;
• Authorising the transfer of raw materials to production;
• Physically transferring raw materials from the raw materials warehouse to the factory;
• Recording the transfer of raw materials to production; and
• Custody of the raw materials once in the factory.
In a computerised system, segregation of duties can be achieved through the implementation of user pro les
whereby an employee is only granted access to the part of the accounting system that is necessary for the
performance of the employee’s duties.
Reconciliations will usually be performed by a clerk and must be reviewed by a senior staff member. In the
event that the person who is responsible for recording transactions in the accounting records also performs a
reconciliation on recorded information (typically of smaller entities), strong and thorough review controls
should be in place over the reconciliation.
Activity Responsible Documents What could Control Account/ Manual controls Alte
party and records; go objective assertion and
master les wrong/risks affected con
com
env
1 STORAGE OF RAW MATERIALS
| RAW MATERIALS WAREHOUSE |
Activity Responsible Documents What could Control Account/ Manual controls Alte
party and records; go objective assertion and
master les wrong/risks affected con
com
env
a
t
w
1 STORAGE OF RAW MATERIALS
| RAW MATERIALS WAREHOUSE |
Activity Responsible Documents What could Control Account/ Manual controls Alte
party and records; go objective assertion and
master les wrong/risks affected con
com
env
1.1AB Perform
independent
cycle counts and
reconcile the
physical (actual)
inventory on
hand to the
recorded
inventory
quantities on a
regular basis.
2 PRODUCTION PLANNING
| MARKETING DEPARTMENT, PRODUCTION DEPARTMENT AND FACTORY |
2.1 Determine Marketing Production The entity A The entity Accuracy, valuation 2.1AB A
the production manager plan may manufactures and allocation of product
needs of the Production Production manufacture inventory that inventory. plan, ba
entity (type manager schedule too much will be sales
and quantity Factory Production inventory for saleable. forecas
of inventory to manager order which there is (Accuracy) sales b
be no demand, inventor
Factory
manufactured) resulting in of nish
personnel
unsaleable goods,
inventory. econom
product
and ord
custom
should
prepare
product
departm
2 PRODUCTION PLANNING
| MARKETING DEPARTMENT, PRODUCTION DEPARTMENT AND FACTORY |
2.2 Determine Production Production The factory D The factory N/A: Operational 2.2DEFG
the raw manager schedule may run out has suf cient control, no factory
materials Factory Raw of raw raw materials nancial reporting personn
needed to manager material materials during the implications. should
ful l the Factory requisition during the production a raw m
production personnel production process. requisit
needs process, (Operational based o
established in which will control) quantiti
2.1 and lead to delays required
request the in production. product
raw materials schedu
from the raw
materials
warehouse.
2 PRODUCTION PLANNING
| MARKETING DEPARTMENT, PRODUCTION DEPARTMENT AND FACTORY |
3.1 Raw Raw materials Incorrect A The raw N/A: Operational 3.1A T
Prepara‐ materials requisition Raw raw materials control, no raw
tion and storemen materials materials transferred nancial reporting mater
transfer transfer note may be match the raw implications. storem
of the raw transferred materials should
materials. to the requisition. match
factory. (Operational raw
control) mater
requis
to the
mater
transf
note.
3.1A T
raw
mater
store
manag
should
compa
the ra
mater
transf
note t
raw
mater
transf
to the
factor
before
raw
mater
are
transf
3 TRANSFER RAW MATERIALS TO PRODUCTION
| RAW MATERIAL WAREHOUSE, FACTORY AND ACCOUNTING DEPARTMENT |
3.2 Inventory Raw materials Raw B All the raw Existence of 3.2B T
Receipt receipting transfer note materials materials inventory (should invent
of raw clerk might be transferred there be a risk that receip
materials (dedicated damaged from the inventory can be clerk
at the factory and/or warehouse are stolen). should
factory. worker) stolen received at the inspec
during the factory and are raw
transfer not damaged. mater
process. (Accuracy, receiv
completeness) the fa
for qu
quant
and
descri
and
compa
them
raw
mater
transf
note.
she sh
sign a
of the
transf
note (
retain
the ra
mater
store)
3 TRANSFER RAW MATERIALS TO PRODUCTION
| RAW MATERIAL WAREHOUSE, FACTORY AND ACCOUNTING DEPARTMENT |
3.3 Inventory Perpetual The transfer C All transfers Classi cation of 3.3CD
Record clerk inventory of the raw of raw inventory. invent
the records/Inventory materials to materials to clerk
transfer master le production production are should
on the may not be recorded. record
perpetual recorded at (Completeness) transf
inventory all. the ra
system. mater
the fa
on the
perpet
invent
system
the
invent
transf
journa
4 PRODUCTION
| FACTORY |
5.1 Factory Finished Un nished A Only nished Classi cation 5.1A The
Finished personnel goods goods may goods are of inventory. factory
goods transfer be transferred to foreman
transferred note transferred the nished should
from to the goods compare the
factory to nished warehouse. nished
the goods (Validity) goods
nished warehouse. transfer note
goods to the goods
warehouse. to be
transferred
to the
nished
goods
warehouse.
5 TRANSFER FINISHED GOODS TO FINISHED GOODS WAREHOUSE
| FACTORY, FINISHED GOODS WAREHOUSE AND ACCOUNTING DEPARTMENT |
5.3 Record Inventory Finished The transfer C The transfer Classi cation 5.3C The 5
the clerk goods of the of the nished of inventory. inventory A
transfer on transfer nished goods to the clerk should in
the note goods to the nished goods record the p
perpetual nished warehouse is transfer of c
inventory goods appropriately the nished b
system. warehouse recorded. goods to the th
may not be (Completeness, warehouse in
recorded, or accuracy, on the s
may be validity) perpetual e
recorded inventory th
inaccurately. system via o
Finished the inventory
goods not transfer g
actually journal. w
transferred 5.3C c
to the Finished a
nished goods a
5 TRANSFER FINISHED GOODS TO FINISHED GOODS WAREHOUSE
| FACTORY, FINISHED GOODS WAREHOUSE AND ACCOUNTING DEPARTMENT |
6.1 Finished
Implement goods
physical warehouse
controls manager
to
safeguard
the
nished
goods in
storage.
Inventory items returned by customers (e.g. damaged goods and incorrect deliveries) will also have to be
safeguarded and recorded. e sales returns process is covered in Chapter 6. e returned inventory will
form part of the entity’s inventory and therefore it will be subjected to the same processes and controls as the
storage of raw materials and the storage of nished goods in Table 8.4, function 1 and Table 8.9, function 6.
7.1 Cost Perpetual The costs A The costs Accuracy, 7.1ABC The 7.1A
Allocation accountant inventory allocated to allocated to valuation cost cost
of raw records inventory inventory are and accountant can
materials, Labour could be accurately allocation of allocates auto
labour costs incorrectly calculated. inventory. raw allo
and records calculated. (Accuracy) Classi cation material, vari
overhead Overhead The costs B The costs of inventory. labour and cost
costs to cost allocated to allocated to Accuracy, overhead inve
work-in- records inventory inventory are valuation costs to the qua
progress Production could be valid and quantities of man
and reports invalid (not expenditures, allocation of inventory reas
nished Costing applicable applicable to inventory. recorded in che
goods. records to inventory. the still
inventory). (Validity) perpetual requ
inventory Rele
records proc
The
7 COST ALLOCATION AND UPDATING OF costs
INVENTORY C All the costs
RECORDS
| ACCOUNTING DEPARTMENT | allocated to that should
inventory have been
Activity Responsible Documents could
What becould allocated
Control to Account/ Manual Add
party and incomplete.
go inventory
objective are assertion controls con
records; wrong/risks allocated. affected com
master (Completeness) syst
les
based on cont
the app
production ens
records and app
general of c
ledger allo
accounts. (refe
The 5.9
calculation Cha
of the costs 7.1A
allocated to syst
inventory prod
should be vari
reperformed and
(checked) by repo
another inve
staff man
member.
7.1ABC The
actual cost
per
inventory
item should
be
compared to
the
budgeted
cost per
item and
variances
should be
investigated.
7.2 Accounting General The costs D The costs Accuracy, 7.2D The
Recording clerk journal allocated to allocated to valuation recording of
of the inventory inventory are and the
allocated could be correctly allocation of allocated
labour incorrectly recorded. inventory. costs should
and recorded. (Accuracy) be checked
overhead by a second
costs to employee.
nished
goods
inventory.
Table 8.11: Maintenance of inventory records
WHY? Why is it necessary to arrange all the inventory items in the warehouses and on the
sales oor neatly?
• Will it be easy for the client’s staff to nd items in a disorganised warehouse while the
inventory count is in progress, and will it not be possible to miss some items in the
count?
• How will the counting teams know whether items were counted or not if the inventory is
not neatly organised?
• Will it be possible for the inventory count supervisor to accurately compare the rst and
second counts if inventory is not neatly organised?
REFLECTION
Why is it preferable to have two different teams each counting inventory items separately?
• The use of two independent counts will result in any incorrect recording of count quantities as a
result of human error being detected and corrected.
How are large quantities of low-value items (e.g. screws and nails) counted?
• How long will it take to count these low-value items? And more likely than not, errors will be made
when the individual items are counted.
• Therefore, in practice, these small items (e.g. the screws and nails) are ordinarily weighed and the
total weight is converted back to a quantity of items (using the standard weight of each item as
denominator in the equation).
What are the risks if scales are used for weighing inventory items during the inventory count and
how can these be mitigated?
• The scale reading might not be accurate as a result of inaccurate scale readings. But why?
• Over time, scales can lose accuracy due to normal wear and tear as a result of regular use and
age.
• The solution: Each scale used needs to be calibrated on a regular basis to restore the scale’s
results back to the standard/correct weights.
Why should damaged and/or obsolete inventory items be identi ed during the counting process
and to which inventory assertion does this relate?
• In terms of IAS 2 inventory has to be carried at the lowest of cost price and net realisable value.
• The net realisable value of damaged and/or obsolete inventory will most probably be lower than
its cost price.
• Therefore, damaged and/or obsolete inventory need to be identi ed during the inventory count in
order to write it down.
• As this deals with the carrying amount at which the inventory will be included in the nancial
statements the accuracy, valuation and allocation assertion will be applicable.
What will happen if the inventory count controller does not control inventory movement during the
count and which assertion(s) will be affected as a result?
• If inventory movement is not controlled during the inventory count, the possibility exists than
some items might be double counted and other items might not be counted at all.
• If items are double counted, the existence assertion will be affected; on the other hand if items
are omitted from the count, the completeness assertion will be affected.
Ntsimbi Piping makes use of process costing and the manufacturing process takes place at Ntsimbi Piping’s
manufacturing plant in Cape Town. e manufacturing plant consists of a raw materials warehouse, the
production line and the nished goods warehouse (refer to the factory oor plan shown in Figure 8.7). e
manufacturing plant is situated in a secure building, has only one controlled entry and exit point and entry is
restricted to warehouse and factory employees only. Access to the manufacturing plant is controlled by
means of a ngerprint reader.
In order to ensure efficient and effective operations, Ntsimbi Piping’s marketing department prepares a
production plan, based on, among other things, sales forecasts, sales budgets, inventory levels of nished
goods, economic production runs and orders from customers. is production plan is reviewed and
authorised by John Buckley, the production manager, after which a copy is sent to Raymond Harris, the
production manager in the factory.
Raymond Harris uses his copy of the production plan to prepare production schedules on which the
required raw materials are indicated, after which he sends it to John Buckley for review and approval. As part
of John Buckley’s review procedures, he compares the production schedules to the copy of the production
plan.
After the approval of the production schedules, John sends them to personnel at the factory where they
are used to prepare raw materials requisitions based on the quantities on the production schedules.
Raymond Harris reviews and compares the raw materials requisitions to the production schedules, after
which he authorises the raw materials requisitions by signing them. e authorised raw materials
requisitions are then sent to the raw materials warehouse.
On receipt of the authorised raw materials requisitions at the raw materials warehouse, either Jonathan
Maliti or Hayley Stanford selects the requested raw materials and prepares a raw materials transfer note. e
selected raw materials are then compared to the raw materials transfer note by Louis Lynwood, after which
the raw materials are transferred to the factory.
On receipt of the raw materials at the factory, a designated factory worker inspects the raw materials
received at the factory for quality, quantity and description and compares them to the raw materials transfer
note. He signs the raw materials transfer note as evidence.
andi Sebokwe (inventory clerk in the accounting department) records the transfer of the raw materials
to the factory from the raw materials transfer notes on the perpetual inventory system via the inventory
transfers journal (raw materials). Jason Naidoo (senior bookkeeper) checks the recording to ensure that the
raw materials transfer notes have been accurately and completely recorded and that only valid transfers were
recorded.
8.8.5 Production
• Function performed by Ntsimbi Piping’s factory.
• Persons involved in function:
• Lindiwe Xolile (factory supervisor)
• Raymond Harris (production manager in the factory)
• Saul Mkhize (operations director).
e production process is supervised by Lindiwe Xolile (factory supervisor). e production process for PVC
pipes, for example, starts with a mixture of the material, followed by shaping the mixture around a cast. e
casts are made the exact width of the pipe. e mixture is poured into a cast and surrounded by an outer
shell. e complete set is then placed into an oven to be cooked. Once the pipe has solidi ed, it is cooled and
moved into nishing. Sections of the pipe are then cut based on common sizes and needs. e sections are
then coated in a chlorine solution to prevent harmful bacteria from growing during shipping and use. Once
the coating has dried, the ends of each section are nished. If the pipe is a smooth connection, the top of the
pipe is sanded down to ensure a perfectly at surface. For tted pipes, a machine engraves a series of grooves
into the pipe. As the grooves are cut, high-pressure water is sprayed on the pipe to remove excess PVC
fragments. After the grooves have been added, the ends are smoothed and the sections are sent for testing to
ensure quality. e pipes are tested for their seal, connection (on grooved sections), and strength. If a section
fails at any point in the process, it is sent back to be melted down and reconstructed. 1 Most of the controls
over these processes to ensure that a quality product is manufactured are operational controls and fall
outside the scope of this text.
Raymond Harris (production manager) is ultimately responsible for the entire production process and he
ensures that proper quality control procedures are implemented to limit spillage to a minimum. He
compares the production reports prepared by Lindiwe Xolile (factory supervisor) with the raw materials
transfer notes in order to detect spillage and theft, after which the production reports are reviewed and
approved by Saul Mkhize (operations director).
After production and the quality control process have been completed, Lindiwe Xolile prepares a nished
goods transfer note, which Raymond Harris compares to the physical nished goods being transferred to the
nished goods warehouse.
On receipt of the nished goods at the nished goods warehouse from the factory, Jan Steenkamp
(storeman in the nished goods warehouse) inspects the nished goods for quality, quantity and description
and compares them to the nished goods transfer note. He signs the nished goods transfer note as
evidence.
andi Sebokwe (inventory clerk in the accounting department) records the transfer of the nished
goods from the factory to the nished goods warehouse from the nished goods transfer notes on the
perpetual inventory system via the inventory transfers journal ( nished goods). Jason Naidoo (senior
bookkeeper) checks the recording. It is necessary for him to do this to ensure that the nished goods transfer
note has been accurately and completely recorded and that only valid transfers were recorded.
On receipt of the nished goods from the factory and after all the necessary internal controls regarding the
transfer of the nished goods to the nished goods warehouse have been performed, the nished goods are
neatly packed into the nished goods warehouse. Similar processes and controls to those in the raw
materials warehouse are in place.
Imraan Daniels (cost accountant) performs the calculation of the raw material, labour and overhead costs to
be allocated to inventory (based on approved production reports) and prepares the journal entries to record
these. James Khumalo ( nancial manager) reperforms the calculations and compares the actual cost per
inventory item to the budgeted cost per item to detect spillage and theft, and variances are investigated.
James then authorises the journal entries for processing.
andi Sebokwe (inventory clerk) records the journals in the general ledger. e recording of the journals
is checked by Jason Naidoo (senior bookkeeper).
James Khumalo ( nancial manager) inspects the supporting documentation for all inventory adjustments
(e.g. resulting from differences between actual and theoretical quantities identi ed during cycle counts, and
changes to the type of products used by the company, etc.) and authorises these adjustments by signing the
inventory adjustment forms. andi Sebokwe (inventory clerk) then records the adjustment, using the
authorised inventory adjustment forms, on the inventory master le, having accessed this application using
her username and password. Jason Naidoo (senior bookkeeper) then compares the adjustments recorded to
the details on the inventory adjustment forms.
Assessment questions
For questions 1 to 4, select the correct answer:
1. Which one of the following is not an objective of the inventory and production cycle? (LO 1)
a) Authorisation of inventory acquisition
b) Safeguarding inventory against theft and damage
c) Controlling the movement of inventory during the production process
d) Recording the movement of inventory during the production process
2. Which one of the following assertions will be affected if an entity’s inventory is not safeguarded against
theft? (LO 7 & 10)
a) Existence of inventory
b) Completeness of inventory
c) Rights to inventory
d) Accuracy, valuation and allocation of inventory
3. Which one of the following assertions will be affected if an entity’s inventory is not safeguarded against
damage? (LO 7 & 10)
a) Existence of inventory
b) Completeness of inventory
c) Rights to inventory
d) Accuracy, valuation and allocation of inventory
4. Which one of the following statements regarding inventory counts is incorrect? (LO 12)
a) e only difference between cycle counts and year-end counts is the fact that cycle counts are
performed throughout the year while year-end counts are only performed at year-end.
b) As part of the planning of an inventory count, all the inventory items need to be neatly arranged
and all the areas need to be numbered according to the prepared plan.
c) Inventory movement should be carefully controlled during an inventory count.
d) If differences are found between the quantities counted by the two different counting teams, those
items should be recounted.
7. If the accuracy control objective is achieved in an entity’s inventory and production cycle, the risk of
material misstatement regarding the accuracy, valuation and allocation of the business’s inventory will
be reduced. (LO 9 & 10)
8. e authorisation of a request for raw materials from the raw materials warehouse will always be a
manual control activity. (LO 12)
9. To achieve the accuracy of inventory and production transactions, the transaction should be recorded at
the appropriate amount. An appropriate amount would be calculated correctly and the transaction
should also be correctly classi ed and correctly summarised and posted to the entity’s accounting
records. (LO 10)
10. Explain why and how the purpose of the inventory and production cycle will differ for a retail entity and
a manufacturing entity. (LO 1)
11. Explain how the other business cycles link to the inventory and production cycle. (LO 2)
12. Which general ledger accounts are affected by the inventory and production cycle? (LO 2)
13. Describe the functional areas in the inventory and production cycle and list the documents and records
applicable to each of the functional areas. (LO 4)
14. Describe the ow of the transactions in the inventory and production cycle through the information
system, including the use of source documents and accounting records. (LO 5)
15. What are the duties of the counting teams while conducting an inventory count? (LO 12)
16. What are the duties of the inventory count controller when planning for, conducting and nalising an
inventory count? (LO 12)
17. Explain the difference between a business’s actual inventory and its theoretical inventory. (LO 3)
18. Why does a business compare its actual inventory to its theoretical inventory? (LO 3)
19. Identify the weakness with regard to the storage of inventory in the following paragraph, assuming that
the entity is a retailer:
On transfer of the goods from the goods receiving section into the raw materials warehouse, the
warehouse clerk compares the physical goods to the GRN and acknowledges receipt by signing the
GRN. Any discrepancies are reported to the warehouse supervisor immediately. e goods are then left
at the entrance to the warehouse and moved into the warehouse when the warehouse personnel have
free time available. (LO 11)
20. Describe two controls that can be implemented in a business to ensure that inventory is not damaged.
(LO 12)
Henriëtte Scholtz
CHAPTER CONTENTS
Learning outcomes
9.1 What are the nature, purpose and accounting implications of the cycle?
9.2 What functional areas occur in the cycle?
9.3 What information system is used in this cycle?
9.4 What could go wrong (risks) in the cycle?
9.5 What computer technologies are used in the cycle?
9.6 What are the control objectives in the cycle?
9.7 What are the controls in the cycle (manual and computerised)?
9.8 Cycle illustration: e human resources cycle at Ntsimbi Piping
Assessment questions
LEARNING OUTCOMES
IN THE NEWS
SA’s national minimum wage could hurt small rms and rural workers
27 April 2017
Cape Town – South Africa is set to adopt a national minimum wage of R20,00 per hour. There are
questions as to whether this is enough to be termed a victory for the country’s working poor. If
historical trends continue, this might be bene cial only for some workers. Others, especially those in
small rms and rural areas, may not be so fortunate.
Workers in rural areas and those currently working in small enterprises could be particularly
susceptible to job losses as a result of the national minimum wage. The wage bill acknowledges
these vulnerabilities. Its recommendations provide temporary exemption for small employers in
particular, but none for rural jobs. That means that workers in rural areas could be adversely
affected. With its raging unemployment and many low-paying jobs, South Africa faces a dilemma as it
introduces a national minimum wage. Higher wages are necessary for better living standards; but
wage growth can potentially exacerbate already high unemployment and consequently reduce living
standards. Simple economic models predict that minimum wages destroy employment. However,
decades of intense research show that the basic model is not an empirical certainty in all
circumstances. Consensus is slowly shifting, with greater recognition for the role of minimum wages
in reducing inequality. Latin America is a case in point where inequality was initially extreme, but
declined (at least partially) in response to minimum wages at the turn of the century. One might
expect the same bene ts in South Africa, which has remained close to the top of world inequality
rankings.1
WHAT What if the entity is a manufacturing concern? Why are the salaries and wage expenses
of these entities particularly important from a nancial reporting perspective?
IF? For manufacturers, the wage expenses will also in uence the inventory valuation assertion
(because of the requirements of IAS 2 Inventories).
is cycle is at risk of contributing to material misstatements in the nancial statements for possible fraud
(misappropriation of assets), rstly as remuneration could be paid in cash (necessitating cash on hand on
the premises), and secondly for the creation of ctitious (or ghost) employees (refer to the news story: ‘Ghost
Employees’ on the previous page). Salaries and wages are also usually a major expense for most entities,
which increases the risks of material misstatements arising as a result of the large numbers involved. Wages
often also comprise small amounts being paid per transaction, but with a high volume of transactions, which
may increase the inherent risk of material misstatements arising in wages.
Payments of salaries and wages are typically internally generated transactions without any supporting
external documentation, which makes the documentation less reliable from an auditing perspective as it
lacks involvement of objective third parties (this is discussed in more detail in Chapter 11, section 11.6).
Furthermore, compensation paid to employees may include elements such as contributions to retirement
plans and share options, which require speci c disclosure in the nancial statements.
Wages are:
• Paid only for productive hours worked;
• Usually paid weekly or fortnightly; and
• Sometimes paid in cash (or more recently also by way of EFT).
9.1.1.2 Purpose
e main purpose of the cycle is to address:
• Appointment of personnel, authorisation of any changes to salaries and wages rates and deductions, and
maintenance of personnel records;
• Time keeping and control over hours worked;
• e preparation of salary and wage transactions and the recording of these transactions;
• Preparation of the salaries and wages to be paid;
• Payment of salaries and wages; and
• Paying over of deductions to the relevant parties (e.g. SARS).
In terms of the accounting function, salaries and wages are recorded as expenses (debited) in the Statement
of Comprehensive Income (in manufacturing concerns, some of these expenses are later transferred to
inventory in the Statement of Financial Position) and the bank account is credited for the payment made.
Provisions for leave pay and deductions from remuneration not yet paid over at year-end (i.e. medical aid
payments not yet paid over) should be provided for at year-end as liabilities. It is imperative that all salary
and wage expense transactions are recorded, all calculations are performed and recorded accurately, all
payments and deductions are authorised and that all deductions are paid over timeously (or provided for if
not paid over at year-end) otherwise the nancial statements will re ect an incorrect picture of the true
performance of the entity.
No matter what business type or circumstances, as a result of this cycle, funds will ow out of the
business in the form of salaries and/or wages and related expenses.
A business will have to implement proper internal controls in its human resources cycle to ensure
that proper record is kept of time worked and that the paying of wages and salaries is properly
handled and recorded.
As soon as one of the above triggers occurs, the human resources cycle becomes applicable and the internal
controls within the cycle will start.
e cycle will repeat itself every time a new transaction takes place.
CRITICAL THINKING
How is a salary or wage transaction recorded in the accounting records?
A wage transaction is ordinarily recorded when the clock cards or time sheets are received and then
posted to the wage journal/payroll. An employee listing is obtained from the personnel division that
contains the wage amounts and deductions in respect of each employee. A payment of the net wage
is then made. The payment is recorded in the cash book and posted by debiting the wages account
and crediting the bank account in the general ledger.
Salary transactions are recorded on a monthly basis when the updated employee listing, which
includes employee names and gross salaries and deductions in respect of each employee, is
received from the personnel division. This is then posted to the salaries journal.
The payment of the net wage is then recorded in the cash book and debited to the salaries
account, crediting the bank account in the general ledger.
Refer to the notes to the nancial statements of Ntsimbi Piping for information on directors’ emoluments (page
21). Also refer to its Detailed Income Statement in the supplementary information (page 26) and note the line
item ‘Employee costs’.
2. Statement of Financial Position
• Inventory (direct wages form part of the cost of inventory for a manufacturing concern);
• Bank;
• Accruals for deductions payable (e.g. pension, medical aid and PAYE); and
• Provision for leave pay.
Refer to the Statement of Financial Position of Ntsimbi Piping (page 7). Note the line item ‘Trade and other
payables’ with a balance of R13,381,893. Refer to note 11 (Trade and other payables) (page 19). e amount of
R1,191,473 for ‘other payables’ would include liabilities accrued for any deductions from employees’
remuneration not yet paid over to third parties.
REFLECTION
Look up the requirements of the JSE Listings Requirements in relation to the disclosure of directors’
emoluments. Then select a listed company, nd its nancial statements and see if you can nd out
whether it complies with these requirements.
e CCMA will:
• Conciliate workplace disputes;
• Arbitrate disputes that remain unresolved after conciliation;
• Facilitate the establishment of workplace forums and statutory councils;
• Compile and publish information and statistics about its activities; and
• Consider applications for accreditation and subsidy from bargaining councils and private agencies.
e CCMA may:
• Supervise ballots for unions and employer organisations; and
• Give training and advice on:
• e establishment of collective bargaining structures;
• Workplace restructuring;
• Consultation processes;
• Termination of employment;
• Employment equity programmes; and
• Dispute prevention.9
IN THE NEWS
Executive remuneration
Executive remuneration remains a controversial topic, especially in South Africa where the wealth
gap between rich and poor is still on the increase (Wray, 2008).10 With the nancial crises it is not
surprising that executive remuneration attracted the attention of investors, the media, the public at
large, trade unions and researchers. The following extracts and headlines from recent media articles
provide examples:
• Executive pay remains one of the most discussed topics within remuneration. The relativity of
executive pay compared to other staff members is placed increasingly under the microscope as
the world is faced with more evidence that wealth inequality is continually on the rise. (10 April
2018)11
• Executive remuneration is under scrutiny in the UK as politicians, the public and investors
demand a clampdown after a wave of big pay-outs. (12 April 2018)12
• Why it is time to curb the madness of executive pay (9 May 2016)13
• Shareholders demand the right to limit executive pay (23 Feb 2018)14
• King IV™ tightens corporate remuneration (1 November 2016)15
• Can the grim reality of published pay ratio really curb executive pay? (6 September 2017)16
e salary and wages cycle can be split into the following functional areas:
1. Personnel;
2. Time keeping (wage-earning employees only – if the company has no wage-earning employees, this
functional area is omitted);
3. Calculation and recording of salaries and wages and deductions;
4. Payment preparation and payment of salaries and wages;
5. Payment of deductions; and
6. Recording of salary and wage transactions in the accounting records.
A brief summary of each functional area for a typical manufacturing company, such as Ntsimbi Piping,
follows:
1. Personnel
Purpose: To ensure that proper appointment and dismissal procedures are followed and appropriate
records are kept for all staff.
Main activities: Recruitment, appointments, dismissals, salary and wage negotiations, labour disputes,
maintenance of personnel records, issuing of employment contracts, wage rate and salary adjustments,
deductions, communicating any amendments of salaries or wages, de ning job descriptions, employee
development and performance appraisal procedures.
Persons involved in this area: Human resources clerk, human resources manager/director, appointments
committee, line managers.
WHY? Why is the responsibility for appointing wage-earning employees and setting new wage
rates assigned to the personnel division and not to the foreman who oversees the
employee?
The foreman can create ctitious (ghost) employees or be subjective when appointing
employees or changing wage rates, leading to employee dissatisfaction.
WHAT What if an employee is kept on the payroll after resignation? What might the nancial
implications for the business be?
IF? The salary and wage expense of the entity will be excessively high, resulting in loss of
pro ts to the entity.
2. Time keeping (wage-earning employees only – if the company has no wage-earning workers, this
functional area is omitted)
Purpose: To ensure that valid, accurate and complete time records are kept for wage-earning employees, in
order to ensure that wages are paid only for hours actually worked.
Main activities: Preparation and issuing of clock cards, supervision during the clocking in and out process,
collection of clock cards after a wage week, calculation and authorisation of hours worked.
Persons involved in this area: Time keeping clerks, line managers (such as factory foremen).
WHY? Why are the wage clerks responsible for the preparation of the payroll and not the wage-
earning employees’ supervisor (such as the divisional foreman)?
If the supervisor handles both functions, this will result in insuf cient segregation of
duties. The supervisor may be able to create ctitious employees and steal the wages of
those employees.
5. Payment of deductions
Purpose: To ensure deductions have occurred and are authorised, that the deductions to the relevant third
parties are calculated accurately and that all the deductions are paid over.
Main activities: Preparation of returns, paying over of deductions.
Persons involved in this area: Administrative assistant in payroll division or accounting department,
accountant, senior manager (to approve payments).
HUMAN
PAYROLL DIVISION
RESOURCES PAYROLL DIVISION ACCOUNTING DEPARTMENT
(ADMINISTRATIVE)
DIVISION
CRITICAL THINKING
How will wages in a manufacturing concern be dealt with in the nancial statements?
Salaries and wages for a manufacturing concern include direct labour and indirect labour costs.
Direct labour costs are those amounts paid in respect of those employees who spend all their time
working directly on the product being manufactured. Indirect labour costs are the amounts paid in
respect of other factory employees involved in production.
The direct and indirect salaries and wages related to manufacturing (as part of overheads) in
respect of work-in-progress and nished goods on hand will form part of the cost of inventory. That
related to nished goods sold will be included as part of the entity’s cost of sales gure in the
Statement of Comprehensive Income.
Proper record keeping of new appointments, hours worked (on clock cards), payroll amendment forms,
deduction authorisation forms and termination of service forms in journals (such as the salaries and wages
journals) and in the general ledger is therefore critically important for reliable nancial reporting. Should the
information system (including the accounting system) fail to ensure proper record keeping, an entity’s salary
and wage expenses might be materially misstated (and for a manufacturing concern the value of inventory
may also be materially misstated).
2. Employment contract
An employment contract is issued on the appointment of an employee and sets out the rights and
obligations of the employer and employee in respect of the employment.
Example: Refer to document 4A in the appendix at the end of the book.
3. Employee le
An employee le has to be kept for each employee. Copies of the employment contract and other relevant
personal documents relating to the employee, for example a copy of the ID document, have to be kept in
these les. ese les can be kept electronically.
1. Wages journal
e wages journal is used to record all the wage-earning employees’ names and details, and for each
employee the normal time and overtime hours worked, and the wage rates and deductions made from the
employee’s wage. e gross and net wages, as calculated, are also indicated here.
Example: Refer to document 4J in the appendix at the end of the book.
2. Salaries journal
e salaries journal is used to record all the salary-earning employees’ names and details, and for each
employee the salary rate and deductions made from the employee’s salary. e gross and net salary
amounts, as calculated, are also indicated here.
Example: Refer to document 4K in the appendix at the end of the book.
3. General ledger
e general ledger contains accounts drawn from all journals to serve as a collection point for all
transactions that occurred in the various business cycles of an entity. e general ledger facilitates the
compilation of a trial balance and the nancial statements. It further enables a double-entry bookkeeping
function, which controls the recording of transactions in an accounting system (e.g. a debit to the salary or
wage account will always be matched to a credit to the bank account). In addition to salaries and wages
ledger accounts, control accounts relating to the various deductions will have to be set up.
9.3.4 Reports
Employee listing (summary list of all employees)
e employee listing is generated from the employee master le for computerised systems. A computer
application will typically allow a user to choose which information (data elds) to include on the list (e.g.
employee’s number, employee’s name, remuneration details, and deductions). In a manual system, a
manual list could be set up in writing or typed out to include the employee’s name, employee number,
remuneration details, and deductions.
9.3.5 Reconciliations
1. Salary/wage reconciliation
A salary/wage reconciliation takes place between the totals of the salary and wage journals for a speci c
period and the totals of the previous period’s salaries or wages journal respectively, and the total budgeted
salaries/wages. e total number of employees can also be reconciled to the previous period’s number.
It will facilitate effective control over the payment of salaries and wages. While there will be
timing differences between recording the transaction and payment, the amount transferred
and the cash out ows for salaries and wages should always net off to zero. If they do not
net off to zero, there is a problem somewhere and being able to identify the difference
timeously will help to rectify the problem promptly.
In addition to the loss of entity resources (cash) as a result of these misappropriations, the effect on the
nancial statements is that salaries and wages expenses are incorrect as the transactions did not occur.
In order to reduce or eliminate the above-mentioned nancial and misappropriation risks, management
must implement and maintain a system of internal controls to achieve the control objectives of validity,
accuracy and completeness of nancial information related to the human resources cycle.
IN THE NEWS
Payroll fraud - how to detect and ght it19
18 May 2016
One of the biggest tips for business owners is to become suspicious if a member of your payroll
department never goes on leave, arrives early and leaves late. This should raise a red ag, as this
person may be taking steps to ensure that nobody else does their job and cannot discover their
crime.
1 Ghost employees
The hardest type of payroll fraud to orchestrate and detect, but also potentially the most lucrative, is
the engineering of a ghost employee. The employee that is created is either ctional or could be a
real person who doesn’t work for the company he or she is being paid by. The payroll administrator
will add the ghost employee to the payroll and then the monthly salary will be paid. If it’s a wage
employee, then this is more dif cult to prove, but with electronic payments a payment trail is left and
can be spotted.
9.6.1.2 Consequences if the control objectives in the cycle are not achieved
Table 9.2 looks at the consequences if the control objectives are not achieved.
CONTROL
CONSEQUENCE IF CONTROL OBJECTIVE IS NOT ACHIEVED
OBJECTIVE
Account balances
Refer to the Statement of Financial Position in the nancial statements of Ntsimbi Piping (page 7).
Note the line item ‘Trade and other payables’ with a balance of R13,381,893. Also refer to note 11
(Trade and other payables) (page 19). The amount of R1,191,473 for ‘other payables’ includes
liabilities accrued for any deductions from employees’ remuneration not yet paid over to third parties.
• In relation to existence, liabilities for deductions not yet paid over making up the balance exist
(i.e. the constituent liabilities are not ctitious).
• In relation to obligations, Ntsimbi Piping is the party liable to pay the amounts making up the
balance. The liability is not that of another entity.
• In relation to accuracy, valuation and allocation, the balance of the liabilities for deductions not
yet paid over is considered an appropriate amount (e.g. the balance re ects the appropriate
value of the underlying liabilities due to be paid in the future). Further, any adjustments as to the
value or allocation of the underlying liabilities have been recorded appropriately, and also any
related disclosures have been appropriately measured and described.
• In relation to completeness, all liabilities for deductions not yet paid over, and which are
liabilities of Ntsimbi Piping, have been recognised as such in the nancial statements
(notwithstanding the measurement thereof, which is dealt with separately under the accuracy,
valuation and allocation assertion), and all related disclosures have been included.
• In relation to classi cation: the liabilities not yet paid over and which are liabilities of Ntsimbi
Piping have been classi ed as liabilities (i.e. have been classi ed as liabilities of Ntsimbi Piping
in the Statement of Financial Position).
• Presentation: All the nancial information presented and described in the nancial statements
has been appropriately presented in terms of the nancial reporting framework and has been
clearly expressed to avoid ambiguity. For instance, vague descriptions have been avoided.
e assertions for the classes of transactions and account balances impacted by the human resources cycle
are linked to the control objectives in the cycle as shown in Table 9.3.
Refer to Chapter 4, section 4.3.2.4 for details of the above-mentioned types of controls.
Table 9.3: Assertions for salaries and wages and the related account balances
Accuracy Accuracy and Classi cation Accuracy, valuation and allocation and
A control achieving the accuracy Classi cation
objective for salaries and wages will A control achieving the accuracy
ensure that the transaction is recorded objective for transactions for the
at the correct amount (including accrual of deductions making up a
employee, rates and deductions and liability will ensure that the gross
correct calculations) (accuracy). It will valuation of the liability is appropriate.
further ensure the transaction has been Furthermore, a control achieving the
correctly classi ed, summarised and accuracy objective for any transaction
posted to the correct account in the resulting in a valuation or allocation
nancial records in accordance with its adjustment to the gross amount of the
nature (classi cation). liability will ensure that the net amount
of the liability is accurately valued,
allocated and classi ed (accuracy,
valuation and allocation and
classi cation).
Note: Controls that achieve the control objectives of validity, accuracy and completeness collectively contribute
to management being able to properly present both classes of transactions and events and related disclosures,
and account balances and related disclosures in the nancial statements. Consequently, the Presentation
assertion is not included explicitly in the table above.
9.7.1.2 Authorisation and approval
One of the most effective ways to ensure the validity of the human resources cycle is to have the new
appointment of employees authorised (before they have taken place) or changes approved (ideally before
they are implemented). In most cases, authorisation and approval is a duty carried out by management.
e person who initiates the transactions (e.g. requests the appointment of an employee, which will
normally be the line manager), should not be the person who executes the transaction (e.g. should not be
solely responsible for making the nal recommendation for appointment – normally the section head) and
should not be the person who authorises the transaction (e.g. the personnel manager normally signs the
appointment letter and appointment documentation). ese persons should also not be allowed to record
the transaction in the salary or wage journal (recording should take place in the payroll department).
In a computerised system, segregation of duties can be achieved through the implementation of user
pro les whereby an employee is only granted access to that part of the accounting system that is necessary
for the performance of the employee’s duties.
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party records; master wrong/risks affected controls
les
3.3ACDF
Payroll cl
B should
verify the
hours (fo
wages on
against c
cards),
tariffs an
deductio
against t
amendm
forms an
deductio
authorisa
forms,
employee
listing an
deductio
tables
respectiv
3.3BE Pa
clerk B
should
reperform
the
calculatio
on the
journals
salary an
wage
reconcilia
and sign
salary an
wage
journals
reconcilia
as eviden
that this
been don
3 CALCULATION AND RECORDING OF SALARIES, WAGES AND DEDUCTIONS
| PAYROLL DEPARTMENT |
3.4BEF T
payroll
manager
should
select a
sample o
the
transacti
recorded
the salar
and wage
journals
reperform
some of
transacti
and
calculatio
and
elements
the
reconcilia
and sign
salary or
wage jou
as proof
this.
Activity Responsible Documents What could go Control objective Account/assertion Manual controls
party and wrong/risks affected
records;
master
les
4 PAYMENT PREPARATION AND PAYMENT OF SALARIES AND WAGES
| PAYROLL DEPARTMENT |
4.2 Safe- Payroll Cash could C Cash is kept Existence of 4.2C The cash
keeping of clerks be stolen. in safe custody cash. should be
cash. and not stolen. locked away in
(Validity) the safe when
it arrives from
the bank, as
well as after
the wage
envelopes
have been
made up
(before pay-ou
of the wages)
4.3 Payroll Payslips Incorrect D Payslips are N/A Operational 4.3D Payslips
Preparation clerks payslip correct in control, no should be
of payslips prepared. terms of all nancial prepared by
for wage- information reporting payroll clerk B
earning contained implications. for each wage
employees. therein. (No earning
control employee,
objective containing the
applicable as computation o
this is an the net wage.
operational
control.)
4 PAYMENT PREPARATION AND PAYMENT OF SALARIES AND WAGES
| PAYROLL DEPARTMENT |
4.4 Making- Payroll Wage Cash placed E The correct Accuracy of 4.4E Two
up and clerks envelopes in the wage wages are wage expenses. independent
checking of envelopes is placed in the payroll clerks
wage the incorrect wage (not
envelopes. amount. envelopes for responsible fo
each the wage
employee. journal) shoul
(Accuracy) make up the
wage
envelopes
referring to th
amount and
employee
name and
number in the
wage journal
and compare
to the payslip
4.4E The
payroll clerks
should check
one another’s
work by
performing
spot checks o
wage
envelopes
made up and
comparing thi
to the wage
journal.
4.5 Payment Supervisor Wage Not all A All wage- Completeness of 4.5AB The
of wages. journal employees earning wage expenses. wage
Line who should employees envelopes
manager Payslips be paid are entitled to Occurrence of should be
paid. payment wage expenses. locked away
Wage receive until the pay-
envelopes Wages are payment. out.
paid to non- (Completeness)
employees of 4.5AB The
the company. B Payment of supervisor of
wages is made division
to actual should, when
employees of the wage
the company. envelopes are
(Validity) handed to him
or her by the
payroll clerks,
count the
4 PAYMENT PREPARATION AND PAYMENT OF SALARIES AND WAGES
| PAYROLL DEPARTMENT |
number of
wage
envelopes,
compare it to
the list of
employees to
be paid and
sign the wage
journal if he o
she is satis e
that there is a
wage envelop
for each
employee. At
least two
employees (i.e
the superviso
of the division
as well as
another
independent
person) shoul
conduct the
wage pay-out.
4.5AB When
collecting the
wage envelop
the employee
• Identi es
him/herse
• Counts the
money and
compares
to the
payslip; an
• Signs the
list of
employees
4.5B Wages
should only be
paid to the
employee in
person and no
to anyone els
4.5AB
Employees no
present during
the wage pay-
4 PAYMENT PREPARATION AND PAYMENT OF SALARIES AND WAGES
| PAYROLL DEPARTMENT |
out should be
indicated as
‘unclaimed’ o
the list of
employees.
4.6 Safe- Payroll Wage Unpaid A Cash from Existence of 4.6A The wag
keeping and secretary journal wages are unclaimed cash. journal along
payment of Supervisor Unpaid stolen. wages is Occurrence of with the wage
unclaimed adequately envelopes not
Line wages are Unclaimed wages
wages. stolen. wages are safeguarded. expenses. claimed durin
manager (Validity) the wage pay-
Wage paid to the
wrong B Unclaimed out should be
envelopes taken to an
person. wages paid are
paid to actual independent
person (e.g.
correct
employees of the payroll
the company. secretary).
(Validity) 4.6A The
secretary
should count
the number of
envelopes and
compare it to
the list of
employees an
sign if he or
she is satis e
as evidence o
receipt of the
unclaimed
wages.
4.6A The line
manager and
supervisor
present at the
wage pay-out
should record
employees wh
4 PAYMENT PREPARATION AND PAYMENT OF SALARIES AND WAGES
| PAYROLL DEPARTMENT |
did not attend
the wage pay-
out and have
not collected
wages in an
unclaimed
wage register.
This should b
checked by th
payroll
secretary.
4.6A The wag
envelope
should be
locked away
until it is
collected by
the employee
4.6B When
collecting the
unclaimed
wage, the
employee
should:
• Identify
him/herse
• Count the
money and
compare it
to the
unclaimed
wage
register;
and
• Sign the
unclaimed
wage
register.
4.6A
Unclaimed
wages not
collected
within a
reasonable
time should b
deposited bac
into the bank
account of the
business.
4 PAYMENT PREPARATION AND PAYMENT OF SALARIES AND WAGES
| PAYROLL DEPARTMENT |
4.6A The
unclaimed
wage register
should be
referenced to
the deposit
slip for
unclaimed
wages
deposited.
4.6A Regular
monitoring of
unclaimed
wages should
be done by an
independent
manager
following up o
long-
outstanding
unclaimed
wages and
employees wh
regularly
appear on the
unclaimed
wage register.
5 PAYMENT OF DEDUCTIONS
| ACCOUNTING DEPARTMENT |
5.2AC The
nancial
manager
(reviewer 2)
should also
review the
salary and
wage
journals
and returns
and sign
them. He
or she
should
stamp the
returns
‘paid’ and
sign the
request for
payment as
second
reviewer.
5.2B The
nancial
manager
must
ensure that
all
payments
that are
5 PAYMENT OF DEDUCTIONS
| ACCOUNTING DEPARTMENT |
due, but
have not
been paid
before year-
end, are
raised as a
liability in
the general
ledger.
If a potentially suitable candidate is identi ed from the interviews, the next steps are:
• Following up with the candidate’s references (to con rm whether the candidate is indeed a suitable
candidate to appoint);
• Querying whether the candidate has a criminal record (from an online database);
• Checking the candidate’s quali cations (e.g. if minimum quali cation for this position is Grade 12, it is
con rmed that the candidate is indeed in possession of a valid Grade 12 certi cate); and
• Performing competency testing on the candidate.
Should the candidate be appointed, an employment contract is drawn up by Marguerite Malan, setting out
the employment conditions and terms of appointment, as well as the hourly rate as agreed for the particular
position. e employment contract is signed by Herman Heunis and Louis Lynwood. Rose Metsetswe sends
two copies of the employment contract to the candidate to sign. One signed copy is kept by the candidate
and the other copy is sent back to Rose along with a certi ed copy of the appointee’s ID document,
quali cations, proof of address, bank account name and bank account number. Deduction authorisation
forms are also completed by the new employee for all deductions from his or her salary or wage (excluding
regulatory deductions for taxation and UIF).
Rose opens an employee le for the new employee. e copy of the employment contract that is returned
by the employee is led in the permanent le. e employee comes in and provides two ngerprints (one as
a backup) for access control purposes. e biometric system electronically scans hundreds of data points (on
the nger) and processes them as a data string through two proprietary systems. e result is a series of
random numbers used to identify the employee for check in/out purposes.
Typical changes to the employee master le that require a master le amendment form include:
• Additions and deletions of employees;
• Setting of and changes to tariffs; and
• Changes to deductions
Mabel Smith creates the wage journal for each week in the PVCACC payroll module. e employee names
and numbers, approved wage tariffs and deductions are automatically retrieved from the master le. e
hours stored by the biometric reader on the ‘hours worked’ transaction le is imported into the payroll
software package automatically when the wage journal for a certain period is created. e system
automatically splits the hours between normal and overtime hours. e system calculates a batch total of
hours worked, as processed, and displays this on the screen. Mabel agrees this with the total hours worked
according to the ‘hours worked’ transaction le and then clicks on the ‘proceed’ button (refer to Chapter 5
for a description of batch controls).
Tandi Mnazana creates the salary journal for each month in the payroll package. e employee names
and numbers, approved salary tariffs and deductions are automatically retrieved from the master le when
the salary journal is created for a particular month.
Access to the salary and wage journals is restricted by the logical access controls as discussed in Chapter
5. Any additional employee deductions (such as loan instalments) or bene ts (such as bonuses) are loaded
by way of master le amendment forms. e master le amendments are loaded by Rose Metsetswe in a
similar manner to that described in section 9.8.2 above and authorised by Herman Heunis and the employee
(for non-statutory deductions). Mabel Smith and Tandi Mnazana have no write-access to the master le
data. Deductions and hours are included in the wage journal (for wages).
e processing of the salary and wage journals is automatically carried out by the system. e system
performs reasonability and limit checks on the results of the processing as discussed in Chapter 5.
e salary and wage journals and exception reports are then printed. Mabel Smith (for wages) and Tandi
Mnazana (for salaries) do reconciliations by comparing the number of employees, hours (for wages), tariffs
and deductions to the prior period and follow up on any differences. ey sign the reconciliations as proof
that they have performed these. If necessary, the wage journals and exception reports are then printed again
and handed to Ben Franco. Ben compares the number of employees to the number of employees on the
master le, compares salaries and wages among divisions, and compares the number of employees and the
expense to the budget and follows up on any exceptions included in the exception reports. If satis ed, Ben
signs the exception reports and les them. He then approves the salary or wage journal as the rst approval
on the system and has no other write-access to the le.
