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[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
7.4 What could go wrong (risks) in the cycle? 278 7.4.1 Financial reporting risks 278 7.4.2 Misappropriation risks 280
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
7.6 What are the control objectives in the cycle? 281 7.6.1 Control objectives in the cycle 281 7.6.2 Achievement of the control objectives in the cycle 281 7.6.3 Link between the control objectives in the cycle and management's assertions 283
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
Assessment questions 318
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
Learning outcomes 3 Reference list 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
Assessment questions 29
iv Auditing Fundamentals in a South African Context
CHARTER 2 Ethics 31
Learning outcomes 31 Reference list 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
Assessment questions 83
CHARTER 3 Legal responsibiiities of Öie auditor 85
Learning outcomes 85 Reference list 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
Learning outcomes 321 Reference list 321
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
8.6 What are the control objectives in the cycle? 337 8.6.1 Control objectives in the cycle 337 8.6.2 Achievement of the control objectives in the cycle 338 8.6.3 Link between the control objectives in the cycle and management's assertions 339
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
Assessment questions 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
9.4 What could go wrong (risks) in the cycle? 384 9.4.1 Financial reporting risks 384 9.4.2 Misappropriation risks 384
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
9.6 What are the control objectives in the cycle? 387 9.6.1 Control objectives in the cycle 387 9.6.2 Achievement of the control objectives in the cycle 387 9.6.3 Link between the control objectives in the cycle and management's assertions 388
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
Assessment questions 415
Second edition xi
CHARTER 10 Investment and financing cycle
Learning outcomes 419 Reference list 419
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
10.6 What are the control objectives in the cycle? 439 10.6.1 Control objectives in the cycle 439 10.6.2 Achievement of the control objectives in the cycle 441 10.6.3 Link between the control objectives in the cycle and management's assertions 441
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
Assessment questions 447
PART C: THE EXTERNAL AUDIT PROCESS 449
CHARTER 11 Overvlew of the audit process 4SI
Learning outcomes 451 Reference list 451
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
Assessment questions 466
CHARTER 12 Pre-engagement and plarming activities 469
Learning outcomes 469 Reference list 470
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
Assessment questions 532
Second edition xiii
CHARTER 13 Audit procedures: Esserrtial concepts 537
Learning outcomes 537 Reference list 539
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
Assessment questions 583
Appendix 585
CHARTER 14 Audit procedures: Specific considerations 589
Learning outcomes 589 Reference list 591
14.1 Introduction 591
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
Assessment questions 642
Appendix: CAATs example 645
CHAPTER 15 Completion of the audit 647
Learning outcomes 647 Reference list 648
15.1 Introduction 650
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
Assessment questions 676
CHAPTER 16 The independent review 679
Learning outcomes 679 Reference list 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