ASPECTS OF INTERNAL CONTROL OF IMPORTANCE TO AN AUDITOR

(AUE301P)

Study Unit 2.1

Background to internal control
A schematic representation of the audit process:

Step 1: PRE-ENGAGEMENT ACTIVITIES

Step 2: PLANNING
(2.1) Overall audit level (financial statement level)
(2.2) Detailed audit planning for classes of transaction, accounting balances and disclosure (assertion
level)

Step 3: EXECUTION OF THE AUDIT PLAN – DETAILED TESTING:

OBTAINING AUDIT EVIDENCE

Step 4: EVALUATION, DRAWING CONCLUSIONS AND REPORTING

During the planning phase of the audit, the auditor identifies the risk of material misstatement at the
financial statement level and the individual statement level (for material class of transactions, balances
and disclosure).

Internal control has the following influence on the audit:

1. While performing the risk assessment procedures the auditor does the following:
 Obtains an understanding of the internal control at the enterprise
 Evaluates the design of the entity’s internal controls & determines whether it has been
implemented. The auditor should determine whether a control would be sufficient to
effectively prevent, detect & correct material misstatement. This would also help the auditor to
decide on the nature, timing and extent of any further audit procedures that are required.
2. While performing further procedures in response to the assessed risks the auditor would do the
following:
 Perform tests of control since the auditor is of the opinion that the execution of substantive
procedures alone is not sufficient to provide relevant audit evidence, because it would not be
possible or practical to reduce the risk of material misstatement at the statement level by
carrying out substantive procedures alone.
 Perform tests of control when he expected the risk of material misstatement to be low because
the company had effective controls in place.

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Step 1: Preliminary stage (Pre-engagement activities)
These are activities which take place before an audit engagement is accepted. They include:

 Determining whether the audit firm wishes to establish or continue the client relationship;
 Establishing whether the client can be appropriately serviced;
 Evaluating whether the firm is able to comply with the ethical requirements relating to the
engagement, e.g. is there a threat to independence?;
 Establishing an understanding of the terms of the engagement.

Step 2: Planning stage

The activities within this stage include:

 Establishing the audit strategy – the scope, timing and direction (focus) of the audit will be and
what resources will be needed on the audit;
 Considering materiality – auditor making judgment about the size of misstatements which will
be material;
 Planning risk assessment procedures – this entails planning the procedures which will be
conducted to obtain an understanding of the entity and its environment;
 Conducting risk assessment procedures – this entails carrying out the planned risk assessment
procedures & identifying & assessing the risk of material misstatement as they progress;
 Planning “further” and “other” audit procedures – planning procedures which will be conducted
to address the identified risks, in such a manner that audit risk (the risk of giving an
inappropriate opinion) is reduced to an acceptable level.

The auditor in effect develops one audit plan with two sections, namely:
 Section 1 will describe the nature, timing and extent of procedures to identify and assess risk;
 Section 2 will describe the nature, timing and extent of further audit procedures which are needed
to respond to the risks identified; and
 Section 2 will also describe other audit procedures which must be carried out to ensure that the
audit complies with the ISAs.

Step 3: Responding to assessed risk stage

ISA 330 states that the auditor should obtain sufficient, appropriate audit evidence regarding the
assessed risks of material misstatement through designing and implementing appropriate responses to
those risks. The auditor’s first response to assessed risk is to plan “further” and “other” audit
procedures & thereafter –

 Respond to assessed risk at financial statement level, e.g. assigning appropriately experienced
and skilled individuals to the audit team to execute the plan;
 Respond specifically to assessed risk at assertion level by carrying out tests of controls and
substantive tests in order to gather sufficient, appropriate evidence that material misstatement
has not gone undetected; and
 Carry out those procedures which are required to comply with the ISAs.
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Step 4: Concluding stage
This stage of the process consists of:

 Evaluating and concluding on the audit evidence gathered – this means evaluating all the audit
evidence gathered to determine whether it is sufficient and appropriate to draw a conclusion of
fair presentation;
 Formulating the audit opinion & drafting the audit report which conveys that opinion.