After performing the above checks and if he is satis ed with all payment information, Ben accesses the
‘Salary or wage payments module’ on PVCACC with his username and supervisor password and ags the
electronic version of the payment schedule as ‘Ready for payment’.
If the above review indicates no discrepancies, James accesses the EFT application by entering his unique
username and password. James rst instructs the computer to transfer automatically the information on the
electronic version of the payment schedule (as prepared by Ben Franco in section 9.8.4 above), and banking
details from the employee master le, to the EFT application. e EFT application has been set up in such a
way that it can interface with the payments schedule on the accounting system, decreasing the risks of:
• Inaccurate payment details being furnished to the EFT application;
• Employees being inappropriately added to the payment run; and
• Employees being omitted from the payment run.
As an added control after the transfer of the payment data to the EFT facility, the computer automatically
reconciles the data transferred onto the EFT application with the data on the payment schedule to ensure all
payment data has been transferred to the EFT facility (this is done prior to the nal approval for the
payments to be made).
If James and Lee-Ann are both satis ed with the payment information, they each individually approve
the payments on the EFT application by selecting ‘Process payment’. (Any discrepancies would have been
referred back to Ben, Mabel or Tandi for correction prior to payment.)
A ‘con rmation of payment’ report is printed from the EFT application indicating the nal amounts paid
to each employee. Should the report indicate that a payment could not be processed (e.g. employee has
closed his or her bank account or incorrect bank account details have been identi ed), the payment
documentation is handed to Ben Franco for resolution and resubmission. Ben downloads the bank
statements for the wage and salary bank accounts and compares them to the EFT report as printed. Any
discrepancies are followed up and resolved.
After performing a successful payment run, the payment signatories stamp the payment schedule and all
supporting documentation in the salary and wage pack as ‘Paid’ to avoid the documents from being
resubmitted for payment in the future.
Jason Naidoo performs a reconciliation between the change in the balance of the wage and salary bank
accounts before the transfer and after the transfer, and the totals of the wage and salary journals for the
period. e reconciliation is reviewed and approved by Lee-Ann Losper.
Susan Mzwakali prints a payslip from the system for each employee. is contains the total payments for
the month or week, deductions made and year-to-date payments. One copy is sent to the employee and
another copy is led in the payroll division.
If the above review indicates no discrepancies, James accesses the EFT application by entering his unique
username and password. James rst instructs the computer to transfer automatically the information on the
electronic version of the payment schedule (as prepared by Ben Franco above) to the EFT application. e
EFT application has been set up in such a way that it can interface with the payments schedule on the
accounting system. As an added control after the transfer of the payment data to the EFT facility, the
computer automatically reconciles the data transferred onto the EFT application with the data on the
payment schedule to ensure all payment data has been transferred to the EFT facility (this is done prior to
the nal approval for the payments to be made).
If James and Lee-Ann are both satis ed with the payment information, they each individually approve
the payments on the EFT application by selecting ‘Process payment’. (Any discrepancies would have been
referred back to Ben, Mabel or Tandi for correction prior to payment.)
A ‘con rmation of payment’ report is printed from the EFT application indicating the nal amounts paid
for each deduction. Should the report indicate that a payment could not be processed (e.g. bank account has
been closed or incorrect bank account details have been recorded), the payment documentation is handed
to Ben Franco for resolution and resubmission.
After performing a successful payment run, the payment signatories stamp the payment schedule and all
supporting documentation in the salary and wage pack as ‘Paid’ to avoid the documents from being
resubmitted for payment in the future.
SITE, PAYE and UIF payments to SARS are made into the SARS bank account by making use of the web-
based e- ling system of SARS.
Assessment questions
1. List the general ledger accounts that are affected by the human resources cycle. (LO 2)
3. Indicate which of the other cycles interface with the human resources cycle. (LO 1)
4. Which one of the following documents and reports relates to the human resources cycle? (LO 5)
a) Purchase order
b) Wage and salary journal
c) Production report
d) Inventory listing
5. What are the responsibilities of the payroll department in the processing of payroll transactions? (LO 3)
9. Describe the internal controls that should be present during the time keeping for wages. (LO 11)
10. Describe the advantages if a company were to switch from a clock card system to a biometric reader
system. (LO 7)
11. Below are two columns. Column A contains information regarding the risks that could exist within a
human resources cycle. Column B contains a list of control objectives. Link the two columns with each
other by writing the letter in column B next to the appropriate number in column A. (LO 7 & 8)
COLUMN A COLUMN B
12. Describe two controls that can be implemented in a business to ensure that no ctitious employees are
created in a computerised accounting system. (LO 11)
13. e following relates to GFT (Proprietary) Limited, a manufacturer of motor vehicle parts. Identify the
weaknesses in internal control, indicate what the risks would be for the business, and describe
recommendations to address each weakness: (LO 4, 10 & 11)
Blank clock cards are kept in a box close to the entrance of the factory. When a wage-earning employee
reports for work on a Monday morning, he or she takes a blank clock card from the box, enters his or her
details in pencil on the clock card and from Monday to Friday records his or her arrival and departure
times thereon. On the Friday afternoon the clock card is placed back into the box near the entrance to
the factory.
14. Describe which controls should be implemented over unclaimed wages. (LO 11)
16. e following weaknesses were identi ed in the salaries system of HTM Limited. Indicate for each
weakness what the risk would be to the business. Also suggest an improvement that will address the
weakness. (LO 10 & 11)
a) Only staff from the human resources division are involved in interviews to ll vacancies.
b) e line manager authorises appointment forms after the human resources official has completed
all relevant particulars.
c) Nobody checks the salary clerk’s calculations of the salaries in the salary journal.
d) Employees receive their salaries in the form of cheques by mail.
e) e accountant signs the request for payment and reconciles the salary bank account.
18. Deductions not yet paid over at year-end are classi ed as a current liability, as the company has to pay it
in the forthcoming year. (LO 2)
19. Direct wages are included as part of the cost of inventory of a product. (LO 2)
20. e following internal control was implemented in HJK Limited when the wage packets were made up:
‘e wage packets are compared to the wage journal to ensure that all employees receive a wage packet.’
e control objective that will be achieved by the above-mentioned control is completeness of wages
and the management assertion affected is completeness of wages. (LO 8 & 9)
21. Which of the following actions trigger a transaction in the human resources cycle? (LO 1)
a) e payment of the wage
b) e clocking in of the wage-earning employee
c) e appointment of the wage-earning employee
d) e dismissal of the wage-earning employee
22. Describe the three types of authenticating information that can be used when an automatic access
control system is used. (LO 7)
1 Dieter von Fintel & Marlies Piek. Stellenbosch University. [Online]. Available: e Conversation https://theconversation.com/amp/south-
africas-national-minimum-wage-could-hurt-small- rms-and-rural-workers-76474 [Accessed April 2018].
2 Source: Cape Argus, IOL. [Online]. Available: https://www.iol.co.za/capeargus/news/national-bus-strike-seems-to-be-inevitable-14347108
[Accessed April 2018].
3 Buthelezi, S. [Online]. Available: https://www.iol.co.za/sunday-tribune/news/four-officials-implicated-as-ghost-employees-loot-coffers-
14054739 [Accessed May 2018]. Reprinted with permission of e Sunday Tribune/Independent Media.
4 Deloitte IAS Plus. [Online]. Available: http://www.iasplus.com/en/standards/standard17 [Accessed 28 March 2013].
5 Deloitte IAS Plus. [Online]. Available: http://www.iasplus.com/en/publications/global/guides/pub1349 [Accessed 28 March 2013].
6 Erasmus, J. [Online]. Available: https://www.accountancysa.org.za/analysis-king-iv-and-remuneration-disclosure/
7 [Online]. Available: http://www.mywage.co.za/main/salary/minimum-wages [Accessed 18 September 2012].
8 [Online]. Available: http://www.ens.co.za/newsletter/briefs/Labour%20and%20Employee%20Bene ts_%20South%20Africa.pdf
9 [Online]. Available: http://www.ccma.org.za
10 Wray, Q. 2008. Business Report, 25 April. [Online]. Available: http://genderlinks.org.za/country-events/gender-and-media-diversity-
centre/deputy-president-warns-on-widening-wealth-gap-business-report-2008-04-25/ [Accessed May 2017].
11 Moneyweb. [Online]. Available: https://www.moneyweb.co.za/news/south-africa/executive-pay-under-the-microscope [Accessed April
2018].
12 Mooney, A, Financial Times. [Online]. Available: https://www.ft.com/content/30abb36c-3805-11e8-8b98-2f31af407cc8 [Accessed April 2018].
13 Financial Times. [Online]. Available://www.ft.com/content/b3cee000-15d1-11e6-9d98-00386a18e39d [Accessed April 2018].
14 Financial Times. [Online]. Available: https://www.ft.com/content/6df9902a-f8fc-11e6-9516-2d969e0d3b65 [Accessed April 2018].
15 Njobeni, S. Business report. [Online]. Available: https://www.iol.co.za/business-report/economy/king-iv-tightens-corporate-remuneration-
2085413 [Accessed April 2018].
16 e Conversation. [Online]. Available: https://theconversation.com/can-the-grim-reality-of-published-pay-ratios-really-curb-executive-pay-
83279 [Accessed April 2018].
17 [Online]. Available: http://www.legalnexus.co.za/news/news3.html
18 Security information watch. [Online]. Available: http://www.securityinfowatch.com /article/10498285/understanding-card-connected-
access-control-systems [Accessed 2 April 2013].
19 Source: [Online]. Available: http://www.sage.com/za/newsroom/sage-hr-and-payroll/2016/05/01/payroll-fraud-how-to- nd-it-and- ght-it
[Accessed August 2018]. Copy courtesy of Sage South Africa (Pty) Ltd.
Investment and CHAPTER 10
nancing cycle
Dana Nathan1
CHAPTER CONTENTS
Learning outcomes
Reference list
10.1 What are the nature, purpose and accounting implications of
the cycle?
10.2 What functional areas occur in the cycle?
10.3 What information system is used in the cycle?
10.4 What could go wrong (risks) in the cycle?
10.5What computer technologies are used in the cycle?
10.6What are the control objectives in the cycle?
10.7What are the controls in the cycle (manual and computerised)?
10.8Cycle illustration: e investment and nancing cycle at
Ntsimbi Piping
Assessment questions
LEARNING OUTCOMES
1. Explain the nature and purpose of the cycle.
2. Identify and describe the major general ledger accounts affected
by the cycle.
3. Identify and describe the documents and records, both manual
and computerised, utilised in the cycle
and describe the purpose of each.
4. Identify and describe the risks of misstatement affecting account
balances, classes of transactions and events in the nancial
statements.
5. Describe the computer technologies used in the cycle.
6. Formulate control objectives for the cycle.
7. Describe how internal controls may assist in achieving the control
objectives in the cycle and how these control objectives relate to
management’s assertions in the nancial statements.
8. Critically analyse internal control systems in order to identify and
explain weaknesses in the control system and recommend
improvements by describing the required internal controls.
9. Design a system of internal controls, both manual and
computerised, that will achieve the cycle’s
control objectives.
REFERENCE LIST
IN THE NEWS
Eskom signs R20-billion credit facility with banks2
28 February 2018
Eskom has today signed a R20-billion short-term credit facility
with a consortium of local and international banks.
The government guaranteed facility will form part of the
nancing of Eskom’s current capital expenditure programme‚ the
utility said in a statement.
The terms of the facility are comparable to Eskom’s existing
facility agreements and pricing is aligned to market benchmarks
of similar structures‚ it added.
Eskom’s Interim Group Chief Executive Phakamani Hadebe
said: ‘We view the successful execution of this facility as a
demonstration of the nancial markets’ con dence in Eskom’s
turn-around strategy. We are cognisant of the challenges that are
still ahead for the business and we are committed to ensuring
that we expediently transition Eskom’s operational and nancial
pro le to adequate standards. Eskom remains a critical enabler
for South Africa’s economic growth and it is critical that we attain
maximum operational ef ciency for the business to avoid
negatively impacting the macro-environment’.
Acting Chief Financial Of cer Calib Cassim said: ‘Concluding
this facility with the suite of banks reiterates the renewed
willingness by nancial markets to engage with Eskom. The
funding provides Eskom with suf cient liquidity to allow the
company time to continue resolving its governance related
issues and enables Eskom to recommence with its normal
funding programme required to execute the FY2018/19 funding
plan’.
e news article typi es the investment and nancing cycle within a
company, displaying what is often a very direct link between obtaining
further nancing and an entity experiencing issues around short-term
liquidity and going concern (addressed in Chapter 15).
Eskom required funding for its ‘turnaround strategy’ and ‘sufficient
liquidity to allow the company time to continue resolving its
governance related issues.’ Ultimately the funding of 20 billion rand
($1.7 billion) obtained through a short-term credit facility with a group
of banks should have been used to assist in stabilising the company in
the short term. It should also have been utilised in funding the further
development of the company’s assets (i.e. its ‘capital expenditure
programme’) which should ultimately generate additional returns for
the company.
is additional nancing obtained ‘aligned to market benchmarks of
similar structures’ will result in signi cant nance charges and
repayments to be made, which will ultimately affect the cash ow of the
company.
CRITICAL THINKING
How does the investment and nancing cycle link to other
cycles?
Since investment transactions involve acquisitions and
payments, the cycle interfaces with the purchases and payments
cycle (Chapter 7) where the purchase of routine goods and
services transactions take place. Similarly, when cash is
disbursed for interest and dividend payments, redemption of
shares and repayments of borrowings, these interface with the
purchases and payments cycle, where payments are addressed.
Since the receipt and accrual of interest income and
dividends received on investments involve revenue and cash
receipts transactions, the cycle also interfaces with the revenue
and receipts cycle (Chapter 6) where receipt and accrual
transactions are addressed. Aspects of this cycle will also apply
to the receipt of a loan or equity funding of the entity.
REFLECTION
Think about how these aspects differ from the entity’s holding of
inventory (addressed in Chapter 8).
It is clear from the annual nancial statements that other than the
activities mentioned above, no additional investment of funds took
place, nor were there any other forms of nance (other than the day-to-
day bank overdraft) utilised during the nancial year.
You will have noticed how the Statement of Cash Flows presents a
tidy summary of investment and nancing activities during the
nancial year.
1. Issue of shares
Purpose: To obtain cash in ows by allowing potential (or current)
shareholders to purchase an interest in the company.
CRITICAL THINKING
Ntsimbi Piping is 100% owned by Ntsimbi Piping Investments.
Why might Ntsimbi Piping want to issue additional shares?
1. The company needs nance to fund an expansion to its plant
and machinery, the holding company does not have the funds
to lend to the company and it is proving dif cult (or costly) to
secure further long-term borrowings. An external investor
could provide these funds.
2. The company wants to diversify its shareholder base. Perhaps
it wants to attract BBBEE investors to assist in gaining
tenders from the government. Creating a 25% black African
ownership structure might help secure work that the company
is currently unable to secure given the current composition of
its shareholding.
CRITICAL THINKING
How would the process of issuing shares differ if Ntsimbi Piping
were a public company listed on the JSE and not a private
company?
Offerings to the general public (both initial and secondary) have
to comply with Chapter 4 of the Companies Act (‘Public offerings
of company securities’).
In addition to the Companies Act requirements that have to
be met, JSE Listings Requirements also have to be complied
with.
All buying and selling of shares in listed companies is
directed through stockbrokers. An individual will not contract
directly with the company when buying shares in the company.
Share certi cates are not issued. Shares are regarded as
being uncerti cated and details thereof are maintained typically
by a Central Securities Depository (CSD). In South Africa, Strate
is the licensed CSD. All trading in these shares is then recorded
by the CSD.
2. Payment of dividends
Purpose: To provide returns to shareholders for their investment in the
company by declaring and paying dividends to the shareholders for the
period for which shares remain in issue.
Main activities:
• A dividend is authorised by a resolution of the board of directors
during a meeting. is distribution has to comply with section 46 of
the Companies Act, which requires that the board, by resolution,
acknowledges that it has applied the required solvency and liquidity
test, and has reasonably concluded that the company would satisfy
this test immediately after completing the proposed distribution. e
resolution must be minuted.
• e settlement of the dividend takes place in accordance with the
board’s decision (amount of the distribution and the timing of the
payment thereof ). A similar process to that described in Chapter 7
for payments takes place.
• e dividend is then recorded in the accounting records. Assuming
the dividends are paid in cash, the journal entry would be:
Dr Dividends paid
Cr Bank
Note: Instead of a journal entry recorded in the general journal, this
payment will probably be recorded in the entity’s cash book, but the
ledger accounts affected are the same.
Persons involved in this area: Board of directors, company secretary,
accountant.
CRITICAL THINKING
Can you determine why Ntsimbi Piping took out the additional
interest-bearing borrowings during the year? What did they use
this nance for?
A review of the Statement of Cash Flows shows that the loan
was used partly to nance the additions to plant and machinery
(the only major investment activity during the year).
The balance of the additions appears to have been funded
primarily through cash ows from operating activities. It therefore
appears that Ntsimbi Piping was unable to nance the additions
exclusively through operating activities and that they therefore
had to extend their borrowings to acquire the new plant and
machinery.
Main activities:
e decision to raise nance is most likely to be linked to a decision
• to acquire new plant and machinery. Having decided that the entity
has to invest in a new plant, the directors have to decide how best to
nance the acquisition.
In Ntsimbi Piping’s case, the board of directors would have asked
Lee-Ann Losper (the nancial director) to do the necessary research
and feasibility studies around the nancing decision. She would
then have presented her ndings to the board for them to consider
and make the nal decision. e board resolution approving the
nancing arrangement (e.g. bank loan) would have to be made in
terms of the company’s Memorandum of Incorporation and would
have to be formally minuted.
• Having obtained approval for the bank loan from the board,
agreement will have to be reached with the bank to nalise the
repayment terms, interest rates, and any other conditions of the loan
(the new plant as security for the loan, for example). is will be
documented in a formal loan agreement between the entity and the
bank.
• On signing the loan agreement, the funds are advanced by the bank
either directly to the supplier of the plant or to the entity, which then
has to pay the supplier. e general ledger accounts are then
updated to record the transaction as follows:
• If the monies are rst paid to the entity and then to the supplier:
Dr Bank
Cr Interest-bearing borrowings
(Receipt of loan monies from bank)
CRITICAL THINKING
How often do these transactions occur?
The frequency of nance charge payments and loan repayments
will vary depending on the nature of the loan. This will be in
terms of the loan agreement entered into with the lender/bank.
10.2.2 Investments
e following are examples of key areas that exist in the cycle and the
overall processes that are in place to ensure that related transactions are
executed appropriately and correctly recorded in the accounting
records.
CRITICAL THINKING
Under what circumstances is an item of property, plant and
equipment likely to require an impairment adjustment other
than that already re ected through normal use over time?
If the item becomes redundant. If Ntsimbi Piping found that a
certain type of PVC product was no longer saleable, and
accordingly a decision was taken to terminate production
thereof, then the plant that was solely used to manufacture that
product would potentially require an impairment adjustment to
its carrying value.
1. Capital budget
A capital budget caters for items of a capital nature, such as property,
plant and equipment, to be acquired during the year. Capital budgets
should be approved by the board of directors prior to the
commencement of the nancial year to which the budget relates and
actual acquisitions should be monitored against the budget.
2. Memorandum of Incorporation
e Memorandum of Incorporation of a company may contain
stipulations in respect of investment activities that have to be adhered
to when investment transactions are considered for approval by the
board of directors.
4. Asset requisition
An asset requisition is completed by an employee (usually
management), setting out the requirements of an asset and requesting
that it be purchased.
CRITICAL THINKING
What key information may be included in a xed asset
register?
A detailed breakdown of each asset on hand including:
• Serial number of asset
• A description of the asset
• The location of the asset
• The date of acquisition
• The original cost price
• Useful life of the asset
• Accumulated depreciation to date
• Any impairment details
• Any revaluation details
• Any disposals during the period
• Carrying amount.
9. Schedules of calculations
Various non-standard schedules may be created and utilised by
management in the calculation of impairments, revaluations and pro ts
and losses on sale of assets, to be recorded in the nancial statements.
2. Memorandum of Incorporation
e Memorandum of Incorporation details the authorised shares of a
company and any restrictions on borrowings or nancing transactions.
CRITICAL THINKING
Overstating assets falsely re ects a nancially stronger entity as
a result of the inclusion of ctitious assets or expenses that do
not qualify as assets in terms of the applicable nancial
reporting standards.
Understating liabilities, through exclusion of nancial
obligations and related expenses, re ects a nancially stronger
company, as it leads to more favourable liquidity or solvency
ratios being reported in the Statement of Financial Position.
CRITICAL THINKING
How can the risk of misappropriation be reduced?
• By segregation of duties – Personnel requesting the
acquisition of an asset should not be involved in authorising
the purchase (i.e. management approval should be required),
or in the payment for the purchase. (The concept of
segregation of duties was addressed in Chapter 4.)
• By physical access controls – which will reduce the
opportunity for employees and others to steal the entity’s
assets.
Besides keeping these assets under lock and key, what other
forms of security controls could management implement to
keep these items safe?
CRITICAL THINKING
How does maintaining the xed asset register entirely in
electronic format affect the recording
of depreciation?
Depreciation is then calculated and processed electronically
based on the relevant criteria per the electronic register, which
includes the depreciation method, and each asset’s useful life
and residual value. The resulting carrying values of the assets
will also be computed automatically, thus minimising
the risk of calculation/clerical errors.
CRITICAL THINKING
How is the barcoding of plant and equipment used by an
entity?
Each item of plant and equipment (e.g. every machine and
computer) is marked with a unique barcode which is then
recorded in the entity’s electronic xed asset register. When the
entity performs xed asset veri cations/counts on a regular
basis, the barcode system can then be used by scanning each
item that is physically on hand, thereby facilitating the
identi cation of items recorded in the xed asset register that
are not on hand for further investigation (they may have been
misappropriated).
10.6.1.1 Investments
In respect of the movements in the non-current, intangible and
nancial instrument investment asset accounts:
• To ensure that investment transactions are valid, all assets and other
investment transactions should be genuine. In other words,
acquisitions, disposals and other fair value adjustments were
authorised in accordance with management’s policy. Moreover, all
the investment transactions that were recorded should have
occurred during the period (thus not be ctitious) and be supported
by sufficient documentation.
• To ensure that investment transactions are accurate, a transaction
should be recorded at the appropriate amount. An appropriate
amount implies that all transactions have been appropriately
measured in accordance with the relevant IFRS requirements (e.g.
depreciation, impairments and revaluations). e transaction
should also be correctly classi ed in terms of the entity’s chart of
accounts and correctly summarised and posted to the accounting
records.
• To ensure that investment transactions are complete, all investment
transactions that took place in a given period should have been
recorded in the accounting records in a timely manner. In other
words,
no authorised transaction that occurred should be omitted from the
entity’s accounting records.
CRITICAL THINKING
What do movements refer to?
Additions, disposals and revaluations, as well as related
investment revenues and expenditures (re ected in the
Statement of Comprehensive Income), such as investment
income, depreciation, amortisation, impairments, pro ts and
losses on disposal.
10.6.1.2 Financing
In respect of movements in the shareholders’ equity, reserve, loan and
debenture accounts:
• To ensure that nancing transactions are valid, all equity and
liability transactions should be genuine. In other words share issues,
dividends and loans received were authorised in accordance with
management’s policy and, if applicable, the requirements of the
Companies Act. Moreover, all nancing transactions that were
recorded should have occurred during the period (thus not be
ctitious) and be supported by sufficient documentation.
• To ensure that nancing transactions are accurate, a transaction
should be recorded at the appropriate amount. An appropriate
amount implies that all transactions (recorded issues and
repayments of equity and borrowings, related dividends and nance
charges) have been measured correctly in accordance with IFRS.
Recorded issues and repayments of equity and borrowings, related
dividends and nance charges should also have been correctly
classi ed in terms of the entity’s chart of accounts and correctly
summarised and posted to the accounting records.
• To ensure that nancing transactions are complete, all transactions
that took place in a given period should have been recorded in the
accounting records in a timely manner. In other words, no
authorised transaction that occurred should be omitted. Equity and
borrowing issues, repayments of capital amounts, and dividends
declared and nance charges during the reporting period should all
have been recorded.
CRITICAL THINKING
What do movements refer to?
Share issues and repurchases, loan advances and repayments,
as well as related expenditure such as nance costs (including
debenture costs) and dividends.
Table 10.1: Consequences if the control objectives in the cycle are not
achieved
MANAGEMENT ASSERTIONS
Note: is is not a complete list of all the risks, functional areas and
required controls, but rather examples of some overall key risks and
controls that management may implement in order to address the risks
and control objectives.
Financing activities
Financing activities
in line with the requirements of issue or repurchase
the Companies Act, the decisions. This should be
Companies Regulations or the by way of resolutions of the
company’s Memorandum of board of directors.
Incorporation). • Before the resolution is
passed, speci c
consideration must be
given to the requirements
of the:
• Applicable statutory
requirements, such the
Companies Act, with
regard to share issues
or repurchases; and
• Company’s policies and
the Memorandum of
Incorporation, such as
the number
of authorised shares in
issue.
• The company’s company
secretary or legal
compliance department
should be responsible for
con rming that the above
requirements are satis ed.
• All statutory and
governance requirements
that have to be met for a
KEY RISKS EXAMPLES OF CONTROLS TO
BE IMPLEMENTED
Financing activities
decision must be
adequately minuted.
Financing activities
The necessary controls
over payments, as
addressed in Chapter 7
(the purchases and
payments cycle), should be
• in place with regard to the
dividend payments.
Financing activities
• The company’s policies
and the Memorandum of
Incorporation; and
• The projected cash
requirements of the
entity, as evident from
entity budgets and
necessary cash ow
forecasts. (Effective
controls should be in
place for the preparation
of these budgets and
forecasts.)
• Legal advice should be
obtained to consider the
implications for the entity
before concluding any
material agreement.
• Transactions involving long-
term loan nancing should
be properly initiated by
authorised individuals in
the entity.
• Properly signed agreements
should be entered into and
should include all relevant
terms and conditions.
Financing activities
Invalid, incomplete and/or based on properly signed
inaccurate nance charges loan agreements that
and/or repayment transactions include all relevant terms
may be recorded and paid. and conditions.
• Quali ed personnel should
perform these calculations.
• Detailed calculation
schedules/amortisation
tables (e.g. for debentures)
must be prepared and
updated on a regular basis.
• These nance charge
calculations should be
checked by a second (more
senior) employee and the
calculation schedule
initialled as evidence of the
check.
• The necessary controls
over payments, as
addressed in Chapter 7
(the purchases and
payments cycle), should be
in place with regard to the
nance charge payments
and loan repayments made.
• If applicable, an internal
audit department should
perform regular reviews of
adherence to the above
KEY RISKS EXAMPLES OF CONTROLS TO
BE IMPLEMENTED
Financing activities
controls and report to
management in this regard.
Investment activities
Financing activities
could be by way of
resolutions of a xed
asset committee, a
steering committee, an
investment committee or
the board of directors.
These resolutions
should be minuted.
• Before these resolutions
are passed, due
consideration should be
given to the entity’s
policies (if applicable)
and the entity’s budgets
and cash ow forecasts
(e.g. is adequate funding
available to settle the
purchase
consideration?).
(Note: Effective controls
should be in place for the
preparation of these
budgets and forecasts.)
• Adequate controls over
the purchasing of items
should be in place, such
as obtaining multiple
quotes from preapproved
suppliers before entering
into a purchase
transaction.
KEY RISKS EXAMPLES OF CONTROLS TO
BE IMPLEMENTED
Financing activities
All material tangible assets
should be physically
secured by security guards,
cameras and locks to avoid
theft of assets and loss to
•
the entity.
• A detailed xed asset
register should be kept (as
per section 10.5). On a
regular basis (possibly
monthly or semi-annually)
and at least once a year, a
physical count should be
performed and each
material asset in the
register should be
inspected and its condition
assessed for any indication
of impairment.
• Any items in the xed asset
register that were not
physically veri ed should be
investigated by
management and the
reasons thereof
ascertained.
• Plant, machinery and
vehicles should be serviced
on a regular basis in order
to maintain their
functionality.
KEY RISKS EXAMPLES OF CONTROLS TO
BE IMPLEMENTED
Financing activities
Financing activities
Detailed
depreciation/amortisation
calculation schedules must
be prepared and kept up to
date.
• Material decisions with
regard to these
impairments or
revaluations should be
made by the relevant high-
level management
committee responsible,
based on all available
information.
• Where necessary, experts
should be contracted to
assist with the
determination of the
appropriate asset values
(i.e. for the revaluation and
impairment of assets).
• If applicable, an internal
audit department should
perform regular reviews in
the cycle, such as physical
asset
inspections/veri cations to
the xed asset register, and
report to management in
this regard.
10.8 Cycle illustration: The investment and
nancing cycle
at Ntsimbi Piping
You would have noticed that each of the preceding chapters that deals
with business cycles (Chapters 6–9) includes a section that illustrates
how the cycle is applied in Ntsimbi Piping. Due to the widely varied
nature of the investment and nancing cycle among different entities,
this chapter does not include such a section. Instead, the principles of
the cycle have been demonstrated throughout the preceding sections in
this chapter by using Ntsimbi Piping as an example.
Assessment questions
For questions 1 to 3, question 5 and question 9, select the most
appropriate answer(s) from the options provided:
1. Which of the following transactions would not be classi ed as an
investing activity? (LO 1)
a) e disposal of a motor vehicle
b) e amortisation of a trademark
c) e receipt of interest revenue
d) e payment of nance charges
e) e receipt of dividend revenue
8. State the control objectives that should be met when accounting for
the payment of nance charges on interest-bearing borrowings.
(LO 6)
e) Depreciation is accurate
10. Describe a control activity that an entity could implement to
prevent the inaccurate recording of depreciation. (LO 8 & 9)
Vincent Motholo
CHAPTER CONTENTS
Learning outcomes
Reference list
11.1 Introduction
11.2 What terminology is used by the auditor when performing an
audit?
11.3 What are the objectives of an audit?
11.4 What are the International Standards on Auditing (ISAs)?
11.5 How is the audit and audit evidence documented?
11.6 What are the stages in the audit process?
11.7 How do computerised environments impact on the audit
process?
11.8 Is there a link between the stages of the audit process and the
ISAs?
Assessment questions
LEARNING OUTCOMES
REFERENCE LIST
International Federation of Accountants (IFAC). (Dec 2016). Handbook
of International Quality Control, Auditing, Review, Other Assurance, and
Related Services Pronouncements. Glossary of Terms. New York: IFAC.
International Auditing and Assurance Standards Board (IAASB) (Dec
2009) International Standard on Auditing (ISA) 200 Overall Objective of
the Independent Auditor and the Conduct of an Audit in Accordance
with International Standards on Auditing.
International Auditing and Assurance Standards Board (IAASB) (Dec
2009) International Standard on Auditing (ISA) 230 Audit
Documentation.
11.1 Introduction
is chapter brie y revises the objectives of an audit that were
introduced in Chapter 1 and then provides an overview of the audit
process, in other words the steps that the external auditor follows from
commencement until the completion of the audit engagement. e next
four chapters address each phase of the audit process individually and
in much greater detail.
Before reading further, study the meanings of the above terms in the
IAASB Glossary of Terms.
11.5.1.1 Sufficiency
is aspect focuses on the amount of audit evidence that has to be
obtained about a particular assertion.
Using the example contained in the working paper above on the
accuracy of depreciation, if the auditor only recalculated the
depreciation amount without con rming the underlying elements used
in the depreciation calculation (i.e. cost of machinery and depreciation
rate), this will not be considered sufficient audit evidence. In order for
the auditor to obtain sufficient audit evidence about the accuracy of
depreciation, the auditor will have to obtain evidence about all the
components used in the depreciation calculation as demonstrated in
the example of a working paper shown above.
11.5.1.2 Appropriateness
is aspect focuses on the relevance and reliability of the audit evidence
gathered.
Say, for instance, the auditor wants to obtain audit evidence about
the existence of debtors. e auditor will rst obtain permission from
the audit client’s management to send a request for con rmation to the
debtors (in auditing terminology, this is called circularising the
debtors). Once permission has been obtained, the auditor will send
con rmation letters to debtors requesting that they con rm the balance
owing.
e con rmations returned by the debtors will provide audit
evidence that the debtors exist. However, it will provide no evidence
that the debtors balance is complete. e con rmations are therefore
considered to be relevant audit evidence for the existence assertion as
it relates to debtors, but not for the completeness assertion.
e con rmations returned by the debtors will provide evidence
from parties external to the entity (the debtors themselves) that the
debtors exist. e con rmations will be considered more reliable audit
evidence than the internally prepared invoices and statements issued to
debtors by the entity, or a statement by management regarding the
existence of debtors (called a written representation and discussed in
Chapter 14), which could be manipulated or even fraudulently issued
by management.
Once sufficient appropriate audit evidence has been obtained and
documented to reduce audit risk to an acceptably low level, the auditor
will be able to conclude the audit and issue the audit opinion.
CRITICAL THINKING
Would an auditor be able to design ef cient audit procedures
necessary to audit an entity’s inventory balance at the end of
the reporting period if he or she did not understand the nature
of the inventory – where it is stored, how it is stored, who is
responsible for it, what control activities are in place around it
and the potential for misstatement.
The auditor would not!
Step 3: Having obtained the required understanding of the entity,
assess the degree to which the nancial statements may
contain material misstatements
ere will always be a risk that the auditor expresses an opinion that is
inappropriate. One possibility is that the auditor concludes that the
nancial statements are not fairly presented when in fact they are. is
risk is not a major concern as discussions between the client and the
auditor prior to nalising the auditor’s report will normally resolve the
wrong opinion being expressed.
e other possibility is that the auditor concludes that the nancial
statements are fairly presented when in fact they are not (i.e. when they
contain material misstatements). is is known as audit risk, and is a
major concern to the auditor. erefore, the auditor has to focus on the
management of this risk by reducing it to acceptable levels.
To reduce audit risk to acceptable levels, the auditor rst has to
evaluate the potential for there to be material misstatements in the
nancial statements. e bigger the potential for material
misstatements is, the more the auditor needs to do to reduce to
acceptably low levels the risk that he or she fails to detect these
misstatements. However, should the auditor evaluate the potential for
misstatement to be low, then this will result in the auditor needing to do
relatively less audit work to be satis ed that there are no material
misstatements in the nancial statements.
In determining the risk (potential) that the nancial statements
contain material misstatements, the auditor has to draw on his or her
understanding of the entity (including its internal controls) and the
environment in which it operates. is illustrates the vital importance of
the auditor understanding the entity, and the vital importance of the
auditor assessing the degree to which its nancial statements contain
material misstatements. It has a fundamental impact on the manner in
which the audit is approached.
In summary:
• Audit risk is the risk that the auditor expresses an inappropriate
audit opinion when the nancial statements are materially
misstated. Audit risk is the function of (1) the risks of material
misstatement, and (2) detection risk.
• Risks of material misstatement are the risks that the nancial
statements contain material misstatements prior to the audit. is
consists of two components, described as follows at the assertion
level:
• Inherent risk is the susceptibility of an assertion about a class of
transaction, account balance or disclosure to a misstatement that
could be material, either individually or when aggregated with
other misstatements, before consideration of any related controls.
• Control risk is the risk that a misstatement that could occur in an
assertion about a class of transaction, account balance or
disclosure and that could be material, either individually or when
aggregated with other misstatements, will not be prevented, or
detected and corrected, on a timely basis by the entity’s internal
control.
• e auditor is required to identify and assess the risks of material
misstatement in the nancial statements during the planning phase
of an audit, using the understanding of the entity and its
environment, including the entity’s internal control, that the auditor
has gained.
• Detection risk is the risk that speci c audit procedures1 performed
by the auditor will not detect a material misstatement.
• Having assessed the risks of material misstatement (inherent and
control risks), the auditor is required to conduct (substantive) audit
procedures to reduce detection risk to a level that results in an
acceptably low level of audit risk.
ese arrangements form part of the planning phase of the audit and
would ordinarily include considerations such as:
• Determining staffing requirements;
• Determining time frames within which, and by when, work needs to
be completed and reviewed;
• Setting deadlines for reporting deliverables; and
• Setting time budgets for the work involved and negotiating the
resultant fees with the entity’s management.
11.6.3 Obtaining audit evidence
Once the audit has been planned appropriately, the auditor has to
obtain sufficient appropriate audit evidence by performing audit
procedures in order to maintain audit risk at an acceptably low level.
Obtaining audit evidence is the third stage of the audit process.
e audit procedures performed by the auditor would have been
initially formulated as part of the planning stage when determining the
appropriate responses to the assessed risks to reduce audit risk to a low
level. ese involve tests of controls and substantive procedures.
However, as audit evidence is gathered, a revision of the risk assessment
may become necessary, and accordingly the audit procedures may have
to be performed in response thereto. (Refer to Chapters 13 and 14 for a
detailed discussion.)
1. Pre-engagement activities
2. Planning activities
STAGES AND STEPS OF CHAPTER
ISA REFERENCES
THE AUDIT PROCESS REFERENCE
4.3 Prepare and issue ISA 700, ISA 701, ISA Chapter 15
the auditor’s report 705, ISA 706, ISA 710,
ISA 720, SAAPS 2,
SAAPS 3
Assessment questions
For questions 1 to 5, select the correct answer:
1. Risk of material misstatement comprises which of the following
components of risk? (Only one answer
is possible.) (LO 1 & 8)
a) Inherent, control and detection risk
b) Inherent, control and signi cant risk
c) Inherent, detection and signi cant risk
d) Inherent and control risk
12. State, and brie y explain, each of the stages of the audit process.
(LO 11)
13. What does ‘sufficient appropriate audit evidence’ mean? (LO 6)
15. De ne inherent risk, control risk and detection risk and describe
the relationship between them in
the context of an audit of nancial statements. (LO 9)
16. State, with reasons, which assertion(s) will be applicable when the
auditor sends out an external con rmation to debtors to con rm
their balances at year-end. (LO 12)
1 ese are called ‘substantive procedures’ and are discussed in detail in Chapters 13 and 14.
Pre-engagement and CHAPTER 12
planning activities
Graeme O’Reilly
CHAPTER CONTENTS
Learning outcomes
Reference list
12.1 Introduction
12.2 How does the auditor perform pre-engagement activities?
12.3 How are the terms of the engagement documented?
12.4 How does the auditor obtain an understanding of the entity?
12.5 How does the auditor assess the risk of material misstatement?
12.6 How can the auditor respond to identified risks of material misstatement?
12.7 What is materiality and how is it calculated?
12.8 Attending to the logistics of the audit
Assessment questions
LEARNING OUTCOMES
1. Explain the terms ‘overall audit strategy’, ‘audit approach’ and ‘audit plan’ and describe
the differences between them.
2. Describe the quality control requirements pertaining to the engagement acceptance
process.
3. Describe and apply the matters that an auditor considers in deciding on whether or not to
accept or retain an audit engagement.
4. Describe the contents of a basic engagement letter.
5. Describe the importance of obtaining a thorough understanding of the entity, including
an understanding of its internal control, when planning an audit.
6. Describe the information that has to be obtained when understanding an entity, and how
to obtain it.
7. Explain the primary difference between audit risk and business risk.
8. Explain and apply the audit risk model (inherent, control and detection risk).
9. Identify and assess risk of material misstatement at both financial statement level and
account balance/class of transactions level.
10. Explain what a significant risk is and describe how the auditor should respond to such a
risk.
11. Explain the need to consider going concern as part of the audit planning process, and
how to identify risks of material misstatement relating to the going concern basis of
accounting being inappropriately applied.
12. Explain the need to consider the risk of material misstatement arising from fraud, and
how to identify such risks.
13. Explain when risks of material misstatement are such that substantive procedures alone
would not provide sufficient appropriate audit evidence to address them, and how the
auditor should respond to such risks.
14. Explain how to respond to risk of material misstatement at financial statement level.
15. Explain how to respond to risk of material misstatement at account balance/class of
transactions level by assertion.
16. Explain and apply the concepts of ‘nature, timing and extent’ of planned responses to
risk of material misstatement.
17. Explain what the difference is between a combined and a substantive audit approach.
18. Explain what materiality, performance materiality, and clearly trivial levels are, and how
these are used in an audit.
19. Calculate, with reasons, materiality and performance materiality.
20. Explain the administrative/logistical aspects associated with conducting an audit.
REFERENCE LIST
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Quality Control 1 Quality Control for Firms that Perform Audits and Reviews of
Financial Statements, and Other Assurance and Related Services Engagements.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 210 Agreeing the Terms of Audit Engagements.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 220 Quality Control for an Audit of Financial Statements.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 240 The Auditor’s Responsibilities Relating to Fraud in an Audit
of Financial Statements (Specifically Paragraphs 1 to 30 and Related Application and Other
Explanatory Material).
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 300 Planning an Audit of Financial Statements.
International Auditing and Assurance Standards Board (IAASB) (Dec 2013) International
Standard on Auditing (ISA) 315 (Revised) Identifying and Assessing the Risks of Material
Misstatement through Understanding the Entity and its Environment.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 320 Materiality in Planning and Performing an Audit.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 330 The Auditor’s Responses to Assessed Risks.
International Auditing and Assurance Standards Board (IAASB) (Dec 2016) International
Standard on Auditing (ISA) 570 (Revised) Going Concern.
IN THE NEWS
Steinhoff International Holdings NV (Steinhoff)
In December 2017, Steinhoff triggered the biggest corporate scandal that South African
has ever seen. On 6 December, shortly before they were due to release their 2017 audited
financial statements, Steinhoff issued a press release admitting to ‘accounting
irregularities’ and delaying the release of these financial statements. This was followed by
the immediate resignation of Marcus Jooste, the company’s CEO. Steinhoff appointed
PwC to head up an internal investigation into the irregularities.
Shortly after this, Steinhoff issued a further press release warning shareholders that
they should not rely on the 2016 audited financial statements and also that the 2015 (and
possibly even the years before that) annual financial statements might need to be re-stated.
Steinhoff is one of the best-known companies in South Africa, and, prior to the
scandal, was one of the top ten companies on the JSE by market capitalisation. In the
month following the 6 December 2017 announcement, Steinhoff’s share price fell by 90%,
wiping out R180 billion in market capitalisation.
Steinhoff is a complex organisation. It has its headquarters in South Africa; its parent
company is registered in the Netherlands; and it is listed on the Frankfurt stock exchange.
It also has a secondary listing on the JSE. Steinhoff was Europe’s second-largest furniture
retailer after IKEA. It employed over 130 000 staff and operated almost 12 000 outlets
across over 30 different countries. The Steinhoff stable has over 40 different brands
including in South Africa the likes of Pep, Tekkie Town, Russells, HiFi Corp, Incredible
Connection, and Hertz car rental. In the first 9 months of 2017 (unaudited results), the
group generated R242 billion in revenue, mostly from Europe (52%) but then also from
Africa (27%), the United States (15%) and Australasia (6%). More than 50% of its assets
are reported to be intangible.
It is not completely clear at the time of writing what the exact nature of the
irregularities are but there are reports that suggest the use of undisclosed off-balance sheet
vehicles (that are controlled by associates and former Steinhoff executives) to inflate
profits and conceal losses.
REFLECTION
The external auditors of Steinhoff had apparently already red-flagged the irregularities in
the Steinhoff group. Can you imagine the depth of knowledge that would have been
required to fully understand the Steinhoff group structures?
The group auditors would need to have considered:
• The intricacies involving the over 40 different brands (12 000 different outlets!) and
their corporate structure in relation to the group;
• The impact of the differing tax and business legislation from over 30 different
countries on the trading operations of this group; and
• The structures and complexities around the acquisition and financing of the spate of
acquisitions that took place between 2014 and 2016.
It would have been important for the group auditors to understand fully these aspects of
the company and its subsidiaries so that they could properly assess any risk of material
misstatement arising therefrom and design audit responses that were appropriate to reduce
the risk of their expressing an inappropriate audit opinion on the company’s consolidated
annual financial statements.
This chapter focuses on the processes that all Registered Auditors in South Africa are
required to follow, when performing the pre-engagement and planning activities for
entities that they audit.
12.1 Introduction
With reference to the Steinhoff example provided above, it should be clear that with a
company like Steinhoff, the auditor would need to have spent considerable time and effort
preparing to audit this entity.
The registered auditor first, however, needs to give serious consideration to whether or not
he or she is willing to conduct this audit (or continue to conduct it), prior to accepting it for the
current year. An auditor is under no obligation to perform, or to continue to perform, an audit
for an entity – agreeing to perform the audit is a conscious choice that the auditor makes.
Having decided that he or she is willing (and able) to conduct the audit, the auditor then
needs to apply his or her mind to how he or she intends to do this. The auditor needs to
understand sufficiently the entity he or she is about to audit so that he or she can identify and
assess potential risks of material misstatement. The auditor can then design appropriate audit
procedures to gather the necessary evidence to mitigate these assessed risks. This then enables
the auditor to support his or her conclusions regarding the fair presentation of the entity’s
annual financial statements.
This chapter provides an in-depth look at the pre-engagement and planning activities that
an auditor has to perform. In Chapter 11, you were introduced to the diagram shown in Figure
12.1 below. The two areas highlighted are the areas covered in this chapter.
Figure 12.1: The audit process
12.1.1 The concepts of overall audit strategy, audit plan and audit
approach
As with any aspect of the auditor’s work, it is important that the decisions and findings of the
auditor are suitably documented. Planning any audit engagement requires the creation of two
main documents to record the planning process. Both of these documents are explained in
more detail in ISA 300, the standard dealing with planning an audit of financial statements.
Firstly, the overall audit strategy needs to be decided on and properly formulated. This
typically establishes and documents in broad and general terms (the big picture):
1. The scope of the audit (what has to be done);
2. The timing of the audit (by when it needs to be done); and
3. The direction of the audit (how it is going to be done).
These high-level considerations set out in the overall audit strategy then guide the development
of the second document, the audit plan, which establishes the nature (what), timing (when) and
the extent (how much) of the audit procedures necessary to:
• Assess the risk in the audit engagement (risk assessment procedures);
• Respond to the identified and assessed risk (sometimes also referred to as the audit
approach); and
• Comply with any other requirements of the ISA.
CRITICAL THINKING
Can you think of any specific planning considerations that might arise out of other
requirements arising from the ISA? Here are a few examples, but perhaps you can think
of more.
• ISA 600 – the use of component auditors. This would require upfront planning in
terms of their identification and appointment, as well as correspondence that would be
necessary to clarify the scope of their engagement.
• ISA 620 – the use of an auditor’s expert. Like for component auditors, choices would
need to be made upfront regarding their selection, appointment, and the scope of work
to be undertaken.
• ISA 501 – specific considerations for selected items. Decisions regarding the physical
counting of inventory, or dealing with consignment inventory, would need to be made
upfront during the planning process.
The audit plan is therefore the detailed execution of the overall audit strategy and consists of a
list of detailed procedures to be performed by the audit team.
The overall audit strategy can be combined with the audit plan to create one planning
document that records the auditor’s understanding of the entity, identification of risks of
material misstatement, planned responses to identified risks, setting of materiality and
performance materiality levels, and the logistical arrangements pertaining to the audit, all of
which are discussed in detail in this chapter.
REFLECTION
The audit planning process can be likened to any major decision we might take in our
lives. Say, for example, you wanted to go on an overseas holiday. It is very unlikely that
you would just arrive at the airport one day and take it from there. Wouldn’t you plan your
holiday first?
You would need to first determine the ‘scope’ of your holiday: Where do you want to
go? What do you want to do there? For how long will be staying?
