AUDITING NOTES FOR SOUTH AFRICAN STUDENTS NINTH EDITION

AUDITING NOTES FOR SOUTH AFRICAN STUDENTS NINTH EDITION JACKSON AND STENT Downloaded by david matina () lOMoARcPSD| PREFACE TO THE NINTH EDITION This ninth edition of the book has been compiled specifically to assist students at tertiary institutions in South Africa with their studies in auditing. The book is not designed to be used on its own and will swork bestswhen used in conjunction with the Companies Act 2008 and its Regulations 2011, the International Standards on Auditing and the (SAICA) Code of Professional Conduct. Extensive reference is made to these and other pronouncements. The primary reason for the ninth edition is to bring the text right up to date. A number of ISAs have been revised and some changes in the SAICA (and IRBA) Code of Professional Conduct have been made. These changes are not major but needed to be dealt with. With the increase in the number of independent review and compilation engagements which are now being undertaken by practitioners, International Standards of Review Engagements ISRE 2400 – Engagements to Review Financial Statements and International Standards on Related Services ISRS 440 – Compilation Engagements, have taken on new significance. Both of these statements have been revised and re-issued, and are covered in depth in the ninth edition. Changes have also been made in many other chapters, mainly to address a change in legislation, provide a better illustrative example or simply to improve explanations. Our intention has been to 'simplify' what has proved to be a difficult subject for many generations of auditing students. We hope that we have achieved this. Any comments or suggestions to improve subsequent editions would be most welcome, especially from students who use the book. R D C Jackson B.Acc (Natal), M.Com (Rhodes), CA(SA) Former Professor in the School of Accounting, University of KwaZulu-Natal, Durban. W J Stent B.Com (Hons) (Rhodes), M.Com (RAU), HDE (Rhodes), PhD (Massey), CA(SA), CISA. Former Senior Lecturer in the School of Accounting, University of KwaZulu-Natal, Durban. Copyright subsists in this work. No part of this work may be reproduced in any form or by any means without the publishers written permission. Any unauthorised reproduction of this work will constitute a copyright infringement and render the doer liable under both civil and criminal law. © 2014 LexisNexis 215 North Ridge Road Morningside, Durban. 4001 Telephone: 031 NINTH EDITION ISBN 978 0 409 05726 3 Downloaded by david matina () lOMoARcPSD| CONTENTS Please see the end of the book for detailed chapter by chapter index Chapter 1 Introduction to Auditing 1/1 - 1/24 Chapter 2 Professional Conduct 2/1 - 2/53 Chapter 3 Statutory Matters 3/1 - 3/93 * Companies Act 2008 and Regulations * Close Corporations Act 1984 * Auditing Profession Act 2005 Chapter 4 Corporate Governance 4/1 - 4/38 Chapter 5 General Principles of Auditing 5/1 - 5/33 * Internal control * Audit evidence * The auditor’s toolbox * Audit sampling Chapter 6 An Overview of the Audit Process 6/1 - 6/23 Chapter 7 Important Elements of the Audit Process 7/1 - 7/44 Chapter 8 Computer Audit - The Basics 8/1 - 8/50 Chapter 9 Computer Audit - Networks and Related Concepts 9/1 - 9/35 Chapter 10 Revenue and Receipts Cycle 10/1 - 10/72 Chapter 11 Acquisitions and Payments Cycle 11/1 - 11/52 Chapter 12 Inventory and Production Cycle 12/1 - 12/29 Chapter 13 Payroll and Personnel Cycle 13/1 - 13/43 Downloaded by david matina () lOMoARcPSD| Chapter 14 Finance and Investment Cycle 14/1 - 14/31 Chapter 15 Going Concern and Factual Insolvency 15/1 - 15/11 Chapter 16 Reliance on Other Parties 16/1 - 16/13 Chapter 17 Sundry Topics 17/1 - 17/26 * Initial Audit Engagements - Opening Balances – ISA 510 * Subsequent Events – ISA 560 * Related Parties – ISA 550 * Audit Documentation – ISA 230 * Specific types of Audit Evidence External confirmations – ISA 505 Enquiries regarding litigation and claims – SAAPS 4 External confirmations from financial institutions – SAAPS 6 Written Representations – ISA 580 Analytical Procedures – ISA 520 * Using a Service Organisation – ISA 402 Chapter 18 The Audit Report 18/1 - 18/19 Chapter 19 Review Engagements and Related Service Engagements 19/1 - 19/22 * Engagements to review historical financial statements * “Agreed upon procedures” engagements * Compilation engagements Downloaded by david matina () lOMoARcPSD| 1/1 CHAPTER 1 INTRODUCTION TO AUDITING CONTENTS Page THEORY AND PHILOSOPHY OF AUDITING 1. What is an auditor? 1/2 2. Why is there a need for auditors? 1/5 3. More about assurance engagements 1/6 4. Reasonable assurance, limited assurance and absolute assurance 1/8 THE ACCOUNTING PROFESSION 1. The nature of professional status 1/10 2. Accounting bodies in South Africa 1/11 3. Pronouncements which regulate the (auditing) profession 1/12 THE FINANCIAL STATEMENT AUDIT ENGAGEMENT 1. Introduction (public interest and public interest score) 1/13 2. A model of the independent audit of the financial statements of a company 1/15 3. The roles of the various parties 1/16 4. The role of the Companies Act 2008 and Companies Regulations 2011 1/16 5. The role of the Auditing Profession Act 2005 1/17 6. The role of the International Standards on Auditing (ISAs) 1/17 7. The role of the assertions 1/17 8. The role of professional scepticism 1/19 9. The role of professional judgement 1/19 SUMMARY 1/19 APPENDIX: AUDITING POSTULATES 1/20 Downloaded by david matina () lOMoARcPSD| 1/2 THEORY AND PHILOSOPHY OF AUDITING 1. WHAT IS AN AUDITOR? 