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 Study Unit 2.2
The influence of internal control on the audit process
REASONS WHY THE OBTAINING OF AN UNDERSTANDING OF THE ACCOUNTING AND INTERNAL
CONTROL SYSTEMS FORMS PART OF THE AUDIT PROCESS

The objective of an audit of financial statements is to enable the auditor to express an opinion as to
whether or not the financial statements fairly present, in all material aspects, the financial position of
the entity at a specific date, and the results of its operations & cash flow information for the period
ended on that date, in accordance with an identified financial reporting framework.

When an auditor studies the accounting & internal control systems, he gains knowledge of the design &
operation of the systems.

The knowledge and understanding of the accounting & internal control systems that are applicable to all
the transactions and balances will therefore assist the auditor to:

 Evaluate the adequacy & suitability of the systems;

 Formulate the most suitable audit approach based on the accounting & internal control systems,
in other words, decide on the nature, timing & extent of the tests of internal controls & the
substantive procedures;
 Plan the audit efficiently;
 Understand control risk & design audit procedures accordingly;
 Express an opinion on the financial statements

FINANCIAL STATEMENT ASSERTIONS

Financial statement assertions are assertions which management makes on the financial statements
submitted to the auditor. Examples would be assertions made by management that the information in
their statements is complete, accurate, correctly classified & correctly valued.

In order to express an audit opinion on the fair presentation of the financial statements, the auditor
collects audit evidence to substantiate each statement for classes of transactions, account balances and
presentation & disclosure.

This procedure involves the audit objectives. Audit objectives are the criteria against which the auditor
measures the information in the financial statements to determine whether management’s assertions
relating to the financial statements are valid. These audit objectives therefore revolve around the
assertions in the financial information & are derived directly from management’s assertions in the
financial statements. The audit objectives represent what the auditor wants to achieve by performing
an audit of the financial statements.

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Financial statement assertions can be divided into the following categories:

 assertions concerning the classes of transactions and events

 assertions concerning account balances
 assertions concerning presentation and disclosure

The following is a summary of the specific assertions that management makes with regard to
transactions, events, balances and presentation & disclosure:

Assertion Transactions &events Balances: assets, Presentation &

liabilities & equity disclosure
interests
Occurrence X X

Completeness X X X

Accuracy X X

Cut-off X

Classification X X

Existence X

Rights & obligations X X

Valuation & allocation X X

1.1 Assertions about classes of transactions and events for the period under audit:

a) Occurrence: transactions & events that have been recorded, have occurred & pertain to the
entity.
b) Completeness: all transactions & events that should have been recorded, have been recorded.
c) Accuracy: amounts relating to recorded transactions & events, have been recorded
appropriately.
d) Cut-off: transactions & events have been recorded in the correct accounting period.
e) Classification: transactions & events have been recorded in the proper accounts.

1.2 Assertions about account balances at the period end:

a) Existence: assets, liabilities & equity interests exist.
b) Rights & obligations: the entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.
c) Completeness: all assets, liabilities & equity interests that should have been recorded, have
been recorded.
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 d) Valuation & allocation: assets, liabilities and equity interests are included in the financial
statements at appropriate amounts & any resulting valuation or allocation adjustments are
appropriately recorded.

1.3 Assertions about presentation and disclosure:

a) Occurrence and rights andobligations: disclosed events, transactions, and other matters have
occurred & pertain to the entity.
b) Completeness: all disclosures that should have been included in the financial statements, have
been included.
c) Classification & understandability: financial information is appropriately presented &
described, and disclosures are clearly expressed.
d) Accuracy & valuation: financial & other information are disclosed fairly & at appropriate
amounts.

Example 1:
When the auditor gathers evidence about sales transactions, he will be seeking evidence to
support the following assertions:
- Occurrence: all sales included are genuine sales (not fictitious) of the entity (a genuine sale
of the company’s goods / services have occurred);
- Completeness: all sales which were made, have been included in the total of sales made
for the year;
- Accuracy: all sales have been recorded appropriately, this implies prices are correct & that
the correct discount & VAT rates have been used & correctly calculated;
- Cut-off: all sales recorded, occurred in the accounting period being audited;
- Classification: all sales have been posted to the proper account. This implies that a credit
sale has been posted to the correct debtor’s account & that VAT has also been correctly
posted.

The assertions which DO NOT apply to sales are existence, valuation and rights &
obligations. Why is this? These 3 assertions apply to balances in the balance sheet which
are carried forward to the following period, and not to transactions.