You would then need to start considering the ‘timing’ of the activities that will need to
be performed to enable this holiday to happen: By when do you need to arrange your
flights and accommodation? When do you need to apply for your visa to ensure you get it
issued in time?
You would be likely to have a very detailed list of things that needed to be done for the
holiday to be a success.
These three aspects could be likened to the audit strategy – establishing the big picture
in terms of what we need to do, by when it needs to be done, and how we aim to tackle it.
From there, we would move into the more detailed planning process for our overseas
holiday. Included in these activities would be our ‘risk assessment procedures’ which
might include things like the weather conditions (might influence when we travel?),
medical considerations (do we need vaccinations or do we need to organise certain
medication to take with us?), language issues (how are we going to communicate if we
can’t speak the local language?), obtaining currency (are we able to readily access cash in
our planned destination?), and many others.
From there we would develop detailed responses address these risks (i.e. to reduce
them to acceptable levels) and ensure that we have an amazing holiday – our ‘audit
approach’.
Before we get too wrapped up in the planning process, it is important that we first turn our
attention to the initial decision that the auditor has to make regarding the audit engagement
(made well before having to perform the planning activities) – is the auditor prepared to accept
(if a first-time engagement), or continue with (if a continuing engagement), the engagement?
Only once the auditor decides to perform the audit, would he or she then start to perform the
planning activities.
Prior to considering activities to be undertaken by the auditor during this phase, it is important
to ensure that the:
1. Auditor is eligible to act as the registered auditor of the entity; and
2. Relevant statutory requirements surrounding the appointment (or reappointment) of the
auditor have been complied with.
These statutory aspects concerning the appointment of the auditor are prescribed by the
Companies Act 71 of 2008 and the Auditing Profession Act 26 of 2005 and have been covered
in depth in Chapter 3.
If you cannot remember these, it may be a good idea to revise them before continuing with
this chapter.
Once the statutory aspects relating to the appointment have been complied with, there are
several auditing standards, a standard on quality control, and even the SAICA/IRBA Codes of
Professional Conduct (COPCs), that all then provide guidance as to what the auditor should do
when performing pre-engagement activities.
12.2.1 Requirements
Let us now explore the various requirements pertaining to the pre-engagement phase of the
audit set out in the ISAs as well as in ISQC 1 (the International Standard on Quality Control 1)
and the COPCs.
CRITICAL THINKING
What are these preconditions for an audit?
• The financial reporting framework to be applied in the preparation of the financial
statements must be acceptable. Without an acceptable framework, management does
not have an appropriate basis for the preparation of the financial statements, nor does
the auditor have suitable criteria for auditing the financial statements.
• Management must agree that it acknowledges and understands its responsibility with
regard to the following:
• The preparation of the financial statements in accordance with the relevant financial
reporting framework;
• The implementation of such internal control as they deem necessary to enable them
to prepare financial statements that are free from material misstatement; and
• That they will provide the auditor with access to all information relevant to the
preparation of the financial statements, any additional information that the auditor
may request for purposes of the audit, and unrestricted access to persons in the
entity from whom the auditor may determine it to be necessary to obtain audit
evidence.
CRITICAL THINKING
What is an acceptable financial reporting framework?
• In South Africa, legislation or regulation often prescribes the financial reporting
framework to be used by an entity in preparing its financial statements. In such cases,
the prescribed framework will ordinarily constitute an acceptable framework.
• The Companies Regulations 2011, and more specifically, regulation 27, prescribes the
financial reporting standards that companies must use when preparing financial
statements. Public companies are required to prepare their financial statements using
International Financial Reporting Standards (IFRS), while private companies have to
use either IFRS or IFRS for SMEs. In the public sector, the use of Generally
Recognised Accounting Practice (GRAP) is frequently prescribed.
• For more information on what constitutes an acceptable financial reporting framework,
read SAAPS 2 (Revised) on financial reporting frameworks and the auditor’s report.
Once the auditor is satisfied that he or she is not prohibited from conducting the audit in terms
of the ISA 210 requirements, he or she is then guided by ISQC 1 and ISA 220 (Quality control
for an audit of financial statements) on the appropriateness and sufficiency of procedures that
need to be performed regarding the acceptance (or continuance, in cases of existing audit
engagements) of the engagement.
CRITICAL THINKING
What is the difference between ISQC 1 and ISA 220 – they both deal with quality
control? Why have both standards?
ISQC 1 provides guidance in terms of firm-wide quality control considerations. These
requirements would therefore apply to, or affect, all engagements (i.e. audit as well as
other non-audit engagements, such as independent reviews and compilations) conducted
by the auditing firm.
ISA 220 provides guidance with regard to the conducting of an individual audit
engagement.
Both standards are therefore equally important when it comes to quality control, as the
auditing firm in general needs to comply with ISQC1 and then individual audit
engagement partners in that firm also need to comply with ISA 220 for the specific
engagements for which they are responsible.
12.2.1.2 ISQC 1
This standard requires that the auditing firm must establish policies and procedures regarding
engagement acceptance that provide reasonable assurance that it will only undertake
engagements where the auditing firm:
1. Is competent to perform the engagement and has the capability to do so (including time
and resources);
2. Can comply with relevant ethical requirements; and
3. Has considered the integrity of the client and does not have reason to doubt this integrity.
ISA 220 further suggests that significant matters that have arisen during the current or past
engagements should be considered in terms of their implications for the acceptance or
continuance of the current engagement.
CRITICAL THINKING
ISQC 1 and ISA 220 both refer to the auditor having to ensure that the auditing firm can
comply with relevant ethical requirements. What are these requirements?
The ethical responsibilities of the auditor were explored in depth in Chapter 2. You should
recall the need for an almost continuous consideration of whether there are any significant
threats to any of the fundamental principles in the Code of Professional Conduct and, if
so, the need to safeguard them adequately.
Do you remember the five fundamental principles? If not, it may be a good idea to
revisit briefly Chapter 2 at this point.
Obviously, when considering whether an auditor should accept an audit engagement,
the auditor must consider whether or not this engagement will present any significant
threat to any of the fundamental principles, because if it does and he or she is unable to
safeguard adequately against those threats, then the auditor should not accept the
engagement.
In addition to these activities, ISA 300 also requires that for initial engagements only (where
the auditor has not been involved in the previous audit of that entity), the auditor needs to
communicate with the previous (outgoing) auditor to establish whether or not there are any
ethical reasons why the new auditor should not accept the engagement. This communication
process is governed by the Codes of Professional Conduct and is discussed in detail in section
2.6.3.2. of Chapter 2.
CRITICAL THINKING
What are some reasons that a previous auditor may give to an incoming auditor as to why
he or she should possibly not accept the engagement?
• The outgoing auditor has been dismissed for not supporting the management of the
entity in its desire to manipulate the entity’s financial statements.
• There are unresolved uncertainties regarding management integrity.
• There are unresolved uncertainties regarding identified or possible fraud at the entity.
2. Is the auditor satisfied that he or she is not prohibited from doing the audit in terms of the
ISA 210 requirements?
You will have seen from the requirements above that the auditor is prohibited from
accepting the audit engagement if the preconditions for an audit have not been met or if
there is a significant scope limitation (that may result in the auditor disclaiming their
opinion on the financial statements). Clearly, should either of these situations be present,
the auditor should not accept the engagement.
REFLECTION
KPMG South Africa resigned as auditors and advisors in April 2016 to the Oakbay Group
of entities. Their last sign-off as auditors was in respect of the February 2015 year-end.
The Oakbay Group is owned by the infamous Gupta family. With the amount of negative
press associated with the Gupta family, is it any surprise that KPMG chose to end their
association with this group of companies?
Interestingly, the banking industry did likewise, with the major South African banks all
closing any Gupta-linked bank accounts, also in order to avoid any negative press
associated with these individuals.
Accordingly, the ability to audit such an entity is restricted, for example, to RAs
accredited by the JSE in terms of the JSE Listings Requirements (refer to Chapter 3 for
more information around the requirements to audit entities listed on the JSE).
2. Does the auditor have staff members available when they will be required?
The time frame during which the audit needs to be conducted and by when the final
opinion of the financial statements is required are important considerations for the auditor.
Will he or she have the required number of staff (at the required levels of expertise) to be
able to assign appropriate staff to the engagement when they will be required? It would be
inappropriate to accept an engagement that has to be performed during the busiest period
for that auditing firm if all staff are likely to be already allocated to other engagements.
3. Does the auditor have resources other than staff available to conduct the audit?
The auditor needs to consider the availability of any specific resources other than staff
that may be required (such as audit software to interrogate entity databases or industry-
specific experts). If the auditor requires these additional resources and they are not
available, he or she should not accept the engagement.
Question 4: Are there any ethical reasons why the auditor should not accept the engagement?
Having established that the auditor wants to do the audit (question 2) and that he or she is
capable of doing it (questions 1 and 3), the fourth question now requires that the auditor
consider whether there are any ethical reasons why he or she should not accept the
engagement.
The IRBA and SAICA Codes of Professional Conduct require auditors to consider whether
there may be any significant threats to any of the five fundamental principles contained in the
Codes when making their decisions regarding the acceptance of an audit.
WHAT What if the financial director of the potential audit client is the cousin of one of
the members of the audit team?
IF?
ISA 300 requires that the auditor give specific consideration to independence
when considering the ethical requirements surrounding the acceptance of an
audit engagement. Would these circumstances present a threat to the objectivity
of the audit team? Have a look at Chapter 2 again if you are not sure.
To be able to answer this question, the auditor thus needs to consider the engagement in the
light of any potential threats to these principles. Should the auditor identify a potential threat to
any of the fundamental principles, he or she needs to consider whether this threat is significant,
and if so, whether or not it can be adequately safeguarded before accepting the engagement.
Remember that ISA 300 also requires that where the engagement is a new engagement, the
incoming auditor must contact the outgoing auditor to enquire as to whether or not there are
any professional (including ethical) reasons why he or she should possibly not take on the
engagement. If, during this phase, a significant threat to any of the five fundamental principles
is identified that cannot be adequately safeguarded by the auditor, then the engagement should
not be accepted.
Client:
Ntsimbi
Ref: A1
Piping (Pty)
Ltd
Financial
year-end: 31 Reviewed
December by:_______________________________________
20X1
Prepared by:
Date
Audit
reviewed:______________________________________
manager
Date: 20 April
20X1
Subject: Pre-
engagement
considerations
checklist prior
to re-
acceptance of
the audit
Are there any significant threats No All staff have completed ethics
to any of the fundamental declarations in respect of this
principles and if so, can they be engagement and no threats to
adequately safeguarded? any of the principles were
identified. (Refer A19).
Are there any statutory reasons why we should not re-accept this engagement?
Conclusion
Based on the above considerations and the related findings, there are no
reasons why we should not continue with this engagement. The engagement is
therefore to be re-accepted for the 20X1 financial year.
FURTHER READING
Take a few minutes to read through the example of an audit engagement letter contained
in Appendix 1 to ISA 210. Note how it complies with the five aspects mentioned above.
This phase starts with obtaining the necessary understanding of the entity.
REFLECTION
None of the remaining phases of planning can be properly completed if the auditor does
not have a comprehensive understanding of the entity he or she is about to audit:
• The auditor cannot identify the risks of material misstatement in the financial
statements.
• The auditor cannot design audit procedures to respond to identified risk of material
misstatement.
• The auditor cannot set appropriate levels of materiality.
• The auditor cannot assign appropriate levels and numbers of audit staff (at the right
locations).
REFLECTION
Before continuing, give some thought to how the auditor’s understanding of each of these
components may assist in planning and performing the audit.
Some of the more important matters that would have to be understood include:
a) Organisational structure of the entity
Is the entity a single standalone entity or is there a group structure? If there is a group
structure, what is the nature of the relationship between the holding company and its
component parts? Are the components subsidiaries or joint ventures, for example? Where
there are subsidiaries, are they audited and, if so, by the auditor of the holding company or
by another auditor?
Consider an entity that is a group with a diverse geographical spread of subsidiaries
(possibly even into countries outside South Africa). This structure will have major
implications for the planning process when it comes to deciding on which subsidiaries
have to be audited, to what extent they have to be audited and who will conduct their
audits.
Go back and have a quick look at the company that was presented at the beginning of this
chapter (Steinhoff). Consider how important it would be for its auditors to fully
understand the complexity of that particular organisational structure (12 000 stores,
incorporating 40 different brands, operating in 30 different countries!).
EXAMPLE
Audit risks versus business risk
Audit risk is the risk that the auditor expresses an inappropriate opinion on the financial
statements when the financial statements are materially misstated. This is clearly a risk to
the auditor and not to the entity. Expressing an inappropriate opinion on the financial
statements when they are not in fact materially misstated is less of a concern to the
auditor, as the entity’s management will no doubt take this up with the auditor, and the
appropriate opinion will be expressed in the final version of the auditor’s report.
Business risk, however, is a risk to the entity. It usually reflects a potential threat to the
business in terms of its ability to generate profits or minimise losses, remain sustainable,
or to achieve its social and environmental objectives. Examples of potential business
risks may include:
• Inappropriate response to a change in the market;
• Development of a new product that fails;
• New entrant into the market;
• The entity’s products becoming redundant;
• Poor quality products or services;
• Loss of a key customer or supplier; and
• Labour disputes.
The important thing to note here is that business risk may well result in audit risk.
Producing poor quality products (a business risk) may cast doubt over the net
realisable value of any inventory reflected in the entity’s financial statements at year-end
(an audit risk).
Loss of a major customer (a business risk) may result in going concern problems for
the entity that may cast doubt over the adequacy of the basis for the preparation of the
financial statements (an audit risk).
Not all business risks give rise to audit risks but understanding the business risks will
enable the auditor to make this assessment.
Examples of some of the matters the auditor should consider when understanding the
business risks facing the entity include the following:
a) Developments in the industry and the entity’s ability to respond to these changes;
b) The launch of any new products or services and the degree to which these may fail or
cause potential product liability;
c) Expansion to the business and the degree to which the entity is ready to expand or has
correctly assessed the market needs prior to the expansion;
d) New accounting or regulatory requirements and the degree to which the entity has
responded to them. The potential for penalties or fines for non-compliance would also
have to be understood; and
e) The degree to which the company is dependent on information technology and the
extent to which the entity keeps their information systems and business operations up
to date and technologically current.
To identify these measures of success for the entity, the auditor considers the following
information:
a) Key performance indicators (financial and operating), and key ratios, trends and statistics;
b) Management accounts presented on a regular basis and an emphasis on what is being
reported on therein;
c) Budgets, forecasts and targets and the manner in which they are monitored;
d) Employee performance measures and incentives, for example a sales director who
receives a bonus if revenue figures meet predetermined targets may attempt to do
everything he or she can to achieve those targets and this would clearly create a risk of
misstatement in the financial statements to which the auditor would have to respond; and
e) Comparison of performance of the entity with its competitors or against industry norms.
Having identified how the entity measures its success, the auditor then also performs a review
of the entity’s performance to date. This review encompasses the performance of trend analysis
(year-on-year comparisons) in the entity’s liquidity, solvency and profitability ratios.
This provides the auditor with a good understanding of the general direction in which the
entity is heading. Is the entity becoming more or less liquid, solvent, and profitable?
This understanding is essential as a mechanism to identify potential risk of material
misstatement in the financial statements. An entity whose performance is declining, for
example, will be under pressure to turn things around and this may result in management
manipulating the financial results to achieve this. The auditor has to be aware of this possibility
when designing his or her procedures to respond to this identified risk of material
misstatement.
The degree to which internal control is effective has a potentially significant impact on the
auditor’s assessment of risk of material misstatement. An entity that has strong internal control
is far more likely to be able to prevent or detect (and correct) misstatements in their records by
itself. This provides the auditor with assurance that misstatements are therefore less likely to be
present in the financial statements – the risk of misstatement will be reduced. However, an
entity that has poor or weak internal control is unlikely to be able to prevent or detect (and
correct) by itself misstatements in its financial records. This in turn increases the risk of
material misstatement perceived by the auditor.
Understanding the entity’s internal control is therefore an important part of this planning phase
and typically involves the auditor considering the following aspects:
a) The entity’s control environment: This involves assessing the culture that management
has created regarding the importance of internal control – management’s attitude towards
sound internal control.
b) The entity’s risk assessment process: This involves the auditor understanding the process
that management follows to identify internally and respond adequately to business risks.
c) The entity’s information system: This involves understanding how the entity processes its
significant transactions (such as sales, purchases and payroll) from initiation of the
transactions through to updating the general ledger and financial statements to reflect the
financial results of the transactions (refer to section 4.3.2.3 for more information). The
auditor has to understand the documents that are used to record the transactions and how
the information is transferred through the information system.
It is only necessary for the auditor to understand the information system in so far as it
relates to the financial records and statements (and therefore is relevant to the audit).
Purely operational controls and compliance controls that have no potential impact on the
financial records and statements are not relevant to the audit and therefore the auditor
generally does not have to gain an understanding of these controls.
d) The entity’s control activities: This involves obtaining an understanding of what the entity
does to prevent or detect (and then correct) errors that may occur in its financial reporting
information system. It is not necessary for the auditor to gain an understanding of all
control activities – simply those sufficient to enable him or her to assess the risks of
material misstatement at the assertion level and to design further audit procedures to
respond to the assessed risks. The emphasis is on identifying and obtaining an
understanding of control activities that address those areas where the auditor considers
that material misstatements are more likely to occur.
In obtaining an understanding of control activities that are considered to be relevant to the
audit, the auditor is required to obtain information pertaining to both the design and
implementation of these control activities.
Understanding the design of a control activity involves the auditor considering whether or
not the identified control activity is capable of preventing or detecting misstatement in
theory. The auditor first considers the control as it was intended to be (i.e. ‘on paper’).
Should the control activity be poorly designed, then the auditor can provide feedback to
management of the entity as to how it could be improved. Clearly, a control activity that is
poorly designed will never be relied on by the auditor to reduce the assessment of risk of
material misstatement in the financial statements.
Having understood the design of the control activity, the auditor next considers whether
there is evidence to suggest that the entity has actually been using/performing the control
activity (i.e. has it been implemented by the entity). Clearly, no matter how well designed
a control activity is, if it has not been adequately implemented, the auditor will not be able
to rely on it to reduce the assessment of risk of material misstatement.
It is only by first understanding the design and implementation of control activities
relevant to the audit that the auditor can then make the decision as to whether or not to
place reliance on them to reduce his or her assessment of the risk of material
misstatement. Should he or she choose to place reliance on them, the auditor then plans to
perform tests of control to obtain evidence about the operating effectiveness of these
control activities.
The decision on whether to test control activities or not is further elaborated on in section
12.6.4.3 of this chapter.
REFLECTION
ISA 265 (Communicating deficiencies in internal control to those charged with
governance and management) specifically requires the auditor to communicate to the
entity’s governing body what he or she regards as being a significant deficiency in internal
control (a deficiency meriting the attention of those charged with governance).
This requirement would apply to control deficiencies where the auditor believes an
important/key control activity is poorly designed, or is well-designed but has not been
adequately implemented by the entity.
e) The entity’s monitoring of controls: This final component involves understanding how the
entity ensures that its internal control is functioning as intended and how it responds to
instances where deficiencies in internal control are identified.
It is important to note that although the auditor is required to obtain an understanding of the
entity’s internal control, including its information system and relevant control activities, (i.e.
the design and implementation of control activities), this does not mean that he or she will
necessarily need to perform tests of controls to test their operating effectiveness. There are
several factors that influence the decision as to whether the auditor will test controls or not and
these are discussed in much more detail in section 12.6.4 when exploring the difference
between a combined audit approach (which includes tests of controls) versus a substantive
audit approach (which does not include tests of controls).
Working paper B1 contains the review notes of the audit manager about the audit work
performed by the audit team in respect of gaining an understanding of Ntsimbi Piping during
its 20X1 audit.
Client:
Ntsimbi
Ref: B1
Piping
(Pty) Ltd
Financial Reviewed
year-end: by:___________________________________________
31
December
20X1
Prepared
Date
by: Audit
reviewed:_________________________________________
manager
Date: 13
December
20X1
Title: Review notes in respect of our documented understanding of the
entity
Note: The review notes in the working paper above only deal with the documentation of the
auditor’s understanding of the industry within which the client operates, as well as the nature
of its business. In addition, the working paper subjected to these review notes is not
specifically included in the case study, but the assumption has been made that much of what
has been documented in the Ntsimbi Piping Company Profile (at the start of the book) has been
included in the working paper subject to this review.
These procedures (when performed as an audit planning activity1) are often referred to as
preliminary analytical procedures and include the review of the following aspects relating to
the entity’s results:
a) Year-on-year comparisons (Statement of Comprehensive Income and Statement of
Financial Position);
b) Month-on-month comparisons (of sales or wages for example); and
c) Calculation and review of trends in key ratios relating to profitability, liquidity and
solvency.
Refer to working paper C1 on the following page for an example of a working paper in respect
of a preliminary analytical procedure for Ntsimbi Piping.
Client: Ntsimbi
Ref: C1
Piping (Pty) Ltd
Financial year-
Reviewed
end: 31 December
by:_________________________________
20X1
Prepared by: Date
Audit senior reviewed:________________________________
Date: 10 January
20X2
Title: Preliminary analytical review procedures – Statement of
Comprehensive Income
UNAUDITED AUDITED
20X1 20X0
UNAUDITED AUDITED
20X1 20X0
Notes in respect of the review above (to follow up with the entity):
1. 31% increase in revenue. This is significantly higher than expected for what
has apparently been a difficult year as indicated in our understanding of the
entity. Growth in the PVC consumables market was only 3% for the year
and the economic outlook both globally and locally is depressed. How then
can revenue have increased by such a significant degree? This may
represent potential overstatement of revenue and we would have to
establish the reasons for the huge growth in revenue.
It is likely that the growth in cost of sales is related to the growth in
revenue. If they sold that much more, they would have been required to
purchase an associated increase in materials. The growth in revenue is,
however, less than the growth in cost of sales (which may account for some
of the drop in GP% – refer note 5 below). This may be as a result of
supplier price increases exceeding those given to customers or alternatively,
the company discounting its prices in order to increase sales volumes. We
would need to understand more fully the reasons behind this movement in
cost of sales and the reasons why it differs from the associated increase in
revenue.
2. The growth in operating expenses is much higher than the normal CPI
increases that may be expected normally. We would have to try to
understand which components of operating expenses increased to result in
an overall increase like this. In other words, does this relate to genuine
increased costs associated with the increased revenue or could it represent
fictitious or unauthorised spending?
3. This is a significant increase in investment revenue, particularly given that
there are no investments disclosed on the face of the Statement of Financial
Position and the fact that cash and cash equivalents have decreased since
20X0! The nature of this revenue would need to be investigated as there is
currently a potential overstatement of income (or understatement of
investment assets).
4. Finance costs have reduced by only 1%. However, if we review the
Statement of Financial Position, interest-bearing borrowings have increased
from R429k to R1,396k in the current year and the bank overdraft has
increased from R75k to R4,022k. Surely, we would therefore be expecting a
sizeable increase in finance costs and yet they have decreased? We would
need to establish the reasons behind this as this suggests a potential
understatement of finance costs.
5. We are aware that there have been operational inefficiencies and the drop in
gross profit percentage (GP%) is therefore perhaps not unexpected, but a
16% drop in GP% is significant. We would need to discuss this with the
entity. It is unlikely that this drop would be due to understated revenue
(because revenue appears to be much larger than expected) and so it may
represent a potential overstatement of cost of sales.
6. The large drop in operating profit as a % of revenue is perhaps to be
expected as a consequence of the other movements in this Statement of
Comprehensive Income and does not warrant investigation on its own.
12.5 How does the auditor assess the risk of material
misstatement?
Having accepted the engagement (phase 1) and having obtained (or updated) his or her
understanding of the entity (phase 2), the auditor is now ready to assess the degree to which
there is risk that the financial statements may be materially misstated (i.e. to perform risk
assessment procedures) and will thus move into phase 3 of the audit planning process.
WHY? Why is it unavoidable that some level of audit risk remains on every audit?
Because the complete elimination of audit risk is impossible due to the inherent
limitations of the external audit – see section 1.4.5.2 of Chapter 1.
In terms of the ISAs, the auditor is required to reduce this audit risk to acceptably low levels.
After the completion of any audit procedures that the auditor believes are necessary, he or she
therefore needs to end up with an acceptably low level of risk (based on the client’s specific
circumstances) that the opinion expressed on the financial statements is not inappropriate.
It is conceivable that, under differing circumstances, what might be an acceptably low level
of audit risk for one audit client, may be completely different to that for another audit client. In
other words, reducing the level of audit risk to say 5% (i.e. a 5% probability that the auditor
expresses an inappropriate opinion on the financial statements when they contain material
misstatements) may be an acceptably low level of audit risk for one audit client, while
reducing it to say 3% may be seen to be necessary for a different audit client. What an
acceptably low level of audit risk is, is a matter for the auditor’s judgement exercised on the
basis of his or her experience. This is called professional judgement.
REFLECTION
What type of audit risk is associated with Ntsimbi Piping?
Ntsimbi Piping is unlikely to be a high-risk engagement as there is not a high degree of
public interest in its financial statements nor is the auditor aware of any specific reliance
being placed on the audit opinion. It is, however, also unlikely to be a low-risk
engagement as there is clearly some degree of public interest.
Ntsimbi Piping is thus likely to be classified as being a normal (or medium) risk
engagement.
Staff competence Staff are not competent and Staff are competent and so
so there is a higher risk that there is a lower risk that the
the financial statements may financial statements may
contain misstatement. contain misstatement.
INDICATOR OF HIGHER INDICATOR OF LOWER
INHERENT RISK FACTOR
INHERENT RISK INHERENT RISK
Staff integrity Staff lack integrity and are Staff are seen to have
thus seen to be more likely integrity and are thus seen to
to manipulate financial be unlikely to manipulate
information and there is financial information and
therefore a higher risk that there is therefore a lower risk
the financial statements may that the financial statements
contain misstatement. may contain misstatement.
Age of the information system Systems are new and tend to Systems are neither new nor
be problematic initially until outdated and are therefore
staff know how to use them stable and less likely to
and/or any bugs have been contain programming flaws
ironed out, or systems are that may lead to
old and tend no longer to be misstatement. Staff using
able to meet the processing these systems are also
needs of the entity and so familiar with them and so, are
tend to crash more less likely to make mistakes.
frequently with resultant
potential loss of data.
INDICATOR OF HIGHER INDICATOR OF LOWER
INHERENT RISK FACTOR
INHERENT RISK INHERENT RISK
Design of the information Unique, tailored systems are Accounting software has been
system developed in-house to cater purchased off-the-shelf and is
for the entity’s specific therefore tried and tested and
processing needs. These has not been customised at all
systems are relatively for the entity. These systems
untested and are therefore are generally less likely to
more likely to contain flaws create misstatements.
leading to misstatements that
are only resolved over time
as they are picked up.
There are numerous further examples of inherent risks that could be put forward, but the
examples provided above should suffice for you to understand the nature of an inherent risk.
Clearly, where an inherent risk is identified, this increases (or decreases) the assessment of
the risk of material misstatement and the auditor therefore needs to do something to reduce (or
increase) the resultant level of audit risk back to the level that is acceptable. What these
responses may include is discussed in detail later in this chapter.
Control activities Control activities are poorly Control activities are well
designed (or non-existent) designed and have been
and are not capable of implemented by the entity.
preventing, or detecting and They are therefore capable of
correcting, misstatement, or preventing or detecting
well-designed control misstatement which thus
activities have simply not reduces the risk that
been implemented by the misstatements will reach the
entity. In both cases financial statements.
misstatement is unlikely to
be prevented, or detected
and corrected.
As with the examples pertaining to inherent risks, the factors described above are only a
selection of possible factors that could influence the auditor’s assessment of control risk –
many more exist in any business.
By using audit staff with experience, or by increasing the type and extent of audit testing (and
therefore the reliability and amount of evidence to support a conclusion), for example, the
auditor is able to reduce the risk that material misstatements will go undetected (detection risk
is thus reduced). Conversely, if audit staff are inexperienced, they are much less able to
determine whether procedures are appropriate or not, or whether enough evidence has been
gathered (detection risk is thus increased). Also, if the extent of testing is reduced, the amount
of evidence will be reduced and conclusions will be less easily justified – the less the testing is,
the more likely it is that the auditor will not detect misstatement (and thus the higher the
resultant level of detection risk will be).
12.5.1.3 Understanding the relationship between the three components that affect
audit risk
In ISA 200, risk of material misstatement is defined to be the product, or net result, of inherent
and control risk. The inherent and control risk levels can be assessed by the auditor. The higher
the assessed level of the risk of material misstatement is, the more detection risk must be
reduced in order to re-establish the required low level of audit risk.
Given that detection risk is the only one of these three factors that the auditor can control
(the other two factors can only be assessed by the auditor), detection risk becomes a very
important mechanism that can be used to return the level of audit risk to acceptably low levels.
WHAT What if, for example, the auditor is faced with a situation where there is high
inherent risk?
IF?
Because of this increased inherent risk, risk of material misstatement will
automatically be assessed at a higher level and this will therefore push audit
risk to a level that is higher than that which will be acceptable to the auditor.
What can the auditor now do to reduce this level of audit risk back to
acceptable levels (to mitigate the effect of the increase in inherent risk)?
1. The auditor can consider designing the substantive procedures in such a way
that detection risk is reduced, thereby offsetting the increase in inherent risk
and returning audit risk to an acceptable level; or
2. The auditor can consider incorporating tests of control into the audit
approach such that he or she is able to justify reduced levels of control risk
to offset the increased levels of inherent risk.
Consider Table 12.3 below.
Table 12.3: The relationship between inherent, control and detection risk
REFLECTION
Under which circumstances might control risk be considered to be medium?
It could be argued that if we test the operating effectiveness of control activities and
conclude that they are working, control risk will then always be low, and if we do not test
operating effectiveness of control activities, control risk must then surely be high. So,
when might we justify medium control risk?
If we follow a rotation plan regarding the testing of control activities (ISA 330 para 13
and 14 – refer also to section 13.4.4), for audit purposes we would be placing reliance in
the current year on control activities that were tested in a prior year. It might then be
argued that because we didn’t actually test the control activities in the current year, that we
couldn’t justify a low control risk. But equally because we tested the controls in a prior
period (and concluded that they were working in that period), it wouldn’t be appropriate to
assess control risk as high. This may be a situation where control risk assessed at a
medium level may become justified.
What is clear is that inherent risk and control risk have to be assessed so that the resultant level
of required detection risk (that the auditor can control) can be established. The audit plan can
then be created in such a way that it addresses (responds to) the required level of detection risk.
This relationship between inherent, control and detection risk is often formalised in what has
become known as The Audit Risk Model.
This is a good way to visualise the relationship between the component factors that affect audit
risk. Given that AR (audit risk) must remain at the level set by the auditor as being acceptable
for the specific engagement, if IR (inherent risk) and CR (control risk) for a particular audit
engagement are both high, DR (detection risk) must be very low to enable the auditor to
achieve the required level of acceptable AR. For this engagement, the auditor must therefore
plan their procedures in such a way that once they have been performed, there is a very low
risk that these procedures will not have detected material misstatements.
In theory, this model should probably rather be referred to as the Detection Risk Model since it
is actually the level of required detection risk that the auditor is trying to determine.
It may, however, just complicate things if the model were to be presented as follows:
The original layout of the audit risk model does make it easier to understand the nature of the
relationships between the different components of the model but can lead to the mistaken
belief that it is being used to determine the level of audit risk. It is not! It is being used to
determine the required level of detection risk in order to maintain audit risk at a level that is
considered to be acceptably low for the engagement concerned.
12.5.1.4 Risk at the financial statement level versus risk at the account
balances/classes of transactions/ disclosures level
ISA 315 requires the auditor to consider risk of material misstatement (the product of inherent
and control risk) at two different levels. The consideration of these two levels has major
significance when it comes to the auditor’s planned response to achieve the resultant level of
detection risk that needs to be attained.
Risks at the financial statement level result from those risk factors that could have an
impact across the entire set of financial statements, affecting many account balances, classes of
transactions or disclosures. It is therefore not possible to pinpoint the effect of these risks to
just one or two individual account balances/classes of transactions/disclosures. The effects of
these risks are pervasive to the financial statements as a whole.
Risks at the assertion level for classes of transactions, account balances and disclosures
(refer to section 1.3.3 in Chapter 1 if necessary where these concepts have been explained in
detail), however, result from risk factors that are likely only to have an impact on a limited
number of transactions, the related account balances, and/or disclosures.
Before working through a few examples of risks at these two different levels, let’s consider
the effect of risk at these different levels in terms of the resultant level of detection risk.
If the auditor discovers an inherent risk that could impact on the entire set of financial
statements (the potential for misstatement is thus present across multiple account balances
and/or classes of transactions and/or disclosures), this means that IR at financial statement
level is seen to be high. The auditor therefore has to design an approach that ensures that DR at
financial statement level is appropriately reduced. This means that the planned response to
achieve this lower level of DR that is now required would have to be such that it results in a
reduced risk that the auditor would fail to detect material misstatement across all classes of
transactions and account balances and disclosures.
Now consider instead a situation where the auditor identifies an increase in inherent risk in
just one particular account balance or class of transaction or disclosure. Clearly, the inherent
risk for only that account balance or class of transaction or disclosure (and its related double-
entry account of course) increases and the auditor must then plan an audit approach that results
in DR for only that account balance or class of transaction or disclosure being appropriately
reduced. The important thing to note here though is that this response only has to reduce DR in
this one account balance or class of transaction or disclosure (and its related double-entry
account if applicable) and should not have any effect on the DR for any other account
balance/class of transaction/disclosure. This is very different from the financial statement level
where the planned response has to ensure that DR is adjusted for all account balances/classes
of transaction/disclosures.
This may initially seem fairly complex. We discuss the nature of these required responses
in more depth later on in the chapter.
Refer to Table 12.4 below where the inherent risk factors described in Table 12.1 have been
further broken down to show when they might apply at the financial statement level as opposed
to at an account balance/class of transaction/disclosure level.
Table 12.4: Inherent risk at nancial statement level and at account balance level
Staff integrity There is concern about the There is concern about the
integrity of the entity’s integrity of a staff member
management. As with responsible for a particular
competence above, the account. As with competence
impact of this risk could be above, the impact of this risk can
felt in any (or every) only be felt in a limited number
account balance/class of of account balances or classes of
transaction/disclosure. transactions (only those for
which the applicable staff
member is directly responsible
and their double-entry accounts
of course).
Level of sophistication of The entire information Only certain parts of the overall
information system system is sophisticated and information system are
therefore all account sophisticated. For example,
balances and classes of revenue is processed through a
transactions are affected. complex information system
while the other classes of
transactions are not.
Design of the information The entire information Only certain parts of the overall
system system has been developed information system have been
in-house and therefore all developed in-house or purchased
account balances and off-the-shelf. For example, the
classes of transactions are payroll is processed through a
affected. standard purchased software
package (in which case only the
The general ledger system
salaries and wages classes of
always has an impact at a
transaction are affected).
financial statement level.
Age of the information This applies where the Different parts of the system
system entire system is the same have been developed and added
age. at different stages. It is therefore
possible that for certain classes of
transactions, inherent risk may be
high (brand new system) while
for other classes of transactions,
it may be low (established
system).
Degree of subjectivity in the This is unlikely to have any This applies where individual
determination of gures impact at this level since account balances require
subjectivity is only relevant subjective determination of
to certain account balances amounts – accounting estimates
where accounting estimates or fair value adjustments, for
are required. example.
INHERENT RISK INDICATOR OF RISK AT INDICATOR OF RISK AT
FACTOR IDENTIFIED FINANCIAL ACCOUNT
IN TABLE 12.1 STATEMENT LEVEL BALANCE/CLASSES OF
TRANSACTION/DISCLOSURE
LEVEL
Management/staff For the same reasons as Any other incentives (other than
incentives targets above, where profit-based incentives) usually
incentives are profit-based, create risk at the relevant account
this creates risk at a balance/class of transaction level
financial statement level only. This is because any
because of the large potential manipulation to attain
number of account balances the target is going to be limited to
and classes of transactions the affected account balance or
that can be manipulated to class of transaction only.
have an effect on profit.
Refer to Table 12.5 where the control risk factors described in Table 12.2 have been further
broken down to show when they may apply at a financial statement level as opposed to at an
account balance/class of transaction/disclosure level.
Table 12.5: Control risk at nancial statement level and at account balance level
Degree to which duties are Applies at this level where Applies at this level where the
segregated the duties of senior duties of staff members
financial staff who are responsible for certain account
responsible for multiple balances or classes of
account balances or classes transactions only are not
of transactions are not adequately segregated.
adequately segregated.
Control environment Can only apply at this level Not applicable unless
since the control management responsible for one
environment is concerned class of transactions have a
with management’s overall different mind-set regarding
attitude towards internal internal control to the board
control in general. (which is possible).
Control activities Applies where control Applies often at this level since
activities are designed to control activities are put in place
detect and correct to prevent or detect and correct
misstatements in the misstatement in the processing of
financial statements as a transactions and therefore relate
whole (for example, the to certain individual account
review of management balances and classes of
accounts against budgets transactions.
by the board of directors or The control activities over the
the authorisation of all payroll class of transactions, for
journal entries by a senior example, cannot have any
member of management). bearing on the control risk over
the revenue class of transactions,
since they are two independent
systems with their own
independent control activities.
The auditor may therefore have a
situation where the payroll class
of transactions is regarded as
having low control risk while the
revenue class of transactions is
seen to have high control risk.
CONTROL RISK INDICATOR OF RISK AT INDICATOR OF RISK AT
FACTOR IDENTIFIED FINANCIAL ACCOUNT BALANCE/CLASS
IN TABLE 12.2 STATEMENT LEVEL OF
TRANSACTION/DISCLOSURE
LEVEL
Working paper D1 below shows how the assessment of the risk of material misstatement at
financial statement level is documented in the audit working papers of the 20X1 audit of
Ntsimbi Piping.
Client:
Ntsimbi
Piping Ref: D1
(Proprietary)
Limited
Financial
year-end: 31 Reviewed
December by:______________________________________
20X1
Prepared by: Date
Audit senior reviewed:____________________________________
Date: 10
January
20X2
Title: Assessment of risk of material misstatement at financial
statement level
The company trades (imports and There is the risk that the company
exports) across borders. suffers significant foreign exchange
losses, which increases the risk that the
company may not be a going concern.
Furthermore, the nature of these cross-
border transactions Is likely to be
inherently complex.
There are significant related This increases the likelihood of
parties across multiple manipulation of numbers between
transaction types. entities.
Conclusion
Based only on the above factors, the overall risk of material misstatement at
financial statement level in this engagement is regarded as being MEDIUM.
Note: Working paper D1 does not include information about control risk at financial statement
level as the available information about Ntsimbi Piping does not include sufficient information
in this regard.
12.5.1.5 Introducing the financial statement assertions into risk assessment at the
account balances/ classes of transactions/disclosures level
Chapter 1 has introduced you to the concept of assertions (refer to section 1.3.3 of Chapter 1)
and from reading Chapter 11 you will be aware that auditors need to perform procedures
necessary to obtain sufficient appropriate evidence that none of these assertions made by
management about year-end balances, transactions and events, and disclosures result in
material misstatement.
The nature, timing and extent of the required procedures for each assertion as it applies to
each account balance, class of transaction or disclosure is influenced by the degree of assessed
risk of material misstatement relating to that particular assertion. For example, if there is a
greater risk of material misstatement that accounts receivable are not fairly valued, the auditor
will design (and then perform) more extensive procedures on the accuracy, valuation and
allocation assertion for accounts receivable (which will result in lower levels of detection risk
being achieved for the accuracy, valuation and allocation assertion – which in turn will offset
the original higher risk of material misstatement in this assertion and will restore audit risk to
acceptably low levels).
It therefore becomes essential to be able to determine the level of required detection risk
for each assertion separately when considering the account balances, classes of transactions or
disclosures that have to be audited.
EXAMPLE
Accounts Receivable
The following information pertains to the Accounts Receivable account balance of an
entity being audited:
Staff who manage the account balance are competent. Historically, whereas
there have not been instances of misstatement with regard to the recording or
classi cation of the sales transactions that give rise to the related debt, there was
reason to be concerned about the manner in which the entity provides for
irrecoverable credit losses. Management use a subjective formula to determine the
allowance for credit losses and the level of this allowance recorded has seldom
been a re ection of the actual subsequent write-off of bad debts.
There is no reason to believe that management may want to record ctitious
sales transactions, nor that management have pledged or secured their debtors
book in any way. Nor is there any reason to suspect that management have not
recorded all credit sales transactions.
Although there are no speci c control activities in place around the
determination of the allowance for credit losses, control activities ensuring the
completeness, validity and accuracy of recorded sales transactions appear to be
well designed and there is evidence that they have been implemented by the entity
throughout the year. Given the size of the Accounts Receivable balance, the
auditors have historically found it most cost-effective to adopt a combined approach
to the audit of Accounts Receivable (i.e. perform tests of control).
Now: How does the auditor assess the risk of material misstatement in the Accounts
Receivable balance at year-end (ignoring the presentation assertion)?
Inherent risk by assertion (account balances, and related disclosures at period end)
• Existence: No reason to believe that the client has created fictitious debt, so the
inherent risk of non-existent debt is low.
• Completeness: No reason to believe that the client has failed to record all credit sales
transactions, so the inherent risk of the Accounts Receivable balance being
incomplete is low.
• Rights: No reason to believe that the client has pledged or secured its debtors book, so
the inherent risk pertaining to inappropriate identification of rights to debtors is low.
• Classification: No reason to believe that the client has incorrectly classified debtor’s
balances, so the inherent risk pertaining to this assertion is low.
• Accuracy, valuation and allocation: Historically there have been problems with the
allowance for credit losses, there has been use of a subjective formula, and the
allowance seldom equates to the actual subsequent write-off. The inherent risk that the
valuation of this account balance will be incorrect in the current year is therefore high.
Note that because there are no reasons to believe that the accuracy or allocation of
Accounts Receivable are misstated, these elements of this assertion will remain a low
inherent risk.
Control risk by assertion (account balance at period end)
• Existence: There appear to be well designed and implemented control activities over
the valid recording of sales and therefore debtors. Assuming that the auditor plans to
rely on these controls again in the current year and that he or she will therefore
perform tests of control to confirm their operating effectiveness, the risk that controls
will fail to prevent, or detect and correct, non-existent debt (fictitious sales) can
therefore be assessed as low on a preliminary basis (tests of control would have to be
performed to confirm this preliminary assessment).
• Completeness: As with existence above, control activities over the complete recording
of sales (and thus trade debtors) appear to be well designed and implemented, and
assuming the auditor plans to rely on these controls and test their operating
effectiveness, control risk for this assertion can also be assessed as low on a
preliminary basis (tests of control would have to be performed to confirm this
preliminary assessment).
• Rights: This assertion is generally difficult to implement control activities over
(management seldom introduce control activities to detect instances where rights are
not identified) and control risk for this assertion is therefore usually high.
• Classification: Given that there appear to be well designed and implemented control
activities over the accurate recording of sale transactions, and assuming these control
activities extend to ensuring that transactions are posted into the correct account, and
given that we are likely to test controls for existence and completeness, it seems
appropriate that we also rely on controls for classification. Control risk for this
assertion will thus also be set as low on a preliminary basis.
• Accuracy, valuation and allocation: There are no control activities in place that can be
relied on to prevent misstatement with regard to the valuation of Accounts
Receivable. Control risk here is therefore high for the valuation element of this
assertion. Note that given the well-designed control activities in place over the
recording of the related sales transactions, control risk for the accuracy and allocation
elements of this assertion are likely to be low.
Level of detection risk therefore required for the assertions pertaining to Accounts
Receivable to restore AR to acceptably low levels:
What becomes apparent in this example is that there are three different levels of detection
risk that have to be managed by the auditor in this one account balance. The auditor’s
response therefore has to vary from one assertion to the next, given that the required level
of detection risk is different for each assertion.
The main issue in this example is with the carrying amount (accuracy, valuation and
allocation) of Accounts Receivable. It therefore makes sense to perform extensive
(additional) audit procedures on the allowance for credit losses (i.e. which forms part of
the accuracy, valuation and allocation assertion), as this is where the high risk of material
misstatement lies (this is therefore where the risk that the auditor’s procedures will fail to
detect material misstatement – the detection risk – needs to be at its lowest). It makes no
sense to perform extensive audit procedures on the existence or completeness of accounts
receivable, as levels of detection risk can remain very high for these assertions.
If the auditor does not separately assess risk at the assertion level, situations may
arise where the auditor looks at Accounts Receivable, declares there to be a potential
problem given the history around the allowance for credit losses and so proceeds to
declare Accounts Receivable to be a high-risk balance. The auditor may then respond by
increasing the extent of audit testing to be done for the balance as a whole rather than just
for the accuracy, valuation and allocation assertion, which is where the main concern lies.
This will lead to an inefficient and unnecessarily costly audit.
Working paper E1 below shows how the assessment of the risk of material misstatement at
account balance and assertion level is documented in the inventory audit working papers of the
20X1 audit of Ntsimbi Piping.
Client: Ref: E1
Ntsimbi
Piping
(Pty) Ltd
Financial Reviewed
year-end: by:_______________________________________________
31
December
20X1
Prepared Date
by: Audit reviewed:_____________________________________________
senior
Date: 13
January
20X2
Title: Assessment of Inherent risk for the inventory account balance
Conclusion
Based on the risk factors identified above, there appears to be relatively high
inherent risk in all the assertions pertaining to inventory at year-end with the
exception of classification and presentation (given that there do not appear to
be any indications that these assertions are at risk).
Accuracy, High risk for raw materials, work in progress, and finished
valuation and goods in relation to both the cost of inventory (accuracy) and
allocation its net realisable value (valuation)
12.5.2 The need to consider risk arising from going concern issues
Financial statements are prepared by management on the assumption that the entity will
continue trading in the foreseeable future and that it will realise its assets and discharge its
liabilities in the normal course of business. This entity can be referred to as a going concern.
While this may appear to be a consideration only for when the financial statements are
prepared (or during the finalisation phase of the audit), ISA 570 (Going concern) specifically
requires the auditor to consider whether there are any indicators that the entity may not be a
viable going concern during the risk assessment phase of the audit.
These indicators of an entity’s potential inability to continue trading as a going concern, as
suggested by ISA 570, are grouped into three main headings and all three should be considered
during the planning phase in order to reach a decision on potential inherent risk related to
going concern issues.
FURTHER READING
Take a few minutes to read through the list of specific indicators under these three
categories in ISA 570 para A3.
Reflect on how each one might cast doubt about an entity’s ability to continue trading
as a viable going concern and thus present increased inherent risk that the accounts may
have been manipulated.
Should the auditor have detected the presence of any indicators of potential going concern
problems that have occurred, or should he or she believe these are likely occur in the 12-month
period following the end of the financial reporting period subject to audit, the auditor would
then need to be concerned about whether management have any plans in place to mitigate the
identified going concern problem. A consideration of these plans and management’s intended
disclosures in the financial statements relating to them are critical to the auditor in assessing
the resultant level of inherent risk for the audit.
Inherent risk is created when an entity is potentially not a viable going concern. This
inherent risk arises because of the potential pressure management is now under to present
results that reflect a better situation than the entity is actually in. An entity that is struggling
financially is unlikely to be able to attract any additional finance or investment funding and yet
this is usually just what these entities desperately require if they want to survive. This pressure
that management are under creates an increased risk that management may manipulate the
financial statements to try to show the entity as being in a better position than it actually is.
This will amount to fraudulent financial reporting, which is discussed in more detail in the next
section of this chapter.
The inherent risk associated with a potential going concern problem is regarded as being at
a financial statement level as there are numerous ways in which management can inflate assets,
understate liabilities, inflate profits and understate expenses to present better-looking results. In
situations where there is perceived to be a risk that the entity will not continue as a going
concern, inherent risk at financial statement level will therefore increase, increasing audit risk.
