[SECOND EDITION] AUDITING FUNDAMENTALS in a South African

[SECOND EDITION]

AUDITING

FUNDAMENTALS

in a South African Context

Frans Prinsloo (editor) Pieter Von Wfelligh (editor)

Gerrit Penning I Rika Butler I Dana Nathan (Josset)

Graeme O'Reilly I Rolien Kunz I Vincent Motholo

Riaan Rudman I Henriette Scholtz

CHAPTER6 Revenue and receipts cycle 191

Learning outcomes 191 Reference list 191

6.1 What are the nature, purpose and accounting implications of the cycle? 192 6.1.1 The nature and purpose of the cycle 192 6.1.2 Forms of revenue from sale of goods and rendering of Services 193 6.1.3 The varied nature of the cycle 194 6.1.4 How transactions in the cycle are triggered (initiated) 194 6.1.5 Major accounts affected by the cycle 196 6.1.6 IFRS 15 and the treatment of revenue for hnancial reporting purposes 197

6.2 What functional areas occur in the cycle? 197 6.2.1 Description of the functional areas 197 6.2.2 Summary of functional areas by department 200

6.3 What Information system is used in the cycle? 201 6.3.1 Accounting for revenue and receipt transactions 201 6.3.2 Supporting documents, journals and ledgers 202 6.3.3 Databases and master dies (computerised Systems only) 205 6.3.4 Reports 206 6.3.5 Reconciliations 206 6.3.6 Illustration: Transaction flow in the revenue and receipts cycle 206

6.4 What could go wrong (risks) in the cycle? 210 6.4.1 Financial reporting risks 210 6.4.2 Misappropriation risks 213

6.5 What Computer technologies are used in the cycle? 215 6.5.1 Point-of-sale Systems and barcode scanning 215 6.5.2 Electronic funds transfer 215 6.5.3 Online sales (internet-based) 216

6.6 What are the control objectives in the cycle? 216 6.6.1 Control objectives in the cycle 216 6.6.2 Achievement of the control objectives in the cycle 217 6.6.3 Link between the control objectives in the cycle and management's assertions 218

6.7 What are the controls in the cycle (manual and computerised)? 221 6.7.1 Internal control activities in the cycle 221 6.7.2 Internal control tables 223

6.8 Cycle Illustration: The revenue and receipts cycle at Ntsimbi Piping 246 6.8.1 Credit management 246 6.8.2 Receiving Orders from customers 247 6.8.3 Authorisation of sales Orders 249 6.8.4 Picking of goods from warehouse 249 6.8.5 Despatch and delivery of goods to customers 250 6.8.6 Invoicing 250 6.8.7 Recording of sales in the accounting records 251 6.8.8 Receipt of cash from customers 252 6.8.9 Recording of receipts in the accounting records 253 6.8.10 Processing and recording of returns and other sales adjustments 254

Assessment questions 255

viii Auditing Fundamentals in a South African Context

CHARTER 7 Purchases and payments cycle 259

Learning outcomes 259

7.1 What are the natura, purpose and accounting implications of the cycle? 261 7.1.1 Ihe nature and purpose of the cycle 261 7.1.2 Forms of purchases 261 7.1.3 Ihe varied nature of the cycle 262 7.1.4 How transactions in the cycle are triggered (initiated) 262 7.1.5 Example of a typical transaction in the purchases and payments cycle 262 7.1.6 Major accounts affected by the cycle 263 7.1.7 Accounting treatment of certain specific transactions in the cycle 263

7.2 What functional areas occur in the cycle? 267 7.2.1 Description of functional areas 267 7.2.2 Summary of functional areas by department 269

7.3 What Information System is used in the cycle? 269 7.3.1 Accounting for purchases and payments transactions 269 7.3.2 Supporting documents, journals andledgers 270 7.3.3 Databases and master files (computerised Systems only) 273 7.3.4 Reports 274 7.3.5 Reconciliations 274 7.3.6 Illustration: Transaction flow in the purchases and payments cycle 275