Example 2:
When the auditor gathers evidence about plant & equipment, he will be seeking evidence to
support the following assertions:
- Completeness: all plant & equipment owned by the company, is included in the balance
reflected in the financial statements;
- Existence: all plant & equipment included in the balance, existed at balance sheet date;
- Valuation & allocation: the plant & equipment has been reflected in the balance sheet at
appropriate amounts; this means that reasonable adjustments have been made for
depreciation, impairment and obsolescence;
- Rights: the company has right of ownership to the plant & equipment reflected in the
balance sheet.

The assertions which do not apply to plant & equipment are occurrence and accuracy, cut-off
and classification. Why is this? It is because these assertions apply only to
transactions/events and not to balances contained in the balance sheet.
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Once the auditor has gathered sufficient, appropriate evidence relating to the financial statement
assertions, he will be in a position to evaluate the evidence & express an opinion on the fair
presentation of the financial statements.

2. INTERNAL CONTROL FROM A BUSINESS PERSPECTIVE

Objectives for a business are set & the risks relating to achieving those objectives will be identified and
suitable measures will be put in place to address those risks. This will include addressing the risks
associated with matters like:
 Safeguarding the assets of the company, e.g. inventory, from theft or damage
 Preventing fraud
 Complying with the laws & regulations applicable to the entity
 Producing reliable financial information necessary to run the business & satisfy the financial
reporting requirement, e.g. the AFS
 Operating the business efficiently & effectively

Internal control is the responsibility of everyone in the business; those charged with governance of the
company, management at all levels as well as ordinary employees;

 The board will have overall responsibility and accountability;

 Management will also be involved in the process of identifying risk & will be primarily responsible
for designing & implementing the necessary books, records, documents, policies & procedures.
Management will also be responsible for maintaining the process i.e. ensuring that policies &
procedures are carried out properly & timeously & that they remain effective
 Most of the time, it is the ordinary employees who are responsible for executing the internal control
procedures, e.g. signing a document, issuing a receipt, reconciling an account, and the success of the
procedure will depend on them.

An efficient internal control system therefore contributes to increased certainty regarding the
reasonableness of the statements in question, i.e. that transactions have been validly, accurately and
completely accounted for. It is therefore aimed at transactions that take place in the enterprise on a
daily basis. This is in contrast to the audit objectives, which focus on transactions and balances.

The following table, which reflects the audit objectives of transactions, events, balances and internal
control objectives, should highlight the relationship between the
 audit objectives of transactions, events and balances; and
 internal control objectives of transactions.

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Assertion Transactions and events Balances: assets, liabilities & equity
interest
X
Audit objective
 No fictitious transactions have been
recorded
 All recorded transactions did in fact
Occurrence take place
Example of non-compliance
 Invoice duplicated in the sales
journal
 Invoice prepared but goods never
delivered
X X
Audit objective Audit objective
 There are no unrecorded  There are no unrecorded assets,
transactions liabilities or other balances
 All transactions that did take place &  All assets, liabilities and balances
should have been included have that exist have been recorded
Completeness been recorded
Example of non-compliance Example of non-compliance
 Goods delivered without an invoice  Machine in use in the factory does
being prepared not appear in the fixed asset register
 Goods delivered & invoice prepared,  Debtor A’s account is not included in
but invoice not recorded in the sales the debtors’ ledger
journal
X
Audit objective
 Transactions recorded at the correct
numerical amounts
Example of non-compliance
Accuracy  Number of items delivered differs
from the number of items that
appear on the invoice
 Price x quantity incorrectly
calculated during the preparation of
the invoice
 The amount of the invoice differs
from the amount recorded in the
sales journal
X
Audit objective
 Transactions recorded on the date
on which they took place
Cut-off Example of non-compliance
 Goods delivered but invoice only
recorded 3 days later
 Cash received a week ago only
deposited & recorded today
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 X
Audit objective
 Transactions correctly classified in
the records according to their
nature & therefore recorded in the
Classification correct account
Example of non-compliance
 Cash sales transaction recorded as
credit sales
 Improvements to fixed assets
recorded in the repairs account
X
Audit objective
 No fictitious balances recorded
 All recorded assets, liabilities &
Existence other balances do exist
Example of non-compliance
 Non-existent vehicle recorded in the
fixed assets register
 The debtors’ list contains an amount
owed by debtor X that has already
been repaid in full
X
Audit objective
Rights &  Recorded assets & liabilities belong
Obligations to the enterprise
Example of non-compliance
 Stock held on behalf of a 3rd party
appears in the records
X
Audit objective
 Assets, liabilities & equity interest
included at appropriate amounts &
Valuation & any adjustments or allocation
allocation correctly accounted for.
Example of non-compliance
 Inadequate provision for bad debts
 Stock not valued at the lowest of
cost price or net realizable value