The auditor will therefore have to find ways to reduce detection risk at financial statement
level to compensate for this and thereby return audit risk to acceptably low levels.
Note: Where going concern is identified to be a potential problem during the planning phase,
this will increase the risk of inappropriate disclosure relating to going concern being made in
the final financial statements, and/or the inappropriate basis of accounting being applied (i.e.
the going concern basis of accounting cannot be used if the entity intends ceasing operations
six months after the end of the financial reporting period).
REFLECTION
What is the assessment of going concern risk for Ntsimbi Piping?
Go back and have a look at the working paper that considers risk at financial statement
level for Ntsimbi Piping. One of the considerations that affected the risk assessment was
the potential going concern problems highlighted through the client profile and the annual
financial statements.
The formal assessment of the going concern ability of the entity is, however, not concluded
during audit planning. Instead, it is concluded after performing specific audit procedures
during the finalisation of the audit. These procedures are covered in detail in Chapter 15. It is
during this finalisation phase where the appropriateness of the final preparation of the financial
statements on the going concern basis is considered and also where the adequacy of any
required disclosure relating to any material uncertainties about going concern are considered in
the context of expressing the appropriate audit opinion on the financial statements.
REFLECTION
What is the difference between fraud and error?
Fraud is defined in ISA 240 to be ‘the intentional act by one or more individuals …
involving the use of deception to obtain an unjust or illegal advantage’.
Error, however, does not have any intent (no one sets out to make a mistake), nor
deception (usually individuals are unaware that they have made an error and so they will
not try to cover it up in any way), nor any unjust or illegal advantage (again, individuals
who make an error are usually doing so unknowingly, and certainly not because they are
trying to achieve any personal gain or benefit).
Owing to its nature, fraud is inherently more difficult for the auditor to detect than
error because perpetrators of fraud do so knowingly and therefore attempt to find ways to
cover it up.
There are two types of intentional misstatements that the auditor is concerned with:
1. An intentional manipulation of the financial statements (referred to as ‘fraudulent
financial reporting’ in ISA 240). This is also sometimes referred to as window-dressing
(portraying a different picture to the one that really exists).
2. Theft (referred to as ‘misappropriation of assets’ in ISA 240).
12.5.3.2 Exploring the fraud risk factors as a means to identify risk of fraud
To be able to consider whether fraud may have taken place or not, the auditor needs to be alert
to the reasons why fraud takes place. One needs to be able to think like a thief to catch a thief.
So, why then would anyone commit fraud? There are three different reasons why someone
may commit fraud and one overriding precondition that needs to be present for them to do so.
Once these reasons and the precondition are understood, it will make it much easier to identify
the risk of fraud taking place.
Reason 2 – Because they feel they have no choice. They feel forced into it. There is pressure
placed on them that results in their being driven to commit the fraud.
Reason 3 – Because they feel it is the right thing to do. They do not believe that what they have
done is unjust or illegal. There is a rationalisation to their act (as twisted as their logic might
sometimes be).
Overriding precondition – none of the above reasons to commit fraud can take place unless
there is also the opportunity to do so. As much as there may be an incentive, pressure or
rationalisation to commit fraud, it will simply not be possible if there is not also the
opportunity.
A sales manager may be under intense pressure to overstate revenue but if he or she has no
opportunity to do so, it cannot happen. A petty cash box left open and unattended on
someone’s desk presents a perfect opportunity to steal cash but if anyone does steal the cash, it
is because there is an incentive to do so, not simply because there was the opportunity. Would
anyone steal the contents of a rubbish bin even if the rubbish bin was in a location where there
was easy access to its contents? It would be unlikely not because there was not the opportunity,
but rather because there is no incentive, pressure or rational reason to steal rubbish.
Now, how do these fraud risk factors help the auditor in identifying possible risk of
material misstatement arising out of fraud?
Having obtained his or her understanding of the entity, the auditor then answers the following
questions to determine whether there are any fraud risks:
1. Are there incentives for anyone to manipulate the amounts and disclosures in the financial
statements?
2. Is anyone under pressure to manipulate the amounts and disclosures in the financial
statements?
3. Could there be any sort of rationalisation for why someone may want to manipulate the
amounts and disclosures in the financial statements?
4. Are there any incentives for anyone to steal any of the company’s assets?
5. Is the auditor aware of anyone who may be under sufficient pressure that they would steal
company assets?
6. Could there be any sort of rationalisation for why someone would steal company assets
believing it to be completely acceptable (as compensation for something they feel the
company has not given them, for example)?
7. If the answer to any of the above questions was ‘Yes’, then who would this person be, and
would they have had any opportunity to commit the potential fraud?
FURTHER READING
Appendix 1 in ISA 240 provides a comprehensive list of examples of possible fraud risk
factors for both fraudulent financial reporting and misappropriation of assets under the
headings of incentives/pressures (note that the ISA combines these into one reason),
rationalisations and opportunities (again note that the ISA refers to opportunities being a
fraud risk factor, yet in this text it is regarded as a precondition rather than a risk factor in
its own right).
Work through the appendix to gain valuable insight into possible indicators of fraud
risk that may become apparent through the auditor’s understanding of the entity.
Are there any fraud risk factors present when considering Ntsimbi Piping?
It is not clear from the client profile whether there are any incentives or possible
rationalisations to manipulate the financial statements, but the financial position of the
entity at year-end, the difficult trading conditions being experienced, and the uncertainty
around going concern all create pressure on management to produce better results.
It would then need to be evaluated whether management has the opportunity to
manipulate the financial statements. This will largely depend on the adequacy of the
company’s systems of internal control, both general and application controls.
Having identified a potential risk of fraud, this risk can then be categorised as either being at
financial statement level or being at an account balance/class of transaction/disclosure level.
Depending on the nature of the fraud risk indicator that has been identified, the fraud risk
will then also be classified as being either inherent or control risk.
Note that revenue recognition is deemed by ISA 240 to be a fraud risk in every audit
engagement. In other words, the auditor needs to ordinarily presume that the client has
manipulated its recognition of revenue either to overstate or understate its revenue. This
presumption can only be overturned should the auditor be able to document sufficient
reasoning as to why he or she believes the entity has not manipulated its revenue recognition.
ISA 240 also requires that the auditor consider, and respond to, the risk that management may
override (or bypass) internal control because of the unique position management are in that
enables them to operate outside normal control processes. As a minimum, auditors are
therefore required to design and perform procedures:
1. That consider the appropriateness of journal entries in the general ledger and other
adjustments made in the preparation of the financial statements (journal entries create a
significant opportunity to manipulate the financial statements);
2. That review accounting estimates for bias, as this may indicate manipulation by
management to achieve desired results. For example, if management wish to increase
profits as much as possible, they may intentionally understate all valuation adjustments to
minimise the effect thereof on the profit figure. The auditor should thus be alert to
whether misstatements with regard to accounting estimates present a consistent trend or
not; and
3. That consider the business rationale behind any significant transactions that are outside
the normal course of the entity’s business.
As with other identified risks of material misstatement, the auditor has to consider the effect of
fraud risk on the level of required detection risk and has to design appropriate responses to
attain these required levels of detection risk.
Fraud risk is an example of a risk that is classified as a significant risk, which is discussed
in the next section.
ISA 315 suggests that the auditor should consider at least the following when exercising his or
her judgement as to what may constitute a significant risk:
• Whether it is a fraud risk or not.
• Whether the risk arises out of recent significant developments (economic, accounting or
otherwise) and therefore requires specific attention.
This may include instances where, for example, there has been a significant change in
legislation, accounting standards, interest rates or foreign exchange rates. This change has
then triggered a potential risk of material misstatement which, if seen to be significant, will
thus require specific consideration by the auditor.
• Where complex transactions are identified.
Given the complexity of certain transactions, the potential for material misstatement is
greatly increased. The auditor may even find it difficult to understand the transaction, let
alone determine whether it has been appropriately accounted for.
Should the auditor therefore identify transactions that are seen to be sufficiently complex,
he or she may well flag these as significant risk areas and therefore design specific
procedures (including, for example, the use of an expert) to obtain the necessary evidence
regarding their correct recognition, measurement, presentation and disclosure in the
financial statements.
• Where significant transactions with related parties are identified.
Related parties cause concern for the auditor in that there is opportunity to manipulate
transactions between the related parties to achieve objectives of those parties that may not
be consistent with the objectives of the entity that the auditor is concerned about.
The charging of administration fees and rental, for example, as well as the sale of products
between related parties create ample opportunity to manipulate profits across different
entities.
Where these transactions are identified, they are therefore often judged by the auditor to be
a significant risk area and the auditor designs procedures to ensure that nothing untoward
has occurred in these transactions.
• Where there is a high degree of subjectivity in the determination of amounts.
Where there is considerable subjectivity in determining amounts, this presents the entity
with opportunities to manipulate results. Accounting estimates or fair value adjustments
that are subjective are difficult for the auditor to verify and are thus open to abuse.
For example, should an entity want to maximise its profits, it will look to minimise its fair
value write-downs of its assets. Should the determination of these write-downs be
subjective, it will be much easier for the entity to argue that little or even that no write-
down is necessary, and the auditor will be hard-pressed to prove them wrong.
These subjective areas will therefore need to be looked at carefully by the auditor and
hence will be flagged as significant risks that require special consideration.
• Where significant transactions outside the normal course of business are identified.
As soon as an entity does something that is not part of its normal business operations, the
auditor needs to question why this has been done and whether this presents a significant
risk or not. Given that these transactions are unusual, it is important for the auditor to
understand why management entered into them. There is also an increased likelihood of
material misstatement given that these transactions are not what the entity normally does
and is therefore familiar with.
Significant risks are usually linked to the account balance/class of transaction level because
they are usually related to individual transactions or account balances but there may also be
instances where a significant risk is seen to affect multiple account balances (fraud risk where
there is an incentive to manipulate profits, for example).
Significant risks are usually classified as inherent risks given that they arise independently
of any internal control considerations.
REFLECTION
Are there any significant risks in Ntsimbi Piping?
It is likely that there will be significant risks in Ntsimbi Piping, such as the following:
1. There are bound to be several complex transactions (including the manufacturing of
inventory as well as the importation of raw materials, for example).
2. There are significant related parties and therefore there will be significant related party
transactions.
3. There are bound to be significant accounts that require high degrees of subjectivity in
their determination. For example, the residual value and useful life of manufacturing
plant, and the obsolescence allowance required for inventory.
12.5.5 Risks for which substantive procedures alone do not
provide sufficient appropriate audit evidence
ISA 315 highlights that there may be certain identified risks of material misstatement where it
is not possible, or practical, to obtain sufficient appropriate audit evidence to mitigate the risk
through substantive procedures alone. In these circumstances, detection risk is not able to be
reduced to sufficiently low levels to compensate adequately for the high level of inherent
and/or control risk. The only course of action the auditor has is to seek to reduce the level of
control risk by testing the related control activities and concluding therefrom that the controls
are effective. The auditor will then have reduced his or her assessment of control risk and this,
together with the reduction in detection risk resulting from the substantive procedures he or she
is able to perform, will adequately mitigate the high levels of inherent risk and restore audit
risk to an acceptably low level.
An example of a situation where the above may be the case would be the auditor in the
audit of a large retailer (like Pick n Pay, Shoprite or Woolworths). These organisations process
high volumes of sales transactions for a wide range of different products and at different
values. It would be impossible for the auditor to obtain sufficient appropriate audit evidence
regarding the sales class of transactions through performing substantive procedures alone and
he or she would need to test the operating effectiveness of control activities over sales
transactions in order to obtain sufficient audit evidence.
WHAT What if the auditor was unable to obtain sufficient appropriate evidence
through substantive procedures alone and yet, when seeking to place reliance
IF? on control activities, discovered that control activities were not capable of
adequately preventing, or detecting and correcting, material misstatements?
Under these circumstances, the risk of material misstatement for the affected
account balance/class of transactions could never be adequately mitigated and
audit risk could therefore not be reduced to acceptably low levels.
The auditor would therefore need to issue a modified audit opinion on this
account balance/class of transactions, effectively indicating that he or she was
unable to reach a conclusion on whether the account balance/class of
transactions is fairly presented or not.
LEVEL OF
DETECTION RISK RELATED LEVELS OF INHERENT AND CONTROL RISK
REQUIRED
High Low inherent risk and medium control risk or medium inherent risk
and low control risk
Medium High inherent risk but low control risk or high control risk but low
inherent risk or medium inherent risk and medium control risk
Low High inherent risk and medium control risk or medium inherent risk
and high control risk
Remember that the lower the level of required detection risk, the lower the risk has to be that
the auditor will fail to detect material misstatements through his or her procedures.
Also remember that as the focus here is on detection risk at the financial statement level,
anything that the auditor does to adjust the level of detection risk at this level must be done in
such a way that it affects all account balances/classes of transactions/disclosures.
Table 12.7: Available responses to the auditor (per ISAs 240 and 330) to adjust
detection risk at a nancial statement level
Change professional Ensure that the engagement Ensure that the engagement
scepticism team is made aware of the team is made aware of the
need to increase the degree to need to reduce the degree to
which they have to be which they have to be
sceptical of representations sceptical of representations
from management or when from management or when
considering the sufficiency of considering the sufficiency of
audit evidence (which will audit evidence (which will
reduce the risk that increase the risk that
misstatement will not be misstatements will not be
detected). detected).
The message to the audit team The message to the audit team
is ‘Keep your eyes wide is ‘Don’t worry too much
open!’ about challenging the evidence
– if it seems OK at face value,
then accept it.’
TO REDUCE DETECTION TO INCREASE DETECTION
RISK (WHERE THERE ARE RISK (WHERE THERE ARE
AVAILABLE
HIGHER OVERALL LOWER OVERALL LEVELS
RESPONSE
LEVELS OF INHERENT OF INHERENT AND
AND CONTROL RISK) CONTROL RISK)
Change the composition of Assign more experienced audit Assign less experienced audit
the engagement team staff to the engagement who staff to the engagement. These
are more able to design staff members will be less able
appropriate procedures and/or to design appropriate
evaluate the adequacy of audit procedures and/or evaluate the
evidence. This will make it adequacy of audit evidence.
less likely that misstatement This will make it more likely
will not be detected. that misstatement will not be
detected.
Change the overall nature Seek to obtain better quality Be prepared to accept lower
and/or timing of audit audit evidence, such as an quality audit evidence, such as
procedures increased use of external an increased use of evidence
documentary evidence. This internally generated by the
will increase the strength of audit client (rather than
the evidence obtained and so evidence from an external
reduce the likelihood of not source). Auditors could also
detecting misstatement. place greater reliance on oral
Seek to perform procedures or visual evidence. This will
just before year-end or after reduce the strength of the
year-end (as opposed to earlier evidence obtained and so
increase the likelihood of not
in the year). This allows for
detecting misstatement.
the entire financial year to be
tested and, as a result, reduces Seek to perform procedures at
the risk of errors not being an interim stage
detected as a result of the (complemented by further
entire year not being included procedures later in the year),
in the testing. as the auditor can accept a
higher risk of not detecting
errors that occurred during the
period between the interim
testing and the year-end.
TO REDUCE DETECTION TO INCREASE DETECTION
RISK (WHERE THERE ARE RISK (WHERE THERE ARE
AVAILABLE
HIGHER OVERALL LOWER OVERALL LEVELS
RESPONSE
LEVELS OF INHERENT OF INHERENT AND
AND CONTROL RISK) CONTROL RISK)
Adjust the strength of the Make the review process more Make the review process less
review process rigorous and with a greater rigorous and less probing than
depth than normal (work done normal (work done by the
by the audit junior is reviewed audit junior is reviewed
by the audit senior and then directly by the audit partner –
again by the audit manager the audit senior and manager
and then finally again by the are skipped in the review
audit partner). This will make process). Given that there is
it less likely that misstatements only one review of the work,
will not be detected. this will make it more likely
that misstatements will not be
detected.
TO REDUCE DETECTION TO INCREASE DETECTION
RISK (WHERE THERE ARE RISK (WHERE THERE ARE
AVAILABLE
HIGHER OVERALL LOWER OVERALL LEVELS
RESPONSE
LEVELS OF INHERENT OF INHERENT AND
AND CONTROL RISK) CONTROL RISK)
Change the degree of audit Ensure the audit partner (who Ensure the audit partner is not
partner involvement probably has the best very actively involved in the
understanding of the entity and audit process. Have the audit
its potential for audit risk) is planned by a less senior
more actively involved in the member of the audit team
audit process (especially the (with it just being reviewed by
planning and review phases). the audit partner, for example).
This will make it more likely This will make it less likely
that risks and responses thereto that risks and responses
will be appropriate and thereto will be appropriate and
therefore the likelihood of therefore the likelihood of
misstatements not being misstatements not being
detected will reduce. detected will increase.
Introduce unpredictability Make regular changes to the Do not make any changes to
into the design of the audit audit approach (nature, timing the audit approach from year
procedures and extent of audit procedures) to year. It does not matter that
from year to year alternating the client is able to predict
between different ways of what evidence the auditor is
obtaining the necessary audit likely to be looking for. The
evidence. This will ensure that fact that the client may be able
the client is unable to predict now to anticipate the auditor’s
what evidence the auditor is procedures will increase the
likely to be looking for and so risk of not detecting
reduce the risk of not detecting misstatements.
misstatements.
REFLECTION
If you were the auditor of an entity, would you be comfortable with the suggestions made
in the right-hand column of Table 12.7?
Would you be comfortable, for example, to reduce the level of scepticism, or reduce the
amount of testing, or even reduce the extent of the supervision or review process? Would
you be happy to keep the audit partner out of the planning process?
Most students are quite comfortable with the middle column dealing with responses to
decrease the likelihood of not detecting misstatement, but they struggle with increasing the
likelihood of not detecting misstatement (the third column).
Remember that where the auditor is looking to increase the levels of detection risk, it
is because there is a low risk of material misstatement – inherent risk is low (the auditor is
not expecting misstatement) and/or control risk is low (the auditor is satisfied that the
client’s internal controls should prevent, or detect and correct, material misstatements).
The auditor therefore does not need much additional assurance about the presence of
misstatement through his or her substantive procedures. In other words, it is absolutely
fine that there is a higher risk of not detecting misstatements through his or her substantive
procedures.
REFLECTION
What might the auditor do to respond to the medium level of risk at financial statement
level for Ntsimbi Piping?
Any of the previously mentioned responses could be considered. Given that it is medium
risk, it would probably be necessary to reduce marginally the overall level of detection
risk to restore the level of audit risk to acceptable levels.
There are three areas pertaining to substantive procedures that the auditor can alter to respond
to a changing level of desired detection risk. These options are all discussed in more depth in
Chapter 13 but are summarised below:
Note: In each of the above examples, the first option provides stronger, more reliable evidence,
and hence reduces the level of detection risk to a greater extent.
All these options enable the auditor to vary what he or she plans to do to obtain the necessary
audit evidence to address the level of detection risk for each assertion. So, for example, if an
auditor needs to respond to a required level of detection risk that needs to be low for the
accuracy, valuation and allocation of trade debtors, the auditor could choose to make greater
use of external documentary evidence, possibly even provided by an auditor’s expert. If,
however, the auditor’s required level of detection risk is high, he or she could then opt for
substantive analytical procedures on internally generated documents as a means to obtain
relatively high levels of detection risk.
Both of the examples presented above reflect a change in the nature of testing in response
to the required level of detection risk that must be achieved.
Note: In each of the above examples the first option provides stronger, more reliable evidence,
and hence reduces the level of detection risk to a greater extent.
Note that modifications to the timing of planned audit procedures may also be influenced by
other factors, such as by when the audit has to be completed (if there is very little time after
year-end, the auditor may have to incorporate tests before year-end rather than after year-end)
or what audit approach is going to be adopted (e.g. if following a combined approach, it would
be important to schedule the substantive procedures to be after the tests of control). (Audit
approaches are discussed in the next section of this chapter.)
Remember that in responding to detection risk at financial statement level, the auditor may
already have planned to increase, for example, the extent of testing in all account balances and
classes of transactions (by having reduced performance materiality).
When considering the individual assertions, the auditor now considers whether for a
particular assertion to increase even more the extent of testing (a possible response to lower
levels of detection risk being required for the assertion being considered) or whether to
reduce/offset this overall increase in extent of testing (should the auditor wish to raise
detection risk for a specific assertion instead).
It is important to understand that there are therefore two elements affecting how much audit
work has to be performed for a particular assertion in a particular account balance/class of
transactions/disclosure. These are:
1. The auditor’s determination of performance materiality (which may or may not have been
adjusted to respond to financial statement level risk of material misstatement) (discussed
in more detail later on in this chapter); and
2. The desired level of detection risk for the specific assertion being considered (which is
influenced by inherent and control risk specific to that assertion only).
REFLECTION
What might the auditor do to respond to the high level of risk of material misstatement in
the accuracy, valuation and allocation assertion for the inventory account balance of
Ntsimbi Piping?
The auditor could consider making changes to:
• The nature of testing (e.g. through use of management’s experts (refer to ISA 500 for
further information about this) to assist in determining the net realisable value of
finished goods);
• The timing of testing is unlikely to be affected; and
• The extent of testing (through performing increased amounts of testing – i.e. larger
number of items to be audited – on the accuracy, valuation and allocation assertion,
both from a cost (accuracy) and a net realisable value (valuation) perspective).
WHY? Why does the auditor always have to perform at least some substantive
procedures? Why can he or she not adopt an audit approach that simply places
reliance on the operating effectiveness of internal controls?
Tests of control only provide the auditor with evidence about the operating
effectiveness of internal control and not regarding the rand value of the related
account balance/class of transactions. Tests of controls on their own will
therefore never provide sufficient audit evidence to support a conclusion about
the fair presentation of an account balance or class of transactions.
Also, the financial statements are a set of rand value figures. It would be
inappropriate for the auditor not to consider specifically the reasonableness of
these rand values in reaching conclusions about their fair presentation.
images
Figure 12.4: Diagrammatic representation of the audit risk model
When an auditor is considering the level of control risk, control risk can only ever be initially
assessed as low under the following conditions:
• The relevant control activity is well designed (it is capable of preventing, or detecting and
correcting, material misstatement); and
• The relevant control activity has been implemented (has been put in place by the client and
has been used throughout the period of intended reliance); and
• The auditor plans to place reliance on the relevant control activity (based on his or her
consideration of their design and implementation) and will therefore seek to obtain audit
evidence (through the performance of tests of controls) that the control activity is operating
effectively (is working as intended). Note that this is a planning decision and that it is only
after the subsequent tests of controls have been performed that this initial assessment of low
control risk can be confirmed.
The important point to note is that control risk can only ever be set as LOW when the auditor
plans to test the operating effectiveness of the relevant control activity, and tests of controls
subsequently performed by the auditor confirm that the control activity was operating
effectively for the period.
Note that the auditor does not have to test operating effectiveness of any controls (even if
they are well designed and have been implemented), unless, of course, he or she has to respond
to a risk for which substantive procedures alone cannot provide adequate audit evidence (refer
to section 12.5.5 of this chapter).
Tests of controls will always be performed prior to substantive tests because of the need
first to confirm that the initial assessment of low control risk is, in fact, appropriate. If tests of
controls indicate that controls are not, in fact, operating effectively, control risk would then
need to be increased and would in turn reduce the required level of detection risk, the planned
response to which would then need to be reconsidered and would probably require more
extensive substantive procedures to be performed.
REFLECTION
What would the implications be for either of these circumstances should the auditor
conclude that controls are not operating effectively?
In the case where the auditor is testing controls because substantive procedures alone
cannot provide sufficient evidence, a conclusion that controls are not operating effectively
would result in a modification to the audit opinion because without evidence that controls
are operating effectively, substantive procedures cannot give the auditor enough evidence
to support his or her conclusion.
In the case where the client has requested it, should the auditor conclude that controls
are not operating effectively, they would be able to communicate these deficiencies to
management, set control risk as high, reduce detection risk accordingly and then proceed
to design the necessary (more extensive) substantive procedures to obtain the required
level of evidence. This would not have any impact on the audit opinion.
2. Is it possible/feasible?
The second consideration is whether it is possible or feasible to test internal controls. A key
consideration is whether, based on the auditor’s understanding of the auditee’s internal control
system, he or she believes that the controls system is adequate to prevent, or to detect and
correct, fraud and errors (i.e., are the control activities well designed and is there evidence that
they have been implemented?).
Also, does the auditor have the necessary expertise or access to the software or technology
to test the operating effectiveness of controls? Is the information system structured in such a
way that it is possible to test controls should we wish to?
A situation where it is necessary to test controls but not possible will result in a limitation
on the scope of the audit and, if material, a modification or even disclaimer of the audit opinion
(unless the necessity arose out of a request by management – refer to the earlier reflection on
this matter).
A situation where it is not necessary to test controls and where it is not possible or feasible
anyway will not impose any scope limitations on the audit, as the auditor does not need to test
operating effectiveness. The auditor will have another avenue to follow to obtain the necessary
evidence about the affected account balances by adopting a substantive audit approach.
Obviously, if it is not possible to test controls, control risk must be set at high since there
will be no audit evidence obtained through tests of controls to suggest that controls are
operating effectively.
3. Is it desirable?
In the event that it is not necessary to test controls but is possible, this third consideration
becomes the deciding factor. This factor requires the auditor to consider the cost-effectiveness
of the two possible audit approaches (combined versus wholly substantive) as well as any other
factors that may influence his or her decision on whether to test controls or not.
When faced with the choice of either performing tests of controls and then limited
substantive procedures (a combined audit approach) or no tests of control and extensive
substantive procedures (a substantive audit approach), the auditor has to consider which route
is going to be more cost-effective. Which route would take less time and therefore be less
costly? Which route would be easier? If following a combined approach would take less time,
then performing tests of controls would be desirable. Obviously, if performing tests of control
would be more time consuming, given that it is not necessary to test controls, the auditor
would rather opt for a substantive audit approach.
There may be other circumstances where an auditor chooses to test internal controls even
though it is not necessary and not necessarily the most cost-effective route to reaching the
required levels of evidence. An example of this is a situation where the client has an historic
expectation that they will receive feedback on the operating effectiveness of internal controls
from their auditor. To manage that expectation, the auditor may choose to test controls just so
the client can receive their expected feedback. This allowance on the part of the auditor may
enhance the auditor–client relationship and may be a strategic choice that the auditor makes for
the longer term retention of that client.
12.6.5 Updating the audit approach and plan throughout the audit
The audit approach and plan (in other words, the auditor’s response to identified risks of
material misstatement) are updated as new circumstances come to the auditor’s attention,
making planning an iterative and continual process throughout the audit engagement. During
the audit process, information may come to the auditor’s attention that differs significantly
from the information that was available when the auditor initially planned the nature, timing
and extent of the procedures. Based on a revised consideration of the risk assessment at the
financial statement and/or assertion level for some or all of the classes of transactions, balances
or disclosures, the auditor re-evaluates the planned audit procedures.
For example, through performing interim tests of controls at a client, the auditor may
obtain audit evidence that indicates that reliance on internal controls, as was initially planned,
cannot be placed on specific controls and therefore additional substantive procedures are
required. Alternatively, while performing detailed substantive analytical procedures, results
may identify possible material misstatement in a class of transactions that was previously not
assessed. If this is the case, the audit plan needs to be updated accordingly to incorporate
substantive tests of details to respond to the increased risk.
12.7.1 Definition
ISA 320 (Materiality in planning and performing an audit) defines misstatements to be
‘material’ if:
Individually, or in the aggregate (i.e. together with other misstatements), they could
reasonably be expected to influence the economic decisions of users taken on the basis
of the financial statements.
Before this definition is unpacked, it is important to note that the ISA goes on to make two
further suggestions that assist in understanding when a misstatement is judged to be material.
First, the ISA suggests that judgements about materiality ‘are made in light of the
surrounding circumstances, and are affected by the size or nature of a misstatement, or a
combination of both’.
Second, the ISA suggests that where judgements are made about matters that may be
considered material to users of financial statement information, these judgements are ‘based on
a consideration of the common financial information needs of users as a group’. It goes on to
suggest that ‘the possible effect of misstatement on specific individual users, whose needs may
vary, is not considered’.
• The auditor does not need to consider the possibility that individual users may make
personal economic decisions that are different to the main user group of which they are a
part. Typically, user groups fall into one of several different categories:
• Shareholders: This group has already invested money in the company and is looking to
decide whether they should retain their shareholding. This is likely to be influenced by
the ability of the company to generate acceptable profits and also possibly by the
potential for growth in the capital value of their investment. Profitability and potential
for growth are important to this group.
• Potential investors: This group is looking to invest their money in a viable investment
vehicle (often having the option to choose from several different opportunities). This
group would probably be most concerned with potential for capital growth and potential
for future returns, and would be looking for the company producing the best potential in
these two areas. As with shareholders, who are existing investors, this group is also
looking at profitability and potential for future growth.
• Debt funders: This group has either already advanced finance to the company or is
considering doing so. Their main concern and decision-making process is going to be
influenced by the ability of the company to meet its interest and capital repayment
commitments. Solvency and liquidity are going to be important to this group.
• Other groups: Naturally, there may be other groups that can be identified, each of which
also have their own decision-making needs when it comes to using the financial
statement information. Other groups could include the following:
• Government in awarding tenders or grants to companies;
• The South African Revenue Service (SARS) in reviewing the reasonableness of the
company’s tax compliance;
• Landlord – in entering into long-term rental arrangements with the company; and
• Suppliers in advancing credit to the company.
When making assumptions about the needs of a group of users of the financial statements, we
are entitled to assume the following:
1. They have a reasonable knowledge of business and economic activities and accounting,
and a willingness to study the information with reasonable diligence;
2. They understand the financial statements are prepared, presented, and audited to levels of
materiality;
3. They recognise the uncertainties inherent in the measurement of amounts based on the use
of estimates, judgement, and the consideration of future events; and
4. They will make reasonable economic decisions on the basis of the information in the
financial statements.
There are two different terms relating to materiality that will be elaborated on in the text below.
It is useful to start off with a high-level overview of these terms:
Materiality This refers to the level of acceptable misstatement for the financial
statements as a whole, as typically determined when establishing the
overall audit strategy. Materiality can also be set at differing levels
for particular classes of transactions, account balances or disclosures
if it is felt that misstatements of amounts less than materiality in
these instances might affect decisions taken by users of the financial
statements.
In practice, this calculation of materiality is often referred to as
‘Planning materiality’ because it is determined during the planning
process for an audit.
In practice, there are a series of steps that the auditor typically follows to arrive at this number:
The auditor needs to choose the component that he or she believes users would be most
interested in when making decisions based on their user group. Operating profit is often an
important component to most user groups, but, given its possible relative instability from year
to year, it is often replaced by revenue or gross assets, which tend to be more stable.
The nature of the business also plays a part in choosing the most appropriate component. A
service company, for example, is unlikely to have a large asset base and assets are thus unlikely
to be used as a benchmark for this type of company. A manufacturing company, however, is
likely to have an extensive asset base, making the use of assets for this type of company
appropriate for consideration as a benchmark for materiality.
The entity’s ownership structure and how it is financed may also have a bearing on which
component is chosen. Where there is a lot of debt finance, lenders may be most interested in
the asset base, which represents their security in the event the entity is unable to repay them.
It is also possible to set different levels of materiality for different classes of transactions,
account balances or disclosures where misstatements that are less than materiality in these
specific elements might affect the decisions taken by the users of the financial statements. Take
a property-owning company for example: The Statement of Financial Position (SOFP) will
reflect a large rand value in terms of Property, Plant & Equipment and yet the Statement of
Other Comprehensive Income (SOCI) is only likely to include rental income and related
operating expenses, resulting in a relatively small operating profit. If gross assets were used as
the sole component in the materiality calculation, it is likely that none of the individual
amounts in the SOCI would be individually material! It may thus be more appropriate to
determine two materiality numbers – one (based on gross assets) that is applied to the SOFP
accounts and another (possibly based on rental revenue) that is applied to the SOCI accounts.
Note, however, that this is the exception rather than the rule.
Although auditors are free to determine their own range, most auditing firms in South Africa
use some of the following ranges:
• If using revenue as a base: from ½% to 1% of revenue
• If using gross profit as a base: from 1% to 2% of gross profit
• If using operating profit before tax as a from 5% to 10% of operating profit
base: before tax
• If using gross assets as a base: from 1% to 2% of gross assets
• If using equity as a base: from 2% to 5% of equity
If, for example, the auditor has chosen to use revenue as the benchmark and the adjusted
revenue figure (based on prior year audited financial statements adjusted for a percentage
increase in current year trading activity) was R100 million, then the range within which the
auditor would set the level of materiality would be:
½% of R100m to 1% of R100m
R500 000 to R1 000 000
It should be noted that there is no prescription in ISA 320 regarding how to calculate
materiality and while most audit firms use the ranges and methodology taught in this text, there
will be audit firms whose materiality calculations differ from this. For example, some audit
firm do not calculate a range from within which to choose materiality. Instead they simply
specify a single % that must be used.
images
Figure 12.5: Setting of materiality
The final setting of materiality becomes an exercise in professional judgement on the part of
the auditor (i.e. where in the range he or she will choose to set the materiality figure).
It is important to note that materiality is not adjusted based on the level of required detection
risk at financial statement level. Any desired changes to the extent of testing are effected
through modifications to the level of performance materiality (which is then based on the
calculated materiality determined as described above).
The auditor uses performance materiality when working on individual account balances,
classes of transactions or disclosures. This figure is lower than materiality and reduces the risk
that cumulative misstatement will significantly exceed materiality.
Typically, this figure is established through applying a fixed percentage to the materiality
figure. The setting of this percentage is an exercise in professional judgement by each auditing
firm and will therefore differ among the audit methodologies of different firms.
Auditing firms often apply a different performance materiality percentage based on
whether the audit is regarded as a high- or low-risk engagement. For them, this is therefore an
automatic response to the level of detection risk at financial statement level (e.g. the lower the
performance materiality is, the more items will need to be tested and the lower the level of
acceptable misstatement will be, thus reducing the level of detection risk).
EXAMPLE
The following options might be available to an audit firm in terms of adjustments to the
level of performance materiality dependent on the assessment of risk of material
misstatement (ROMM) at an overall/financial statement level:
• High ROMM – need to reduce overall DR, so use 70% of materiality when
calculating performance materiality
• Medium/normal ROMM – no need to adjust overall DR, so use 80% of materiality
when calculating performance materiality
• Low ROMM – need to increase overall DR, so use 90% of materiality when
calculating performance materiality.
There will be misstatements detected during the audit process that, even when considered
cumulatively with other identified misstatements, will never be significant enough in their own
right so that they will affect the decisions taken by users of the financial statements. These
misstatements are referred to as being ‘clearly trivial’.
The determination of this level of misstatement regarded as clearly trivial is again a fixed
percentage of materiality. As with determining performance materiality percentages, auditing
firms again use professional judgement to set this level as a fixed percentage of materiality.
The percentage is usually small to ensure that the misstatements it then excludes could never
be seen to be significant individually or cumulatively, together with other uncorrected
misstatements.
Should a clearly trivial misstatement be identified, the auditor can ignore it for the purposes
of considering the cumulative effect of identified misstatements on the financial statements.
Identified misstatements that are not clearly trivial are accumulated in a working paper called a
schedule of audit differences, which is discussed in detail in Chapter 15.
REFLECTION
Can a misstatement that is clearly trivial ever be seen to be material?
Yes, it is possible…
Clearly trivial is only a reference point to be used when considering quantitative
materiality and is not to be used when considering the qualitative nature of the
misstatement.
It is possible that a misstatement that is clearly trivial in terms of its rand value may
still be regarded as material to decisions taken by users of the financial statement
information due to its significant nature.
Consider fraud committed by a director as an example. Regardless of the amount
involved, this action is likely to be very important to users and may well affect their
decisions on whether they retain their investment or not. Shareholders, potential investors
and funders are all likely to become nervous should they discover that the very people
they have entrusted to look after their money, are embezzling it. The amount involved will
not be important to them – their decisions will be affected by the nature of the matter.
The application of the steps in the determination of materiality, performance materiality, and
clearly trivial figures discussed above are illustrated in the working paper that follows for the
audit of Ntsimbi Piping.
1 Note for the reader: For the purpose of this example, the assumption was made that the figures available at
the planning stage of the audit and those eventually appearing in the final audited financial statements are
materially the same, and that no material adjustments had to be made between the figures available at the
planning stage and the final figures.
3. The scheduling of any meetings (internal or external) that might be required to facilitate
the process:
a) Dates and times of client planning meetings.
b) Dates and times of meetings to request, and discuss, required management
representations.
c) Dates and times of internal planning meetings (including a discussion on identified
risk of material misstatement and planned responses, specifically including any fraud
risk considerations).
d) Details of scheduled feedback meetings with the audit engagement partner/manager.
e) Dates of inventory count planning meetings with the client.
f) Dates of final sign-off meetings with the client to discuss the auditor’s findings and
any recommendations that they may have.
4. The setting of an audit budget that will guide the audit team’s work:
a) The determination of how long it would be expected to take to complete the various
sections of the audit and what this would likely cost (time x charge-out rate of staff
member concerned).
b) The determination of any additional costs that might be required (such as, travel and
accommodation costs if staff need to travel to other locations to perform procedures).
5. The negotiation of an acceptable fee for the auditor to perform the audit. Ideally, the audit
fee should not be negotiated with a client until the engagement partner has clarified the
scope of the engagement and completed the planning process so that the resultant costs to
discharge the auditor’s duties (e.g. in executing the audit strategy and audit plan) have
been determined.
Assessment questions
For questions 1 to 3, indicate whether the statement is true or false:
1. ISQC 1 requires that auditing firms do not accept engagements for which they cannot
comply with relevant ethical requirements. (LO 2)
2. A consideration of whether or not the entity appears to be a viable going concern should
be undertaken during the pre-engagement phase of the audit. (LO 3)
3. An entity that processes a very large number of transactions on a daily basis would be an
example of a situation where substantive procedures alone could seldom be likely to
provide sufficient appropriate audit evidence. (LO 13)
For questions 4 to 18, select the correct answer(s). More than one answer is possible:
4. Which of the following activities do not form part of the pre-engagement process? (LO 3)
a) Deciding which audit staff members need to be assigned to the audit engagement
b) Determining whether or not it is likely that the auditors will be paid by the audit
client
c) Assessing the risk of material misstatement in the financial statements
d) Finalising the audit fee for the engagement with management
e) Reaching agreement on the scope of the audit engagement
5. Which of the following circumstances would have only limited impact on an auditor’s
decision on whether to accept an audit engagement? (LO 3)
a) The preconditions for an audit have not been met.
b) There are question marks about the integrity of the sales manager.
c) The industry is highly complex and systems are extensively computerised.
d) The previous auditor resigned from the engagement because of a dispute with the
financial director over who is the best driver in Formula 1 (it is obviously Fernando
Alonso but the financial director kept insisting it is Lewis Hamilton!).
e) The auditor and his or her staff do not have available capacity.
f) The financial director is a personal friend of the auditor (which is why the auditor
was given the opportunity to tender for the engagement).
g) All of the above
6. Why is it important for the auditor to document his or her understanding of the terms of
the engagement in an engagement letter prior to commencing with the audit work? (LO 4)
a) To avoid any misunderstanding when it comes to who is responsible for what in
relation to the audit
b) To set out the actual audit fee (and payment terms) in writing so that there is no
dispute about fees after the audit has been completed
c) To ensure that management do not have any misunderstanding when it comes to
what the scope of the audit encompasses
d) To make it clear to management that it is the auditor’s responsibility to prepare the
financial statements in terms of the applicable financial framework and that they
should not impose any restrictions on the auditor when it comes to having to meet
this requirement
e) All of the above
9. Which of the following factors would be likely to result in a requirement for the auditor to
reduce detection risk at financial statement level through substantive procedures? (LO 9)
a) The auditor has reason to believe that management lacks integrity.
b) The auditor has no reason to doubt the competence of the financial accountant.
c) The control environment is weak.
d) Control activities over the revenue and receipts cycle are well designed and have
been implemented throughout the year.
e The entity is seen to be a viable going concern.
10. Which of the following would not be classified as fraud from an audit risk perspective?
(LO 12)
a) Theft of petty cash by a junior employee (not regarded as management)
b) A decision made by management to cut off the processing of transactions early so as
to move transactions into the following financial year
c) A mistake made by management when determining the impairment adjustment for
inventory that resulted in profits being significantly overstated
d) An employee who ‘borrows’ an asset from the company but then ‘forgets’ to return it
e) A journal entry being processed by management to correct a classification error with
regard to the categorisation of various investments, this has the effect of improving
the ‘look’ of the financial statements.
11. Which of the following considerations would be classified as a response involving the
planned nature of testing? (LO 16)
a) Choosing to perform substantive tests of details prior to year-end as well as after
year-end
b) Choosing to perform a debtors’ circularisation rather than a subsequent receipts test
to conclude on the existence of accounts receivable
c) Choosing to extract a sample of items to test rather than choosing items haphazardly
d) Choosing to increase the number of items to be tested in detail from 25 to 35
Choosing to make use of an expert to assist with the valuation of plant and
e)
equipment at year-end.
12. Which of the following circumstances would have to be present for an auditor to choose
to adopt a combined audit approach? (LO 17)
a) Control activities have been adequately implemented by the entity.
b) It is necessary for the auditor to perform tests of control.
c) It is feasible for the auditor to perform tests of control.
d) A substantive approach must be more cost-effective than a combined approach.
e) Control activities have been well designed.
13. We refer to the 4 Ps when it comes to the various sources from which information about
the entity can be obtained. Which one of the following is not one of the 4 Ps? (LO 6)
a) Paper
b) People
c) Analytical Procedures
d) Premises
e) None of the above – each of them is one of the 4 Ps.
14. If inherent risk in the valuation assertion for inventory is regarded as being high and the
auditor has determined that it would not be possible to place any reliance on control
activities over this assertion, what would the likely level of detection risk for the valuation
assertion be? (LO 9)
a) Very high
b) High
c) Normal
d) Low
e) Very low
15. Which of the following conditions would not be indicative of a significant risk? (LO 10)
a) Transactions are complex.
b) There has been a significant change in taxation legislation.
c) A new accounting standard has been released.
d) A fraud risk has been identified.
e) None of the above – they are all indicative of a significant risk.
16. If detection risk at financial statement level is required to be high, which of the following
audit responses might be appropriate? (LO 14)
a) Increase the extent of partner involvement in the audit process.
b) Increase the level of performance materiality.
c) Increase the amount of professional scepticism to be adopted by the engagement
team.
d) Increase the amount of supervision over the audit process.
e) All of the above responses
f) None of the above responses
17. Choose which sequence of the following events is most correct when it comes to the
determination of performance materiality. (LO 19)
1. Determine the materiality figure to be used.
2. Consider your planned responses to overall financial statement level risk.
3. Choose a set of figures on which to base your calculation.
4. Consider how sensitive user groups of the financial statements are to misstatements.
5. Determine the performance materiality figure to be used.
6. Calculate the range within which you will choose the materiality figure.
7. Choose the component that best reflects users’ priorities.
a) 3 7 6 2 1 5
b) 7 3 4 6 2 1 5
c) 3 7 6 4 1 2 5
f) None of the above
18. Indicate which figure best represents the likely level of materiality under the following
circumstances: (LO 19)
• Revenue has been chosen as the most appropriate component.
• Prior year revenue (per the audited accounts) was R100,000,000.
• Your understanding of the entity reveals a 20% growth in sales in the current year.
• Users are not seen to be very sensitive to misstatement.
a) R2,000,000
b) R1,100,000
c) R900,000
d) R750,000
e) R500,000
19. Explain briefly what the main difference is between an overall audit strategy and an audit
plan. (LO 1)
20. Why is it important for an auditor to obtain a thorough understanding of the entity before
he or she commences his or her planning activities? (LO 5)
21. Why is it important for the auditor to understand any business risks present in the entity?
(LO 7)
22. Why is it important to consider the entity’s going concern status during the planning phase
of an audit? (LO 11)
23. How does the auditor respond to assessed inherent risk and control risk at the class of
transactions level for a particular assertion? (LO 15)
CHAPTER CONTENTS
Learning outcomes
Reference list
13.1 Where do audit procedures fit into the audit process?
13.2 What are audit objectives?
13.3 What is the nature of further audit procedures?
13.4 What is the timing of further audit procedures?
13.5 What is the extent of further audit procedures?
Assessment questions
Appendix
LEARNING OUTCOMES
There are a large number of International Standards on Auditing covered in this chapter. What is listed here
are those Standards that you are expected to read in detail in conjunction with this text.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International Standard on
Auditing (ISA) 330 The Auditor’s Responses to Assessed Risks.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International Standard on
Auditing (ISA) 500 Audit Evidence.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International Standard on
Auditing (ISA) 520 Analytical Procedures.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International Standard on
Auditing (ISA) 530 Audit Sampling.
Other Standards, not listed above, but referred to in the chapter, should also be consulted to understand fully
the requirements that apply to Registered Auditors in South Africa.
To develop the nature, timing and extent of audit procedures required to reduce audit risk to an acceptably low
level, the audit plan should deal with the following:
• The nature, timing and extent of risk assessment procedures (these procedures have been covered in
Chapter 12) in order to gather evidence on which to assess the risk of material misstatement at the financial
statement and assertion levels;
• The nature, timing and extent of further procedures to respond to the assessed risks of material
misstatement (such as tests of controls and substantive procedures – these are covered in this chapter); and
• The nature, timing and extent of other audit procedures that are required to ensure that the engagement
complies with ISAs (such as procedures to ensure that reliance can be placed on experts and internal
auditors where appropriate – these are covered in Chapter 14).
By now you are familiar with Figure 13.1 below that depicts the audit process. In this chapter, we focus on the
highlighted area.
Figure 13.1: The audit process
The nature, timing and extent of the further audit procedures are discussed in detail in this chapter:
• Nature refers to the purpose of the procedures that the auditor chooses to perform (such as tests of controls
and substantive procedures) and to the types of procedures used for obtaining audit evidence (e.g. enquiry,
analytical procedures, third-party confirmation) (i.e. what to do).
• Timing refers to when the audit procedure is performed (e.g. performing testing at an interim period, year-
end stage, or at a specific date), as well as the period or date to which the audit evidence applies.
• Extent refers to the quantity (i.e. how much) of the audit procedures to be performed, therefore often
referring to the sample size used for an audit procedure, whether test of controls or substantive procedures.
Each of these critical auditing concepts is addressed in depth in this chapter in order to facilitate a detailed
understanding of their practical application and their relevance to the entire audit process. After first
introducing the concept of audit objectives, an extensive discussion about the nature of audit procedures
follows. The timing and extent of audit procedures respectively are dealt with in two sections that follow.
Imagine an empty bucket representing a vessel that the auditor has to fill with audit evidence to support a
specific assertion (e.g. the completeness of sales) (Figure 13.2). The risk assessment procedures will inform
the risk assessment which will determine the size of the empty bucket (the higher the assessed risk, the larger
the bucket). The audit objective is (as above) to test that all sales transactions have been completely recorded
in the accounting records and none have been omitted. The auditor can achieve this objective and, in doing so,
gather the necessary audit evidence by performing:
• Tests on the operating effectiveness of controls over the completeness of sales (this will provide some of
the audit evidence required to fill the bucket, but more evidence from another source (substantive
procedures) will be required – see bullet below) (you will recall this from Chapter 12 as a controls-based
(combined) audit approach); and/or
• Substantive procedures on the completeness of sales:
• This will provide either the remainder of the audit evidence required (if tests of controls have provided
some already – see bullet above); or
• All the audit evidence required (if no tests of controls have been performed) (you will recall this from
Chapter 12 as a substantive audit approach).
In the remainder of this chapter, we focus on the formulation of these two types of audit procedures.