7.5 What Computer technologies are used in the cycle? 280 7.5.1 Electronic funds transfer (EFT) 280 7.5.2 Electronic data interchange (EDI) 281


7.7 What are the controls in the cycle (manual and computerised)? 286 7.7.1 Internal control activities in the cycle 286 7.7.2 Internal control tables 288

7.8 Cycle Illustration: The purchases and payments cycle at Ntsimbi Piping 308 7.8.1 Purchase requisition 308 7.8.2 Ordering goods from suppliers 308 7.8.3 Receiving goods from suppliers 310 7.8.4 Recording of purchases 312 7.8.5 Payment preparation 313 7.8.6 Paying the supplier 315 7.8.7 Recording of payment 316 7.8.8 Returning goods and recording a purchase return 316


Second edition ix

Contents

Acknowledgements xvii Preface xviii List of authors xx About the book xxii Ntsimbi Piping (Pty) Ltd Company Profile xxiii

PART A: THE CONTEXT WITHIN WHICH THE EXTERNAL AUDITOR OPERATES 1

CHARTER 1 Introduction ^3


1.1 Background 5

1.2 What is the purpose of and need for accounting records? 6 1.2.1 Purpose of accounting records 6 1.2.2 Examples of accounting records 7

1.3 What is the objectiveof and need for financial Statements? 8 1.3.1 The objective of financial Statements 8 1.3.2 Responsibility for accounting records and financial Statements 8 1.3.3 The assertions made by the preparers of the financial Statements 9 1.3.4 Companies Act requirements for accounting records and financial Statements 11

1.4 Why are external auditors needed and what is the purpose of an external audit? 12 1.4.1 The need for external auditors 12 1.4.2 The history of auditing 13 1.4.3 The history of the external auditing profession in South Affica 14 1.4.4 The purpose of an external (financial Statement) audit 14 1.4.5 Providing assurance 15 1.4.6 The definition of an external audit 19 1.4.7 Auditing postulates 20 1.4.8 Types of auditors 20

1.5 What are examples of major corporate accounting scandals in recent years? 21 1.5.1 International corporate accounting scandals 21 1.5.2 South African corporate accounting Standards 25

1.6 What are the structures of the accounting and auditing professions? 26 1.6.1 Professional bodies 26 1.6.2 International accounting bodies 27 1.6.3 Structure of the accounting and auditing professions in South Africa 28


iv Auditing Fundamentals in a South African Context

CHARTER 2 Ethics 31


2.1 What is the nature of ethics? 33

2.2 Why do professions have codes of ethics? 33 2.2.1 Background to codes of ethics of professions 33 2.2.2 Rules-based versus principles-based codes of ethics 34 2.2.3 Examples of ethical misconduct by auditors 34

2.3 What are the ethical codes and rules applicable to external auditors in South Africa? 36

2.4 What constitutes prohibited actions for the external auditor? 37 2.4.1 IRBA Rules Regarding Improper Conduct 37 2.4.2 SAICA's punishable offences 38

2.5 How do the SAICA and IRBA disciplinary processes work? 39 2.5.1 SAICA disciplinary process 39 2.5.2 IRBA disciplinary process 40 2.5.3 Examples of SAICA and IRBA disciplinary processes 41

2.6 What is the content of the SAICA and IRBA Codes of Professional Conduct? 42 2.6.1 Background to the SAICA and IRBA Codes of Professional Conduct 42 2.6.2 Differences between SAICA and IRBA Codes of Professional Conduct 42 2.6.3 The SAICA Code of Professional Conduct (CPC) 44 2.6.4 Part 1: Complying with the code: Conceptual framework approach 47 2.6.5 Part 2: Professional accountants in Business 49 2.6.6 Part 3: Professional accountants in public practice 59 2.6.7 International Independence Standards (Part 4) 72

2.7 How does ethics fit into the audit process? 81


CHARTER 3 Legal responsibiiities of Öie auditor 85


3.1 Introduction 86 3.1.1 Legislation and regulations governing the audit function 88 3.1.2 Legislation and regulations with which the auditor has to be familiar 88