The above internal control objectives could therefore be made applicable to the various applications in
an enterprise, such as the salaries & wages application:
Internal control objective Objective specifically applicable to wages
Occurrence To ensure that wages only paid to bona fida employees for hours that
they actually worked
Completeness To ensure that all payroll costs are accounted for, such as deductions &
amounts payable to authorities such as PAYE and UIF

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Accuracy To ensure that employees are paid for the correct hours, at the correct
rates, after the correct deductions have been made from the payroll.
The payroll calculation is correct
Cut-off The ensure that payroll costs are recorded in the correct accounting
period under audit, for example leave provision, bonus provision, etc.
Classification To ensure that payroll costs are posted to the correct ledger account
Authorisation To ensure that:
 The appointment of new members of staff is authorized by
management;
 The termination of services is authorized by management & is
properly accounted for;
 Wage rates are approved by management;
 Time worked (and specifically overtime) is authorized by
management;
 Payroll deductions are authorized

If the internal control objectives of an entity are achieved, it gives the auditor greater assurance that the
assertions in the financial statements are reasonable & that the risk of material misstatement is
reduced.
If the auditor has established that the entity’s internal control is reliable, a reduction in the extent of
substantive procedures could possibly be justified.

Control risk is defined as follows:

The risk that a misstatement that may occur in a financial statement assertion & that may be material
will not be prevented or detected & timeously corrected by the accounting and internal control
systems.

It is important that an auditor obtain an understanding of the accounting & internal control systems of
an entity, and decide on the basis of an evaluation of the systems.

If the accounting & internal control systems are functioning ineffectively, the auditor would put the
control risk as high. The opposite is true as well: if the accounting & internal control systems are
functioning effectively to prevent, detect & correct material misstatements, the auditor would evaluate
the control risk as lower.

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The following schematic representation summarises the way auditors evaluate control risk:

Control risk Reason

Low (1) Internal controls, related to the assertion, are present which
- should prevent material misstatement, or
- should detect and correct it

High (2) Accounting system and internal controls are ineffective

High (2) The auditor has decided not to rely on the internal controls because it
would serve no purpose, but rather to carry out extensive substantive
procedures to reduce the overall audit risk to an acceptable level

(1) If the auditor has assessed the control risk as low, he should perform the tests of controls required
to obtain audit evidence to prove that the internal controls were operating as they were designed to
do during the audit period.

(2) If the auditor has assessed the control risk as high, he should determine which errors & irregularities
are likely to occur as a result of the weaknesses in the accounting system and internal controls and
he should determine appropriate substantive procedures that could detect such errors.

CONTROL RISK
Control risk is a function of the effectiveness of the design & operation of internal control in achieving its
objectives but because of the limitations of internal control itself, it is very unlikely that a client’s system
will be perfect. There are limitations inherent to internal control, these limitations may be described as
follows:

i. management’s usual requirement that the cost of an internal control does not exceed the
expected benefits to be derived (cost/benefit). Control may be sacrificed due to the cost of
implementing the control, thus increasing the risk that misstatement goes undetected.

ii. most internal controls tend to be directed at routine transactions rather than non-routine
transactions.

iii. the potential for human error due to carelessness, distraction, mistakes of judgement & the
misunderstanding of instructions.

iv. the possibility of circumvention of internal controls through the collusion of a member of
management or an employee, with parties inside or outside the entity.

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 v. the possibility that a person responsible for exercising an internal control could abuse that
responsibility, e.g. a member of management overriding an internal control.

vi. the possibility that procedures may become inadequate due to changes in conditions, and
compliance with control procedures may deteriorate.

It is not sufficient for an auditor to simply identify the presence of weaknesses in a client’s internal
control system, but to evaluate the effect which the identified weaknesses may have on the financial
statement assertions.