CRITICAL THINKING
What is the difference between an audit objective and a control objective?
Control objectives were described as follows in section 4.4.2.1 of Chapter 4:
‘Each class of transactions that flows through the accounting system of an entity carries with it certain
risks, in other words, things that could go wrong in the execution of that particular class of transactions.
In order to address these risks, management and those charged with governance should formulate
objectives that they want to achieve for each class of transactions. This will prevent the risks associated
with that particular class of transaction from materialising, and, if they do materialise, to detect and
initiate corrective action to mitigate the resulting negative consequences. These objectives are called
control objectives.’
It is clear from the above that control objectives are management’s objectives with the controls that
they implement.
This is worlds apart from audit objectives that were introduced in this section – they are the auditor’s
objectives that are achieved by performing audit procedures (i.e. tests of controls and substantive
procedures).
Nature refers to the purpose of the procedures that the auditor chooses to perform and to the types of
procedures used for obtaining audit evidence (i.e. what to do).
As discussed in preceding chapters, the nature of the procedures that the auditor chooses to perform to gather
sufficient appropriate audit evidence relating to the financial statements depends on the purpose of the
procedures, being either tests of controls or substantive procedures. The nature of procedures also relates to
the types of procedures that would be appropriate in the circumstances, such as inspection, reperformance,
observation, enquiry, recalculation, analytical procedures and requesting third-party written confirmations. As
part of the audit plan, the auditor has to determine the appropriate combination of the audit procedures to be
performed to gather sufficient appropriate audit evidence about a particular assertion.
In responding to the assessed level of risk of material misstatement at the assertion level, the auditor must
decide whether to perform tests of controls (with limited substantive procedures) or whether to perform
substantive procedures exclusively. In making this decision, the auditor generally evaluates the following
(refer to section 12.6.4.3 of Chapter 12 for more details):
• The necessity of placing reliance on internal controls;
• The possibility of placing reliance on internal controls; and
• The desirability of placing reliance on internal controls.
The necessity of placing reliance on controls would arise if the auditor’s assessment of risk of material
misstatement at the assertion level includes an expectation that the controls are operating effectively.
Necessity also arises if substantive procedures alone cannot provide sufficient appropriate audit evidence
at the assertion level.
A test of controls-based audit approach may therefore be considered necessary because of the following:
• The nature of the business and the effect of information technology on the audit;
• Client dependence on a computerised system (some accounting data may only be available in
electronic format);
• A tight audit deadline; and/or
• Complexity of the computerised system or a large volume of information processed.
In evaluating the possibility, the system of internal control needs to be sufficiently strong to justify
reliance. The entity also has to allow the auditor access to the system for sufficient periods of time in
order for adequate testing to be performed. Furthermore, in a computerised environment, the client’s
systems also have to be compatible with the auditing firm’s audit software (used to perform audit
procedures on the client’s systems and data).
The desirability of a controls-based audit approach will often depend on whether it will be cost-
effective, considering the time to be spent on tests of controls versus the time to be saved on performing
substantive procedures. To perform tests of controls, the auditor may need to include the use of CAATs
(discussed in Chapter 14), as well as specialised computer personnel (experts), which may prove to be
extremely costly in relation to the benefits, such as time savings, to be obtained.
Whether or not a controls-based audit approach is desirable may also be affected by work performed
by other parties, such as internal auditors within the entity (internal auditors are addressed later in section
14.3.4 of Chapter 14).
Lastly, it should be borne in mind that there are certain audit procedures that are particularly well suited to
address specific areas of the financial statements. These include the attendance of a client’s inventory count or
wage payout (to gather evidence about the existence of inventory and occurrence of wages respectively),
performing debtors circularisations (to gather evidence about the existence of trade receivables) and
requesting written confirmations from financial institutions for bank balances (to gather evidence about the
assertions relating to the bank balance). These types of audit procedures are discussed in Chapter 14.
Now that we understand that the auditor has two broad categories of further audit procedures at his or her
disposal, let’s look at these in detail. We start off with tests of controls and then move on to substantive
procedures.
Tests of controls are audit procedures that the auditor performs to obtain audit evidence regarding the
operating effectiveness of controls in place at the entity to prevent, or detect and correct, material
misstatements at the assertion level for the period subject to audit.
As transactions that occur within an entity are recorded on source documents and then are processed through
the accounting system, they are subjected to a range of internal control procedures. It is management’s
responsibility to ensure that these internal controls are properly designed and implemented and are operating
effectively and efficiently to prevent, or detect and correct, misstatements in the financial statements. If these
accounting systems and related internal controls prove to be sound and operating effectively, it improves the
reliability of the resultant balances and totals produced by the financial information systems. In other words, if
controls achieve the control objectives they are intended to achieve, management can make their assertions in
the financial statements with reasonable confidence. Refer to section 4.4.2.4 of Chapter 4 for a more detailed
explanation of the link between control objectives and assertions.
The auditor performs audit procedures (tests of controls) on the client’s internal control procedures on
which he or she wishes to rely, in order to obtain audit evidence that the controls have been operating
effectively for the period under audit. Should the auditor conclude that the controls tested can be relied on, it
suggests that there is a much lower probability that the assertions for the related classes of transactions,
account balances and other disclosures contain material misstatements. Having so concluded, the auditor can
therefore now spend less time on substantive procedures to obtain sufficient appropriate audit evidence that
the specific assertions are free from material misstatement.
Remember that testing the operating effectiveness of controls is different from gaining an understanding of
the design and implementation of the controls. In order to carry out an effective audit, the auditor always has
to first understand the client’s internal control system. Gaining an understanding of the design and
implementation of controls is done as part of the risk assessment procedures addressed in Chapter 12. Only if
the controls have been designed and implemented properly can testing of the controls be considered by the
auditor.
Tests of controls can be carried out using one or a combination of the following types of procedures:
• Inspection: Inspecting source documents for evidence to verify whether or not the internal controls are
operating effectively (e.g. inspecting for the appropriate signature on an EFT authorisation to confirm that
the relevant management authorisation of the transaction was obtained, in order to verify the validity
(control objective)/occurrence (assertion) of the payment made);
• Enquiry: Questions directed at persons as to the internal control procedures that are in place, who performs
the procedure and what exactly they do, in order to confirm the operating effectiveness of a specific control
in operation (and thereby obtain evidence about the relevant control objectives and related assertions);
• Reperformance: Repeating the exact same internal control procedure as previously performed by the
entity’s staff (e.g. reperforming a control in place over the granting of credit to new customers that meet
certain criteria, in order to determine whether the control procedure was originally performed in the way it
should have been performed); and
• Observation: Observing a process or procedure being performed by an employee (e.g. observing the
process that the security guard performs when a delivery truck leaves the warehouse, such as inspecting the
goods in the delivery truck and comparing these to the accompanying delivery notes, to verify whether the
control is operating effectively to prevent theft of inventory (validity control objective), thus providing
audit evidence about the existence of inventory and accuracy/completeness of sales (assertions)).
CRITICAL THINKING
Why is the use of ‘observation’ as an audit procedure not very reliable?
Although observation provides evidence about the procedure, it is limited to the point in time when the
observation takes place. For example, the security guard, knowing he or she is being observed, will most
likely perform his or her duties correctly at the time, but may not do so for the remainder of the period
that is subject to the audit.
Note: The demonstration is not comprehensive and highlights only a selection of key controls and
corresponding tests of controls. Also, note that not all functional areas in the cycle are addressed. The
intention is to provide a range of examples of how tests of controls can be applied and should be formulated,
so that readers can apply the principles to any of the business cycles and their functional areas.
Control deviations may be indicative of deficiencies in internal control. The auditor may react to them as
follows:
• Enquiring from management as to the reasons for the deviations identified;
Identifying compensating controls if applicable (addressed in Chapter 4) and possibly testing them, or
• alternatively setting control risk at a maximum level and adjusting the nature, timing and extent of
substantive procedures accordingly (see section 13.3.2.4.2 below); and
• Reporting the control deviations/weaknesses to management and, if appropriate, those charged with
governance of the entity.
Reliance on tests of controls therefore reduces the extent of substantive tests required, provides more
flexibility on their timing, and allows for less reliable evidence to be obtained from them, but will never
obviate the need for substantive procedures. The reasons for this are as follows:
• Internal controls may have been strong at the time that the auditor performed the tests of controls, but not
at other times during the year.
• Internal control systems have inherent limitations (as addressed in Chapter 4).
• The auditor’s assessment of risk (e.g. inherent risk) is judgemental and may not identify or take into
account all factors impacting on the risk of material misstatement. In other words, the nature, timing and
extent of tests of controls performed are responsive to the auditor’s risk assessment for the assertion, which
could be incorrect.
Therefore, some substantive procedures will always have to be performed on every material assertion in the
financial statements even if these procedures are confined solely to substantive analytical procedures.
Assertions addressed
The valuation component of the accuracy, valuation and allocation of accounts receivable.
2. Enquire from management about any changes to the system of credit checking that might
have taken place during the year and observe the relevant staff member at the service
organisation performing a credit background check for a new credit customer to assess the
credit controller’s level of understanding of the control being performed.
3. Enquire from management whether the control is, in management’s view, sufficient to
ensure the recoverability of debt granted to credit applicants, and corroborate their opinion
with prior and current audit knowledge of the amounts of bad debts that were written off.
4. Reperform the credit background check for the sample of credit customers selected.
W Inspected the customer’s credit application form and confirmed that a credit limit (as
documented above) appeared on the form as evidence of DebtACheck (Pty) Ltd having
allocated a credit limit to the applicant. Further inspected the form for evidence of
approval of the credit limit and noted on each form the signature of the credit
controller, Mike Milton.
Q For each debtor in the sample, attached to its credit application form was a ‘consumer
credit report’ showing the debtor’s current credit rating of either AA or BB and its
credit history, as prepared by DebtACheck, to verify the creditworthiness of the
customer.
X No consumer credit report was attached to the customer’s credit application form.
Enquiry from Mr Milton revealed that the credit background was performed, but that
DebtACheck never attached the supporting documentation to the credit application
form.
Z For the exception noted (see above: symbol ‘X’), and in terms of procedure (4), the
credit background check was reperformed by logging onto a credit bureau’s website
using the audit firm’s username and password. (Note that the audit firm has a standing
read-only account with a credit bureau who offers a paid-for service, allowing
subscribers to perform online credit checks and observe the credit limits allocated to an
entity by other entities in the past). The bureau’s name will be specified in the working
paper under the procedure performed.) It was noted that the applicant, ENH Telecoms,
has a clean credit record at query date and had been awarded limits by other suppliers
to a maximum of R20,000 in the past, in line with the limit of R18,000 awarded by
Ntsimbi Piping. The customer has an ‘AA’ credit rating.
N/A Procedure not applicable, as the consumer credit report from DebtACheck attached to
the application form is considered sufficient and appropriate for the purpose of testing
the effectiveness of the controls surrounding the verification of debtors’
creditworthiness.
2. With management’s permission, a visit to DebtACheck’s premises was arranged. Observed
on 28 October 20X1 the credit officer at DebtACheck assigned to Ntsimbi Piping
performing a credit background check on a new credit applicant named ADK Stores (no. 6
in the sample), by logging onto a national credit database, with his username and password
and entering the applicant’s business registration number. Based on the results of the credit
check and the credit rating of the applicant, the credit officer recommended a credit limit of
R120,000 for the applicant (by writing the limit on the application form). Enquired from
the credit officer about his understanding of the credit check process and it was determined
that his understanding is in line with the system description thereof (refer WP R-004).
Enquired from Mr Mike Milton (credit controller) and Mr James Khumalo (financial
3. manager) respectively whether the credit check control is, in management’s view, sufficient
to ensure the recoverability of debt granted to credit applicants and both replied that the
control is sufficient to this effect. Their view is in line with the results of audit procedures
performed on a comparison of actual bad debts written off for the year to date and the prior
year allowance for credit losses. (Note that a reference to the applicable working paper
where bad debts and the allowance were tested will be included here).
4. For each of the new credit customers in the sample, the credit background check was
reperformed by following the procedures as described under symbol ‘Z’ above and for each
of the customers it was noted that they had an ‘AA’ or ‘BB’ credit rating and that the credit
limit recommended by DebtACheck and approved by the credit controller is in line with
credit limits previously awarded to the customers by other entities.
Conclusion
Based on the audit procedures performed and the audit findings obtained for the sample
selected, it is concluded that the internal controls ensuring the approval of new debtor
accounts and the verification of customers’ creditworthiness lead to valid (authorised) sales
transactions in the financial records.
Note: The working paper above does not contain all the tests of controls that the auditor will carry out in
relation to the validity control objective for sales transactions. In line with the functional area ‘Authorisation
of sales orders’ previously illustrated in this chapter, additional tests of controls will be performed. Other
functional areas may also affect the validity control objective for sales transactions and have not been
illustrated here.
Substantive procedures, consisting of analytical procedures and tests of details (of classes of transactions,
account balances, and disclosures), are procedures that the auditor performs in order to obtain audit
evidence specifically designed to detect material misstatements at the assertion level. They are
specifically aimed at detecting material misstatements of amounts and disclosures.
In other words, the objective of substantive procedures is to verify directly whether an assertion (relating to a
class of transactions and events and related disclosures, an account balance and related disclosures, or other
disclosures) is free from material misstatement.
CRITICAL THINKING
How does this differ to the objective of tests of controls?
The objective of tests of controls is to evaluate the operating effectiveness of the internal controls in
preventing, or detecting and correcting, material misstatements for an assertion (i.e. did the controls work
or not? Did they work throughout the period?) and then relating the evidence obtained to the assertion
level, thereby providing indirect evidence about whether the related assertions are free from material
misstatement. The objective of tests of controls is therefore not to directly detect misstatements of
amounts and disclosures in the entity’s financial statements.
Three types of substantive procedures are discussed separately in this section, namely:
• General substantive procedures: These are substantive procedures that are performed on every audit in so
far as they are applicable.
• Substantive analytical procedures: These involve evaluations of financial information through analysis of
plausible relationships among both financial and non-financial data (e.g. ratio and trend analysis), as well
as the subsequent investigation of any unusual relationships identified.
• Substantive tests of details: These consist of inspection, enquiry, external (third-party) confirmation,
recalculation, and reperformance. (Note that observation of a process or procedure being performed cannot
serve as a substantive procedure, as it cannot provide audit evidence about an amount or disclosure. It can,
however, serve as a test of controls, as was described in section 13.3.2.1.)
EXAMPLE
Ntsimbi Piping (Pty) Ltd
General ledger account: Trade receivables
(Notes (1) – (6) illustrate the procedures discussed above)
• That all disclosures which should have been included in the financial statements, have been included
(completeness);
• That all disclosed transactions/events have occurred and pertain to the entity (occurrence);
• Financial and other information disclosed has been appropriately measured and described (accuracy,
valuation and allocation);
• Transactions, events and account balances have been recorded in the proper accounts (classification);
and
• Transactions, events and account balances are appropriately aggregated/disaggregated and clearly
described, and the related disclosures are relevant and understandable in the context of the
requirements of IFRS (or other applicable financial reporting framework).
Substantive analytical procedures use comparisons and analyses of relationships among financial and
non-financial data to assess whether account balances and the totals of classes of transactions appear
reasonable in comparison to the auditor’s expectations (as per ISA 520 - Analytical procedures, addressed
previously in Chapter 12).
Substantive analytical procedures often involve, amongst others, ratio analysis, trend analysis and
comparisons of financial data (such as current year data versus the previous year, versus budget or versus
industry data) and non-financial data.
The auditor’s considerations when deciding on the suitability of using an analytical procedure as a substantive
procedure include the following:
• The assessment of the risk of material misstatement, as the higher the risk of material misstatement (and
consequently the lower the acceptable level of detection risk), the lower the reliance that should be placed
on substantive analytical procedures;
• The audit evidence that is available from other audit procedures (both tests of controls and substantive tests
of details) directed towards the same assertion; and
• The reliability of the data on which the analytical procedures will be performed (which is imperative, as the
underlying data has to be valid, accurate and complete to be capable of meaningful comparison and
analysis). This includes the following:
• The source of the data – whether it is internal or external information and from a reputable and credible
source;
• The comparability of the data – for example, in the case of industry data, certain ratios (such as gross
margins) may not necessarily be comparable, even between entities operating in the same industry;
• Controls applied over the preparation of the data – whether they are designed to ensure the reliability of
the information, that is, its completeness, accuracy and validity; and
• The ability of the auditor to develop sufficiently precise expectations for the substantive analytical
procedures to be performed (and against which the results from the analytical procedures will be
evaluated).
20X1 R 20X0 R
20X1 R 20X0 R
Based on the nature of this expense item, it is expected that, excluding the above factors, the cost should
remain fairly stable over the 12-month period. As no changes to the entity’s premises occurred during the
20X1 financial year, the auditor may thus perform substantive tests of details for one month of the year
and then form an expectation for the full 12-month period.
If July 20X1 is selected for the performance of substantive tests of details, the auditor will obtain and
inspect all relevant electricity and water invoices for this month.
This amount may then be annualised to form an expectation for the 20X1 financial year. If the total
amount audited for July 20X1 was verified as R208,295, and assuming a consistent level of production,
and taking into consideration that electricity and water costs increased by (say) 9% in August 20X1, the
amount for the 12-month period should then take this escalation into account and the annual amount can
then be expected to be in the range of (approximately) R2,593,273 – calculated as [R208,295 x 7] +
[(R208,295 x 109%) x 5].
The actual amount of R2,671,303 (per the 20X1 financial statements), compared to the estimated
calculation of R2,593,273, can be considered reasonable based on the fact that water and electricity
amounts fluctuate on a monthly basis and an exact estimation cannot be performed. The difference
(which is not material) is considered acceptable and no further testing is considered necessary in this
regard.
13.3.3.4 Substantive tests of details
Substantive tests of details drill down into the details of the transactions that make up a particular amount or
disclosure in the financial statements, with the objective of obtaining direct audit evidence to support the
amount or disclosure. These transactions would have been processed by the accounting system for a particular
business cycle. A sound understanding of the source documents and records used in the business cycle, as well
as the related accounting processes, is vital to be able to formulate substantive tests of details on the classes of
transactions, account balances and disclosures relating to the business cycle. In essence, this entails an
understanding of how the entity’s accountant would have gone about processing the relevant entries into the
entity’s financial records, including the documentation he or she would have needed and the parties he or she
would have needed to have spoken to in the process. Furthermore, a proper understanding of the relevant IFRS
and Companies Act requirements is required.
CRITICAL THINKING
How will the use of reperformance be different when it is used as a test of controls as opposed to a
substantive test of details?
Guidance: Go back to section 13.3.2 and revise the objective or purpose of tests of controls and compare
that to the purpose of substantive procedures.
• External confirmation by obtaining direct written confirmation from external (third) parties, such as banks,
debtors, lawyers or consignees (in relation to inventory) (confirmations are addressed in detail in Chapter
14).
• Recalculation – by verifying that the arithmetical accuracy of source documents and accounting records is
correct. For example:
• Recalculating the depreciation expense in terms of the entity’s accounting policy (as has been disclosed
in the financial statements); and
• Recalculating the interest expense that should have been recorded on a loan, based on the interest
percentage verified in a loan agreement or a bank confirmation.
• Enquiry through discussions with internal parties (e.g. management or employees of the entity) and
external parties related to the entity (such as suppliers), thus verbally obtaining information as audit
evidence. For example:
• Enquiring from management regarding assumptions that have been used in calculating an estimate such
as an allowance for credit losses or obsolete inventory. (Remember that if audit evidence can be
obtained in writing and from third parties it is considered more reliable than verbal enquiries from
internal sources.)
You will recall that the assertions are described in ISA 315.A129. It is always a good idea to refer to this
paragraph when formulating substantive tests of details.
The auditor develops these substantive tests of details by following the four steps below:
Step 1:
Identify all classes of transactions impacting the revenue/expense account for which substantive
procedures are to be formulated. This is best achieved by drawing up the particular T-account in the
general ledger and indicating the various types of debit and credit entries that typically appear in the
account. Each type of debit and credit entry represents a class of transactions impacting the account. For
example, as shown in the T-account for sales below, a sales account will consist of (1) cash and credit sales
entries on the credit side (from the sales class of transactions) and (2) sales returns and other adjustments
entries on the debit side (from the sales returns and adjustments class of transactions).
The summarised sales account in the general ledger of Ntsimbi Piping is set out below:
SALES
Sales returns and other x xxx Credit sales xxx xxx xxx
adjustments
Step 2:
Formulate the audit objective(s) that has to be verified by means of the substantive procedures for each
class of transactions. For both the sales and sales returns and other adjustments classes of transactions,
these are to test the completeness, occurrence, accuracy, cut-off, classification and related presentation of
sales and sales adjustments.
Step 3:
Identify all relevant documents and client personnel 1 involved in each class of transactions (refer to
Chapters 6 to 10 in which the documents and people involved in each of the business cycles were
discussed). For credit sales, these would include the sales journal/transaction file, sales invoices and
delivery notes. For sales adjustments, these would include the sales adjustments journal/transaction file,
credit notes, goods returned vouchers, original sales invoices and the sales manager.
Step 4:
Select the type of procedure 2 to be performed (such as inspection, reperformance, recalculation as
addressed in the previous section) to achieve each audit objective for each class of transactions.
In developing the substantive procedures, the auditor always has to consider the risk of material misstatement
and be mindful of what could have gone wrong when the entity’s accountant recorded the transaction/s, based
on the documents, entity’s personnel and processes relevant to the recording.
Now let’s apply steps 2 to 4 above to formulate substantive tests of details on the credit sales class of
transactions identified in step 1 above.
This is accomplished by phrasing what has to be done as an instruction that always contains:
• A verb or verbs derived from the available types of procedures to describe the action to be performed (e.g.
the verb ‘inspect’ is derived from the procedure-type ‘inspection’); and
• The document/subject matter on which the verb has to be performed (e.g. an invoice).
Audit objective
All credit sales transactions that took place have been completely recorded in the accounting records and none
have been omitted and all related disclosures have been provided.
Once the same process has been completed for each of the relevant audit objectives, the substantive tests of
details for the credit sales class of transactions will be complete and ready for inclusion in the audit plan.
REFLECTION
Can you formulate the substantive tests of details for the audit objectives (b) to (f) in step 2 above,
following steps 2 to 4 again?
Next, we discuss the audit of the revenue and expenses classes of transactions in more detail in order to
demonstrate some important principles in respect of substantive tests of details on classes of transactions.
1. Auditing revenue
Completeness: When auditing revenue, one of the main risks that the auditor has to focus on is that all revenue
that accrues to the entity in respect of goods sold, services rendered, and other income accrued/received during
the period, has been completely accounted for and that no revenue has been omitted, and all related
disclosures have been provided.
WHY? Why would revenue be intentionally understated?
Revenue may be understated by management in order to reduce the entity’s tax liability or
franchise fees (that may be calculated based on a percentage of revenue).
REFLECTION
Is completeness always considered a high risk assertion in the audit of revenue?
• In performing substantive tests of details for revenue or other income accounts, completeness has to
therefore be verified by auditing from source documents (such as invoices, sales contracts and agreements
of loans provided to a third party) to the accounting records of the entity, in order to test for the
understatement of revenue. It is, of course, first necessary to verify that the source documents are all
accounted for, in other words to verify that no transactions have taken place during the period subject to
audit without a source document having been prepared.
By performing the substantive procedure from source documents that are relevant to the revenue/income being
audited, the auditor will be able to detect any documents (thus revenue/income) that have not been recorded or
disclosed in the accounting records and has thus resulted in the class of transactions being audited, being
incomplete.
Occurrence: The auditor has to verify that all revenue that has been recorded or disclosed during the period
arises from transactions that actually occurred (are valid) and relate to the entity.
• In performing substantive tests of details on revenue, occurrence has therefore to be verified by auditing
from the accounting records to source documents (such as invoices, sales contracts, agreements of loans
provided to third parties, confirmations and minutes of meetings) and, when inspecting these source
documents, verifying that they relate to the entity (i.e. are in its name) in order to detect the overstatement
of revenue.
By performing the substantive procedure from the accounting records relevant to the revenue/income account
being audited, the auditor will be able to detect any recorded or disclosed revenue/income that is not valid (i.e.
for which a valid source document relevant to the entity does not exist) and has thus been invalidly recorded in
the accounting records, resulting in the class of transactions being audited, being overstated.
The ‘from’ and ‘to’ discussions above are referred to as the direction of testing.
WHY? Why is the occurrence assertion generally assessed as being high risk in the auditing of
revenue?
Think about whether this assessed risk of material misstatement would relate to error, fraud,
or both? Also consider any responsibilities in this regard in terms of ISA 240.
WHY? Why is it sometimes necessary for the auditor to evaluate whether the Companies Act
requirements have been complied with, and review the client’s statutory records, in auditing
the occurrence assertion?
This is addressed in detail in section 13.3.3.4.5.
Accuracy: In performing substantive tests of details, the auditor has to verify that transactions are recorded
and disclosed at the correct amounts.
• In performing substantive tests of details on revenue, accuracy needs therefore to be verified by confirming
(when inspecting source documents such as contracts and invoices) that correct data (such as quantities,
prices, interest rates, foreign exchange rates and other relevant data) has been used and that calculations
have been performed correctly.
Evaluating the accuracy of the transactions recorded in the accounting records, by verifying the amounts in the
underlying source documents and the correctness of underlying calculations, will enable the auditor to detect
any revenue/income that has been recorded in the accounting records (or disclosed in the financial statements)
at the incorrect amount and has thus resulted in the accounting records being either over or understated
(depending on the type of misstatement recorded).
Cut-off: In performing substantive tests of details, the auditor has to verify that all revenue transactions are
accounted for in the correct accounting period to which they relate. A high risk of revenue being recorded in
the incorrect period, either intentionally or unintentionally, should be considered, due to the complexity of the
nature of certain types of revenue.
• In performing substantive tests of details on revenue, cut-off will therefore have to be verified by selecting
transactions around financial year-end (just before and after) from the accounting records and tracing them
to the source documents (such as invoices, contracts and loan agreements), and also in the other direction
(i.e. from source documents to the accounting records), verifying that the revenue is recorded in the correct
financial period based on the dates of the documentation inspected (and/or possibly any specific terms or
conditions noted, relevant to transaction).
Verifying the relevant dates of transactions of revenue/income being audited, by inspecting the dates in the
underlying source documents, will enable the auditor to detect any revenue/income that has been recorded in
the accounting records in the incorrect period, thus resulting in the accounting records being either overstated
(if the revenue/income actually relates to the following accounting period) or understated (if revenue/income
relating to the current accounting period has not been recorded).
Classification: In performing substantive tests of details, the auditor has to verify that all revenue has been
recorded in the proper accounts according to its description.
Verifying the correct classification of revenue/income being audited will enable the auditor to detect any
revenue/income that has been recorded in the incorrect accounts in the accounting records (and is therefore
likely to be incorrectly classified in the financial statements).
2. Auditing expenses
Occurrence: Focusing on overstatement and thus the occurrence of the expense, the auditor has to verify that
all expenses that have been recorded or disclosed during the period are in respect of transactions that actually
occurred (are valid) and relate to the entity.
• In performing substantive tests of details on expenses, occurrence has therefore to be verified by auditing
from the accounting records to source documents (such as invoices, purchase contracts, loan agreements
and minutes of meetings) in order to test for overstatement of expenses, and when inspecting the relevant
documentation, verifying that it relates to the entity (i.e. are in its name). (Where applicable, it may be
necessary for the auditor to evaluate whether Companies Act requirements have been complied with, and
review the entity’s statutory records, to verify the validity of a transaction – for example, where Section 75
director’s personal financial interests is applicable to an expense transaction. This is addressed in detail in
section 13.3.3.4.5).
WHY? Why would management intentionally overstate expenses?
They may do so in order to reduce the entity’s profits for the period, in attempting to reduce
the entity’s income tax liability.
Why else could the entity’s expense accounts contain invalid transactions as a consequence
of other fraudulent activity?
Think, for example, about transactions recorded that may not relate to the entity but rather to
an employee’s or management’s personal expenditures…
By performing the substantive procedure from the accounting records relevant to the expense being audited,
the auditor will be able to detect any expense that is not valid (i.e. for which a valid source document relevant
to the entity does not exist) and has thus been invalidly recorded in the accounting records or disclosed in the
financial statements, resulting in the class of transactions (expense) being audited, being overstated.
Completeness: When auditing expenses, the auditor has to verify whether all expenses that occurred during the
period have been completely accounted for or disclosed and that nothing has been omitted.
• In performing substantive tests of details on expenses, completeness is therefore verified by auditing from
source documents (such as invoices, purchase contracts, loan agreements, confirmations and minutes of
meetings) to the accounting records of the entity. It is, of course, first necessary to verify that the source
documents are all accounted for (i.e. to verify that no transactions have taken place during the period
subject to audit without a source document having been prepared).
By performing the audit test from source documents that are relevant to the expense, the auditor will be able to
detect any documents that have not been recorded in the accounting records or disclosed in the financial
statements and have thus resulted in the class of transactions being audited (expenses) being incomplete.
Accuracy: In performing substantive tests of details on expenses, the auditor has to verify that expense
transactions are recorded and disclosed at the correct amounts.
• In performing substantive tests of details on expenses, accuracy has therefore to be verified by ensuring
(when inspecting source documents such as contracts, purchases transactions, and invoices) that correct
data (such as quantities, prices, interest percentages, forex rates and other relevant data) has been used and
that calculations have been performed correctly.
Evaluating the accuracy of the expense transactions recorded in the accounting records, by verifying the
amounts in the underlying source documents and the correctness of underlying calculations will enable the
auditor to detect any expense that has been recorded in the accounting records (or disclosed in the financial
statements) at the incorrect amount and has thus resulted in the accounting records being either over or
understated (depending on the type of misstatement recorded).
Cut-off: In performing substantive tests of details, the auditor has to verify that all expense transactions are
correctly accounted for in the accounting period to which they relate.
• In performing substantive tests of details on expenses, cut-off will therefore have to be verified by selecting
transactions around year-end (just before and after) from the accounting records and tracing them to the
relevant source documents (such as invoices, purchases transactions, contracts and loan agreements) and
also in the other direction, verifying that the expense is recorded in the correct accounting period based on
the dates of the documentation inspected (and/or possibly any specific terms or conditions noted, relevant
to transaction).
Verifying the relevant date of the expense transaction being audited by inspecting the dates in the underlying
source documents, will enable the auditor to detect any expense that has been recorded in the accounting
records in the incorrect period, thus resulting in the accounting records being either overstated (if the expense
actually relates to the following accounting period) or understated (if the expense relates to the current
accounting period and has not been recorded).
Classification: In performing substantive tests of details, the auditor has to verify that all expenses have been
recorded in the proper accounts according to description.
• This should include verifying that, for example, maintenance expenses recorded do not include
improvements of a capital nature that should instead have been included in an asset account, or vice versa.
Verifying the correct classification of expenses being audited will enable the auditor to identify any expense
that has been recorded in the incorrect account in the accounting records (and is therefore likely to be
incorrectly classified in the financial statements).
A summary of the entries in the trade receivables general ledger account of Ntsimbi Piping is set out below:
Recall that the opening balance in the general ledger account is always compared to the prior year’s financial
statements and audit working papers as part of the general substantive procedures that were discussed in
section 13.3.3.2. Therefore, what remains to be tested by the auditor are the classes of transactions in the
account and its closing balance.
When the auditor chooses to perform substantive tests of details in the audit of account balances, a
combination of tests is often performed as follows:
Substantive tests of details on the classes of transactions making up the year-end balance (e.g. the credit
• sales and cash receipts classes of transactions included in the trade receivables balance); and
• Substantive tests of details on the year-end balance (e.g. the trade receivables balance at year-end).
This differs from the substantive procedures that are performed to obtain audit evidence for classes of
transactions (these were discussed in section 13.3.3.4.1). When auditing a class of transactions in the financial
statements (such as sales), only substantive tests of details on the transactions3 are performed – there is no
need to perform substantive tests of details on the year-end total that appears in the Statement of
Comprehensive Income. This is summarised in Table 13.6 below.
Table 13.6:Types of audit procedures for different types of general ledger accounts
Test of controls Y Y
Now let’s apply the four steps in the formulation of substantive tests of details to trade receivables (before
consideration of the allowance for credit losses), assuming that a substantive audit approach is followed in
respect of all classes of transactions that affect this account balance.
In the case of an account balance, we also have to think about whether there are any documents or records that
underlie, support or provide details of the composition of the account balance at year-end. In the case of trade
receivables, these are the following:
It should be clear from the above that a sound understanding of the flow of documentation through a business
cycle and its underlying accounting processes is key to being able to formulate substantive tests of details on
the account balances affected by the cycle.
Audit objective
All trade debtors that owe money to Ntsimbi Piping at year-end are included in the account balance and none
has been omitted and all related disclosures have been provided.
Note: Do not lose sight of the fact that most of the evidence for this assertion is obtained from testing the
completeness of the sales class of transactions and the occurrence of the receipts of debtors and sales returns
and other adjustments classes of transactions (i.e. the classes of transactions making up the account balance at
year-end).
REFLECTION
Can you formulate the substantive tests of details for the audit objectives (a), (b) and (d) to (f) in step 2
above, following steps 2 to 4 again?
A more comprehensive demonstration of the formulation of substantive tests of details for the trade
receivables balance of Ntsimbi Piping is provided in the cycle case study at the end of section 13.3.3.4.3
below.
Next, we discuss the audit of account balances in more detail in order to demonstrate some important
principles in respect of substantive tests of details on classes of account balances.
Existence: When auditing the existence of an account balance, the auditor has to focus on whether all assets
and liabilities recorded by the entity at year-end are valid and thus exist.
• In performing substantive tests of details, existence has to be verified by selecting balances from the
accounting records and agreeing the balances to source documents (purchase invoices or contracts), third-
party confirmations, or by physical inspection, if applicable.
• Agreeing to a source document may, for example, be the inspection of a contract for the purchase of an
intangible asset, such as an operating licence.
• Confirmations obtained from third parties may, for example, be from debtors, banks, or consignees in
relation to inventory being held on consignment, confirming the balances reflected in the accounting
records. All of these are addressed in Chapter 14.
• Physical verification of tangible assets may include inspecting the entity’s furniture, machinery or
inventory on hand to verify that they do exist.
By performing the substantive procedure from the accounting records relevant to the balance being audited,
the auditor will be able to detect any asset or liability recorded in the entity’s records that is invalid (i.e. does
not exist at year-end, is possibly fictitious) and has thus resulted in an overstatement of the asset or liability
balance being audited.
Rights and obligations: In performing substantive tests of details, rights in respect of assets and obligations in
respect of liabilities have to be verified by confirming that the entity holds or controls the rights to the assets
and is obliged to settle the liabilities recorded in the accounting records. Procedures are required to verify
ownership of assets (ensuring that no assets are encumbered, unless otherwise disclosed) and to verify the
entity’s liability obligations. Audit procedures to be performed thus include, among others:
• Reviewing title deeds for property owned by the entity;
• Enquiry of third parties and obtaining third-party confirmations from banks (e.g. for bank account
balances), the entity’s lawyers (for legal liabilities) and consignees (for inventory), addressed in Chapter
14.
• Review of minutes of meetings of the entity for any possible discussions and decisions with regard to the
entity not remaining the legal owner of any assets or not being liable for any of its liabilities; and
• Review of the terms, conditions and other pertinent information in contracts (such as lease contracts, or
contracts for intangible assets) and other relevant entity correspondence.
The auditor performs these substantive procedures to verify that the entity has the legal right to recorded assets
(or obligation for recorded liabilities), thus detecting any account balances that have been incorrectly recorded
in the accounting records or inadequately disclosed in the notes to the financial statements (e.g. encumbrances
on assets) and have thus resulted in the balance being audited, being overstated (assets), understated
(liabilities) or inadequately disclosed.
Completeness: When auditing the completeness of an account balance, the auditor has to focus on whether all
assets owned by the entity and liabilities that exist at year-end have been accounted for and all related
disclosures are provided in the financial statements and that nothing has been omitted. In performing
substantive tests of details, completeness has therefore to be verified by auditing from source documents (such
as invoices, contracts, bank statements, minutes of meetings, third-party confirmations) to the accounting
records of the entity, in order to test for understatement. This will include, among others, procedures such as:
• Performing an unrecorded liabilities test whereby significant payments in the bank statement for a period
shortly after year-end are identified and investigated to ascertain if they relate to entity liabilities that
existed at year-end and, if so, were appropriately recorded as such;
• Obtaining bank and lawyer confirmations (addressed in Chapter 14) and ensuring that any
assets/liabilities/provisions identified therefrom are appropriately recorded; and
• Reviewing minutes of meetings of the governance structures of the entity (such as board of directors, audit
committee) and entity contracts and confirmations (such as lease agreements and loan agreements) and
ensuring that assets/liabilities identified therein have been appropriately recorded.
By performing the substantive procedure from source documents that are relevant to the account balance being
audited, the auditor will be able to detect any amounts that have not been recorded in the accounting records
(or disclosed in the financial statements) and have thus resulted in an incomplete balance being audited.
Accuracy, valuation and allocation: In performing substantive tests of details, the auditor verifies that all assets
and liabilities are included at year-end at the appropriate amounts and any adjustments thereto in respect of
valuation or allocation, have been appropriately recorded, and related disclosures in the financial statements
have been appropriately measured and described.
Substantive testing for the accuracy, valuation and allocation of inventory, includes, for example, detailed
testing of management’s allowance for inventory obsolescence to gain an understanding thereof, and
evaluating the calculation for reasonableness based on any assumptions applied. Also, if possible, a review of
post-year-end sales or signed sales contracts has to be performed (to determine if inventory on hand at year-
end is saleable and, if so, at what amount). Net realisable value testing should also be undertaken to evaluate
the need for possible write-downs in terms of IFRS requirements. The possible use of an expert in complex
inventory situations (i.e. for the valuation of art works) may also need to be considered (the use of an expert is
addressed in Chapter 14).
WHY? Why are estimates and provisions regarded as high risk by the auditor?
In answering this question, consider the nature of these balances and how they are
calculated. Also refer to section 14.3.3 of Chapter 14.
The auditor performs this substantive procedure by verifying that items in the accounting records relating to
the account balance being audited have been included at the correct amount at year-end and appropriately
disclosed (in terms of the measurement requirements of the applicable financial reporting framework (e.g.
IFRS)), thus detecting any amounts that have been incorrectly calculated in the accounting records (and/or
incorrectly disclosed) resulting in the account balance being either under or overstated.
13.3.3.4.3 Substantive tests of details – The ‘presentation’ assertion and other disclosures in the financial
statements
The same four-step process used for classes of transactions and account balances is followed to formulate
substantive tests of details on the presentation assertion and other disclosures in the financial statements (notes
to the financial statements).
For example, in Ntsimbi Piping’s 20X1 financial statements, the following is disclosed in Note 23
Contingent Liabilities:
Litigation is in process against the company relating to a dispute with the Competition Commission,
which alleges that the company has been involved in price fixing in the industry. The information
usually required by IAS 37 Provisions, Contingent Liabilities and Contingent Assets is not disclosed
on the grounds that it can be perceived to be prejudicial to the outcome of the litigation. The directors
are of the opinion that the claim can be successfully defended by the company.
In relation to this contingent liability note, the auditors of Ntsimbi Piping have to verify the existence of this
contingent obligation to the entity, that all the necessary disclosures in regard to this possible obligation have
been provided and that they are relevant and understandable. This includes verifying whether the description is
clear and adequate in the circumstances and that the explanation as to why no amounts have been provided is
reasonable and acceptable. Moreover, the auditor has to obtain sufficient appropriate audit evidence that there
are no other contingent liabilities other than the one disclosed.
In addition to evaluating whether disclosure complies with prevailing accounting standards/IFRS and other
relevant legislation, the auditor verifies accounting policies to confirm that they are consistent with the prior
year, and if not, whether the appropriate adjustments and disclosure in regard to the effect of the change have
been made.
13.3.3.4.5 Substantive tests of details – Incorporation of the requirements of the Companies Act
If there are Companies Act requirements that have to be complied with in order for a transaction or event to be
valid and therefore to have occurred (occurrence assertion) (for example approval by shareholders and the
board of directors for a loan to a director) or where the Companies Act contains requirements for items to be
disclosed in a particular way in the financial statements (presentation assertion), the auditor uses substantive
tests of details to test that these requirements have indeed been complied with, in order to obtain audit
evidence to support the respective assertions.
Assume that Ntsimbi Piping granted financial assistance in the form of a loan to one of its directors at the
beginning of the financial year being audited and that the assistance was not part of an employee share
scheme. Section 45 of the Companies Act applies to the provision of financial assistance to directors and
allows such financial assistance, provided that a number of requirements have been met and provided that the
Memorandum of Incorporation does not contain other requirements in this regard. Let’s assume that Ntsimbi
Piping’s Memorandum of Incorporation is silent on this matter and that therefore section 45 of the Companies
Act applies.
Section 45(6) states that the granting of the abovementioned loan would be void if the requirements of
section 45 for the granting of the loan have not been complied with. Consequently, in order to obtain audit
evidence that the loan asset exists, the auditor would have to obtain audit evidence that the relevant
requirements of section 45 have been complied with.
The auditor would have to determine all the Companies Act requirements to have been complied with for
the company to legally grant the loan. Then he or she would have to design substantive tests of details to
verify that each of these requirements have been complied with.
By way of example, below we look at only some of the relevant requirements of section 45 and the related
substantive tests of details that the auditor could use to obtain audit evidence of compliance with them:
• Section 45(3)(a)(ii) requires a special resolution (by shareholders) approving the provision of such loans to
directors to have been made within two years prior to the granting of the loan. For such special resolution
to have been made by the shareholders, the requirements for valid special resolutions contained in section
65 have to have been complied with. These requirements include that proper notice of the shareholders
meeting involved had to have been given (to test this, the auditor can inspect the notice of the meeting),
that a quorum was present at the meeting (to test this, the auditor can inspect the approved minutes of the
meeting and recalculate whether a quorum was present) and that at least 75% (unless the Memorandum of
Incorporation requires a different percentage) of the shareholders who voted was in favour of the granting
of the loan (to test this, the auditor can inspect the approved minutes of the meeting and recalculate
whether the 75% of shareholders indeed voted to approve the granting of the loan).
• Section 45(3)(b)(i) requires that the board must be satisfied that the company would meet the solvency and
liquidity test (refer to section 4 of the Companies Act) immediately after the granting of the loan. The
solvency and liquidity test has various components of which one is that the assets of the company must
equal or exceed its liabilities, fairly valued, based on financial statements that meet the requirements of the
applicable financial reporting framework. The auditor could test that this requirement has been met by
obtaining the relevant workings of the directors, comparing amounts used therein to Ntsimbi Piping’s
financial statements and accounting records and inspecting that the result of the workings is indeed that
assets equal or exceed liabilities.
Note that, as companies are legal entities as opposed to natural persons, key decisions have to be taken by
directors and/or shareholders. These individuals can only make decisions by means of meetings. Such
meetings have to be properly convened by means of, for example, proper notice and the presence of quorums,
in order for decisions that have been made to be valid. It follows that the auditor would have to test that every
meeting at which a decision that is relevant to the audit had been taken, was indeed properly convened. The
first bullet above provides an example of how the auditor can test this.
It is essential that you are familiar with this cycle prior to working through the demonstration below. If
this is not the case, this is a good time to revise first the revenue and receipts cycle in Chapter 6, but also
the other cycles covered in Chapters 7 to 10. As mentioned before, a sound understanding of the flow of
documentation through a business cycle and its underlying accounting processes is vital to be able to
formulate appropriate substantive tests of details on the classes of transactions, events and the related
disclosures and the account balances and related disclosures affected by the cycle.
This demonstration details some of the key substantive tests of details in relation to trade receivables, the
audit objective(s) and assertion(s) addressed by each procedure and explanation as to how each
procedure was developed.
Note: The substantive procedures included in the table are only examples of the types of procedures that
could be performed. It is not a comprehensive list of substantive procedures to be performed in respect
of each audit objective. The intention with this demonstration is to provide an overview of how
substantive procedures should be formulated, so that the reader can apply the principles to any of the
classes of transactions, events and related disclosures; account balances and related disclosures; or other
disclosures that may be found in an entity’s financial statements. This approach is considered superior to
merely providing lists of substantive procedures for each material component of the financial statements.
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
To test that Ntsimbi Piping holds Rights Inspect contracts with funders to
the rights to all amounts included identify any ceding of the debtors
in the account balance at year-end. book that has taken place.
Evidence may also be obtained
from procedures performed in
other areas of the audit, such as the
review of minutes of board
meetings, and external
confirmations from financial
institutions.
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
To test that all trade receivable Completeness This is usually not a high risk for
amounts owing to Ntsimbi Piping trade receivables. Among others,
at year-end have been accounted procedures to be performed
for and nothing has been omitted, include:
and all related disclosures in • Inspecting the audit work
respect of trade receivables that papers for the results of the
should have been included in the audit procedures performed to
financial statements, have been verify the completeness of
included. revenue class of transactions;
• Inspection of the file of
correspondence with all debtors
(if available) for invoices not
raised at year-end; and
Subsequent receipts testing
post-year-end (inspecting
deposits on the bank statement
after year-end and verifying
that there was a corresponding
•
debtor balance raised at year-
end – if not, it must be verified
that this deposit relates to a
sales transaction that genuinely
occurred after year-end).
To test that trade receivables have Accuracy, valuation and To test the accuracy of the gross
been included in the account allocation amount of the trade receivables
balance at year-end at the balance, testing will need to be
appropriate amounts and any performed on the mathematical
adjustments thereto (i.e. for accuracy of invoices/contracts of
debtors’ balances where the sale. This will include
recovery is considered doubtful) reperforming all calculations
have been appropriately recorded, relevant to the sale, including any
and all related disclosures have VAT and discount calculations and
been appropriately measured and foreign exchange conversions,
described. where applicable.
Detailed testing needs to be
performed on the recoverability of
the balance, including on the
reasonability of the allowance for
credit losses (of R1,519,842),
which has been recorded at year-
end against the gross trade
receivables amount.
The detailed procedures in with
regard to this process are
addressed in Chapter 14, section
14.3.3.
The auditor also needs to inspect
the annual financial statements to
verify the appropriate
measurement and description of
disclosures with regard to:
• Trade receivables on the face
of the statement of financial
position;
• The accounting policy in
relation to trade receivables;
and
• The trade receivables notes to
the financial statements,
including all amounts and
details.
To test that all balances have been Classification Inspect the year-end debtors list,
recorded in the proper accounts. which has been agreed to the
balance on the debtors control
account, to ensure that it contains
no credit balances (as these should
be reclassified as part of
‘payables’).
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
To test that trade receivables and Presentation The auditor needs to inspect the
related adjustments have been annual financial statements with
appropriately aggregated or regard to:
disaggregated and clearly
• Trade receivables on the face
described, and related disclosures of the statement of financial
are relevant and understandable in position;
the context of IFRS. • The accounting policy in
relation to trade receivables
and the allowance for credit
losses;
• The trade receivables and
allowance for credit losses
notes to the financial
statements, including all
relevant disclosures; and
• Ensuring that these disclosures
are described in a manner that
is clear, understandable and
relevant.
REFLECTION
Using the four steps, can you formulate the substantive tests of details to be performed on the following
financial statement items of Ntsimbi Piping?
• Historical cost of plant and machinery (note 2) – Refer to the Appendix to Chapter 13 for suggested
substantive tests of details for this account balance.
• Trade payables (note 11)
• Electricity and water expense (note 14)
• Employee costs (note 14)
• Interest received on trade receivables (note 15).
If tests of controls are performed on the bank reconciliation at year-end, this will also serve as a substantive
procedure – hence it will serve a dual purpose (i.e. audit evidence is obtained about the internal control
system, but also directly about possible material misstatements in the bank balance at year-end).