1.1 Introduction No doubt we all have some idea about what an auditor is and what an auditor does, but these ideas are usually based on what we see in the media, and are often vague or clouded with misconceptions! We hear or read that the “auditors are investigating the matter”, or that the Auditor General “tabled his report in parliament”. On television game shows or talent shows we are told that “the auditors are standing by to verify the results” and we occasionally read in the newspaper that an “environmental audit” has been carried out for a large industrial company. Auditors seem to be involved in numerous different activities and there seem to be numerous different kinds of “auditor”. On the other hand auditors are regularly described as boring, conservative or more rudely as “little grey men (or women)” or sbean counterss, a description which has grown out of the popular image of auditors, serious looking individuals, in their grey suits with laptops tucked under their arms! And yet, despite the slightly mocking image, there is a general acceptance that auditing is a serious business and that auditors have a very important role to play in society. So what do auditors do? Simply stated, auditors of all types provide assurance pertaining to information prepared or presented by one party to another party with the intention of inspiring confidence in the sfairnesss of the information which is being prepared or presented. Example 1, Tramlines (Pty) Ltd goes to BigMoney Bank to request a loan. BigMoney Bank tells Tramlines (Pty) Ltd that before the bank can consider giving the company a loan it must provide BigMoney Bank with financial statements for the company which must be audited. In effect, BigMoney Bank is telling Tramlines (Pty) Ltd that the company can provide the financial information, but that the bank wants some assurance from a source independent of Tramlines (Pty) Ltd that the financial information provided by Tramlines (Pty) Ltd is fair. This is where the auditor comes in. The auditor will examine (audit) the information provided by Tramlines (Pty) Ltd and report to the bank on whether it is “fair”. (If the auditor does not think the information is “fair”, he will say so.) This assurance about the financial information submitted by Tramlines (Pty) Ltd, adds to its credibility and BigMoney Bank will be more comfortable about relying on the information when making the decision on whether to grant the loan. If the (independent) auditor states that the information is fair the bank will be more confident that granting the loan will not result in the bank suffering a loss because Tramlines (Pty) Ltd cannot repay the loan. If BigMoney Bank did not insist on audited financial information, Tramlines (Pty) Ltd could easily manipulate its financial information to deceive BigMoney Bank into granting it a loan. Example 2. How does giving assurance relate to a television talent show and why do the promoters of the show involve auditors? The answer is that the promoter wants the results of the talent show to be credible. He does not want the sponsors, participants and very importantly the public who support the show to think the results are fixed (manipulated). If this impression is given, sponsors are likely to withdraw their support and audiences (and ratings) will decline until there is no talent show. Thus, producers engage auditors, who are generally perceived by all the parties concerned to be honest, reliable and conservative, to give an opinion on whether the information (e.g. votes cast and counted, rules, etc) underlying the result was sfairs. In the context of the accounting and auditing profession we can express this more formally by referring to the International Framework for Assurance Engagements, which defines an assurance engagement as one “in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended user…..” (see point 3 below for a full discussion). 1.2 Types of auditor If we consider the following types of auditor we can get a clearer understanding of what they do and what they have in common * registered (external) auditors – auditors who express an independent opinion on whether the annual financial statements of a company, fairly present the financial position and results of the company’s operations. The external auditor is not an employee of the company. The external Downloaded by david matina () lOMoARcPSD| 1/3 auditor enhances the degree of confidence which users of the financial statements will have in the information in those financial statements. Registered auditors offer their services to the public. They are described as being “in public practice” and must be registered with the Independent Regulatory Board for Auditors (IRBA). An audit of financial statements is by no means the only assurance engagement which registered auditors conduct. As you will see later in this text, registered auditors also frequently perform review engagements, which are also assurance engagements but which provide a lower level of assurance than an audit provides. * internal auditors – auditors who perform independent assignments on behalf of the board of directors of the company. These assignments are varied but usually relate to the evaluation of the efficiency, economy and effectiveness of the company’s internal control systems and business activities and to the evaluation of whether the company has identified and is responding to the business risks faced by the company. In a sense, the internal audit function helps senior management to meet their responsibilities in running the organisation by providing independent information about the company’s departments, divisions or subsidiaries. The internal auditor enhances management’s degree of confidence that the company’s systems are functioning as intended and that the risks are being assessed and addressed. The internal auditor is an employee of the company, but must be independent of the department, division or subsidiary in which the assignment is being carried out. The organisational structure and reporting lines in the company will be designed to ensure that the internal audit function is as independent as possible. An individual is not required to be registered with a professional body to be employed as an internal auditor, but