THE EVALUATION OF THE INTERNAL CONTROL SYSTEM

An auditor should obtain sufficient background information on the entity & the environment, including
the entity’s internal control, to enable him to identify & consider the risks of misstatement of the
financial statements as a result of fraud & errors. The information the auditor obtains in this way should
be sufficient to enable him to design further audit procedures. If a client has a reliable accounting
system& internal controls in place, the information generated by the system will also be reliable. This
implies the information will be valid, accurate, complete and timely.

An ineffective system could result in the financial statements not being a fair presentation of the
enterprise’s results.

If the auditor considers the control risk to be acceptable, he will rely on the system to produce quality
information. In other words, all recorded transactions will be considered to be free of material
misstatements. If the control risk is too high, the auditor would not rely on the products of the system,
but only on evidence he has obtained personally.

THE TESTS OF CONTROLS

If an auditor decides to rely on the company’s internal control system & has therefore provisionally
rated the control risk as low, he must test the system to establish whether it is effective or not. This
refers to tests of control, which are procedures carried out by the auditor to gather audit evidence on
the design of the accounting and internal control systems & the operation of the systems during the
reporting period.

The valuation of the auditor’s findings regarding the tests of control will influence the nature, extent and
timing of the substantive procedures that have to be carried out.

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REPORTING

During the performance of the audit, the auditor may identify weaknesses in the internal control. The
auditor evaluates the effective and continuous operation of internal controls in order to evaluate the
control risk. This is one of the considerations the auditor should take into account when deciding on the
nature, extent and timing of the substantive procedures.

An auditor is obliged to report on any weaknesses in the internal controls of the company of which he
may become aware of during his investigation. The report should be submitted to management at an
appropriate level of responsibility.

Activity:
You are a public accountant and auditor. An old friend pays a visit to your office. He has
bought an existing franchise that sells motor vehicle spares. He is satisfied with the accounting
& internal control systems that are in place, but he believes that there is insufficient control over
cheque payments. He requests your assistance in respect of perceived weaknesses.

Design an internal control system for cheque payments that include only the most important
measures for cheque payments.

1. Unused cheques should be properly controlled.

2. All cheques should be crossed.
3. People empowered to sign cheques should not have access to petty cash. They should not
be permitted to approve cash payments either, or to record cash receipts or do postings to
ledger accounts.
4. Only duly authorised people should be allowed to sign cheques.
5. All cheques must be signed only after they have been prepared.
6. When cheques are presented for signature, accompanying invoices & other essential
evidence & documents should be presented.
7. Invoices & other supporting documents should be cancelled & the word “paid” stamped on
them as soon as the cheques have been signed.
8. A bank reconciliation should be prepared at least once a month.
9. The person who prepares the bank reconciliation should not be permitted to sign cheques,
to handle cash or record any cash transactions.
10. Cheques should preferably be signed by at least two independent senior officials.

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 Study Unit 2.3
Accounting systems
THE USE OF ACCOUNTING SYSTEMS
Accounting systems are used to process transactions & to keep financial records.

DEFINITION OF AN ACCOUNTING SYSTEM

An accounting system is defined as the functions by means of which an entity’s transactions are
processed in order to maintain accounting records.

THE NATURE OF ACCOUNTING SYSTEMS

Every company shall keep in one of the official languages of the Republic such accounting records as are
necessary to fairly present the state of affairs & the business of the company and to explain the
transactions & financial position of the trade or business of the company.

The Companies Act states that it is the duty of the auditor of a company to satisfy himself that proper
accounting records as required by this Act have been kept.

An accounting system is the basis for the creation of accounting records since it is the accounting
system that identifies transactions, assembles and analyses transactions, summarises the information &
generates reports. The flow of transactions in an accounting system can be represented as follows:

Transaction source document (e.g. invoices)

Journals (e.g. the sales journal)

General ledger (e.g. debtors’ control

account)

Trial balance

Financial statements

An accounting system focuses on transactions that include the exchange of assets & services between a
business enterprise & third parties, as well as the transfer or use of services within the company.
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Accounting systems should also provide a complete transaction or audit trail for every transaction. A
transaction or audit trail, which is required by both management & the auditors, may be defined as
follows:
 It is a chain of evidence that is created by coding, cross reference & documentation
and that links account balances & other summary results to the original transaction
data.