13.3.5 Revision
At this point, let’s briefly revise the differences between tests of controls and substantive procedures. Table
13.7 sets out these differences.
Test the operating effectiveness of a control activity. Test directly the correctness of the rand values
(amounts) of account balances or classes of
transactions and whether related and other
disclosures in the financial statements are free from
material misstatement.
Results justify assessed levels of control risk. Results justify levels of detection risk being
achieved.
The result will always be a ‘yes’ or ‘no’ answer. ‘Is The result will always provide a measure of the rand
the control operating effectively – yes or no?’ value of the misstatement that exists in an assertion
Does not enable the auditor to conclude on the rand relating to an account balance/class of transactions.
value effect of misstatements in the account
balance/class of transactions.
The number of errors found does matter when The number of misstatements does not matter – it is
reaching a conclusion about operating effectiveness only the rand value effect of these misstatements that
of a control activity. The rand value (and materiality) is important when reaching a conclusion about
of these misstatements is irrelevant. whether an assertion contains a material
misstatement.
Results of tests of controls will always have an Results of substantive testing never have any impact
impact on the related substantive procedures – if on the amount of control testing to be performed.
controls are operating effectively, less substantive
Tests of controls (if any) are always performed prior
audit evidence is required and if controls are not to substantive procedures in order for the level of
operating effectively, more substantive audit control risk to be established, so that the level of
evidence will be required. detection risk can be determined. This level of
detection risk then drives the nature, timing and
extent of substantive audit tests.
Incorporates only the one type of procedure: tests of Incorporates two types of procedures (in addition to
controls. general substantive procedures): substantive
analytical procedures and substantive tests of details.
13.4 What is the timing of further audit procedures?
Having addressed the nature of further audit procedures in detail in the first part of this chapter, the second
aspect of the audit plan refers to the timing of performing further audit procedures.
Timing of an audit procedure refers to when it is performed, or the period or date to which the audit
evidence applies.
Timing thus includes consideration of performing testing at an interim or year-end stage, or at a
specific date.
The timing of audit procedures is addressed in ISA 330 (The auditor’s response to assessed risks).
CRITICAL THINKING
How can the timing of audit testing be used to address a high fraud risk?
The auditor may choose to perform audit procedures at times that are unpredictable to the client’s
management and staff and/or on a completely unannounced basis.
However, the timing of audit procedures is also frequently influenced (sometimes even dictated) by practical
factors that make it necessary (or more efficient) to conduct tests at a particular time. These include the
following:
• The involvement of other parties, such as internal auditors and experts (e.g. planning to use an expert will
have to be done several weeks or even months before year-end);
• Non-negotiable dates that the client has set – such as for an inventory count or visits to other branches of
the entity with operations throughout South Africa or even the world;
• A tight reporting deadline – which may require the performance of as many audit procedures as possible at
an interim date; and
• The availability of both audit and client staff:
• Availability of key management and staff at the entity (who may only be available at certain times);
• The audit team may be less busy at certain periods of the year (as many audit clients may have the same
year-ends) and it may thus prove to be efficient to use such periods in order to plan the audit and/or
conduct interim testing; and
• The availability of IT staff at the client may affect the timing of when CAATs are performed in the
audit.
CRITICAL THINKING
From a practical perspective, how does testing controls at an interim date improve the efficiency of the
audit?
It assists the auditor to identify the controls that are not operating effectively, and thus gives the auditor
more time to assess the control risk at the client and modify the audit plan accordingly.
It also allows the auditor time to inform management of the client of control weaknesses, so that
likely misstatements in the financial statements can be identified and corrected before the remainder of
the audit is performed. This will result in a more efficient audit being performed.
In determining the nature and extent of audit work to be performed for the remaining period after interim
testing, the auditor should consider factors such as:
• The evaluation of the design, implementation and operation of the relevant controls;
• The results of tests of controls at the interim period – if the relevant controls have been assessed to be
operating effectively up to the date of interim testing, less detailed further audit testing of the controls may
(under certain circumstances) be required for the remaining period to year-end;
• The materiality of the assertion(s) related to the controls being tested – the more material an assertion is,
the greater the need for further testing;
• Whether changes were made to these controls subsequent to them having been tested – should this have
occurred, the nature and extent of additional testing will have to be increased accordingly;
• The length of the remaining period – shorter periods between the interim testing date and year-end may
reduce the need for detailed audit testing to be performed at/after year-end; and
• The planned substantive procedures to be performed on the class of transactions, account balance or
disclosure – should detailed substantive testing be planned, this may alleviate the need for additional
detailed tests of controls to be performed at year-end.
At a minimum, the auditor would have to obtain an understanding, usually by enquiry (of entity management
or employees), about the nature and extent of changes in policies, procedures or personnel relevant to the
controls tested that occurred subsequent to the interim testing.
Remember that substantive procedures aim to provide direct evidence about the entity’s year-end
balances. By performing this testing at an interim date, a potential problem arises with the appropriateness
of the audit evidence gathered. To address this problem, roll-forward procedures have to be performed by
the auditor, between the date of interim testing performed and the financial year-end.
• The objective of the substantive procedures to be performed – the more critical the audit objective is, the
less likely the auditor may be to consider detailed interim testing;
• The assessed risk of material misstatement in the account balance – the higher the risk is, the more likely
the auditor may choose to perform the majority of testing at or after year-end as opposed to an interim date,
in order to address this risk adequately;
• The control environment and relevant controls – the stronger the control environment is, the more likely it
is that the auditor may be to consider performing interim substantive testing;
• The nature of the class of transactions, account balance and relevant assertions – the more volatile and
unpredictable the class of transactions, account balance and specific assertion(s) is, the less likely the
auditor may be to consider detailed interim testing;
• The availability of information necessary for the auditor’s procedures at a later date – for example,
information may be stored electronically for a limited period of time, therefore should this be apparent,
interim substantive testing will be considered essential; and
• The auditor’s ability to reduce the risk that the audit procedures performed to cover the remainder of the
period to year-end do not detect material misstatements – in other words, sufficient reliable evidence of the
transactions that took place in the period between the period considered for interim testing and the entity’s
year-end can be gathered, which allows the auditor to reduce detection risk sufficiently.
Should the auditor perform substantive procedures at a date prior to year-end, selected additional substantive
procedures will generally need to be performed to cover the remaining period. These roll-forward procedures
involve comparing the year-end account balance/total with the account balance/total audited at the interim date
and performing substantive procedures on the movement in the account balance.
CRITICAL THINKING
What will substantive roll-forward procedures entail?
• Inspecting journals and ledgers to identify large or unusual transactions within the account in the roll-
forward period, and performing substantive tests of details on them; and/or
• Performing analytical procedures on the changes in the balance during the roll-forward period to
identify large or unexpected variances, requiring the conducting of further tests of details.
If, while conducting substantive procedures at an interim date, material misstatements are identified, the
auditor may need to:
• Revise the assessed risk of material misstatement for the class of transaction and related disclosure or
account balance and related disclosure;
• Revise the planned substantive procedures for the remaining period; or
• Perform additional substantive procedures at year-end.
The auditor is required to test controls on which he or she intends to rely and to which there have not been
changes, at least in every third audit. Moreover, the operating effectiveness of certain key controls must be
tested on each audit. In other words, the auditor cannot rely on the previous years’ audit evidence for the
operating effectiveness of all the entity’s controls.
Extent refers to the quantity of audit procedures (i.e. the amount/‘how many’) to be performed. Extent
therefore often refers to the sample size used in an audit procedure, whether test of controls or substantive
test of details.
The extent of audit procedures is addressed in ISA 330 (The auditor’s response to assessed risk).
Generally speaking:
• The extent of tests of controls increases as the importance/significance of the control to the audit and the
degree of reliance the auditor intends to place on the control increase; and
• The extent of substantive tests of details increases as the risk of material misstatement increases.
(Therefore, the higher the assessed risk of material misstatement is, the larger the sample sizes are on
which the substantive tests of details must be performed.)
CAATs (addressed in Chapter 14) are useful for increasing the extent of audit procedures as they enable more
extensive testing by harnessing the processing power of computers. Selecting items for audit testing can be
done as follows:
• Selecting key or problem items for performing audit procedures. Auditor judgement is used to select items
that may include, among others, unusual items (e.g. items that have unusual characteristics), high-value
items, items prone to higher risk (e.g. specific debtors for which credit checks were never performed when
credit was initially granted), items recorded at a specific point in time (e.g. very close to financial year-end)
or types of items in which errors were identified in previous audits; and
• Selecting all items over a certain rand amount (key items). This may be used when attempting to verify a
large proportion of the population (e.g. all assets in the fixed asset register in excess of a specified rand
amount will be selected for physical inspection) in order to verify their existence. By selecting the largest
rand-value items, the auditor may thus verify this assertion as efficiently as possible (thus saving both time
and audit costs).
Note, however, that by performing the above methods of selecting items for audit testing, the auditor is only
able to conclude on the assertion in relation to the specific items selected for testing – no conclusions can be
drawn about the items that were not selected for testing.
In order to overcome this problem, the auditor should also consider making use of audit sampling, where
possible, when selecting items for testing.
13.5.1 Audit sampling
Audit sampling involves the application of audit procedures to less than 100% of items in a class of
transactions or account balance, enabling the auditor to obtain and evaluate audit evidence about some
characteristic of the items selected. By doing so, the auditor should be able to draw a reasonable
conclusion concerning the entire population from which the sample is drawn.
Audit sampling is addressed in ISA 530 (Audit Sampling).
The population is the entire set of data (records or documents) from which the sample is selected and
about which the auditor wishes to draw conclusions.
The application of audit procedures (both tests of controls and substantive procedures), such as inspection,
confirmation, recalculation and reperformance, involves the selection of items from a population for testing.
All of the items within a class of transactions (such as salaries or revenue for the financial year) or within an
account balance (such as the inventory or accounts receivable balance – or a listing of the items making up the
balance – at year-end) constitute a ‘population’.
The objective as well as the type of audit procedure to be performed is important in identifying the
population to be used. For example, if the auditor’s objective is to test the existence of accounts receivable, the
population could be defined as the detailed accounts receivable listing at year-end. When testing the
completeness of accounts receivable, the population is not the accounts receivable listing, but rather
populations that provide evidence of completeness of the balance (i.e. that nothing has been omitted).
If a population is not homogenous (i.e. the items in the population vary significantly), it may be stratified
by grouping similar items together in smaller subpopulations. Stratification of the population is usually
performed based on factors such as monetary value or nature and characteristics of the population items. This
enables the auditor to focus specifically on population items exposed to a higher risk of material misstatement
as a result of, for example, their monetary value or nature. Each of these subpopulations (or strata) is then
examined separately as part of an audit procedure.
An example of this during the performance of substantive tests of details on the accounts receivable
balance is where the balance consists of several large debtors as well as many small debtors’ balances. The
total population may be stratified (divided) into two strata, namely high-value debtors’ accounts and low-value
debtors’ accounts, so that positive confirmations can be sent to a sample of debtors in the high-value stratum
and negative confirmations to a sample of those in the low-value stratum (debtors confirmations are addressed
in 14.3 in Chapter 14).
CAATs (addressed in Chapter 14) can be used to sort and stratify populations in accordance with specified
criteria.
CRITICAL THINKING
What other kind of criteria do you think the auditor may consider in using CAATS to stratify a
population?
Think of all the different possibilities of characteristics of the items in a population e.g. dates, names of
other parties …
An increase in the use of other substantive audit procedures directed at the same financial statement assertion
will decrease sample sizes needed.
REFLECTION
CAATs (addressed in Chapter 14) allow for the possibility of examination of 100% of items in a
population.
Is this still considered to be ‘audit sampling’?
Sampling risk is the possibility that the auditor’s conclusion, based on a sample selected, may be different
from the conclusion that would be reached if the entire population were subjected to the same audit
procedure.
From tests of controls, the auditor may erroneously conclude as the result of using sampling:
• That control risk is lower than it actually is (i.e. that controls are more effective than they actually are),
which may lead to inappropriate conclusions being drawn and ultimately to an inappropriate audit opinion;
or
• That control risk is higher than it actually is (i.e. that controls are less effective than they actually are),
which may negatively affect audit efficiency as additional and unnecessary audit work will be performed.
From substantive tests of details, the auditor may erroneously conclude as a result of using sampling:
• That a class of transactions and relevant disclosure or account balance and relevant disclosure is free from
material misstatement, when in fact it does contain material misstatement, which may lead to inappropriate
conclusions being drawn and ultimately to an inappropriate audit opinion; or
• That a class of transactions and relevant disclosure or account balance and relevant disclosure contains a
material misstatement when in fact it does not, which may affect audit efficiency, as additional and
unnecessary audit work will be performed.
CRITICAL THINKING
How can sampling risk be reduced?
For both tests of controls and substantive procedures, sampling risk can be reduced by increasing the
sample size. (How will this reduce sampling risk?)
Can sampling risk be reduced to zero?
Statistical sampling – Random selection of a sample whereby all units have a chance of selection and
probability theory is used to evaluate the sample results.
Non-statistical sampling – Using judgemental reasoning, rather than probability theory concepts, for the
determination of sample size, the selection of the sample items, and/or the evaluation of the sample
results.
Statistical sampling techniques require the sample size, sample items selected from the population and the
evaluation of sample results all to be done statistically.
CRITICAL THINKING
What are the advantages of using statistical sampling instead of judgemental sampling?
It results in higher objectivity, less likelihood of over or under-auditing, better audit documentation and
greater confidence in conclusions drawn on the basis of the sample (thus allowing stronger justification to
management should a material misstatement be identified).
What do you think some audit firms consider to be a disadvantage of using statistical instead of
judgemental sampling?
The sampling method that the auditor determines to be most appropriate to use will depend on the particular
circumstances, for example:
• When auditors suspect serious error or manipulation in a class of transactions or year-end balance, they
will use their professional judgement (rather than probability theory) to select a directed judgement sample,
as this method will be more effective in addressing the assessed risk of material misstatement.
• In tests of controls, identifying and analysing the nature and cause of errors (i.e. why they arose, how they
arose) may be more valuable than statistically analysing the presence or absence of a particular control.
(Note, however, that when using statistical sampling for tests of controls, the analysis of the nature and
cause of errors identified is still a necessary and valuable step, in addition to the statistical quantitative
evaluation).
• In substantive tests of details, a statistical analysis and extrapolation of the projected error may be
considered a more appropriate method to use than judgemental sampling, owing to the difficulty in
projecting rand misstatements found in a sample to the entire population, which is facilitated by statistical
sampling techniques.
If the evaluation indicates that there is a possibility of a control not operating effectively:
• Evaluate the possible impact of this on the fair presentation of the financial statements of the entity; and
• Consider adapting the nature, timing and extent of substantive audit procedures accordingly.
Assessment questions
For questions 1 to 6, select the correct answer(s):
1. When an auditor increases the assessed level of control risk due to some control procedures having been
determined to be ineffective, the auditor would most likely increase one of the following: (LO 1 & 5)
a) The planned level of detection risk
b) The planned level of substantive tests
c) The level of inherent risk
d) The extent of tests of controls
e) The audit fee
2. Procedure(s) that would most probably be used by an auditor when he or she performs tests of controls on
a control that involves segregation of duties and that leaves no audit trail is: (LO 10)
a) Reconciliation
b) Inspection
c) Reperformance
d) Observation
e) Enquiry
3. When using substantive analytical procedures, for which of the following accounts is the auditor most
likely to form a reliable expectation of what the total/balance should be at year-end, based on predictable
relationships? (LO 16)
a) Accounts payable
b) Advertising and marketing expense
c) Interest expense
d) Cash and bank
e) Revenue
4. In determining the nature of audit procedures to be performed, the auditor considers the following
factor(s): (LO 5)
a) The necessity of placing reliance on controls
b) The possibility of placing reliance on the internal control system in the entity
c) The desirability of relying on the system of internal control
d) The assessed risk of material misstatement
e) All of the above
f) None of the above
5. Sampling risk can be reduced to zero: (More than one answer is possible) (LO 22)
a) Always
b) Never
c) When the auditor plans the audit appropriately
6. With regard to tests of controls and substantive procedures: (More than one answer is possible) (LO 8)
a) Tests of controls test the operating effectiveness of a control activity.
b) Tests of controls enable the auditor to conclude on the rand-value effect of misstatements.
c) Tests of controls test the correctness of the rand values of balances and related disclosures or classes
of transactions and related disclosures.
d) Substantive procedures enable the auditor to conclude on the rand-value effect of misstatements.
e) Substantive procedures test the correctness of the rand values of balances or classes of transactions
or disclosures.
8. There is a difference in the quality of audit evidence yielded by different types of audit procedures
performed. (LO 7)
9. Results of sampling should be analysed both quantitatively and qualitatively. (LO 22)
10. Substantive analytical procedure is a type of substantive procedure that can be used in the audit of all
classes of transactions, account balances and disclosures. (LO 17)
11. Interim audit testing may increase the effectiveness and efficiency of the year-end audit. (LO 20)
Generally speaking, the extent of substantive procedures increases as the risk of material misstatement
12. increases. (LO 21)
13. The objective of substantive procedures is to verify directly whether the assertions relating to the class of
transactions and related disclosures, or the account balance and related disclosures, are free from material
misstatement. (LO 12)
14. The only types of audit procedures available to an auditor to obtain audit evidence are tests of controls
and substantive tests of details. (LO 6)
15. If the auditor performs tests of controls and obtains evidence that the controls tested are operating
effectively, this increases the likelihood that the assertions applicable to the affected class of transactions
and related disclosures, account balance and related disclosures are likely to be free from material
misstatement. (LO 9)
16. The auditor seeks to eliminate detection risk by determining the nature, timing and extent of the
substantive procedures to be performed. (LO 2 & 3)
17. The audit plan assists the auditor in reducing audit risk to an acceptable level by setting out the nature,
timing and extent of further audit procedures to be performed by the audit team. (LO 2)
18. Describe the circumstances in which the auditor is required to follow a controls-based (combined) audit
approach in an audit of financial statements. (LO 7)
19. Explain for what purpose the auditor would use substantive analytical procedures during an audit and the
circumstances in which it would be appropriate to use these procedures. (LO 17)
20. In auditing accounting estimates, explain the auditor’s approach to designing appropriate audit
procedures. (LO 13 & 15)
21. What factors should be considered by the auditor in determining whether to perform substantive
procedures prior to the year-end date? (LO 19)
22. Why would an auditor consider making use of audit sampling? (LO 22)
23. How will a high assessed risk of material misstatement regarding the appropriateness of the going
concern basis of accounting used in the preparation of the entity’s financial statements affect the audit
plan? (LO 4)
24. Describe the steps that the auditor follows to formulate a substantive test of details. (LO 14 & 15)
Appendix
This additional example is based on Ntsimbi Piping’s investment and financing cycle (as explained in Chapter
10) and illustrates the substantive tests of details to be performed. It is essential that you are familiar with that
cycle prior to working through this illustration. Should this not be the case, it is suggested that you first revise
Chapter 10.
This illustration contains some of the key substantive tests of details in relation to the cost component of
Ntsimbi Piping’s property, plant and equipment (PPE) account balance, and the audit objective(s) and
assertion(s) addressed by each procedure.
Note: The substantive procedures provided below are not intended to be a comprehensive list of all the audit
procedures to be performed in respect of each audit objective, but merely examples of the types of procedures
that can be performed. The principles applied below in formulating the substantive procedures for the PPE
account balance (and explained earlier in this chapter), can be applied equally to any of the classes of
transactions, events (and related disclosures), the account balances (and related disclosures), or other
disclosures that may be found in an entity’s financial statements. Also, the procedures exclude the general
substantive procedures described in section 13.3.3.2 of this chapter.
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
To test that all assets included by Existence Select a sample of assets from
Ntsimbi Piping in the property, plant Ntsimbi Piping’s fixed asset
and equipment account balance at register, and physically inspect these
year-end actually exist i.e. the assets assets on the company’s premises,
are not fictitious. agreeing each asset inspected to the
description (and serial number) in
the register.
For additions that occurred during
the 20X1 financial year, inspect the
related purchase agreements (or
contracts/invoices), verify the
validity thereof, the details of the
assets purchased, and other relevant
information (e.g. the terms and
conditions of purchase).
When inspecting the above
purchase documentation, note the
descriptions of items which may
identify transactions that should
have been expensed (e.g.
transactions of a repairs and
maintenance nature which have
been erroneously capitalised).
For assets purchased during the
20X1 financial year, inspect bank
statements for confirmation of
payments made.
Perform a search for unrecorded
disposals of property, plant and
equipment items by, for example,
reviewing the cash receipts journal
for receipts of a capital nature, and
by inspection of correspondence
with the entity’s insurance company
to identify any fixed assets that have
been removed from the list of
insured items during the financial
year. Also, review disposals listed in
the entity’s 20X1 capital budget and
reconcile these to the assets that
have been removed from the fixed
asset register during the year.
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
To test that Ntsimbi Piping is the Rights For property owned by the entity,
party entitled to the rights of inspect title deeds for evidence of
ownership for the assets making up Ntsimbi Piping’s legal ownership
the account balance (e.g. they do not thereof.
belong to another entity and any For other asset additions, inspect the
assets pledged as security for purchase agreements/invoices for
obligations are disclosed). the name of Ntsimbi Piping and for
other relevant information,
including the terms and conditions
of purchase.
For motor vehicles, inspect the
registration documents and licence
renewals for the name of the
company.
For right-of-use assets, inspect the
lease agreements for the name of
Ntsimbi Piping and for other
pertinent terms and conditions of
the lease agreements to ensure that
the risks and rewards of ownership
have effectively passed to Ntsimbi
Piping (in accordance with IFRS
16).
To test that all assets deemed to be Completeness Inspect Ntsimbi Piping’s approved
property, plant and equipment of capital budgets for items of a capital
Ntsimbi Piping at the end of the nature that were budgeted to be
financial reporting period are acquired during the 20X1 financial
accounted for and nothing has been year, and compare to those actually
omitted, and that all related recorded in the company’s fixed
disclosures that should have been assets register.
included in the financial statements, Inspect the entity’s minutes of board
are included. meetings authorising the acquisition
of items of property, plant and
equipment, and compare to those
actually recorded in the company’s
fixed assets register.
Inspect repairs and maintenance
account(s) in the general ledger for
material items which may represent
acquisitions of assets, but have been
erroneously charged as an expense.
When physically inspecting assets
(for existence), select a sample of
fixed assets on Ntsimbi Piping’s
premises and trace these to the fixed
asset register, agreeing all details
(including description and serial
numbers).
Inspect all lease agreements for
evidence of any assets which have
been leased, but which have not
been capitalised when so required
by IFRS 16.
Inspect the annual financial
statements to confirm the
completeness of IFRS 16
disclosures with regard to:
• The accounting policy in relation
to PPE; and
• The PPE notes to the financial
statements.
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
To test that all items of property, Accuracy, valuation and Inspect purchase documentation to
plant and equipment have been allocation verify that the cost of the asset
included in the account balance at includes the correct cost price,
the end of the financial reporting import duties, shipping charges,
period at the appropriate amounts installation (and any other relevant)
and any adjustments thereto (e.g. for costs. Verify, by inspection, that
possible impairment) have been VAT has been appropriately dealt
appropriately recorded, and all with in determining the cost of an
related disclosures have been asset.
appropriately measured and Reperform the mathematical
described. accuracy of all calculations on
purchase documentation.
If the asset is imported, reperform
the conversion of the foreign
currency amount into rands at the
spot rate on transaction date (after
confirming the exchange rate on this
date with a reliable third party).
Inspect the annual financial
statements to verify the appropriate
measurement and description of
disclosures with regard to:
• PPE on the face of the statement
of financial position;
• The accounting policy in relation
to PPE; and
• The PPE notes to the financial
statements, including all
amounts and details.
Note: As the illustrative audit
procedures are provided for the cost
component of the PPE account
balance, the procedures for auditing
the depreciation charges, and other
adjustments (including impairment)
are not provided here.
To test that all property, plant and Classification For a sample of additions during the
equipment have been recorded in financial year, agree the descriptions
the proper accounts. of items from purchase
agreements/invoices to the accounts
in the general ledger to verify that
the additions have been recorded in
the proper accounts.
EXAMPLES OF TYPES OF
AUDIT OBJECTIVE ASSERTION SUBSTANTIVE TESTS OF
DETAILS TO BE PERFORMED
To test that property, plant and Presentation Inspect the annual financial
equipment and related adjustments statements with regard to:
have been appropriately aggregated • PPE on the face of the statement
or disaggregated and clearly of financial position;
described, and related disclosures • The accounting policy in relation
are relevant and understandable in to PPE, including the IAS 16
the context of IFRS. model that has been adopted by
Ntsimbi Piping; and
• The PPE notes to the financial
statements, including making
sure that all relevant disclosures
(e.g. the detailed breakdown of
the balances reflecting the
different classes of PPE), have
been made in a manner that is
clear, understandable and
relevant.
1 These documents and personnel will be used in the performance of the substantive procedure.
2 This will be formulated as a verb/action, as the auditor is performing a task.
3 Note, however, that depending on the chosen audit approach, instead of or in combination with substantive tests of details, the auditor may also
have used substantive analytical procedures and/or tests of controls to obtain audit evidence about the classes of transactions.
Audit procedures: Speci c CHAPTER 14
considerations
Dana Nathan, Pieter von Wielligh and Gerrit Penning
CHAPTER CONTENTS
Learning outcomes
Reference list
14.1 Introduction
14.2 How do we formulate the nature of further audit procedures for specific classes of
transactions or account balances?
14.3 What are the requirements of International Standards on Auditing for dealing with
specific complexities that may be encountered when performing audit procedures?
14.4 What are computer-assisted audit techniques (CAATs)?
Assessment questions
Appendix: CAATs example
LEARNING OUTCOMES
1. Describe the nature of the audit procedures required to deal with the attendance at an
entity’s wage payout and inventory count.
2. Describe the nature of the audit procedures required to reduce the risk of failing to
detect fraudulent activity in cash and bank to an acceptably low level.
3. Describe the nature of the audit procedures to reconcile the creditors and bank
balances recorded in the auditee’s records to the external counterparty’s records.
4. Discuss the audit considerations applicable to the use of specific methods of obtaining
audit evidence through the use of confirmations from debtors, financial institutions,
lawyers or management.
5. Discuss the audit considerations applicable to the use of specific methods of obtaining
audit evidence through the use of the work of other parties, such as internal audit,
experts and other auditors.
6. Describe the nature of computer-assisted audit techniques (CAATs) and how they are
applied in the audit process.
7. Explain the purpose of using CAATs.
8. Describe the various approaches that can be followed by an auditor in auditing in a
computerised environment and describe the advantages and disadvantages of each
approach.
9. Describe the relationship between CAATs and audit procedures.
10. Describe the various CAAT tools and functions that auditors have at their disposal.
11. Identify the circumstances in which it will be necessary, possible or preferable to use
CAATs on an audit.
12. Identify and describe the type of CAATs that an auditor would apply in a particular
audit approach.
13. Describe how CAATs can be used during each stage of the audit process.
14. Briefly describe the steps that an auditor should follow when planning and performing
CAATs.
REFERENCE LIST
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 505 External Confirmations.
International Auditing and Assurance Standards Board (IAASB) (June 2018)) International
Standard on Auditing (ISA) 540 Auditing Accounting Estimates, Including Fair Value
Accounting Estimates and Related Disclosures.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 580 Written Representations.
International Auditing and Assurance Standards Board (IAASB) (Dec 2013) International
Standard on Auditing (ISA) 610 Using the Work of Internal Auditors.
International Auditing and Assurance Standards Board (IAASB) (Dec 2009) International
Standard on Auditing (ISA) 620 Using the Work of an Auditor’s Expert.
Independent Regulatory Board for Auditors (IRBA) (Oct 2005) South African Auditing
Practice Statement (SAAPS) 4 Enquiries Regarding Litigation and Claims.
Independent Regulatory Board for Auditors (IRBA) (July 2013) South African Auditing
Practice Statement (SAAPS) 6 External Confirmations from Financial Institutions.
Other standards and pronouncements not listed above, but referred to in the chapter,
should also be consulted to fully understand the requirements that apply to Registered
Auditors in South Africa.
14.1 Introduction
As discussed in Chapter 13, in order to develop the nature, timing and extent of audit
procedures required to respond to the risk of material misstatement, the audit plan should
deal with the following:
• e nature, timing and extent of risk assessment procedures (these procedures have been
covered in Chapter 12);
• e nature, timing and extent of further procedures to respond to the assessed risks of
material misstatement (such as tests of controls and substantive procedures – these are
covered in this chapter); and
• e nature, timing and extent of other audit procedures that are required to ensure that the
engagement complies with ISAs (such as procedures to ensure that reliance can be placed
on experts and internal auditors, where appropriate – these are covered in this chapter).
In this chapter, we continue focusing on the same area as introduced in Chapter 13 (i.e. the
highlighted area in the Audit Process Overview Diagram).
Figure 14.1: The audit process
However, this chapter contains guidance in order to formulate the nature of audit procedures
in relation to specific classes of transactions and account balances, and to deal with the
requirements of specific ISAs that have been issued to deal with complex areas that the
auditor is likely to encounter when formulating audit procedures. e chapter also explains
how the auditor can use computer technologies to assist in gathering audit evidence.
Note 1: Surprise attendance can be used by not providing the entity sufficient time to prepare
for the auditor’s attendance. However, the practicalities of arriving on a complete surprise
basis are often difficult, if not impossible, to manage and thus not commonly used in practice.
Note 2: When the auditor is in possession of pay packets/cash relating to the wage payout, he
or she should exercise extreme care to ensure that procedures are in place so that the auditor
cannot be accused of stealing some of the money (e.g. by ensuring that the entity’s staff are
present at all times that pay packets are being handled by the auditor).
WHY? Why have wage payouts become a less frequent occurrence in practice?
Due to the high security risk of wage payouts in cash, more and more
South African entities are choosing to pay wages directly into their
employees’ bank accounts instead of paying them in cash at a wage
payout.
However, since cash payments are preferred by many South African
employees, wage payouts continue to occur, albeit to a much lesser degree
than in the past.
REFLECTION
Think about how the auditor would verify the occurrence of wages if all payments were
made directly into the bank account of employees.
e auditor should therefore understand and test the controls that the management of the
entity has designed and implemented:
• is usually includes evaluating the segregation of duties that is in place in the cash
process – the person receiving cash should not also be responsible for recording it or for
banking it.
• Other controls, such as management involvement in the process, management review
and oversight of cash recording and processing, should also be evaluated and, if
appropriate, tested by means of tests of controls.
• All other manual controls of audit importance in relation to the recording of cash
transactions should be evaluated and, if appropriate, tested by means of tests of controls.
is will include controls that management has implemented with regard to ensuring
that:
• All cash received is recorded immediately (e.g. receipts are issued to customers when
the cash is taken);
• All cash received is banked within a short period of time (in line with an entity policy),
avoiding cash on hand for long periods;
• All cash that is received and banked is recorded in the accounting records of the entity
within a short period of time; and
• In addition to segregation of duties, isolation of responsibility is evident in regard to all
of the above processes.
• All automated controls of audit importance in relation to the recording of cash
transactions (as per above) should be evaluated and, if appropriate, tested by means of
tests of controls.
In addition to the testing of controls as above, further substantive audit procedures to be
performed by the auditor as part of the approach to identify instances where lapping has
occurred include, amongst others, the testing of the accounts receivable balances, for
example by means of external confirmations (refer to the debtors circularisation procedures
as per section 14.3.1.6). In evaluating the responses from debtors, the auditor needs to be
alert to instances where queries are reported in respect of payment dates (e.g. the debtor
indicates that payment was made on a date before that on which it is recorded on the debtors
statement) – as this may indicate that the entity’s staff are engaging in the lapping of cash
takings.
Substantive procedures in regard to the testing of bank and cash balances (as addressed
in the sections that follow), may also assist the auditor in identifying instances where the
lapping of cash has taken place.
IN THE NEWS
Employee fraud
• Counting coins: A former Canadian bus driver stole almost $375,000 from a
public transport company over the course of seven years. He did this by hiding
coins in his bag and taking them home. He stole an average of $200 per day in
quarters, dimes and nickels before he was caught.
• Bookstore embezzlement: At an independent bookstore in North Carolina, the
bookkeeper managed to embezzle $348,975. The bookkeeper had sole oversight
of the company books, and so she would write – and cash – cheques written out to
herself without any oversight.
• Security expert goes rogue: A large communications company hired a former
‘professional’ thief as a theft-prevention specialist, because of his real-life
expertise in the security eld. In this case, the ‘security expert’ found a loophole
where he could write himself cheques (signed using a signature stamp of a co-
worker), cash the cheques, then destroy the cancelled cheques that were returned
to the company by the bank. He made false entries in the company’s accounting
records to cover his actions. Before he was caught, he managed to steal the hefty
sum of $1,138,334.
In evaluating the incidents of employee fraud above, it becomes clear that the following
weaknesses allowed the employees to perform the fraudulent activities:
• First, a lack of proper recruitment processes in the entity may have allowed these
questionable employees to have been recruited.
• Second, a significant lack of segregation of duties provided the bookstore bookkeeper and
the communications company employee their opportunities to commit fraud.
• ird, a lack of controls with regard to the recording of cash and the banking thereof
facilitated the theft of coins at the bus company.
• Finally, a lack of proper independent review of all the employees’ work allowed the thefts
to not only occur, but also go unnoticed for long periods of time.
If the auditor had identified these control weaknesses, the fraudulent activity in all three
instances (if material), would have been identified through the further audit procedures
performed.
A surprise cash count is a procedure that should be performed in the presence of the
entity’s cashier, by the auditor counting the physical cash on hand and comparing the
amount counted with the theoretical cash that should be on hand according to the
supporting documentation (e.g. receipts and payment/petty cash vouchers), therefore
identifying any possible cash shortages. The performance of this procedure may be
regarded as a dual-purpose test.
Audit working paper F1 (on the next page) will be used by the auditors of Ntsimbi Piping to
perform a cash count at 31 December 20X1 in order to confirm the ‘Cash on Hand’ balance
as per the year-end financial statements.
14.2.2.3 Auditing bank reconciliations
e preparation of bank reconciliations by the entity is a key control directly affecting the
audit of cash and bank. erefore, if the entity has in place effective bank reconciliation
procedures performed in a timely manner, the auditor will often choose to test these
reconciliation procedures using tests of controls. If the controls are found to be effective, this
will reduce the extent of the audit work required on the closing balance on the bank account
at year-end. Audit evidence provided by this testing will relate to the assertions related to the
year-end bank balance, most specifically the accuracy, valuation and allocation of the year-
end bank balance.
erefore, when performing tests of controls on the bank reconciliation, the auditor will
test the controls relating to the bank reconciliations (prepared during the entire financial
year subject to audit) in addition to obtaining an external confirmation of the bank account
balances and related information from financial institutions at year-end (i.e. a substantive
procedure is addressed in section 14.3.1.7 of this chapter).
When relying on the controls relating to the bank reconciliation, the auditor could decide
to reperform a bank reconciliation that has been prepared by the entity personnel, thereby
evaluating the control procedures and the effectiveness thereof. e auditor also inspects
evidence (e.g. signature on the reconciliation) that the reconciliation was reviewed by entity
management and that any necessary reconciling items have been adequately investigated (to
ensure their validity, accuracy and completeness).
e auditor should perform the following substantive tests of details on bank reconciliations:
• Agree the bank statement balance and general ledger balance reflected in the
reconciliation to the monthly bank statement and the bank account in the general ledger
respectively;
• Reperform all castings and calculations on the bank reconciliation;
• Review all reconciling items, assessing for logic and reasonableness;
• Review subsequent bank reconciliations the following week or month (depending on the
frequency of preparation) in order to verify that the reconciling items have since been
resolved and thus no longer appear as reconciling in the subsequent reconciliation;
• Where reconciling items are material, obtain and inspect the relevant supporting
documentation, such as outstanding payment documentation and proof of deposits
(either electronic or manual) to verify that they should appear in the reconciliation, and
are reflected in the correct amounts; and
• Verify, by inspection of the adjusting journal entries, that errors or omissions identified in
the bank reconciliation that relate to the accounting records of the entity have
subsequently been corrected in its accounting records.
A cut-off bank statement is a bank statement required by the auditors, usually for a
period of 7 to 10 days after the end of the reporting period, in order to test
reconciling items present in the bank reconciliation and the clearing of these items.
A cut-off bank statement is also used in performing an unrecorded liabilities test
(referred to previously in Chapter 13) in auditing the completeness of liabilities and
accruals recorded in the entity’s nancial statements.
• To identify long-outstanding and suspicious items, the auditor should also consider
extending the audit procedures on the bank reconciliation to examine the reconciling
items in prior months’ bank reconciliations and compare these to those of the current
month. is may provide evidence of items that have remained outstanding for a length of
time and are thus indicative of matters that may require further audit investigation.
• Any journal entries processed to the bank account in relation to items that appear to be
reconciling have to be thoroughly investigated and corroborating evidence obtained.
• In an entity that has a number of bank accounts (such as Ntsimbi Piping), the risk of the
fraudulent misstatement of the bank balances through transfers between the various
bank accounts is a matter that the auditor has to consider, as well as the possibility of
misstatements resulting from transfers of funds that have occurred from or to bank
accounts of related entities.
Below is the bank reconciliation for one of Ntsimbi Piping’s bank accounts (‘Bank Balances’
in note 7 of its 20X1 annual financial statements). It is important to note that a bank
reconciliation would also have been prepared by Ntsimbi Piping’s staff for the company’s
‘bank overdraft’, although not provided in this text.
R
Cheques
In auditing the above reconciliation, the auditors have to perform the following audit
procedures:
• Reperform the casting of all amounts/totals in the reconciliation to ensure accuracy
thereof;
• Agree the amount per (A) to Ntsimbi Piping’s cash book, trial balance and annual
financial statements;
• Obtain Ntsimbi Piping’s bank statement for the period ending 31 December 20X1 and an
external confirmation from the bank at 31 December 20X1, and agree these to the balance
per (B);
• Obtain Ntsimbi Piping’s bank statement for January 20X2 and inspect that the amounts
per (C) have cleared after year-end. Follow up by inspecting supporting documentation to
verify the accuracy and validity of the reconciling items for any items that do not appear
on the January 20X2 bank statement;
• Obtain Ntsimbi Piping’s bank statement for January 20X2 and inspect that the deposit per
(D) is reflected within the first few days after year-end (to verify that it relates to a cut-
off/timing difference); and
• Verify, by inspection of the deposit/EFT receipt documentation, that the effective deposit
date for the deposit per (D) is before year-end. Follow up on any discrepancies in this
regard.
14.2.3.1 Audit evidence obtained when the auditor attends a client’s inventory
count
e auditor observes the client’s staff undertaking the inventory count in order to determine
whether inventory recorded in the accounting records at the end of the reporting period is
correctly counted by the entity’s staff, and hence actually exists. Depending on the auditor’s
risk assessment, the planned audit approach and the nature of the specific audit procedures
carried out during the attendance of the count, the audit procedures performed may serve
as:
• Substantive procedures, providing direct evidence of the existence of inventory and
possibly its completeness and valuation (depending on the nature of the entity and its
inventory); and also
• Tests of controls providing evidence of the operating effectiveness of management’s
controls over the inventory count.
CRITICAL THINKING
Is the auditor responsible for conducting the inventory count?
No – the management of an entity establishes procedures under which inventory is
physically counted, at least once a year (sometimes more regularly) in order to
determine whether the existence and completeness of the inventory that will be
included in the nancial statements and, if applicable, to ensure the reliability of the
entity’s perpetual inventory system (refer to Chapter 8 for the details of these
procedures). Therefore, the entity is responsible for undertaking an accurate physical
inventory count by planning, performing and recording the count.
e auditor performs test counts to corroborate the effectiveness of the controls performed
by the client’s staff during the count. Test counts are carried out as follows:
• Tracing a sample of items selected from the entity’s inventory count records and
inspecting the physical inventory items (and agreeing the quantities) to verify their
existence;
• Tracing a sample of items selected from the physical inventory on hand to the entity’s
inventory count records (and agreeing the quantities) to verify the completeness of
counting and recording; and
• Based on the above findings, advising management of any differences noted.
Note: When using the inventory count as a substantive procedure to provide audit evidence of
the existence of inventory and not merely as a test of controls (attending the count may be a
dual-purpose audit test), the auditor should include items in the sample that are high in value
and/or high risk (in order to obtain the sufficient appropriate evidence required in relation to
the year-end inventory balance).
e auditor during his or her attendance at the inventory count must be on the lookout for
slow moving, obsolete or damaged items of inventory.
WHY? Why is being on the lookout for slow-moving, obsolete or damaged items
of inventory important?
This may indicate areas where write-downs or write-offs of inventory are
required and where obsolescence allowances have to be raised (as
required by IAS2) which will provide evidence about the accuracy, valuation
and allocation of inventory assertion. (Such allowances may not have been
raised or may be over or understated.)
CRITICAL THINKING
What should the auditor look at to identify slow-moving, obsolete or damaged
items of inventory?
There are various possibilities depending on the nature of the inventory items, for
example:
• Use-by dates that have expired on inventory items (such as foodstuffs or
medications);
• Products that may have been damaged by water or other means (such as dented
food tins) and may not be saleable or may need to be sold at reduced amounts;
• Items that may be cracked or chipped (such as glass or ceramic items);
• Rust on inventory items (such as metal items and locks); and
• Inventory that may be old stock and therefore obsolete, (such as technological
items – older model cellular phones, tablets and other computer-related
inventory).
In the Ntsimbi Piping audit, with the company’s principal products being pipes and
mouldings, in attending its year-end inventory count on 31 December 20X1, the auditors will
have to be aware of possible damaged pipes and mouldings that may need to be written down
or written off completely due to their net realisable value being below cost.
When auditing a manufacturing entity, the auditor should be alert to work-in-progress (i.e.
inventory items that are still in the process of manufacture) at year-end. e auditor should
utilise his or her understanding of the business to assess the risk associated with this
component of the inventory balance, and determine the appropriate audit response.
However, with the auditor sometimes having insufficient specialist knowledge of these items,
it is not always easy and possible to identify the quantity of work-in-progress and/or its stage
of completion. In such cases, assistance of an auditor’s expert (or management’s expert) may
be considered in obtaining sufficient appropriate audit evidence. e use of experts is
discussed in section 14.3.4.2.1 of this chapter.
Reliance on the work of an expert may also be required where estimating of the physical
quantities of completed inventories (finished goods) is complex and requires specialised
knowledge, for example estimating the physical quantity of items in the agricultural and
mining industries.
If any material inventory is held by a third party such as by an agent on consignment,
external confirmation of the balances on hand may be required by obtaining representations
from the third party. Depending on the risk of material misstatement, the significance of this
inventory and the integrity and objectivity of the third party, the auditor may also have to
obtain further audit evidence regarding the existence and condition of this consignment
inventory.
CRITICAL THINKING
What other procedures are available to verify the existence and condition of
consignment inventory?
Depending on the circumstances, further audit procedures may include:
• Attending the third party’s physical inventory count;
• Arranging for another auditor to attend the third party’s inventory count;
• Obtaining an audit opinion from the third party’s auditors to verify the adequacy of
the internal controls for ensuring that inventory is properly counted, and
adequately safeguarded to protect from both theft and damage, at the third party;
and
• Inspecting documentation, such as consignment contracts and warehouse
receipts, regarding inventory held by third parties.
CRITICAL THINKING
Does the auditor verify the rights assertion for the inventory account balance at
the count?
The inspection of inventory by the auditor does not provide evidence about the
entity’s ownership of the inventory at year-end.
The auditor must be alert to the possibility that some inventory on hand at year-
end (evident at the count) may be held by the entity on consignment and should not
form part of the entity’s year-end inventory balance.
This must be considered as part of the inventory count audit procedures. The
same applies for inventory already sold but still on the entity’s premises awaiting
collection by customers.
WHAT What if the auditor is only appointed as auditor of the entity after the end
of the nancial period subject to audit (therefore after the inventory
IF? count has occurred)?
It has to be considered whether suf cient appropriate audit evidence can
be obtained by alternative audit procedures, such as possibly counting on a
later date and performing roll-back procedures, in terms of which material
changes in inventory in the intervening period are veri ed in order to
recreate the inventory balance at year-end.
If, however, suf cient appropriate audit evidence cannot be obtained,
the effect of this matter on the auditor’s report will have to be considered.
Note: The above audit approach may also be necessary if the entity’s physical
inventory count is conducted at a date other than the end of the nancial
reporting period.
Reconciling items (which will be reflected in the creditors reconciliation) may arise for the
following reasons:
• e creditor may have prepared his or her statement on a different date from the date for
which the entity is performing the reconciliation. is is common in practice as many
suppliers close off their monthly accounts several days before the end of the calendar
month (e.g. on the 25th of the month), and this balance may therefore differ from the
balance on the supplier’s account in the creditors ledger on the last day of the month
(which is used for the entity’s financial reporting purposes).
• Transactions may not have been recorded by either the entity or the creditor due to
timing differences or errors:
• Invoices may have been omitted or recorded incorrectly.
• Credit or debit notes may have been omitted or recorded incorrectly.
• Amounts paid to the creditor or discounts allowed may have been omitted or recorded
incorrectly.
• Arithmetical errors may have occurred.
• Interest may have been charged by the creditor for an overdue account, but not been
recorded by the entity.
• Creditor balances may have been materially misstated by the entity as a result of
fraudulent activity, thus resulting in invalid reconciling differences.
In order to evaluate this, the following risk assessment procedures should be performed:
• Assess, by enquiry and observation, the competence and efficiency of the creditor’s clerk
in order to evaluate the probability of the prevention of errors occurring;
• Evaluate, by inspection of the organisational chart and enquiry, the segregation of duties
among members of the accounting department to verify that one person serves as a check
on another;
• Evaluate, by enquiry, management’s involvement in the process, for example, the extent
of management review of the reconciliations prepared, as well as their follow-up of
material reconciling items; and
• Evaluate whether, if applicable, an internal audit function in the entity conducts reviews
of the reconciliation process.
If these controls are in place, and then tested for operating effectiveness through tests of
control (such as enquiry of management, inspection of reconciliations, inspection of the
work of internal audit, if applicable) and found to be effective, this will ensure accuracy of
calculations and entries recorded, thus minimising the possibility of fraud or error. e
extent of substantive tests of details required to be performed on the reconciliations will thus
be reduced.
An external con rmation is a written response obtained directly from a third party, in
paper or electronic format, that may be used by the auditor as an effective way of
obtaining suf cient appropriate audit evidence about items such as the entity’s
account balances, contracts, terms of agreements and speci c arrangements with a
third party.
Yielding audit evidence that is ordinarily more reliable than that obtained from the entity’s
management and staff, third party external confirmations are commonly used in practice by
auditors to confirm or request information in respect of items such as bank balances,
accounts receivable balances, loans from/to third parties and inventory held by/for other
entities on consignment. Also, where complex or unusual transactions may have been
entered into, the auditor may attempt to confirm the third parties’ understanding of the
terms and conditions in order to verify whether their client has correctly accounted for and
disclosed the transactions.
CRITICAL THINKING
What audit concerns arise in regard to con rmations received in electronic format?
Using this format may reduce the reliability of responses (e.g. obtained via email), as
responses may have been intercepted and amended in the process. The auditor
therefore has to be sure that such process is properly secured and controlled
through various electronic systems and controls, such as encryption of the data, use
of secure data transmission lines, and the use of digital signatures.
WHY? Why must the auditor consider the relationship of the respondent to the
entity?
As all con rmation responses received have to be assessed for reliability of
audit evidence, the auditor should not merely accept con rmations without
consideration of the competence and objectivity of the respondent and the
con rmation process followed.
The auditor should therefore, for example, ascertain that the
respondent is not related to the entity, and that the entity’s management
had no involvement in the response.
If this is not done, a con rmation of a loan balance received from a
related party, may state that the balance is correct even though it is
materially misstated and/or material information was intentionally withheld.