3.2 What are the statutory and regulatory requirements for an audit? 89 3.2.1 Companies that have to be audited 90 3.2.2 What if a Company does not have to be audited? 94

3.3 How does the statutory appointment, removal and rotation of the auditor work and what are bis or her rights? 94 3.3.1 Requirements to be met by the auditor in order to be appointed 94 3.3.2 Appointment of the auditor 96

Second edition v

CHARTER 8 Inventory and production cycle


8.1 What are the nature, purpose and accounting implications of the cycle? 322 8.1.1 The nature and purpose of the cycle 322 8.1.2 Types of inventory and production 323 8.1.3 The varied nature of the cycle 324 8.1.4 Ihe link between this cycle and the other cycles 324 8.1.5 How transactions in the cycle are triggered (initiated) 324 8.1.6 Example of a typical transaction in the inventory and production cycle 325 8.1.7 Major accounts affected by the cycle 326 8.1.8 LAS 2 and the treatment of inventory for hnancial reporüng purposes 327

8.2 What functional areas occur in the cycle? 327 8.2.1 Description of the functional areas 327 8.2.2 Summary of functional areas by department 330

8.3 What Information system is used in the cycle? 331 8.3.1 Accounting for inventory and production transactions 331 8.3.2 Supporting documents, journals and ledgers 331 8.3.3 Databases and master files (computerised Systems only) 333 8.3.4 Reports 333 8.3.5 Reconciliations 333 8.3.6 Illustration: Transaction flow in the inventory and production cycle 333

8.4 What could go wrong (risks) in the cycle? 337

8.5 What Computer technologies are used in the cycle? 337


8.7 What are the controls in the cycle (manual and computerised)? 340 8.7.1 Internal control activities in the cycle 340 8.7.2 Internal control tables 342 8.7.3 Controls relating to the conducting of inventory counts 354

8.8 Cycle Illustration: The inventory and production cycle at Ntsimbi Piping 356 8.8.1 Background to inventory and production 356 8.8.2 Storage of raw material 358 8.8.3 Production planning 358 8.8.4 Transfer raw materials to production 358 8.8.5 Production 359 8.8.6 Transfer finished goods to finished goods warehouse 359 8.8.7 Storage of finished goods 360 8.8.8 Update of costing records 360 8.8.9 Inventory counts 360 8.8.10 Maintenance of inventory records 361


x Auditing Fundamentais in a South African Context

CHARTER 9 Human resources cycle 363

Learning outcomes 363

9.1 What are the natura, purpose and accounting implications of the cycle? 365 9.1.1 The nature and purpose of the cycle 365 9.1.2 Relationship with other cycles 366 9.1.3 The varied nature of the cycle 366 9.1.4 How transactions in the cycle are triggered (initiated) 367 9.1.5 Major accounts affected by the cycle 367 9.1.6 Applicable accounting Standards, legislation, listings requirements and

corporate governance principles 368 9.1.7 Executive remuneration 371 9.1.8 Deductions from employees'remuneration 371

9.2 What functional areas occur in the cycle? 371 9.2.1 Description of the functional areas in the cycle 371 9.2.2 Summary of functional areas by department 373

9.3 What Information system is used in this cycle? 373 9.3.1 Accounting for salaries, wages and related transactions 373 9.3.2 Supporting documents, journals and ledgers 374 9.3.3 Databases and master files (computerised Systems only) 376 9.3.4 Reports 376 9.3.5 Reconciliations 376 9.3.6 Illustration: Transaction flow in the human resources cycle 376


9.5 What Computer technologies are used in the cycle? 384 9.5.1 Access control Systems 384 9.5.2 Payroll Software 385 9.5.3 Electronic funds transfer (EFT) 386


9.7 What are the controls in the cycle (manual and computerised)? 390 9.7.1 Internal control acdvities in the cycle 390 9.7.2 Internal control tables 391