An effective accounting system = Accounting system + Internal controls

The following example can be used to explain the above:

The management of Piet Limited has implemented an accounting system in terms of which Mr P records
all individual sales transactions on an invoice. These invoices are recorded in the sales journal on a daily
basis. Mr Q is responsible for updating the general ledger on a monthly basis. Mr B uses the ledgers to
prepare annual financial statements for submission to the auditors.

If management does not implement the additional control procedures, such as issuing invoices in
numerical sequence and checking on any missing numbers on a monthly basis, then it is clear that
although an accounting system may be applied, that the system is not sufficient on its own to ensure
that all financial information has been completely recorded.

An effective accounting system should therefore:

1. identify and record all valid transactions.
2. describe the transactions in sufficient detail on a timely basis to permit proper classification of
transactions for financial reporting.
3. measure the value of transactions in a manner that permits recording their monetary value
accurately in the financial statements.
4. determine the time period in which transactions occurred to permit recording of transactions in
the proper accounting period.
5. properly present the transactions and related disclosures in the financial statements.

RESPONSIBILITY FOR THE DESIGN, IMPLEMENTATION AND MAINTENANCE OF

ACCOUNTING SYSTEMS

An accounting system is a series or collection of tasks & records by which transactions are processed to
create financial records. An accounting system identifies, assembles, analyses, calculates, classifies,
records, summarises and reports transactions & other events. The major elements of the accounting
system are people who carry out procedurese.g write out a credit sales invoice, calculate a price, enter

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the invoice in a sales journal, etc, and paper such as order forms, ledgers, lists, invoices etc, which
facilitate the initiation, execution and recording of the transaction.

Management must now add control activities (actions) to the accounting system if it is to produce
financial information which is representative of transactions which have occurred and were authorized
and which is accurate and complete and which is timeously produced. Management now adds control
activities; before the invoice is written out, the salesperson checks that the customer is a valid account
holder & that the customer is not behind on his payments and will not be exceeding his credit limits; a
second salesperson may check the invoice to ensure that pricing, discounts and VAT calculations are
correct. At a later stage, an accounts clerk may confirm that all invoices for the week have been entered
into the sales journal.

The responsibility for the prevention and detection of errors and fraud rests with the management and
the persons who are responsible for the corporate governance of an organization. How do you think
management accomplishes this task?

* by maintaining a suitable accounting system;

* by designing and implementing appropriate internal controls to maintain the reliability &
integrity of the accounting system.

ASPECTS OF IMPORTANCE IN THE DESIGN OF ACCOUNTING SYSTEMS

The management is responsible for the design of an accounting system. The following aspects should
be taken into account by management when designing an accounting system:
 the requirements of the Companies Act, the Standards and any relevant legislation;
 aspects of internal control;
 the availability of technology to determine the type of accounting system (manual or
electronic)

DATA PROCESSING METHODS

Data processing methods have changed to keep pace with changes in technology. Accounting systems
originally relied on manual methods, then they were carried out mechanically and ultimately they relied
on electronic means.

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The various processing methods, with a definition of each, and a description of their influence on the
auditor’s tests, are shown in the following table:

Data processing method Description of data processing Influence of data

method processing method on the
auditor
Manual systems In a manual system the following When performing his tests, the
procedures are done manually: auditor can visually inspect the
documents, journals, ledgers,
- the posting of source documents to trial balances and reports.
the appropriate journals
- the posting of totals from the
respective journals to the general
ledger
- the preparation of a trial balance
from the general ledger
- the preparation of reports from the
general ledger or the trial balance
Mechanical systems Mechanical systems utilize data Since data processing equipment
processing equipment such as unit is involved, auditors have to
record equipment. This equipment understand machine control in
processes all transactions, journals & order to establish whether
ledgers that appear on punch cards. debits and credits have been
For example: correctly posted. The tracing
and visual inspection of
- To update an account, an account transactions is possible with a
card showing the previous balance mechanical system, but it makes
is read. A transaction card is then the auditor’s task more difficult.
read. A new account card showing
the updated balance is then With unit record equipment the
printed. tracing of transactions can still
- Reports are prepared by reading & take place, but the auditor must
printing the amounts on the be able to read punch cards.
updated account balance cards. Visual inspection is more difficult
as a result of the speed at which
data processing equipment
processes the punch cards.
Electronic data processing Computers are used for transaction The auditing of such a system is
systems (EDP) processing. This processing can take far more complex. Since the
place in one of the following ways: processing of transactions takes
place electronically, it is difficult
- Individual transactions are for the auditor to trace a
immediately processed (real time). transaction visually from a
- Accumulated batches of source document to a journal,
transactions are processed ledger, trial balance and
periodically. ultimately a report. The auditor
therefore has to develop other
procedures & techniques in
order to carry out audit tests
effectively.
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Activity:
What are the characteristics of an effective accounting system?