In other words, the auditor would fail to detect a material misstatement in
the nancial statements.
Dear Sir/Madam
The above should be done by reporting directly to our auditors, who are currently in
the process of auditing our nancial statements, namely:
Nolands Inc.
Registered Auditors
Cape Town
Your prompt attention to this request would be appreciated. Please use the
enclosed envelope to submit your reply.
Yours sincerely
L Losper
Financial director
_______________________________________________________________________
Con rmation:
The balance of R836,544, owed by us as at 31 December 20X1, is correct except
as noted below:
Jembo Piping
Although the entity subject to audit is required to provide the auditor with contact details of
its trade debtors, as well as provide letterheads on which the confirmation requests are
prepared, the auditor should maintain full control over the debtors circularisation process to
avoid any room for management manipulation.
CRITICAL THINKING
Which audit objectives/assertions does the debtors circularisation address?
An accounts receivable con rmation will provide evidence of the existence of the
trade debtor and the occurrence, accuracy and cut-off assertions of the classes of
transactions making up the debtor’s balance.
Why is the valuation component of the accuracy, valuation and allocation assertion
not addressed by the con rmation?
Evidence of recoverability of the outstanding balance is not obtained – the debtor is
merely con rming that they owe the amount stated at the speci c date, not that they
can and will pay the full amount owing – the valuation thereof is not con rmed by
means of a con rmation.
Why is completeness not addressed by the con rmation?
Due to the nature of a con rmation request, it is unlikely that a debtor will advise of
understatement of the balance that has been provided to them for con rmation (i.e.
as a result of omissions/errors that the client has made).
Why is the rights assertion not addressed by the con rmation?
The con rmation does not provide evidence that the client has the right to the asset
– the amount may have been provided as security for a loan or ceded, and the debtor
will not be aware of this.
Other auditing procedures need to be conducted in order to obtain suf cient
appropriate audit evidence relating to the above assertions.
14.3.1.6.2 How does the auditor decide which and how many trade debtors to select?
CAATs (addressed in section 14.4 of this chapter) are often used in practice to select
the sample that is required for the debtors circularisation process.
e key factors that affect the auditor’s selection decision are the magnitude of the total
accounts receivable balance, the risk of material misstatement (both inherent and control)
relevant to the existence of the accounts receivable balance, and the number and size of
individual debtor accounts. When selecting accounts, the auditor will want to include the
accounts most likely to contain material misstatement. e emphasis will usually be on
selecting larger and long-outstanding balances for confirmation, as the existence of these
balances will need to be confirmed to verify that the balance is not overstated either
fraudulently or in error.
e effectiveness of using confirmations as a means of obtaining audit evidence, as well
as the availability of other audit evidence relating to the existence of debtors assertion, are
other key factors for the auditor to consider in determining the number of trade debtors to
select.
WHY? Why do you think that negative con rmation requests are a less reliable
source of audit evidence?
Guidance: Consider what the auditor would conclude, should no response
be received. Will this conclusion always be correct? Why is this so?
How does the auditor decide on the type of con rmation to use?
Negative confirmations are a more effective method for the auditor to use when:
• e risk of material misstatement of the accounts receivable balance is lower;
• e total balance consists of a large number of small balances relating to debtors that are
not businesses (i.e. the debtors are individuals);
• A large number of errors is not expected; or
• e auditor does not believe that the respondents will disregard the confirmation
requests.
Negative confirmations are therefore typically used in audits in which accounts receivable
are due from the general public, such as in the banking, medical (hospital) and retail
industries. If, for example, the client is a clothing retailer that sells to the general public on
credit, and has a large number of individually small amounts owing by its customers who are
unlikely to maintain formal records of their accounts, the likelihood of receiving a high rate
of responses is low. Practice has shown that few individuals actually take the trouble to reply
to the confirmation requests.
However, if the entity’s customers comprise mainly other business entities with relatively
large outstanding balances that are likely to have appropriate records of accounts payable
and are thus in a position to respond to a confirmation request, a positive confirmation
request will be utilised. Although, this having been said, it also has to be considered whether
the debtors to whom the confirmations are sent pay on invoice, as, should this be the case,
they will not be in a position to confirm outstanding balances, but rather only individual
invoices outstanding.
Auditors may, and often do, use a combination of these confirmation types where a small
number of large debtors balances and a large number of small debtors balances exist at the
date to which the confirmation pertains. Positive confirmation requests are sent to debtors
with large balances and negative confirmation requests to debtors with small balances.
CRITICAL THINKING
What procedures does roll-forward entail?
The auditor obtains evidence about the nature and extent of any signi cant changes
in internal controls over accounts receivable during the period after the date of the
con rmation and the end of the reporting period and performs tests of controls to
test their operating effectiveness during the roll-forward period, where necessary.
The auditor starts with the debtors balance that has been con rmed (thus audited)
at the date of the con rmation and then performs substantive roll-forward procedures
that may include selecting:
• Material credit sales transactions recorded during the period and agreeing them to
the relevant supporting documentation (such as invoices);
• Material receipts recorded during the period and agreeing them to bank
statements; and
• Other adjusting journals and entries and agreeing them to the relevant supporting
documentation (e.g. credit notes).
CRITICAL THINKING
How should the auditor maintain professional scepticism in the circularisation
process?
With regard to a low response rate or no responses on material balances:
• The auditor should always bear in mind that there is the risk that the client has
fraudulently altered a debtor’s address provided to the auditor.*
• The auditor may therefore consider it necessary to test the correctness of
debtors’ addresses by:
• Reference to any recent correspondence with the debtors;
• Agreeing the debtor’s details appearing on the monthly statement to the details
on the debtors master le; and
• Other means, such as internet searches or visiting the debtor’s website
address, to verify the contact details that the client has provided.
* (WHY might the entity have altered one or more of the debtors addresses provided
to the auditor? In answering, think about the risk of the fraudulent overstatement
of debtors’ balances).
CRITICAL THINKING
Is the debtors circularisation process always appropriate to use on an audit?
Although a frequently used audit procedure, the use of con rmations as an effective
source of audit evidence may not be appropriate in all circumstances, for example
where the auditor is aware that the response rates will probably be poor as a result
of the nature of the business and its debtors.
In practice, this may be the case in the audit of a hospital or a retail clothing
chain store where response rates to con rmations are ordinarily very low.
IN THE NEWS
The Satyam scam case and PriceWaterhouse (PW)
The lesson audit rms should have learnt from the accounting fraud at former
information technology company Satyam Computer Services Ltd, is to verify!
According to the Securities and Exchange Board of India (SEBI), the recurring lapses
in the auditing work undertaken by PW rms in India (Bangalore and Kolkata) of
Satyam’s nancial statements between 2000 and 2008 were due to the lack of
suf cient veri cation. By the admission of Satyam’s founder and chairman, Ramalinga
Raju, the case involved misstatements in excess of the equivalent of 1 billion US
dollars.
The fact that an attitude of professional scepticism was lacking on the part of the
auditors throughout these eight years is inconceivable. Unprecedented in both
severity and scale, the Satyam case resulted in all eleven PW of ces in India being
prohibited from issuing both audit and compliance certi cates for listed companies
and intermediaries for a two-year period. In addition, SEBI also imposed nes of
approximately 4 million US dollars on Price Waterhouse Bangalore as well as two PW
partners.
SEBI examined PW’s audit work to determine its role in the accounting fraud in
various areas, including in the bank and cash balances.
Non-existent cash/bank balances of Rs 5,040 crore (approximately the equivalent
of 700 million US Dollars)
The investigation found that PW did not independently verify bank statements and
xed deposit receipts, nor did it disclose the lack of such veri cation having been
performed (in the auditor’s report issued). PW, however, argued that it had undertaken
this asset veri cation and that the xed deposit receipts had appeared to be genuine.
SEBI found that PW had relied on Satyam to source the con rmations from the bank,
having not once, in eight and half years, requested independent con rmation from the
bank themselves.
In one instance, the regulator cited Satyam’s current account balance of Rs
1,782.6 crore with the Bank of Baroda’s New York branch. In another instance, SEBI
said a balance con rmation letter to PW from ICICI Bank in 2006 did not even contain
the name of the company for which the balance was being con rmed. It was also
found that PW had received two separate sets of xed deposit balance con rmation
letters – one from banks and the other from Satyam. According to the SEBI ndings, it
was noted that:
‘The auditors ignored the rst set of con rmations received directly from the banks and
relied exclusively only on those received from the company, showing deposit balances
which were tallying with what was shown in the books.’
The request of a bank con rmation has to be undertaken in accordance with SAAPS
6.
SAAPS 6 provides guidance to an auditor requesting external con rmations to
obtain audit evidence, either manually or electronically, from nancial institutions in
South Africa, to meet the requirements of ISA 505 (External Con rmations).
SAAPS 6 recognises the rapid advances in the nature of nancial instruments that
entities enter into with a wide variety of nancial institutions, and in respect of which
an auditor may seek external con rmation.
However, the importance of the use of an external confirmation to the financial institution
(bank) in the audit extends beyond the verification of the actual bank balance(s). Other vital
aspects that should be included in the confirmation for the bank to supply to and/or confirm
to the auditor, include the following:
• Interest paid and received during the financial year for all the entity’s banking accounts;
• is is used to verify the occurrence, completeness and accuracy of the entity’s interest
expense/revenue.
• Details of any pledged and ceded balances and any collateral provided for liabilities;
• is can be used to verify the completeness and accuracy of disclosure and the
presentation of, among other things, contingent liabilities in the annual financial
statements, as well as rights, obligations and completeness of the related assets and
liabilities.
• Details of any forward contracts;
• is information can be used to verify the financial instrument, including the relevant
year-end disclosures and presentation provided in the auditee’s annual financial
statements.
• Available overdraft facilities that the auditee may use and the date for review of these;
• is often assists in the going concern evaluation that the auditor performs towards
the end of the audit process, in terms of ISA 570, because it provides information about
the availability and magnitude of short-term funding available to the entity to assist
with dealing with any anticipated cash flow problems.
• Information with regard to the authorised signatories on the bank accounts.
• It has been agreed with the Banking Council – South Africa that the authorised
signatories on the entity’s bank accounts should be provided for confirmation by
banking institutions.
• is information can be used by the auditor when verifying the validity/occurrence of
payments that were made during the financial year in order to identify possible
fraudulent transactions.
CRITICAL THINKING
How can the auditor verify the completeness of his or her client’s bank accounts?
If the risk of material misstatement for the completeness assertion related to
liabilities (loans) from banks and other nancial institutions is high, the auditor has
to perform audit procedures to address this risk appropriately.
Financial institutions are under no obligation to furnish the auditor with any
information relating to accounts that are not speci cally listed in the auditor’s
con rmation request. Therefore, as the auditor cannot rely on the con rmation
process itself to provide audit evidence of the completeness of bank accounts, he or
she must perform other audit procedures to obtain this evidence. The nature and
extent of these procedures will be determined by the risk of material misstatement
relating to the completeness assertion at the auditee and can include the following:
• Requesting that the auditee’s management provide a complete list of accounts;
• Comparing such a list to the accounts audited in the prior year, as per the prior
year audit working papers;
• Inspecting minutes of board meetings during the nancial year for indications of
approvals of new accounts; and
• Inspecting the bank account numbers from which payments, and into which
deposits, were made during the nancial year.
erefore, communication with the client’s attorney assists the auditor in obtaining sufficient
appropriate audit evidence with regard to the following:
• e details with regard to potentially material litigation and claims;
• e probability of any material revenue or other expenses arising;
• Whether all material litigation and claims have been identified by the entity (although it
must be noted that there is no obligation on the attorney to confirm completeness); and
• e identification of all related legal costs with regard to the above.
is evidence will assist the auditor in evaluating the appropriate accounting treatment of
litigation and claims in the auditee’s financial statements and provide audit evidence about
the accuracy/valuation and occurrence/obligation of all related transactions and year-end
provisions, accruals for legal costs, and financial statement disclosures (e.g. contingent
liabilities).
The auditor should try to resolve any of the above issues through
discussion with management and/or the attorney. However, if the auditor is
unable to obtain suf cient appropriate audit evidence by performing
alternative audit procedures, then the auditor will have to consider the
effect (of this possible scope limitation) on the auditor’s report.
In addition to doing this, and the legal confirmation request that is often sent to the entity’s
attorneys, the auditor designs and performs various other substantive procedures to identify
all possible litigation and claims (because there is a risk that the attorneys to whom
confirmation letters are sent may not handle all legal matters for a client, and hence may be
unaware of material litigation and claims involving the client). Among others, these
procedures may include the following:
• Obtain a list from management of litigation and claims (including descriptions of the
matters and their likely financial consequence estimates) and discuss this with them;
• Analyse the legal fees expense accounts, and hold discussions with management;
• is is performed in order to identify potential litigation and claims that the auditor
may have been unaware of and will then be directed to investigate further.
• Review relevant correspondence between the entity and its attorneys, and any documents
indicating an intention to institute legal action; and
• Obtain written representations from the entity’s management in regard to the
completeness of material outstanding litigation and claims.
e following audit procedures that are performed for other areas of the audit may also often
reveal previously undetected litigation and claims:
• Review of minutes of meetings of directors, the audit committee, shareholders and others
charged with governance of the entity;
• Inspection of contracts, loan agreements, leases and insurance policies relevant to the
entity;
• Inspection of bank confirmation information concerning guarantees;
• rough inspection of bank statements (both during and subsequent to the financial
year-end), the auditor may identify payments made to an attorney in settlement of legal
expenses; and
• rough general enquiries of management and other entity employees, the entity’s
potential involvement in litigation and claims may be identified.
Representations should always be obtained about material matters where alternative forms
of audit evidence are limited. Among others, key areas that should be included are going
concern (ISA 570), subsequent events (ISA 560), related parties (ISA 550) and accounting
estimates (ISA 540). It is also important that the auditor obtains written representations from
management to confirm that it has disclosed to the auditor its knowledge of actual,
suspected or alleged fraud in the entity and the results of management’s assessment of the
risk that the financial statements may be materially misstated as a result of the fraud (ISA
240).
erefore, before the 20X1 auditor’s report of Ntsimbi Piping can be signed off by Nolands Inc.,
written representations by the directors of Ntsimbi Piping will have to obtained for all
significant audit areas in terms of the requirements of ISA 580.
ese written representations must be signed off by Lee-Ann Losper (financial director) and
Bongani Arnott (managing director) and dated on or before 26 June 20X2 (the date of the
auditor’s report).
14.3.3.2 How does the auditor assess the risk relating to an estimate?
It is particularly important for the auditor to properly apply professional judgement when
auditing an accounting estimate. is entails not merely accepting the way in which
management of the entity prepared the estimate.
To assess the risk of material misstatement relating to an accounting estimate, the auditor
has to, among other things, understand how management prepared the estimate. In
particular, he or she has to understand matters such as the method used by management to
make the estimate, the internal controls relevant to the estimate, data and assumptions used
in making the estimate and how the risk of management bias has been addressed by
management.
e auditor also has to assess how good management is at making accounting estimates
(the better they are, the lower the risk of material misstatement is). is is done (where
applicable) by looking at estimates in previous financial years and comparing the actual
outcome to the estimate.
In addition, the auditor must consider other relevant information that may impact on the
estimate, such as the complexity of the estimate, the size of the estimate in relation to the
materiality figures set for the audit, and the assessment of fraud risks (e.g. management’s
incentives, opportunities and rationalisation to misstate the financial information).
14.3.3.3 How does the auditor respond to the assessed risk of material
misstatement of an estimate?
To respond to the assessed risks of material misstatement of an accounting estimate, the
auditor must obtain sufficient appropriate audit evidence that the amount of the accounting
estimate is reasonable in the circumstances and is appropriately presented and disclosed in
the financial statements.
e auditor obtains this evidence by doing the following:
• Obtaining a written management representation that specifically covers the
reasonableness of methods, data and assumptions used in making the estimate
(management’s written representations were discussed in section 14.3.2 of this chapter);
• Performing audit procedures to test that management has properly applied the applicable
accounting requirements (recognition, measurement and disclosure) and that the
accounting estimates and related disclosures are reasonable in the context of the
accounting requirements; and
• Performing audit procedures to test the reasonableness of the amount of the estimate.
e auditor can use one or a combination of the following methods to test the reasonableness
of the amount of an estimate:
• Compare an independent estimate made by either the auditor, or an independent
auditor’s expert (discussed later on in section 14.3.4.2.1 of this chapter), to management’s
estimate. For example, Ntsimbi Piping’s auditor can make his or her own estimate of the
allowance that should be raised for credit losses, using the same or different assumptions
from those used by management. is independent estimate can then be compared to
management’s estimate and significant differences resolved with management.
• Review events subsequent to year-end that provide evidence in respect of the estimate.
For example, in the case of Ntsimbi Piping, comparing the actual bad debt write-offs up to
26 June 20X2 (the date of auditor’s report) to the estimated amount of R1,519,842 provided
for in the 20X1 annual financial statements.
• Test the process followed by management to make the estimate – discussed in detail
below.
To test the process followed by management to make the estimate, the auditor does the
following:
1. Gain an understanding of the process followed by management – this includes the
following:
• Understanding the underlying data used by management in making the estimate (e.g.
the debtors age analysis used in the estimate of the impairment allowance of Ntsimbi
Piping);
• Understanding any assumptions made by management (e.g. that 80% of debtors with
balances older than 90 days are deemed to be doubtful); and
• Understanding the method and calculations used by management and assessing
whether they are appropriate and have been applied consistently, or whether any
changes from the prior period are appropriate in the circumstances (e.g. the method of
applying a percentage to the balance of debtors older than 90 days per the age
analysis).
2. Audit the underlying data used by management (e.g. performing tests of controls and/or
substantive procedures to test the completeness and accuracy of the debtors age analysis of
Ntsimbi Piping).
3. Audit the reasonableness of the assumptions used by management (e.g. reviewing
actual write-offs of debtors with balances older than 90 days in previous years in order to
assess the reasonableness of management’s assumption that 80% of these are doubtful).
4. Audit management’s method and calculations (e.g. reperforming management’s
calculation of the allowance for credit losses).
5. Inspect management’s approval of the amount of the estimate – this is normally
evidenced by the minutes of management meetings where estimates are approved, and
these can be inspected by the auditor.
e use of other parties (apart from the audit team) in the audit process, where applicable,
has to be specifically addressed by the auditor in determining the overall audit strategy, audit
approach and nature of further audit procedures. Among others, the following other parties
may be used during the audit process to provide audit evidence:
• Internal auditors of the entity;
• Experts possessing specialist skills (appointed by either entity management or the
auditor); and
• Other auditors (specifically in, but not limited to, group audit situations).
roughout the course of the audit process, using the work of these other parties, where
applicable, should be considered as follows:
• During the pre-engagement and planning stages:
• When obtaining an understanding of the entity and assessing the risk of material
misstatement (the auditor may, for example, identify specific risks relevant to
subsidiaries audited by other auditors and assess the roles played by these auditors).
• Obtaining an understanding of the entity’s controls may include an understanding of
the functions performed by the entity’s internal audit function (if such a function
exists).
• In the design of audit procedures, this may include the evaluation of the scope of the
work assigned to be performed by other auditors, internal auditors or experts in a
particular field.
• During the gathering of audit evidence, the auditor may have to perform specific audit
procedures on the work actually performed by other auditors, internal auditors or experts,
in order to evaluate whether this work can be used as audit evidence.
• During the evaluation, conclusion and reporting stage, the auditor may have to consider
the impact of the audit findings of other auditors responsible for the audit of subsidiaries
on the audit opinion on consolidated financial statements.
As the involvement of other parties in the audit process is a complex area requiring extensive
experience of those in charge of the audit, it is only covered at an introductory level in this
text.
In assessing the function, the auditor thus considers, among other things:
e organisational status of the internal audit function: Gaining an understanding of the
• structure and objectivity of the function in the entity, including its role, operation and the
effectiveness of reporting lines to management and those charged with governance. e
auditor considers the internal audit function’s access to the entity’s audit committee and
board of directors and the entity’s policies to ensure that the function remains both
independent and effective in the entity. is can be evaluated by discussions with entity
management and the head of the internal audit function, review of entity organograms
and review of all relevant minutes of meetings, such as those of the audit committee.
• e level of competence of the internal audit function and of the staff performing the
work: In particular, this means evaluating whether the work is performed by persons with
adequate technical training and proficiency. is can be done by determining whether
they are Certified Internal Auditors (by inspecting certificates of professional registration),
their professional experience and relevant training received.
• Whether the internal audit function applies a systematic and disciplined approach to its
work, including quality control: is includes assessing whether the work is properly
planned, supervised, reviewed and documented. e external auditor can perform this
assessment through the procedures mentioned above (such as discussions with head of
internal audit, review of the Internal Audit Charter and review of minutes of internal audit
meetings), as well as review of internal audit working papers.
e auditor must also consider the scope of the work performed by internal audit to
determine whether it is relevant to the external audit (i.e. the focus of internal audit may be
more on operational controls that have little or no relevance to the financial statement
audit). is involves gaining an understanding of the areas in which internal audit work is
carried out and the types of testing performed, and can be done by performing procedures
such as discussions with the head of internal audit, review of the Internal Audit Charter (if
one is available) and the internal audit plan, as well as review of minutes of meetings.
In order to perform the above assessment, the auditor needs to obtain and review the
internal auditors’ working papers and consider the results of procedures performed by them
during the current financial year.
In order to determine the adequacy of specific internal audit work intended to be used
for external audit purposes, the external auditor has to evaluate and test the work performed
by internal auditors before placing reliance thereon. is can be done by, among other
things, reperforming audit procedures already performed by internal audit (as evidenced in
their working papers).
In using the internal audit function, the external auditor should coordinate the timing of
internal and external audit activities by discussing and planning this with the internal
auditor (and audit committee) and addressing this as part of the overall audit strategy and
the audit plan (by specifically dealing with the nature, timing and extent of the procedures
that will be need to be performed in relation to the internal audit function).
14.3.4.2 Experts
e experts on whose work auditors may consider placing reliance can fall into one of the
following two categories:
1. Experts employed by or engaged by the auditor (addressed in ISA 620 (Using the work of
an auditor’s expert)); and
2. Experts engaged by the management of the audit client (addressed in ISA 500 (Audit
evidence)).
Experts employed or engaged by the auditor are discussed in section 14.3.4.2.1 below,
whereas experts engaged by the client’s management are discussed in section 14.3.4.2.2.
Audit considerations
Audit planning
In attempting to obtain sufficient appropriate audit evidence with regard to the classes of
transactions, account balances or disclosures where expert involvement is applicable, when
planning to use the work of an expert, the auditor should:
• Prior to the appointment of the expert, consider and verify the expert’s professional
reputation and expertise in the industry in which he or she operates – such as the
actuarial industry or property valuation industry – and whether the expert is thus
professionally competent and capable of performing the engagement. is can be done
by, for example, verifying the expert’s professional qualifications and expertise, by
performing procedures such as confirming membership of a professional body,
performing background checks and researching the expert’s experience (e.g. using a
Google search);
• Also, consider the expert’s objectivity in relation to the entity by making appropriate
enquiries (e.g. from the expert); and
• On appointing the expert:
• Do so by way of a formal written agreement/contract; and
• Clarify the scope of the work to be performed by the expert in the audit engagement, so
that sufficient and appropriate audit evidence can be obtained with regard to the
specific audit objective/s and assertion/s under consideration.
CRITICAL THINKING
What happens in circumstances where the auditor places unwarranted reliance on
the work of an expert?
Should the auditor not have performed the above evaluations, or not have performed
them adequately, the auditor will have performed his or her work without the required
professional competence and due care (as per the SAICA and IRBA Codes of
Professional Conduct) and could be guilty of improper conduct and legally liable as a
result.
When using the work of an auditor’s expert in an audit engagement, the expert may have to
be advised of his or her independence requirements, the use that is to be made of the work,
and the coordination, planning and timing of the work, in order for it to be assessed to be
used as audit evidence to support the audit opinion. ese aspects will have to be
incorporated in the overall audit strategy and audit plan.
WHAT What if evaluations and procedures performed indicate that the auditor
cannot rely on the work performed by the expert appointed by
IF? management (e.g. due to the expert’s objectivity, competence or
expertise being assessed as questionable and/or the work performed by
the expert contradicting other audit evidence and is hence assessed as
being unreliable)?
The auditor will have to discuss these issues with management and, if
necessary, appoint another expert to undertake the work.
If suf cient appropriate audit evidence cannot be obtained (e.g.
management refuses to agree that reliance cannot be placed on the
expert’s work), this may constitute a limitation on the scope of the audit, or
a disagreement with management, and the effect on the auditor’s report
will have to be considered.
CRITICAL THINKING
How are other auditors relevant to an audit?
In certain instances, such as for the audit of a group of companies, the auditor will
be responsible for reporting on nancial statements (i.e. consolidated nancial
statements) that include the nancial information of components (i.e. a subsidiary)
that were audited by another auditor (referred to as the ‘component auditor’).
The following Standards set requirements relating to the use of other auditors:
• ISA 600 on special considerations for the audit of group nancial statements
(including the work of component auditors); and
• ISA 402 on audit considerations relating to an entity using a service organisation.
Given the complexity of this area, a detailed discussion falls outside the scope of
this introductory text.
images
Figure 14.3: Illustrative explanation of using an ‘around the computer’ testing approach
Note: Auditing around the computer does not involve the use of CAATs, as the auditor does not
use computer technology to test internal controls or analyse financial data. For this approach,
both tests of controls and substantive procedures (where relevant) are carried out manually
without the assistance of computer hardware or software.
images
Figure 14.4: Illustrative explanation of using a through the computer approach
images
Figure 14.5: Illustrative explanation of using a with the computer approach
WHAT What if an entity through its website entered into hundreds of thousands
of sales transactions with its customers during a nancial year that left
IF? no paper trail behind? Record of all sales transaction data was stored by
the entity only in a computerised sales transaction le.
To manually test the accuracy with which the computer calculated the sale
invoice amounts during the year (e.g. quantity x price, casting of item totals
and value added tax calculations) would require an auditor to request a
printout of the data pertaining to possibly hundreds or even thousands of
sales invoices from the computer system and to recalculate the invoice
amounts by hand using a calculator (auditing ‘around the computer’).
Using CAATs, however, an IS auditor can obtain the sales transaction le
from the entity’s computer system in electronic format (resembling a
spreadsheet) and, using generalised audit software (see 14.4.2.3)
recalculate the accuracy with which sales invoice amounts were calculated
by the entity’s system. The auditor’s recalculation can be done for 100% of
the entity’s sales transactions in this way, using basic computer formulae,
and taking only a minimal amount of time to perform the entire procedure.
By using CAATs, an IS auditor would also be able to input ‘dummy’ sales
transactions (referred to as test data) into a copy of the entity’s sales
system and compare the accuracy of the output with the predetermined
expectations (i.e. what should the results of the system’s calculations have
been if it functions appropriately?) In this way, the auditor will be auditing
‘through the computer’ to determine the reliability of the automated
controls responsible for the accuracy of the calculation of the sales
transactions in the entity’s system.
EXAMPLE
The difference between analysing data and auditing it
It is important to understand that analysing data for anomalies and exceptions using
CAATs is not necessarily the same as auditing the data. Take, for example, an audit
team’s request to an IS auditor to provide it with a report from an entity’s employee
master le of instances where the same bank account number (used for salary
payment purposes) appears more than once on the master le. There is an obvious
risk of a ghost employee receiving a salary, seeing it appears that more than one
salary is paid to the same bank account each month. Based on the audit team’s
request, the IS auditor would extract the relevant data from the entity’s payroll
system, analyse the data using generalised audit software and generate a report of
employees who have the same bank account number. This report does not constitute
suf cient appropriate audit evidence in itself. The audit team would still have to audit
the exceptions on the report by agreeing them to documentation in the physical
employee les to obtain reasons for the shared bank account number (i.e., data
analysis only facilitated the gathering of audit evidence and did not produce
suf cient, appropriate audit evidence in and of itself).
One reason may be that a husband and wife both work for the company, and are
simply sharing the same bank account. It would not have been possible to detect
the cause of this anomaly by only analysing the data using the audit software.
However, the exception may be owing to an actual duplicated (or even ctitious)
employee on the master le, fraudulently earning additional remuneration, thus
providing evidence about material misstatements in the occurrence of salaries and
wages.
14.4.1.5 What does the audit team have to communicate with the IS auditor?
Effective communication between the audit team requesting the CAATs and the IS auditor
(i.e. the CAATs specialist performing the CAATs) is essential.
An audit team would normally provide an IS auditor with a list of computer data
(constituting the client’s business/financial information) required for audit purposes, taking
into account the assessed risk of material misstatement. e audit team has to communicate
clearly to the IS auditor the requirements of the audit procedures they, the audit team, will be
performing on the data. is provides the IS auditor with the context within which the CAATs
need to be performed, taking into consideration the risks of material misstatement identified
by the audit team.
Consider the following example where the audit team requests a report from the IS auditor
about possible duplicated sales transactions in an entity’s accounting system. Note that the
IS auditor would by now have already extracted the sales transaction file from the entity’s
computer system for the purpose of data analysis. e audit team would have communicated
the following to the IS auditor:
1. Risks of material misstatement and assertion(s) relating to the information that will be
tested by the audit team (e.g. overstatement of sales: occurrence of revenue);
2. Purpose of the audit procedure (e.g. to detect duplicated sales transactions with the
same invoice numbers);
3. Population of data to which the data analysis should be applied (e.g. all sales
transactions for the financial year);
4. Financial period to which the tests relate;
5. Date by which the audit team requires the results of the data analysis;
6. Format in which the results should be supplied ( e.g. hard-copy report or electronic
spreadsheet); and
7. Specifications of the data required (e.g. list of duplicate sales invoice numbers
together with the transaction date, debtor number (if credit sales) and sales amount).
Note: Software for audit documentation should be distinguished from software for financial
statement preparation. e former consists of audit file software used by the auditor in
documenting the work performed on an audit engagement, whereas the latter consists of
software that programmatically enables the preparation of financial statements (i.e.
preparation occurs automatically with a computer). Software for financial statement
preparation usually relies on an accurate trial balance having been prepared, which is
imported into the software and from which the financial statement figures are
programmatically generated. Accounting firms frequently assist their clients in preparing
electronic financial statements using such software.
REFLECTION
Do you think there are independence concerns involved for the auditor? Would such
an activity constitute accounting services beyond the scope of what an auditor may
provide to an audit client in terms of the requirements of section 90(2) of the
Companies Act?
14.4.2.3 Can software be used for analysing computer data and testing
controls?
Data analytics and utility software can be used by an auditor for analysing computer data
and testing certain automated controls:
• Data analytics software includes applications that allow an auditor to organise, select,
interrogate, manipulate, and interpret an entity’s data for use in audit procedures. It is
predominantly used in carrying out data-oriented CAATs (refer to section 14.4.2.5 of this
chapter) and can be categorised as follows:
• Generalised audit software (GAS): is is off-the-shelf, ready-made commercial
software applications available to any audit firm. It enables data analysis for use on
audits. GAS ranges from powerful data analytics software with advanced functionality
to add-ons for spreadsheet applications offering basic data analysis techniques.
• Customised audit software: is is dedicated software written for a particular type of
audit procedure or for a specific entity’s data, which may not be readily available to
other audit firms. e auditor may write the software or an expert may be contracted to
design the software on the auditor’s behalf.
• Utility software includes applications that have not been specifically designed for use in
the audit process, but which can be used as an audit tool if required. Such utilities may
already be installed on an entity’s computer system, or be installed by the auditor (with
management’s permission). ese include the following:
• Security monitoring applications that can provide reports to the entity and auditor
about automated controls used in say, mitigating the risks relating to unauthorised
access to the computer systems, and about security violations that took place during
the year. Such applications include anti-virus, network monitoring and firewall
software.
• Embedded audit modules form part of a financial application that can be used by the
client or auditor to detect suspicious or irregular transactions that meet certain criteria
(e.g. all purchases above R500,000 are automatically flagged for follow-up and review
by management or for testing by the auditor).
• Database management tools assist a database manager in ensuring proper database
maintenance, as well as security and restricted access to database information. ese
tools can in some cases be used by an auditor to run database queries and extract
reports about maintenance and security-related issues.
• Report-generating tools can be used to create reports of financial data for further
investigation, such as the age analysis function found in many accounting
applications.
Data analytics software is not used by only external auditors. Internal auditors can
also obtain meaningful information from using data analytics software when analysing
an entity’s nancial data ‘internally’ to identify and address nancial, operational and
compliance risks.
Likewise, nancial managers can utilise data analytics to support more informed
decision-making, by using the software to identify patterns and trends in nancial
information and nding correlations and relationships between nancial gures. In
this way, parties internal to an entity can extract additional insights into risks and the
performance of the entity.
14.4.2.3.1 Which type of CAAT should be used with which particular audit approach?
e objective of the auditor is to obtain sufficient appropriate audit evidence on which to
base the audit opinion. To obtain the evidence, the auditor decides on an audit approach
appropriate for the circumstances of each entity. Audit approaches are discussed in detail in
section 12.6 of Chapter 12. e approach can be either a combined (controls-based)
approach or a substantive approach. In both these types of audit approaches, CAATs can be
applied to assist in obtaining the necessary audit evidence.
images
Figure 14.6: Illustration of test data used by auditor on client’s computer system
CRITICAL THINKING
When is it appropriate to apply test data?
It is appropriate in cases where an auditor has to test the programming logic behind
automated input, processing and output controls in a client’s software application.
The focus is on whether these controls operate as would be expected, but under
simulated conditions using test data.
• Integrated test facility (ITF) involves the creation, with client permission, of dummy
accounts in the (usually live) financial system of an audit client. e dummy account
becomes a test facility for audit purposes. ITFs can be incorporated in an application
during the design and programming phase of a system, or during the set-up of financial
information (such as when trade debtor accounts are created and loaded onto the
system). A human operator does not necessarily carry knowledge of the existence of an
ITF that is present during background processing of data in the computer system.
Dummy accounts may include, among other things, a dummy creditor or debtor account,
or employee record. Whenever transactions are recorded to the creditors ledger for
instance, as part of the entity’s normal processing routines during the year, simulated
transactions (test data – see above – resembling the actual data) would be created at the
same time and posted to the dummy account. For the purpose of the audit, the auditor
will therefore have at his or her disposal a simulated account with which to test the
effectiveness of automated controls that impacted transaction data during the financial
year. It saves the auditor from having to interrogate the entity’s system to the extent of
possibly corrupting ‘actual’ data that will form part of the financial statements (dummy
accounts will not form part of any ‘real’ financial reports).
An ITF can automatically identify deficiencies in automated controls in a live computer
system during a financial year without the auditor’s presence, in order to obtain audit
evidence about the operating effectiveness of automated controls.
CRITICAL THINKING
When is it appropriate to utilise an ITF?
An ITF is suitable where the auditor requires evidence of the operating effectiveness
of automated controls throughout the period of reliance (i.e. for the whole nancial
year). However, dummy accounts would have had to be set up at the beginning of the
nancial period and transactions should have been posted to the dummy accounts
throughout the period.
The use of an ITF on an audit is only possible where the client agrees to have an
ITF installed on its system. In addition, audit resources must allow for the use of an
ITF, for example, expertise in the setting up of an ITF must be available, as well as
skills in the use of test data. Also, where the auditor intends to place reliance on the
operating effectiveness of the automated controls throughout the nancial period,
the ITF must be set up in such a way as either to automatically process test data to
the dummy accounts at regular intervals during the year (or even continuously), or the
auditor will have to test the ITF using test data on several occasions during the year
on visits to the client.
• Parallel simulation involves an auditor processing the same set of data on an entity’s
computer system and on the auditor’s own simulated system, which mirrors that of the
entity’s. Data (which may be for test data or for a copy of actual entity transactions/events)
would therefore be run in parallel between two systems. e auditor would have the
assurance that his or her own simulated system functions properly and contains the
necessary pre-programmed automated controls. Should the results of processing differ
between the entity’s and the auditor’s systems, the test would indicate that the entity’s
system is not functioning effectively. e auditor may choose to run the test data on a
copy of the entity’s system or on the entity’s live system, for comparison with the auditor’s
parallel system.
CRITICAL THINKING
When is it appropriate for an auditor to utilise parallel simulation?
It is appropriate in instances where the auditor requires an independent software
application to simulate the effective operation of automated controls in an entity’s
software application.
For example, should the entity have used an application that can calculate the
depreciation amounts on xed assets for a nancial period, the auditor may use the
parallel simulation technique if he or she has a similar application (or can write a
similar application) that can also perform depreciation calculations and in this way
test the computer’s automated controls over depreciation calculations programmed
into the entity’s software application. Similarly, an auditor may decide to write his or
her own computer program that will be able to recalculate nance charges should the
entity be a nancial institution that makes use of a computer application to calculate
many thousands of account holders’ interest.
Remember: The objective of the use of parallel simulation is to test the operating
effectiveness of automated controls (i.e. a test of controls) and not to directly test
the correctness of amounts that appear in the entity’s nancial statements (i.e. a
substantive procedure).
• SCARF is an acronym for system control audit review file. is technique involves
embedding an audit module into a client’s computer application, to become part of the
software itself, albeit in a monitoring (review) capacity. Reports of errors, exceptions or
deviations from expectations are then written to the SCARF file by the audit module for
subsequent follow-up and review by an auditor. SCARF can be used for a wide range of
functions.
e embedded audit module can, for example, be set up by the auditor prior to the
commencement of a financial year in such a way as to detect and log any purchase
transactions, the value of which exceeds the authorisation limits of staff members who
authorise purchases. In this way, the auditor can identify instances where internal
controls did not prevent unauthorised purchase transactions from being processed by
client staff, or where controls were overridden.
CRITICAL THINKING
When is it appropriate to utilise a SCARF?
In large entities’ computer systems that contain numerous automated controls or
where a signi cant volume of transactions is processed. SCARF would enable the
auditor to focus audit attention on important transactions and events where risks of
material misstatement are most likely to occur. It can also be used in certain areas
of an entity’s computer system that are particularly prone to inappropriate activity by
computer users or where fraudulent activity is suspected.
• Code analysis involves the auditor analysing the coding of an entity’s software to
determine the effectiveness of the automated controls programmed into a computer
application. is technique clearly requires specific knowledge of computer coding
language by the auditor. Where an auditor decides on a code analysis technique, he or she
will typically be concerned with the effectiveness of general controls that were in place
during the design and systems development phase of the entity’s computer application
when most of the program coding was performed by the programmers.
In addition, the auditor will also be concerned about controls over access and changes
to the code once the programme has become operational. If the general controls were
weak during design and development and/or persons could subsequently make
unauthorised changes to the programme code (i.e. weak access and/or programme
change controls), the auditor will be less inclined to rely on the accuracy of the coding of
the applications.
CRITICAL THINKING
When is it appropriate to apply code analysis?
It is appropriate where an entity makes use of customised software, in other words
where the auditor does not have the comfort of relying on standard off-the-shelf
computer software that has been tried and tested by many other entities before. In
cases where customised software is used by an entity, the auditor may want to be
involved during the programming of the software, or perform a subsequent code
analysis in order to increase audit reliance on the controls programmed into the
software.
Regardless of the type of system-based CAATs, whenever test data is processed or dummy
accounts are created on an entity’s live system, the risk exists that the entity’s system may
become corrupted or the test data may become incorporated with the live data, distorting
the actual financial information of the entity. Special care should be taken to keep this risk to
a minimum.
Data analysis comprises the examination of electronic information previously generated by,
and stored on, an entity’s computer system. In order to perform data analysis, the auditor
first has to obtain the data by extracting it from the entity’s system and databases and
importing it into the auditor’s own data analytics software. e auditor follows a ‘with the
computer’ approach when performing data-oriented CAATs. After importing the data, the
auditor can manipulate the data as follows:
• Selection: Organise data by discarding irrelevant data fields and selecting only the data
that will be used in the analysis (i.e. select only information that is required by the audit
team to carry out audit procedures).
• Sorting and stratifying: Sort data in alphabetical or numerical order according to the
relevant data fields and stratifying (separating, grouping and listing) it by nature, category
and type.
• Interrogating: Give instructions, based on which, the generalised audit software can
examine the data to identify potential misstatements by searching for unusual items or
anomalies. Other procedures that can be performed, include:
• Selecting and generating samples; and
• Reperforming calculations on amounts.
Instructions to carry out the above functions may include having the generalised audit
software:
• Recalculate and cast data to test for mathematical accuracy of numbers;
• Identify all items exceeding a specified limit (e.g. all amounts greater than R100,000);
• Isolate items in terms of the criteria set by the auditor (e.g. all negative values, every 10th
item in the population, all duplicated items, etc.);
• Scan for missing fields or gaps in sequential numbering;
• Compare sets of data to identify inconsistencies (e.g. matching of general ledger amounts
with corresponding sub-ledger totals); and
• Perform statistical or ratio analysis and other analytical procedures on data.
14.3.3.1.1 Necessity
Whether performing CAATs would be necessary depends on:
• Volume of electronic data: Should a significant quantity of financial data be kept in
electronic format on the entity’s computer system, the auditor may have no choice but to
apply CAATs to the data, seeing that a manual approach to data selection and
manipulation will be too time-consuming.
• Nature of audit trail: For certain entities, business transactions may only be evidenced in
electronic format, without any supporting paper trail. For example, a mobile phone
operator selling airtime on its website or that allows its customers to buy airtime using
their cell phones, may have no paper trail of the transactions. e details of the
transaction are stored only in an electronic data file. In cases where little or no hard-copy
documentation is generated or kept, the use of data-oriented CAATs may be a necessity in
order to enable further audit procedures to be performed effectively.
• Extent of computerisation: e more dependent an entity is on its computer system for
financial accounting (i.e. using a computer to ensure that transactions are valid, accurate
and complete), the more likely the auditor is to perform CAATs. For example, the more
significant the number of internal controls carried out by the computer on which the
auditor wants to place reliance, the more necessary it would be for the auditor to perform
systems-oriented CAATs in testing those controls.
• Automated transaction generation and processing by the entity’s computer system
may also warrant the auditor’s use of CAATs, for example, in instances where
procedures (and controls) are carried out solely by the entity’s system with little
manual intervention. Examples include where automated general journal entries are
generated, automatic buy/sell instructions for trading in shares take place, and online
purchases of products by customers occur which require no manual intervention
during the processing of the sales order.
• Complexity of the entity’s computerised system: Some computer systems may be
complex or highly sophisticated in their design and operation. e greater the complexity
of a computer system, the more necessary it may become for an auditor to use CAATs. e
complexity of a computer system may or may not go hand-in-hand with the complexity of
the underlying financial transactions being audited. Examples of factors that can
contribute to the complexity of a computer system include:
• Complexity of the design of the computer application that processes the entity’s
transactions. Some systems may be difficult or complex to understand and use,
regardless of whether the transactions processed are straightforward or complex.
• Complicated interaction between financial subsystems, such as a creditors subsystem
interfacing automatically with a payments system where suppliers are paid via
electronic funds transfer. Because the entity is dependent on automated controls to
ensure all creditor information is correctly transferred to the payments system, the
auditor will need to test the automated controls should he or she wish to place reliance
on internal controls over payments to suppliers.
14.4.3.1.2 Possibility
Whether CAATs would be possible depends on:
• e availability of IS skills and resources: Some CAATs require advanced knowledge,
skills and experience of expert individuals. In addition, specialised audit software and
hardware with the necessary processing power may be needed to perform CAATs. Some
audit firms may not have these skills and may also not be in a position to engage outside
experts for this purpose.
• e availability of client data: For the purpose of data analysis, CAATs require an auditor
to obtain electronic data from the entity’s information system. Various factors may curtail
the availability of the entity’s data, including:
• Incompatibility between the entity’s and auditor’s systems (certain older systems do
not make the exporting of data in file formats that will be recognised by the audit
software possible); and
• Electronic data that has been lost or deleted, or data exists only in hard-copy format.
14.4.3.1.3 Desirability
Whether performing CAATs would be desirable depends on:
• Cost implications: Performing CAATs may be expensive, especially where expert IS
auditors and sophisticated audit software are involved. However, the use of CAATs can
result in considerable cost savings, especially where large samples have to be selected
from data kept in electronic format. Assuming the performance of CAATs is not necessary,
the benefit of using CAATs will still have to exceed the cost in order for CAATs to be a
desirable option.
• Time consideration: e use of CAATs can offer significant time savings to an audit team.
• Security implications and the attitude of the client towards CAATs: Some entities may
not be in favour of the use of CAATs owing to:
• Possibly vast amounts of confidential electronic data being in the possession of the
auditor for the purpose of data analysis, and the resultant security concerns should the
auditor’s computer or the data itself become lost or stolen; and
• e processing of test data on an entity’s live computer system and the resultant
concerns over data corruption and integrity.
WHAT What if, at the time the acceptance of the client is being considered by
the auditor, an entity states that it cannot allow an auditor to extract
IF? electronic nancial data from its computer system for the purpose of a
prospective audit engagement, citing, for instance, security concerns?
How would the auditor respond to such a limitation during the evaluation
of whether the engagement should be accepted?
If the auditor will be unable to obtain suf cient appropriate audit evidence
through alternative means, such as from printed records and reports, the
auditor would need to consider whether the preconditions for an audit, as
per ISA 210, are still met. If not, the auditor may have to decline the
engagement.
14.4.4.2 Planning
To comply with ISA 315 (Revised), an auditor has to obtain knowledge about an entity’s
environment and its internal controls, which includes knowledge about the design of the
entity’s computerised systems and extent of automated controls in its information system. As
part of the auditor’s understanding of the internal controls of the entity, the auditor may have
to determine whether the designed controls have been properly implemented. is can be
done by means of walkthrough tests (i.e. a transaction is selected and traced (‘walked’)
through the particular accounting process and related internal controls) for which system-
oriented CAATs may be necessary. In addition, the auditor will also have to determine
whether it is desirable to use CAATs on the engagement.
EXAMPLE
Example of data-oriented CAATs using generalised audit software (GAS)
Assume an auditor obtains from an entity a data le in electronic format of ‘weekly
wages earned’ of its factory employees. The auditor plans to analyse this le to
assist in the audit of a particular week’s wage expense. The le contains the
following data elds, with an example entry:
Data eld description Example entry
• Employee number EMP0043
• Employee name John Modise
• Standard hours worked by employee 40
• Overtime hours worked by employee 8
• Employee’s wage rate per hour R40
• Employee’s gross wage amount R1,920
There are various commands the auditor can give the GAS, after having imported the
le for use on the auditor’s computer, to detect anomalies and exceptions in the
data. Can you think of possible error conditions that might exist for wage data?
The above data-oriented CAAT procedures, and others, are useful for identifying
possible error conditions in the le. However, further audit procedures will need to
be performed to obtain audit evidence about the actual misstatements in the wages
account.
1. Planning steps
1.1 Formulate the objective of the CAATs:
• What is to be achieved through the specific CAAT? What are the risks of material
misstatement or detection risks to be addressed with the CAAT? Are systems-
oriented or data-oriented CAATs to be performed?
1.2 Define the population to be tested:
• Which line item in the financial statements (class of transactions/events or account
balance) is subjected to the CAAT?
1.3 Specify the CAATs procedures that have to be performed:
• What procedures, such as test data for systems-oriented or sorting/stratification
and recalculation for data-oriented CAATs must be performed?
1.4 Specify the format of the data required:
• In what format must the results of the CAATs procedures be presented to the audit
team? For example, the audit team may want the results in the format of an
electronic spreadsheet with specified column headings.
2. Performance steps
For data-oriented CAATs
2.1 Obtain data from the entity:
• Extract electronic data from the entity’s computer system for importing into the
auditor’s data analytics software.