may choose to register with the Institute for Internal Auditors. Many internal auditors are chartered accountants and will be registered with the South African Institute of Chartered Accountants. * government auditors – government auditors perform a role similar to that of the internal auditor – but within government departments. They will evaluate and investigate the financial affairs of government departments, reporting their findings to senior government. They assist government in meeting its responsibilities in running the financial affairs of the country and increase the degree of confidence which the government has in its departments and indirectly, the confidence which the public has in the government’s financial management. The government auditor (called the Auditor General), is an employee of the government but again his status and organisational positioning makes his office independent of the government departments in which assignments are carried out. Registration with a professional body is not required to be employed as a government auditor, but again many government auditors are registered with professional bodies. * forensic auditors – forensic auditors concentrate on investigating and gathering evidence where there has been alleged financial mismanagement, theft or fraud. Forensic audits may be carried out in any government or business entity, but it should be obvious to you that the forensic auditor needs to be independent of the entity under investigation. Where an independent and competent forensic auditor has been involved, the degree of confidence which the court/investigating body has in the financial evidence, is increased. Forensic auditing is a specialist field but because of the emphasis on financial matters, most if not all forensic auditors have a background/qualification in auditing. * special purpose auditors – these are auditors who specialise in a particular field such as environmental auditors, who audit compliance with environmental regulations, and VAT auditors who work for the South African Revenue Services and who audit vendors’ VAT returns. The conclusion presented by the special purpose auditors enhance the degree of confidence which, for example, SARS will have in the “correctness” of the VAT returns audited, or a local authority will have in an environmental impact report. What is the characteristic common to these various audit (assurance) activities? The answer is simple but very important – it is the characteristic of independence. The external auditor is independent of the company, the internal auditor is independent of the department being audited and the VAT auditor is independent of the entity whose VAT returns he may be examining. Regardless of whether it is external, internal, government, forensic, VAT or any other kind of auditing, if the person Downloaded by david matina () lOMoARcPSD| 1/4 performing the “audit” is not independent of the entity being “audited”, the assurance given by the auditor will be worthless. Let’s relate this to Example 1 given earlier. If BigMoney Bank is not satisfied that the auditor who was engaged by Tramlines (Pty) Ltd was independent of Tramlines (Pty) Ltd, then the bank will regard the auditors opinion on the sfairnesssof Tramlines (Pty) Ltd’s financial information as little more than worthless. Similarly with regard to Example 2; the intention of the promoter of a television game show which makes use of an auditor to verify results, is to convey to the public and the show’s sponsors, that there is no “funny business” going on with the results, and that results are not being manipulated. He wants his results and his show to have credibility and the public to be confident that the result was valid. Now, if the auditor is not independent of the game show promoter or is not perceived by the public to be independent, his opinion on the results will be worthless! Finally, the word "auditor" is derived from the Latin word "audire" (to hear). In ancient times, accounting took place orally e.g. a servant would tell his master what he had done to protect and develop crops, land or cattle. The master would listen to such accounts of stewardship and question the servants i.e. the master was the listener or auditor. As the skills of writing and bookkeeping evolved, so auditing evolved with it, growing from merely listening to oral accounts of stewardship to examining written records. In many instances, masters not wishing to attend to such matters, would have appointed a trusted person independent of the stewards to “satisfy himself of the truth” of the steward’s bookkeeping. The foundation for the modern auditor had been laid, e.g. shareholders (master) engage auditors (independent trusted person) to “satisfy themselves as to the fair presentation” of the directors’ (stewards) bookkeeping, which is presented in the form of the annual financial statements. As business has evolved, professional accountants are required more and more to give assurance on all kinds of different information – not only financial statements. However, the basic premise of “enhancing credibility of information” and “increasing confidence of users” remains. Note: Postulates can be regarded as the philosophical foundations of a discipline. In their text, The Philosophy of Auditing, written over 50 years ago, Mautz and Sharaf suggested a number of auditing postulates on which modern day auditing is built. A broad understanding of these postulates will increase ones understanding of the discipline and why some aspects of auditing are as they are! These postulates have been explained in the appendix to this chapter. 