9.8 Cycle Illustration: The human resources cycle at Ntsimbi Piping 410 9.8.1 Background to the human resources cycle of Ntsimbi Piping 410 9.8.2 Appointment of employees and personnel records 410 9.8.3 Time keeping - wage-earning employees 411 9.8.4 Calculation and recording of salaries and wages 412 9.8.5 Payment preparation and payment of wages and salaries 412 9.8.6 Payment of deductions 414 9.8.7 Recording the salary and wage transactions in the accounting records 415


Second edition xi

CHARTER 10 Investment and financing cycle


10.1 What are the nature, purpose and accounting implications of the cycle? 420 10.1.1 The nature and purpose of the cycle 420 10.1.2 Forms of transactions and major accounts affected by the cycle 422 10.1.3 Characteristics of the Investment and financing cycle 423 10.1.4 Relevant accounting Standards 424 10.1.5 How transactions in the cycle are triggered (initiated) 424

10.2 What functional areas occur in the cycle? 425 10.2.1 Financing 425 10.2.2 Investments 428

10.3 What Information system is used in the cycle? 430 10.3.1 Accounting for Investment and financing transactions 430 10.3.2 Supporting documents and journals 430 10.3.3 Illustration: Transaction flow in the Investment and financing cycle 433

10.4 What could go wrong (risks) in the cycle? 436 10.4.1 Financial Statement level risks 436 10.4.2 Assertion level risks 437

10.5 What Computer technologies are used in the cycle? 438


10.7 What are the controls in the cycle (manual and computerised)? 444

10.8 Cycle Illustration: The Investment and financing cycle at Ntsimbi Piping 446


PART C: THE EXTERNAL AUDIT PROCESS 449

CHARTER 11 Overvlew of the audit process 4SI


11.1 Introduction 453

11.2 What terminology is used by the auditor when performing an audit? 453

11.3 What are the objectives of an audit? 453

11.4 What are the International Standards on Auditing (ISAs)? 454

11.5 How is the audit and audit evidence documented? 455 11.5.1 Characteristics of audit evidence 456

xii Auditing Fundamentals in a South African Context

11.6 What are the stages in the audit process? 457 11.6.1 What are pre-engagement activities? 457 11.6.2 What are planning activities? 457 11.6.3 Obtaining audit evidence 461 11.6.4 Evaluating, concluding and reporting 462

11.7 How do computerised environments impact on the audit process? 464

11.8 Is there a link between the stages of the audit process and the ISAs? 465


CHARTER 12 Pre-engagement and plarming activities 469


12.1 Introduction 472 12.1.1 The concepts of overall audit strategy, audit plan and audit approach 473

12.2 How does the auditor perform pre-engagement activities? 475 12.2.1 Requirements 475 12.2.2 Application in practice 478

12.3 How are the terms of the engagement documented? 482 12.3.1 Importance of documenting the terms 482 12.3.2 Contents of the engagement letter 483

12.4 How does the auditor obtain an understanding of the entity? 483 12.4.1 Aspects of the entity to be understood 484 12.4.2 Method of obtaining the understanding 491

12.5 How does the auditor assess the risk of material misstatement? 494 12.5.1 Conceptual aspects of risk assessment 494 12.5.2 The need to consider risk arising from going concern issues 508 12.5.3 The need to consider risk arising of fraud 510 12.5.4 Identification of risks that require special audit consideration (significant risks) 512 12.5.5 Risks for which Substantive procedures alone do not provide sufficient audit evidence 514

12.6 How can the auditor respond to identißed risks of material misstatement? 514 12.6.1 Responding to detection risk at the financial Statement level 515 12.6.2 What opüons are available to the auditor to achieve desired changes to the

level of detection risk at the financial Statement level? 515 12.6.3 Responding to detection risk at the account balance/class of transactions/

disclosure level 518 12.6.4 The implications of combined testing versus Substantive testing 519 12.6.5 Updating the audit approach and plan throughout the audit 523