2.2 Agree CAATs data received with the accounting records that are subject to the
audit:
• is is necessary to ensure that:
• e electronic data received from the entity agrees with the information being
audited (e.g. total as per annual sales transaction file received agrees with the
original data file stored in the entity’s computer system from where the data was
obtained. Note that both the file and the database should, by definition, also
agree with the details in the entity’s trial balance that will be used on the audit);
and
• All data has been accurately and fully imported from the client’s system.
2.3 Organise data:
• Data would most likely have been received in raw format. In order to prepare the
data for use in the generalised audit software, the data needs to be structured into a
workable format.
The trade receivables master le, available in electronic format for extraction from
Ntsimbi Piping’s accounting software package, contains, among other things, the
following headings:
Notes:
1. Assume for this illustration that the nancial statements have not yet been
nalised.
Accordingly, the amounts for ‘Gross balance’ above do not agree to the analysis
of the Gross trade receivables disclosed in Ntsimbi Piping’s nancial statements
(see note 5 on page 17).
2. The key reason for these amounts not agreeing is because negative trade
receivable balances are still included in the above le, whereas they have
already been reclassi ed to trade payables for the purpose of the nal annual
nancial statements. The negative debtors balances, totalling R594,309,
therefore need to be identi ed using the GAS (see steps followed below), and
reclassi ed in order to agree to the gures in the nalised annual nancial
statements.
3. Lee-Ann Losper (Ntsimbi Piping’s nancial director) informed the audit team that,
owing to overpayments made by a number of debtors in December 20X1, some
negative balances have resulted in the gross debtors balances.
The audit manager requested the assistance of the audit rm’s in-house IS auditors
with the following:
• Obtaining an electronic copy of the client’s trade receivables master le that
consists of the population of all individual trade receivable balances at 31
December 20X1;
• Organising the population data into a user-friendly format for the audit team to
use on their computers as part of the audit of trade receivables and which will be
used for sample selection purposes; and
• Identifying and aggregating negative trade receivable balances included in the
master le.
Assessment questions
For questions 1 to 8, indicate whether the statement is true or false and briefly explain
your answer:
1. e auditor’s attendance of the wage payout primarily provides audit evidence about
the completeness of wages. (LO 1)
2. In order to detect the rolling of deposits, it is important to prepare and analyse interbank
transfers. (LO 2)
3. Auditors should ordinarily send confirmation requests to all banks with which the client
has conducted any business during the financial year, regardless of the materiality of the
year-end balance. (LO 2)
6. Analysis of the legal fees expense account of the entity is an essential procedure that
should be performed on every audit. (LO 4)
7. Internal auditors need not be concerned about the validity and accuracy of entity
records if the entity has independent external auditors since they will make the
necessary verification. (LO 5)
8. e use of other parties in an audit slightly reduces the auditor’s responsibility for
issuing of the audit opinion. (LO 5)
9. Identify and explain the two types of external confirmations that are available to the
auditor. (LO 4)
10. Explain why the analysis of differences is important in the accounts receivable
confirmation process, even if the misstatement(s) in the sample are not considered
material. (LO 4)
11. If inventory is held at multiple locations, explain how the auditor would determine
whether or not attendance at these other locations is necessary. (LO 1)
12. How should the auditor deal with a situation where the auditee’s management refuses to
provide the auditor with a signed written representation letter? (LO 4)
13. Describe the audit procedures the auditor should perform in relation to a wage payout,
after he or she has observed the actual physical payout. (LO 1)
14. Explain how the auditor can obtain evidence about the completeness of inventory by
performing test counts. (LO 1)
15. Explain why the accuracy, valuation and allocation assertion relating to an account
balance containing an accounting estimate is often assessed as being at significant risk
of material misstatement. (LO 2)
16. Describe the matters that the external auditor should evaluate to determine whether the
auditee’s internal audit function is likely to provide evidence relevant to the external
audit. (LO 5)
18. Which of the following constitute CAATs performed by the auditor? (More than one
answer is possible.) (LO 6)
a) Using audit file software to prepare work papers
b) Inspecting internal sales orders printed out from the client’s computer system for
evidence of approval
c) Recalculating a column of data on a spreadsheet using spreadsheet software
d) Observing an auditee’s cashier performing cashing-up procedures at the close of
business
e) Calling up an on-screen invoice on an audit client’s computer system and
recalculating the sales prices thereon using a calculator
19. Select the CAAT(s) best performed where an auditor is required to test the automated
input controls of an audit client’s accounting software package: (LO 12)
a) Test data
b) Integrated test facility
c) Parallel simulation
d) SCARF
e) Code analysis
For questions 20 to 24, state whether the statement is true or false and briefly explain
your answer.
20. e use of data-oriented CAATs will be essential in an audit engagement where the audit
client’s computer system is old and data cannot be extracted from the client’s system for
loading onto the auditor’s computer. (LO 11)
21. Assuming than an audit team has acquired the services of an information systems
auditor, the scope of any CAATs performed on the audit engagement is limited only to
what the information systems auditor deems necessary to perform for the audit team.
(LO 6)
22. e use of an integrated test facility as part of the performance of CAATs is ideal in
situations where extensive data analysis of the client’s financial data is required. (LO 12)
23. e more computerised an audit client’s information system is, the more likely the
auditor will perform CAATs on the engagement. (LO 11)
26. Provide a brief description of the following CAAT tools available to an auditor: (LO 10)
a) Data analytics software
b) Utility software
c) Software for flowcharting
27. Describe two benefits to an auditor of using CAATs on an audit where it is both possible
and preferable to use CAATs. (LO 11)
28. Provide a brief explanation of how CAATs can be used during the gathering of audit
evidence phase of an audit where a substantive audit approach is followed. (LO 12)
29. List the steps an IS auditor would typically follow when planning the use of CAATs on an
audit engagement. (LO14)
CAATs can be effectively applied in the audit of the following account balances and classes of
transactions, but are by no means limited to these:
Transaction files: Master files:
• Revenue • Trade debtors
• Expenses • Trade creditors
• Payroll • Inventory
• Fixed assets
Each of the above would most likely be contained in a separate data file in the entity’s
computerised financial system and be transferable in electronic data format for use by an IS
auditor.
Although most of the following CAATs can easily be performed manually due to the
small number of items in the above extract from the inventory database, CAATs
would be a necessity should the complete inventory le, possibly consisting of many
thousands of items, be subject to audit. Using generalised audit software, an IS
auditor would be able to perform the following CAATS:
Vincent Motholo
CHAPTER CONTENTS
Learning outcomes
Reference list
15.1 Introduction
15.2 What is the auditor’s responsibility regarding subsequent
events?
15.3 What is the auditor’s responsibility regarding the going concern
basis of accounting?
15.4 How does the auditor deal with uncorrected misstatements in
the nancial statements?
15.5 How does the auditor draft the auditor’s report?
Assessment questions
LEARNING OUTCOMES
1. De ne ‘misstatements’.
2. Distinguish between the categories of misstatements.
3. Calculate nal materiality and explain the impact on the audit if it
differs from the materiality gure used in planning and performing
the audit.
4. Prepare a schedule of unadjusted audit differences for
misstatements identi ed during the audit.
5. Use nal materiality to evaluate uncorrected misstatements
individually and in aggregate.
6. Describe management’s and the auditor’s responsibilities with
regard to misstatements in the nancial statements.
7. Explain the impact of uncorrected misstatements on the auditor’s
report.
8. Explain the link between the objective of an audit and the auditor’s
report.
9. Describe the structure and content of the auditor’s report.
10. Draft an unmodi ed auditor’s report.
11. Distinguish between the types of audit opinions and reports.
12. De ne ‘key audit matters’ (KAMs).
13. Understand which entities’ auditor reports require KAMs to be
included.
14. Explain how going concern uncertainties, Reportable Irregularities
and contraventions of the Companies Act can affect the audit
opinion and report and their impact on the audit opinion and
report.
15. Explain the impact of the different types of modi cations, material
uncertainty related to going concern, emphasis of matter and other
matters on the auditor’s report.
16. Draft the various types of modi cation, material uncertainty
related to going concern, emphasis of matter and other matter
sections in the auditor’s report for a given scenario.
17. De ne ‘subsequent events’.
18. Distinguish between adjusting and non-adjusting subsequent
events.
19. Explain management’s responsibilities with regard to subsequent
events.
20. Explain the auditor’s responsibilities with regard to subsequent
events.
21. Formulate the audit procedures the auditor will perform with
regard to subsequent events.
22. Explain the going concern basis of accounting used in the
preparation of nancial statements.
23. Contrast the responsibilities of management and the auditor
regarding the going concern basis of accounting used in preparing
the nancial statements.
24. Identify indicators of the going concern risk and also the mitigating
factors.
25. Evaluate the appropriateness of the use of the going concern basis
of accounting for a given set of facts (including risks and mitigating
factors).
26. Describe the audit procedures to respond to the risk of the
inappropriate use of the going concern basis of accounting.
27. Distinguish the categories of insolvency and explain the
signi cance of each to the audit.
28. Explain the purpose of a subordination agreement and its impact
on the auditor’s assessment of the appropriateness of the going
concern basis of accounting.
Explain the impact of going concern uncertainties on the auditor’s
29.
report and apply to basic cases.
30. De ne the term ‘business rescue’.
31. Explain the purpose of business rescue.
32. Formulate the procedures the auditor will perform when a
company is placed under business rescue proceedings.
33. Consider the impact on the auditor’s report of a company in
business rescue proceedings.
REFERENCE LIST
• Financial year-end: Refers to the last date of the financial reporting period
of an entity. For companies, this date is determined in accordance with
section 27 of the Companies Act 71 of 2008.
• Date the financial statements are approved: Refers to the date on which
the financial statements are authorised for issue by management and those
charged with governance (the directors in the case of a company so as to
comply with the requirements of section 30(3)(c) of the Companies Act).
This date will always be after year-end.
• Date of the auditor’s report: Refers to the date on which the auditor
expresses an opinion about the financial statements of an entity and issues
the auditor’s report. The date will be either on or after the financial
statement approval date (it cannot be before the date the financial
statements are approved).
• Date of issue of annual financial statements: Refers to the date on which
the annual financial statements, including the auditor’s report, are made
available to the users of financial statements (i.e. shareholders, creditors,
government, employees and customers).
WHAT What if the court ruling was made on 15 July 20X2 (a date
after the date on which the auditor’s report was issued, but
IF? prior to date of issue of the annual financial statements to
users)? What will the responsibility of the auditor be in this
regard?
If the auditor becomes aware of this outcome, the auditor
will consider the impact of the court ruling on the issued
auditor’s report. If the auditor considers it to be material
(which in this case he or she will, as the amount of the
misstatement of R1,400,000 exceeds the final materiality
figure of R750,000), the auditor will request management
to adjust the financial statements by increasing the
provision to reflect an amount of R2,200,000. If
management refuses, the auditor will withdraw the
auditor’s report and take steps to prevent reliance on the
previous auditor’s report.
In the event that there is material uncertainty that may cast signi cant
doubt on the entity’s ability to continue as a going concern, but
management believes that the entity will nevertheless be able to continue
as a going concern, management is required to do the following:
• Provide plans for future actions to deal with the events or conditions
giving rise to the uncertainty;
• Provide an assessment, stating how the outcomes of these plans are
likely to improve the situation;
• Evaluate if these plans are feasible given the circumstances of the
entity; and
• Adequately describe the principal events or conditions that may cast
signi cant doubt on the entity’s ability to continue as a going concern
in the nancial statements and in management’s written
representation to the auditors.
If management does not believe that the entity will be able to continue as
a going concern, management has to prepare the nancial statements on
a basis other than the going concern basis and disclose this fact, together
with the reasons for this, in the nancial statements.
IN THE NEWS
Going concern issues at South African Airways
The national carrier, South African Airways (SAA), received much
attention from the newsrooms during the years 2016 to 2018. First, it
started with the governance issues pertaining to its board and the ethical
conduct of the chairperson of the board was questioned. As a result, this
led to the entire board being replaced with a new board in October 2017
to restore stakeholder confidence.
The financial statements for the year ended 31 March 2017 were
submitted late to parliament. When the Auditor General, Mr Kim
Makwetu, tabled his independent auditor’s report for the 31 March 2017
year-end in parliament, the independent auditor’s report included a
section on ‘material uncertainty relating to going concern’. For that
period, SAA reported a net loss of over R5 billion. Total liabilities
exceeded total assets by R17.8 billion for the same period.
Management of SAA predicted that the airline would stage a return
to profitability in four years’ time, as its turnaround strategy starts to reap
fruit. Furthermore, the net loss for the 2018 financial year was
anticipated to be less than R5 billion in comparison with the net loss
reported in 2017.
SAA operates in a competitive environment and as a result,
experienced a decline in passenger numbers during the 2017 financial
year. In response to increased competition, SAA dropped fares, resulting
in revenue dipping about R1 billion below what was forecast for that
period. At the same time operating costs rose, largely as a result of
higher fuel costs and volatility in foreign exchange rates. The fuel price
is denoted in US dollars.
In September 2016, government gave a bailout of R3 billion to
prevent SAA from defaulting on its debt obligations to Citibank. This
followed a R2.2 billion bailout in June 2017 to enable the airline to cover
its repayments to Standard Chartered.
Financial factors
e management of SAA and its auditor will have to analyse the
company’s nancial information in order to identify nancial factors that
may indicate that the entity is not a going concern for the foreseeable
future. e analysis will entail, among other things, analysing key
nancial ratios relating to pro tability, solvency and liquidity, and will,
among other things, identify that:
• e reported revenue for the 2017 nancial year of SAA is lower than
the forecasted revenue for that year.
• SAA has reported nancial loss of R3.7 billion over the nine months to
the end of 2017 and is projecting a further loss of just less than R5
billion for the 2018 nancial year.
• In September 2016 and June 2017 SAA was at risk of being in a default
position (liquidity concerns) in making loan repayments to its funders.
SAA received two bailouts from the government in order for it to avoid
the defaults.
Operating factors
In gathering information with regard to the operating factors that may
impact on the company’s ability to continue as a going concern, the
auditor may make enquiries of the following parties: company
management, and its attorneys, employees, suppliers and nanciers.
Important to note is that the decrease in the revenue is as a result of a
decline in passenger numbers and also reduced fares in response to
increased competition.
In the SAA situation, these mitigating factors could entail, among others,
the following:
• Eliminating routes which are not considered pro table;
• Transferring excess aeroplanes to Mango Airlines, a pro table
subsidiary of SAA; and
• Obtaining a bailout from the government (as mentioned in the article)
in order to enable SAA to meet its debt obligations and return to a
pro table position.
e mitigating factors will differ from entity to entity. is is because the
events or conditions indicating going concern problems are likely to
differ.
For example, in certain instances, the entity may not be able to pay its
short-term debts in the ordinary course of business. In such instances,
the entity may consider selling off assets, rescheduling loan repayments
or obtaining additional equity funding.
Where there are risks relating to the inappropriate use of the going
concern basis of accounting, the auditor will evaluate the process
followed by management in the assessment of the entity’s ability to
continue as a going concern. e auditor’s evaluation of the assessment
will include the following additional audit procedures performed by the
auditor:
• Inspect the forecast schedules supporting management’s assessment of
the entity’s going concern ability in order to identify any going concern
indicators, and to evaluate management’s plans for future actions in
relation to its going concern assessment (i.e. will the mitigating factors
be effective?).
• Reperform the clerical accuracy of any forecasts prepared by
management.
• Enquire of management about the data used to prepare the forecast
and agree the data to supporting documentations such as predicted
production schedules.
• Enquire of management the reasonableness of the assumptions used in
preparing the going concern assessment and corroborate this (e.g.
with information available in the market).
• Audit for feasibility any mitigating factors identified in the forecast (i.e. is
there a realistic chance that they will happen), and whether they are
correctly re ected in the forecast.
• Consider whether any additional facts or information have become
available since the date on which management made its assessment.
• Request written representations from management or those charged
with governance regarding their plans for future action and the
feasibility of these plans.
e nal materiality gure has been set at R960,000. After evaluating each
of the above misstatements individually against this materiality gure, the
auditor will evaluate the misstatements in aggregate against the nal
materiality. If this is done for the given example, it can be concluded that
each of the documented misstatements is individually quantitatively
material (i.e. material in amount).
e above schedule of unadjusted audit differences shows that the
assets are overstated in aggregate by R1,500,000, liabilities understated by
R1,720,000 in aggregate and retained earnings overstated by R3,220,000 in
aggregate. Since the misstatements identi ed are material quantitatively
(in amount), individually and in aggregate, the auditor will request that
management adjust the nancial statements with regard to the factual
(item 1) and judgemental (item 2) misstatements to ensure that the
nancial statements are not materially misstated. However, with regard to
the projected misstatement (item 3), the auditor will request that
management further investigate the matter and/or will perform further
audit procedures on the balance of the inventory account that was not
selected in the sample in order to obtain sufficient appropriate audit
evidence in this regard.
If management refuses to adjust the nancial statements in respect of
the misstatements identi ed in the example above, the misstatements
will be considered material and the auditor will modify the audit opinion
accordingly.
1. Inventory (item 1)
The factual misstatement included in the above schedule of
unadjusted audit differences will remain in the schedule. As
the misstatement is below the final materiality of
R1,600,000, the misstatement of R1,570,000 is not
individually quantitatively material (material in amount).
However, when aggregated with other immaterial items, the
aggregate misstatements may well be material.
There is no reason to deem the difference to be
qualitatively material (material in nature).
2. Provision for bonuses (item 2)
This misstatement is individually quantitatively material, as
it is exceeds the determined final materiality of R1,600,000.
There is no obvious reason to deem the difference to be
qualitatively material (material in nature).
3. Allowance for obsolete inventory
The projected misstatement included in the above schedule
of unadjusted audit differences will remain in the schedule.
As the misstatement is below the final materiality of
R1,600,000, it is not individually quantitatively material.
IAS 2 requires that inventory be valued at the lower of
cost or net realisable value. Therefore, by not doing so, the
client has contravened IAS 2. However, from the auditor’s
perspective, as the amount by which inventory is overstated
is not considered to affect the decisions of users of the
financial statements, it is not considered qualitatively
material merely because it contravened IAS 2. The key
question to be asked by the auditor to determine whether
misstatements of this nature are qualitatively material, is
whether the decisions of users of the financial statements
will be influenced by the misstatements.
4. Aggregation
The misstatements also have to be evaluated in aggregate
against the final materiality to determine their impact on the
financial statements. The evaluation in aggregate is as
follows:
Assets: R1,500,000 (overstated)
Liabilities: R1,720,000 (understated)
Retained Earnings: (1,570,000 + 1,720,000) =
R3,220,000 (overstatement)
P O Box 2881 |
Cape Town |
8000
South Africa
Valuation of Financial
Instruments (included for
illustrative purposes only)
Ntsimbi Piping Proprietary
Limited’s disclosures about its
structured financial
instruments are included in the
notes to the financial
statements. The company’s
investments in structured
financial instruments represent
43% of the total carrying
amount of its financial
instruments. Because the
valuation of the structured
financial instruments is not
based on quoted prices in
active markets, there is
significant measurement
uncertainty involved in this
valuation. As a result, the
valuation of these instruments
was significant to our audit.
Ntsimbi Piping Proprietary
Limited has determined it is
necessary to use an entity-
developed model to value
these instruments, due to their
unique structure and terms. We
challenged management’s
rationale for using an entity-
developed model, and
discussed this with those
charged with governance, and
we concluded that the use of
such a model was appropriate.
Our audit procedures also
included, among others,
testing management’s controls
related to the development and
calibration of the model and
confirming that management
had determined that it was not
necessary to make any
adjustments to the output of
the model to reflect the
assumptions that marketplace
participants would use in
similar circumstances.
Name, professional
designations and capacity (e.g.
partner/director) of individual
Registered Auditor. Most
importantly needs to be a
Registered Auditor to sign the
auditor’s report.
In our opinion, except for the effects of the matter described in the
Basis for Qualified Opinion section of our report, the accompanying
nancial statements present fairly, in all material respects, the
nancial position of Ntsimbi Piping Proprietary Limited as at 31
December 20X1 and its nancial performance and its cash ows
for the year then ended in accordance with International Financial
Reporting Standards (IFRSs) and the requirements of the
Companies Act of South Africa.
e matter that has resulted in the quali cation is described in the ‘Basis
for Opinion’ section, which is renamed ‘Basis for Quali ed Opinion’, in a
paragraph immediately following the section heading.
Say, for instance, the auditor was able to obtain sufficient appropriate
audit evidence about the trade and other receivables account balance. In
obtaining the audit evidence, material misstatements with regard to the
accuracy, valuation and allocation assertion were identi ed relating to
the trade and other receivables account balance and the accuracy of
revenue (being the other side of the double entry), and management
refuses to correct the misstatements detected. e uncorrected material
misstatements will result in a quali ed opinion. e auditor will consider
the misstatement to be material only but not pervasive, as it does not
affect the multiple elements of the nancial statements.
Hence the quali ed audit opinion will be expressed, and the ‘basis for
opinion’ section will be modi ed to include a paragraph containing a
description of the nature and nancial effects of the matter that gave rise
to the quali cation. Refer to SAAPS 3 for examples of such paragraphs.
is section has to be placed after the ‘Basis for Opinion’ section and the
‘Key Audit Matters’ section (if applicable).
If the auditor concludes that the use of the going concern basis of
accounting is inappropriate, but the nancial statements are prepared
using the going concern basis of accounting, the auditor will express an
adverse opinion. e reason for this is as follows:
• When the going concern basis of accounting is used, the nancial
statements items are carried at fair value and/or historical cost in
terms of the requirements of IFRSs. ese fair values and historical
costs will in many instances be signi cantly different to values that
should be attributed to the items if the entity is to be liquidated. Use of
the going concern basis of accounting when the entity is facing
liquidation will therefore result in numerous material uncorrected
material misstatements – which will be pervasive.
Assessment questions
For questions 1 to 20, state whether the statement is true or false:
1. Subsequent events are de ned as events occurring between the date
of the nancial statements and the date of the auditor’s report. (LO
17)
8. Factual insolvency exists when an entity is not able to pay its debts in
the normal course of business. (LO 27)
9. e auditor will only assess the going concern ability of the entity if
management or those charged with governance requests the auditor
to do so. (LO 23)
14. When the auditor has obtained sufficient appropriate audit evidence
about the nancial statements and is satis ed that they are fairly
presented, the auditor will express a type of a modi ed audit
opinion. (LO 11)
16. When the auditor has obtained sufficient appropriate audit evidence
and has identi ed material misstatements that are also considered to
be pervasive, and management refuses to correct these
misstatements, the auditor will express an adverse opinion. (LO 11)
18. Other Matter paragraphs, including the Report on Other Legal and
Regulatory Requirements paragraphs, are included in the auditor’s
report to highlight to the users matters presented or disclosed in the
nancial statements. (LO 13)
22. Which one of the following does not constitute an audit procedure
performed by the auditor in assessing the appropriateness of
preparing the nancial statements using the going concern basis of
accounting? (LO 26)
a) Discussion with management or those charged with governance
about events or conditions that may cast doubt on the entity’s
ability to continue as a going concern
b) Review of management’s assessment of the entity’s ability to
continue as a going concern
c) Attending the inventory count to identify obsolete inventory
d) Obtaining management’s written representations regarding
their plans and future actions and the feasibility of these plans
and actions
25. Which type of audit opinion will be expressed by the auditor if, in the
auditor’s judgement, management’s use of the going concern basis of
accounting in the nancial statements is inappropriate? (LO 29)
a) Unmodi ed
b) Quali ed
c) Adverse
d) Disclaimer
27. If an entity has a going concern material uncertainty and the auditor
is satis ed with management’s assessment of the entity’s going
concern ability and the related disclosure, what will the impact on
the auditor’s report be? (LO 14)
a) Quali ed opinion with an Emphasis of Matter paragraph
b) Unmodi ed opinion with a Material Uncertainty Related to
Going Concern paragraph
c) Adverse opinion with an Emphasis of Matter paragraph
d) Unmodi ed opinion with an Emphasis of Matter paragraph
28. Contrast management’s and the auditor’s responsibilities with regard
to the use of the going concern basis of accounting in the nancial
statements. (LO 23)
29. Brie y explain the purpose of the subordination agreement and its
impact on the auditor’s assessment of the appropriateness of the
going concern basis of accounting. (LO 25 & 28)
32. A nal materiality gure of R50,000 has been set for the audit of ABC
Ltd. Management of ABC Ltd has recorded an allowance for credit
losses at R65,000 below the amount recorded in the prior year,
although the trade and other receivables account has increased from
the prior year. e auditor believes that the allowance for credit
losses should in fact be R15,000 more than the prior year.
a) What is the amount by which the allowance for credit losses is
misstated? (LO 4)
b) State what type of misstatement the above will be an example
of. (LO 2)
c) Explain whether the misstatement in the allowance for credit
losses is material. (LO 5)
d) Provide the correcting journal entry for the allowance for credit
losses. (LO 4)
34. If there are uncorrected misstatements that are material only, what
type of audit opinion will the auditor express? (LO 7)
35. How does the auditor word an unmodi ed audit opinion in the
‘Opinion section’ of the auditor’s report? (LO 10)
36. If the auditor disclaims his or her audit opinion, how will the
‘Opinion section’ in the auditor’s report be worded? (LO 16)
Graeme O’ Reilly
CHAPTER CONTENTS
Learning outcomes
Reference list
16.1 What is an independent review?
16.2 What are the statutory and regulatory requirements
surrounding an independent review?
16.3 How does one conduct an independent review?
Assessment questions
LEARNING OUTCOMES
REFERENCE LIST
CRITICAL THINKING
Might a company that doesn’t require an audit or an
independent review, voluntarily elect to have their statements
reviewed rather than audited?
Technically, there is nothing that prevents a company from doing
this. The independent review might then present a more cost-
effective solution to a company that at least wants to provide
some assurance to users about their statements.
CRITICAL THINKING
Which organisations currently qualify to have their members
act as accounting of cers in terms of the Close Corporations
Act?
The Companies and Intellectual Property Commission (CIPC)
currently recognises the following accounting professions for
purposes of appointment as accounting of cers in terms of the
Close Corporations Act 69 of 1984:
• The South African Institute of Chartered Accountants (SAICA);
• Auditors registered in terms of the provisions of the APA (RA);
• The Southern African Institute of Chartered Secretaries and
Administrators (ICSA);
• The Chartered Institute of Management Accountants (CIMA);
• The South African Institute of Professional Accountants
(SAIPA);
• The Institute of Accounting & Commerce (IAC) – members who
have obtained the Diploma in Accountancy;
• The Association of Chartered Certi ed Accountants (ACCA);
• The Chartered Institute of Business Management (MCIBM);
• The South African Institute of Business Accountants (SAIBA);
and
• The South African Institute of Government Auditors (SAIGA).
CRITICAL THINKING
What is an independent professional accountant?
In terms of regulation 26(1)(d), an independent professional
accountant is:
1. A person who quali es to perform an independent review in
terms of regulation 29; and
2. Does not have a personal nancial interest in the company or
a related or interrelated company; (Typical examples of
personal nancial interests include owning shares in the
company or having lent money to the company. Related or
interrelated companies include holding companies,
subsidiary companies or fellow subsidiary companies (i.e.
any company within a group of companies of which the
company concerned is a part)); and
3. Is not involved in the day-to-day management of the
company’s business, nor has been so involved at any time
during the previous three nancial years; or
4. Is not a prescribed of cer, or full-time executive employee of
the company or another related or interrelated company, nor
has been such an of cer or employee at any time during the
previous three nancial years; and
5. Is not related to any person set out above in points 2, 3 or 4.
16.2.3 Reportable Irregularities discovered
during an independent review
Regulation 29(6) requires that independent reviewers send a written
report, without delay, to the Companies and Intellectual Properties
Commission (CIPC) when they are satisfied or have reason to believe
that a Reportable Irregularity has taken, or is taking, place.
Although the guidance relating to Reportable Irregularities for
review engagements in the Companies Regulations is fairly brief, the
principles behind these irregularities are the same principles that drive
the Reportable Irregularities that are required to be communicated by
auditors to the IRBA in terms of the APA.
It is, however, important to note that there are some differences
between these review engagement Reportable Irregularities and their
requirements and those required to be reported on by auditors in terms
of the APA.
Reportable Irregularities within an audit context are covered
extensively in Chapter 3 (section 3.5) and this section therefore focuses
only on the differences between Reportable Irregularities in the context
of a review engagement as opposed to an audit engagement.
Within these four steps, there are however two subtle differences in how
Reportable Irregularities are dealt with in an independent review
compared to when an audit is involved:
1. e regulatory body for the independent reviewer is the CIPC,
whereas for the auditor it is the IRBA.
2. Independent reviewers have 20 business days to discuss the
contents of the report with the members of the board of the
company, whereas auditors have 30 days (no reference to business
days).
CRITICAL THINKING
Is an RA who conducts an independent review of a company’s
annual nancial statements and who identi es a Reportable
Irregularity during the review engagement, guided by the APA
or by the Companies Regulations?
The guideline document published by the IRBA on Reportable
Irregularities for auditors speci cally excludes the independent
review from the de nition of an audit that an RA would have to
report on in terms of the APA’s Reportable Irregularity
requirements.
In other words, RAs performing independent reviews are not
doing so in their capacity as RAs but rather as independent
professional accountants, and so they need to comply with the
Companies Regulations’ regarding independent reviews and their
Reportable Irregularities requirements (and not with the APA
requirements).
Although nowhere near the depth provided in the specific ISAs dealing
with these aspects from an audit perspective, the ISRE does provide
specific guidance with regard to:
• Related parties (paragraphs 50 and 51);
• Fraud and non-compliance with laws or regulations (paragraph 52);
• Use of work performed by others (paragraph 55); and
• Written representations (paragraphs 61 to 65).
CRITICAL THINKING
Why do you think the requirement in paragraph 56 has been
speci cally included?
The focus of an independent review is on enquiry and analytical
procedures. These procedures will generally be performed on the
nancial statement information, because this is what the
independent reviewer is seeking to express his or her review
opinion on. There may therefore be little need for the
independent reviewer to examine any of the actual accounting
records and he or she may thus not pick up any inconsistencies
between the nancial statements and accounting records
through the normal course of review procedures.
It is clearly important that the nancial statements do agree
with the underlying records (which contain the details of the
underlying transactions and events in the business) and hence
the requirement that the independent reviewer speci cally seeks
to con rm this.
NATURE OF THE
PROCEDURES TO
BE PERFORMED THE INDEPENDENT
THE AUDIT
ON THE REVIEW
COMPLETENESS
OF REVENUE
The auditor is
likely to use
external data
(historical
information or
NATURE OF THE
PROCEDURES TO
BE PERFORMED THE INDEPENDENT
THE AUDIT
ON THE REVIEW
COMPLETENESS
OF REVENUE
production gures,
for example) to
predict monthly
sales, gross pro t
percentages, etc.
Where
expectations are
in line with actual
revenue gures,
this provides the
auditor with
corroborating
audit evidence
about the
assertion. Where
they are not in
line, further
investigations will
need to be made
and
substantiated.
NATURE OF THE
PROCEDURES TO
BE PERFORMED THE INDEPENDENT
THE AUDIT
ON THE REVIEW
COMPLETENESS
OF REVENUE
Both ISA 700 and ISRE 2400 (Revised) provide examples of the
forms of the report issued on these engagements.
Read illustrative example 1 in Appendix 2 of ISRE 2400
(Revised) for the content of the report issued for a review
engagement.
Then read illustrative example 1 in the appendix to ISA 700.
Pay particular attention to the differences in wording in
respect of the Auditor’s/Practitioner’s Responsibility and
Opinion/Conclusion paragraphs in the two reports.
Assessment questions
For questions 1 to 5, indicate whether the statement is true or false:
1. A limited assurance engagement results in a positive expression of
the practitioner’s conclusion in the review report. (LO 1 & 7)
1 For purposes of this chapter, engagement risk is defined as ‘e risk that the practitioner
expresses an inappropriate conclusion when the financial statements are materially
misstated’ (consistent with the definition in ISRE 2400 (revised) para 17(b)).
Appendix
1C PICKING SLIP
1D MASTER FILE AMENDMENT FORM
1E DELIVERY NOTE
1F CUSTOMER INVOICE
1G CUSTOMER RECEIPT
1H DEPOSIT SLIP
1I(a) CREDIT APPLICATION FORM
1I(b) CREDIT APPLICATION FORM ANNEXURE - CREDIT LIMIT APPROVAL
1J GOODS RETURN VOUCHER
1K CREDIT NOTE
1L DEBTORS AGE ANALYSIS
2K PURCHASES JOURNAL
2L GENERAL JOURNAL VOUCHER
4J WAGES JOURNAL
4K SALARIES JOURNAL
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Cadbury Schweppes (South Africa) (2008) Annual Report: Cadbury
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Institute of Directors Southern Africa (2009) King Report on
Governance for South Africa, King Code of Governance Principles for South
Africa, Cape Town: Juta Law, 2010.
Institute of Directors Southern Africa (2016) King IV™ Report on
Governance for South Africa 2016.
Treadway, JC Jr. (Chairman) et al. (Oct 1987) Report of the National
Commission on Fraudulent Financial Reporting, US: National Commission on
Fraudulent Financial Reporting, 1987.
Legislation
Auditing Profession Act 26 of 2005
Close Corporations Act 69 of 1984
Companies Act 71 of 2008
Companies Regulations 2011 (Companies Act 71 of 2008)
Electronic Communications and Transactions Act 25 of 2002 Local
Government: Municipal Systems Act 32 of 2000
National Credit Act 34 of 2005
Prevention and Combating of Corrupt Activities Act 12 of 2004
Protection of Personal Information Act 4 of 2013
Public Finance Management Act 1 of 1999
Sarbanes-Oxley Act of 2002 (US Public law 107-204 July 30, 2002)
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Index
A
access controls 125, 162–167
access control systems in human resources cycle 384–385
accounting estimates 618–620
accounting information systems 187–190
accounting records
Companies Act 71 of 2008, requirements 11–12
examples 7
purpose and need for 6–8
responsibility for 8–9
accounting scandals
international 21–25
South Africa 25–26
advanced technologies, identifying controls
electronic commerce and electronic funds transfers 181
service organisations, outsourcing and data warehousing 182
application controls
error protection process 176
input controls 171–173
master le change controls 178–180
other controls 180
output controls 178
processing controls 176–177
recording of data 173–175
assurance
and non-assurance engagements 16–19
providing 15–19
audit approach and plan 523
audit committees 110–111
audit evidence obtained in prior audits, relying 577–578
appropriateness of audit evidence 457
characteristics 456–457
computerised environments, impact 464
documentation 455–457
obtaining 461–462
obtained in prior audits, relying 577–578
sufficiency of audit evidence 456
auditing and accounting professions
international accounting bodies 27–28
professional bodies 26–29
in South Africa 28–29
auditing postulates 20
audit objectives 541–542
audit opinions, types 668–672
auditors
appointment 96
dismissal 97
ethical misconduct, examples 34–36
rms as registered auditors 100
independence 20
inspections of 101
liability for losses suffered by the client and/or third
parties 101–103
limitations on what auditors may do 100–101
replacement auditor, appointment 97
requirements to be met by the auditor in order to be
appointed 94–96
resignation 96–97
rotation 97
shareholders and directors, relationship with 6
statutory duties 101
statutory rights 98
types of 20–21
auditor’s report
audit opinions, types of 668–672
contents 663–668
modi ed opinion 668–672
audit risk
factors affecting level 495
at nancial statement level vs risk at account balances
level 500–503
see also risk
audit sampling 579–582
audits vs independent reviews 681
B
barcode scanning 215
breaches of independence 73
business continuity controls 167–169
business relationships with clients 76
C
cash and bank 594–600
combined assurance 110
combined testing vs substantive testing, implications 519–523
Companies Act 71 of 2008
accounting records and nancial statements,
requirements 11–12
appointment of auditor 96
companies that must be audited 90, 94
independent reviews 681
rotation 97
statutory rights of auditors 98
substantive tests of details 571–573, 571–574
completion of the audit
auditor’s report, drafting 663–676
auditor’s responsibility 657–658
business rescue and its impact on the audit 658–659
nal materiality 660–661
going concern basis of accounting 654–659
introduction 650–651
management’s responsibility 655–657
materiality of uncorrected misstatements, evaluating 661–663
misstatements identi ed during the audit 659–660
subsequent events, auditor’s responsibility 651–654
uncorrected misstatements 659–663
various periods pertaining to subsequent events 652
see also auditor’s report
computer-assisted audit techniques (CAATs)
application in the audit process 638–639
basics 625–630
computer software, use to assist in the audit 630–636
planning and performing 640–642
reasons for using 636–638
computer controls, categories 150–152
computer information systems, key components 148–149
computerised environments, impact on external audit
process 464
computerised environments, risks and controls
advanced technologies, identifying controls 181–182
company computer information systems, reasons for governing 144–
146
computer accounting systems, how they operate 149–150
computer controls, categories 150–152
computer information systems, key components 148–149
information technology, development 141–144
King IV™ 144–145
upgrading from manual to electronic accounting systems 146–148
computer software used to assist in the audit 630–636
computer vs manual controls 171
con icts of interest
professional accountants in business 50–51
professional accountants in public practice 62–63
control activities
human resources cycle 389–409
inventory and production cycle 340–356
investment and nancing cycle 444–446
purchases and payments cycle 286–307
revenue and receipts cycle 221–222
control objectives
vs audit objectives 542
human resources cycle 387
inventory and production cycle 337–338
investment and nancing cycle 439–442
and management’s assertions 218–221
purchases and payments cycle 281–286
revenue and receipts cycle 216–221
control risk 497–498
controls relating to the computerised processing of business
transactions
background 169–171
manual vs computer controls 171
see also application controls
corrective controls 152
credit management 198
creditors reconciliations 604–605
custody of client assets 70–71
D
databases and master les
human resources cycle 376
inventory and production cycle 333
purchases and payments cycle 273–274
revenue and receipt cycle 205–206
data warehousing, service organisations and outsourcing 182
detection risk 498–499
at account balance/class of transactions disclosure
level 518–519
at the nancial statement level, response 515
detective controls 152
documentation of audit and audit evidence 455–457
documenting independent review engagements 689
dual purpose audit procedures 574
due care and professional competence 44–45
E
electronic commerce and electronic funds transfers 181
electronic data interchange in the purchases and payments cycle 281
electronic funds transfer (EFT) 215
controls 184–186
error vs fraud, difference 510
ethical codes and rules applicable to external auditors in South Africa
36–37
ethical misconduct by auditors, examples 34–36
ethical threats to professional accountants in public practice 60
ethics
and audit process 81–82
misconduct by auditors, examples 34–36
nature of 33
reasons for professions having codes 33–36
rules-based vs principles-based codes 34
evaluating, concluding and reporting 462–464
expected errors 580
external audit process
evaluating, concluding and reporting 462–464
objectives of audits 453–454
planning activities 457–461
pre-engagement activities 457
stages 457–463, 465
substantive procedures 461–462
sufficiency of audit evidence 456
terminology 453
tests of controls 461, 462
external audits
adding value 13
de nition 19
inherent limitations 15–16
purpose 14–15
external con rmations 606–617
F
family or personal relationships with clients 76
fees
overdue 74
professional accountants in public practice 67–69
relative size 73–74
nancial interests, compensation and incentives, linked 53–54
nancial interests in clients 74–75
nancial reporting
nature of 15
risks 384
timeliness and balance between bene t and cost 16
nancial statement level risks 436–437
nancial statements
assertions made by preparers 9–10
Companies Act 71 of 2008, requirements 11–12
objective of and need for 8–9
responsibility for 8–9
truth and fairness 20
forensic auditors 21
fraud risk factors 510–512
fraud vs error, difference 510
fraudulent nancial reporting techniques 211–213
G
general controls, categories
access controls 162–167
business continuity controls 167–169
delegation of responsibility 154
operating controls and system maintenance controls 169
organisational controls and personnel practices 153–156
personnel practices 156
reporting, supervision and review 156
segregation of duties 154–156
system development and acquisition 158–161
system development and change controls 157–162
see also computerised environments, risks and controls; control
activities; control objectives
gifts and hospitality 74
going concern indicators 655–656
going concern, independent reviews 688
governance
de nition 115–116
and internal control, relationship 116–119
government auditors 21
H
history of auditing 13–14
human resources cycle 363–418
I
independence
breaches of independence 73
business relationships with clients 76
employment with an audit client 77–78
family or personal relationships with clients 76
fees, overdue 74
fees, relative size 73–74
nancial interests in clients 74–75
gifts and hospitality 74
independence 72–73
litigation, actual or threatened 74
loans and guarantees 75–76
long association of senior personnel with an audit client 79–80
provision of non-assurance services to audit clients 80–81
recent service with an audit client 77
serving as a director or officer of an audit client 77
temporary staff assignments 78–79
Independent Regulatory Board for Auditors (IRBA) 29
code of professional conduct 42–43
disciplinary process 40–41
inspections 101
professional accountants in public practice 59–72
registration 29, 99–100
reportable irregularities, duty to report 105–106
rules regarding improper conduct 37–38
and SAICA codes of professional conduct 37, 42–48
and SAICA, compared 36–37
independent reviews 679–689
inducements including gifts and hospitality 54–56, 69–70
information technology, development 141–144
inherent limitations of internal control systems 127
inherent risk 496–497
input controls 171–173
integrity 44
interim substantive procedures 577
interim tests of controls 576
internal auditors 21
internal control, and governance, relationship 116–119
internal control systems
compensating controls 135–136
components 120–127
control activities 124–126
control environment 120
design 128–136
diagrammatic representation 126–127
entity’s risk assessment process 121
formulation of control objectives 130–133
impact of failure to operate as intended 128
information system 121–123
inherent limitations 127
key controls 135
monitoring of controls 126
operational controls 135
preventative versus detective and corrective controls 134
inventory and production cycle 321–362
inventory counts, attendance 600–604
investing activities 421–423, 424, 425, 437–438
investment and nancing cycle 419–448
J
JSE listings requirements 108
K
King IV™ 109–111, 116, 117, 119, 154, 370, 486
L
legal responsibilities of auditors
companies that do not have to be audited 94
companies that have to be audited 90–94
good corporate governance, role of auditor 109–111
introduction 86–87
legislation and regulations governing the audit function 88
legislation and regulations with which the auditor has to be familiar
88–89
other legislation or regulations 108–109
public sector vs private sector auditing 107–108
reportable irregularities 99–103, 103–106
statutory and regulatory requirements for an audit 89–94
statutory requirements to practice 99–103
legislation and regulations
auditor’s duty to be familiar with 88–89
governing the auditing function 88
regarding the disclosure of directors’ emoluments 370–371
level of detection risk, options available to auditor 515–518
limited assurance engagements 17
link between control objectives and management’s assertions 388–389,
441–444
litigation, actual or threatened 74
loans and guarantees 75–76
long association of senior personnel with an audit client 79–80
low-risk engagements 495
M
management’s written representations 617–618
manual vs computer controls 171
master le change controls 178–180
materiality 524–531
guidelines 685–686
performance materiality 529–530
of uncorrected misstatements, evaluating 661–663
medium risk engagements 495
modi ed opinion 668–672
N
nature of further audit procedures
determinants 542–543
dual purpose audit procedures 574
substantive procedures 553–574
tests of controls 543–553
tests of controls vs substantive procedures 574–575
non-assurance engagements 16–19
non-compliance with laws and regulations (NOCLAR) 56–58, 71–72
O
objectives of audits 453–454
objectivity 44
obtaining understanding of the entity 483–494
operating controls and system maintenance controls 169
organisational controls and personnel practices 153–156
other parties in the audit, use of 620–625
output controls 178
outsourcing, data warehousing and service organisations 182
overall audit strategy 473
P
payroll software 385
personnel practices 156
planning activities 457–461
aspects of entities to be understood 484–491
audit approach and plan, updating throughout the audit 523
audit risk concept 494–495
desired changes to level of detection risk, options 515–518
detection risks at the nancial statement level, responding to 515
engagement documentation 482–483
identi ed risks of material misstatement, responding to 514–515
level of detection risk, options available to auditor 515–518
logistics of the audit 532
materiality 524–531
obtaining understanding of the entity 483–494
overall audit strategy, audit plan and audit approach 473–474
risk arising from going concern issues 508–509
risk assessment, conceptual aspects 494–508
risk of fraud 510–512
risk of material misstatement, assessing 494–514
signi cant risks 512–514
planning and performing CAATs 640–642
point-of-sale systems 215
postulates 20
pre-engagement activities
agreeing the terms of audit engagements 476
application of statutory requirements 478–482
engagement letter, contents 483
statutory requirements 475–478
preparation and presentation of information 51–52
pressure to breach the fundamental principles 59
preventative controls 152
principal-agent theory 5
processing controls 176–177
professional accountants in business
acting with sufficient expertise 52–53
con icts of interest 50–51
nancial interests, compensation and incentives, linked 53–54
inducements including gifts and hospitality 54–56
introduction 49–50
non-compliance with laws and regulations, responding 56–58
preparation and presentation of information 51–52
pressure to breach the fundamental principles 59
professional accountants in public practice
con icts of interest 62–63
custody of client assets 70–71
ethical threats 60
fees and other types of remuneration 67–69
inducements including gifts and hospitality 69–70
non-compliance with laws and regulations (NOCLAR) 71–72
professional appointment, changes in professional appointment 65–
66
professional appointment, client and engagement acceptance 63–65
second opinions 66–67
professional behaviour 45
professional bodies for accountants and auditors 26–29
professional competence and due care 44–45
prohibited actions for external auditors 37–39
provision of non-assurance services to audit clients 80–81
public sector vs private sector auditing, legal responsibilities 107–108
purchases and payments cycle 259–320
R
reasonable assurance 15
reasonable assurance engagements 17
recent service with an audit client 77
recording of data, application controls 173–175
reportable irregularities 682
audits 103–106
independent reviews 682–684
reporting, supervision and review, categories of general controls 156
revenue and receipts cycle 191
risk
arising from going concern issues 508–509
audit risks vs business risk 487
control risk 497–498
detection risk 498–499
nancial reporting risks 210–213
of fraud 510–512
identifying 128–130
inherent risk 496–497
management 116–119
of material misstatement, assessing 494–514
misappropriation risks 213–215
possible risks and their related controls 445–446
risk assessment, conceptual aspects 494–508
risks for which substantive procedures alone do not provide sufficient
audit evidence 514
rules-based vs principles-based codes of ethics 34
S
SAICA Code of Professional Conduct (CPC)
applicable in South Africa 36–37
background 41–43
complying with the Code 44–48
con dentiality 45
integrity 44
multiple rms and assisted holding out 46
objectivity 44
professional behaviour 45, 46
professional competence and due care 44–45
convention for reports or certi cates 46
sample sizes 580
Sarbanes-Oxley Act of 2002 108–109
second opinions 66–67
segregation of duties 125, 127, 136, 154–156, 172, 221–222, 286–287, 342,
391
service organisations, outsourcing and data warehousing 182
signi cant risks 512–514
signing convention for reports or certi cates 46
South African Institute of Chartered Accountants (SAICA) 28
continuing professional development 99
disciplinary process 39–40, 41
punishable offences 38–39
see also SAICA Code of Professional Conduct (CPC)
statistical and non-statistical sampling 581–582
Steinhoff accounting scandal 25–26
substantive procedures 582
external audit process, overview 461–462
further audit procedures, nature of 553–574
system development and change controls 157–162
T
temporary staff assignments 78–79
tests of controls
circumstances under which auditor should consider performing
522–523
nature of 543–553
overview 461, 462
vs substantive procedures 574–575
timeliness of nancial reporting and balance between bene t and cost
16
timing of further audit procedures
audit evidence obtained in prior audits, relying on 577–578
interim substantive procedures 577
interim tests of controls 576
tolerable and expected errors 580
truth and fairness in nancial statements 20
U
uncorrected misstatements
evaluating 688–689
impact on nancial statements and auditor’s report 663
upgrading from manual to electronic accounting systems, impact 146–
148
W
wage payouts, attendance 592–594