1.3 Which type of auditor does this text deal with? This text deals primarily with registered auditors, the external audit of financial statements and the assurance (opinion) given for this common engagement. However, registered auditors frequently carry out independent reviews of financial statements so this type of engagement is also regularly referred to in the text and covered in some detail in Chapter 19. The major difference between an audit engagement and a review engagement is the nature and extent of the work done and consequently the level of assurance which is given by the registered auditor. For a detailed comparison of the two types of engagement see the chart in Chapter 19. As touched on in para 1.2, registered auditors are individuals who are referred to by the assurance engagement framework as “professional accountants in public practice” and who offer their services in auditing, accounting, taxation etc, to the public. Such individuals must be, in terms of the Auditing Profession Act 2005, registered with the Independent Regulatory Board for Auditors (IRBA). In the context of the auditing and accounting profession, the term audit is defined in the Auditing Profession Act 2005. The term sauditsmeans: The examination of, in accordance with prescribed or applicable auditing standards (i) financial statements with the objective of expressing an opinion as to their fairness or compliance with an identified financial reporting framework and any applicable statutory requirements or (ii) financial and other information prepared in accordance with suitable criteria, with the objective of expressing an opinion on the financial and other information. Downloaded by david matina () lOMoARcPSD| 1/5 The point is that the authority to conduct an audit of financial statements or financial information as defined, is restricted to registered auditors. Although other individuals may include the word auditor in their sjob descriptions e.g. internal auditor, forensic auditor, environmental auditor etc, these individuals may not conduct such audits i.e. an audit as defined by the Auditing Profession Act. (Of course if say, a forensic auditor was registered with the IRBA as being in public practice he could conduct audits as defined in addition to his forensic work.) This is similar to the laws relating to other professions. You cannot call yourself a medical doctor or an attorney without registering with the relevant professional body, who in turn will require that you are properly trained and qualified. So how is it then that a person can call himself an “internal auditor” or a “government auditor” without registering with the IRBA? The answer is simple, Sec 41 of the Accounting Profession Act specifically permits it. As for other types of auditors, such as environmental auditors, their role is to report on matters such as compliance with environmental regulations and not on the fairness of financial statements or other information presented in accordance with financial accounting frameworks. Just to make things a little more confusing, many auditors of all different types are also chartered accountants, i.e. members of the South African Institute of Chartered Accountants (SAICA). The reason for this is that qualifying as a chartered accountant provides a wide range of relevant skills which enable the individual to join commerce and industry, go into public practice or choose to be an internal auditor, government auditor, etc. 2. WHY IS THERE A NEED FOR AUDITORS? 2.1 The split between ownership and management The need for modern day auditors, both external and internal, arose out of the natural development of owner-managed businesses into entities which were owned by people who did not manage the business. The owners provided the finance and appointed managers to run the business. The owners would require that the managers report to them at regular intervals on their stewardship (management) of the owners’ money. Many of the providers of finance who, as stated, were not involved in managing the business, had neither the time nor the expertise to determine whether what they were being told by their managers, was a fair representation of the managers’ stewardship. The solution was to appoint an independent person to evaluate the reports of the managers and to provide an opinion on their truth or fair presentation. The need for the external auditor was established and entrenched. As businesses grew and became more complex, so the responsibilities of management to run the business efficiently and effectively and to satisfy shareholders expectations, became more onerous. Out of this came the birth of the internal audit, described above as a mechanism to assist management in meeting its responsibility of running the business efficiently and effectively. The other categories of auditor have also developed out of the growth in business; Government passes laws about protecting the environment – hence the environmental audit. Businesses suffer fraud – hence the forensic audit. 2.2 Confidence in financial information In order to maintain the confidence of those who invest in business, whether they are members of the general public or investment companies, assurance is required that the financial information produced by business organisations is reliable and credible. It is the auditor of the financial information who provides this assurance (credibility). The success of the world's capital markets hinges partially on whether investors are confident that they can rely on financial statements and other financial information to make investment decisions. Auditors (professional accountants) play a crucial role in inspiring this confidence by expressing opinions as to the fair presentation of financial information. In turn, the availability of independently audited financial information assists in: * directing individual investors towards investments that suit their needs eg. risk, return. * developing the economy as a whole, by ensuring that funds are directed towards those entities which provide evidence of sound management, high productivity and strong financial positions. * enabling the government to collect taxes on an equitable basis