12.7 What is materiality and how is it calculated? 524 12.7.1 Definition 524 12.7.2 Calculating materiality 525

12.8 Attending to the logistics of the audit 532


Second edition xiii

CHARTER 13 Audit procedures: Esserrtial concepts 537


13.1 Where do audit procedures fit into the audit process? 539

13.2 What are audit objectives? 541

13.3 What is the nature of further audit procedures? 542 13.3.1 Determinants of the nature of the further audit procedures 542 13.3.2 Tests of controls 543 13.3.3 Substantive procedures 553 13.3.4 Dual purpose audit procedures 574 13.3.5 Revision 574

13.4 What is the timing of further audit procedures? 575 13.4.1 Determinants of the timing of further audit procedures 575 13.4.2 Interim tests of controls 576 13.4.3 Interim Substantive procedures 577 13.4.4 Relying on audit evidence obtained in prior audits 577

13.5 What is the extent of further audit procedures? 578 13.5.1 Audit sampling 579


Appendix 585

CHARTER 14 Audit procedures: Specific considerations 589



14.2 How do we formulate the nature of further audit procedures for specific classes of transactions or account balances? 592 14.2.1 Wages: Attendanceofawagepayout 592 14.2.2 Cash and bank 594 14.2.3 Inventory: Attendance of inventory counts 600 14.2.4 Creditors reconciliations 604

14.3 What are the requirements of International Standards on Auditing for dealing with specific complexities that may be encountered when performing audit procedures? 606 14.3.1 External confirmations 606 14.3.2 Managemente written representations 617 14.3.3 Accounting estimates 618 14.3.4 Use of other parties in the audit 620

14.4 What are computer-assisted audit techniques (CAATs)? 625 14.4.1 The basics of CAATs 625 14.4.2 The auditor's use of Computer Software to assist in the audit 630 14.4.3 Reasons for the use of CAATs in the audit process 636

xiv Auditing Fundamentals in a South African Context

14.4.4 Application of CAATs in the audit process 638 14.4.5 Steps in planning and performing CAATs 640


Appendix: CAATs example 645

CHAPTER 15 Completion of the audit 647



15.2 What is the auditor's responsibility regarding subsequent events? 651 15.2.1 Introduction 651 15.2.2 Various periods pertaining to subsequent events 652 15.2.3 Auditor's responsibility 653

15.3 What is the auditor's responsibility regarding the going concern basis of accounting? 654 15.3.1 Introduction 654 15.3.2 Managements responsibility 655 15.3.3 Auditor's responsibility 657 15.3.4 Business rescue and its impact on the audit 658

15.4 How does the auditor deal with uncorrected misstatements in the hnancial Statements? 659 15.4.1 Misstatements identihed during the audit 659 15.4.2 Final materiality 660 15.4.3 Evaluating the materiality of uncorrected misstatements 661 15.4.4 Impact of uncorrected misstatements on the financial Statements and

auditor's report 663

15.5 How does the auditor draft the auditor's report? 663 15.5.1 Introduction 663 15.5.2 Contents of the auditor's report 663 15.5.3 Types of audit opinions 668 15.5.4 Other sections in the auditor's report 672 15.5.5 Impact of the auditee's going concern ability on the auditor's report 674


CHAPTER 16 The independent review 679


16.1 What is an independent review? 679 16.1.1 The nature of an independent review 679 16.1.2 Differences between independent reviews and audits 680

16.2 What are the statutory and regulatory requirements surrounding an independent review? 681 16.2.1 Applicability of independent reviews 681

Second edition xv

16.2.2 Persons eligible to perform independent reviews 681 16.2.3 Reportable Irregularities discovered during an independent review 682 16.2.4 The scope of an independent review 684

16.3 How does one conduct an independent review? 684 16.3.1 Activities prior to, and during, the acceptance of the engagement 684 16.3.2 Flanning the engagement 685 16.3.3 Performing the engagement 686 16.3.4 Finalising the engagement 688 16.3.5 Reporting on the engagement 689 16.3.6 Documenting the engagement 689

Assessment questions 689 Appendix: Examples of cycle documentation related to the business cycles 691 Bibliography 731 Index 735

xvi Auditing Fundamentals in a South African Context

Documents

[SECOND EDITION] AUDITING FUNDAMENTALS in a South African