An effective accounting system should:

1. Identify and record all valid transactions

2. Describe the transactions in sufficient detail on a timely basis to permit proper classification
of transactions for financial reporting.
3. Measure the value of transactions in a manner that ensures that their proper monetary
value will be recorded in the financial statements.
4. Determine the time period in which transactions occurred to ensure the recording of
transactions in the proper accounting period.
5. Ensure that transactions are properly accounted for and disclosed in the financial
statements.

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 Study Unit 2.4
Internal control systems

THE PLACE OF INTERNAL CONTROL IN THE MANAGEMENT OF AN ENTITY (BUSINESS)

The purpose of internal controls is to address the risk of something undesirable, unintended or illegal,
from occurring.

In a business, management is responsible for running all aspects of the entity. The objectives of the
business will be set, the risks relating to achieving those objectives will be identified and suitable books,
records and documents, and policies and procedures will be put in place to address those risks. This will
include addressing the risks associated with such matters as:

 Safeguarding the assets of the company, e.g. inventory, from theft or damage;
 Preventing fraud;
 Complying with the laws and regulations applicable to the entity;
 Producing reliable financial information necessary to run the business and satisfy the financial
reporting requirements, e.g. the AFS
 Operating the business efficiently and effectively.

WHAT HAVE WE LEARNT ABOUT INTERNAL CONTROL?

1. Internal control is a process. It is a combination of systems, policies and procedures designed,
implemented & maintained to address the risks of running a business.

2. Internal control is affected by people. It does not consist solely of policy and procedure manuals,
ledgers and documents, computers and machines; it involves people at every level of the
organization carrying out an assortment of tasks.

3. Internal control is not the sole responsibility of management. There is a share responsibility for
the internal control process; the directors’ management and ordinary employees are all, in their
own ways, responsible.

4. Internal control is not static. It is essentially a response to the risks of operating a business; risks
change, responses must change.

5. Internal control is not foolproof. It provides only reasonable assurance that the risks that
threaten the objectives of the business will be achieved.

6. Internal control is not a case of a single control addressing a single risk. Internal control policies
& procedures must work in conjunction with each other & with the books, records and documents
used. The control over a risk is best achieved by combinations of actions, policies & procedures.

19
It is the task of management, and not the auditor, to design and implement effective internal control
systems in order to manage the enterprise’s risks and ensure that attention is paid to all aspects of
control.

This means that management is responsible for the preparation of financial statements in accordance
with generally accepted accounting principles (GAAP). The preparation of financial statements is not the
auditor’s task.

DEFINITION OF AN INTERNAL CONTROL SYSTEM

Internal control can be defined as the process designed, implemented and maintained by those charged
with governance, management and other personnel to provide reasonable assurance about the
achievement of an entity’s objectives with regard to:

 the reliability of the entity’s financial reporting;

 the effectiveness and efficiency of its operations; and
 its compliance with applicable laws and regulations

THE EXTERNAL AUDITOR’S INTEREST IN INTERNAL CONTROL

The external auditor is primarily interested in the fair presentation of the entities annual financial
statements. The financial statements are a product of the entity’s information systems which includes
the accounting system. The better the internal control process, the more likely the financial statements
are to fairly present.

ISA 315 – Identifying and assessing the risks of material misstatement through understanding the entity
& its environment, requires that the auditor obtain an understanding of the entity’s internal control &
suggests that a good way of doing this may be to evaluate the five components of internal control. An
understanding of the information systems and control activities are equally important for the auditor as,
without understanding these, the auditor is unable to properly assess the risk that management’s
objective of producing valid, accurate and complete financial information will be achieved.

COMPONENTS OF INTERNAL CONTROL

Internal control

(1) Control environment (2) Control procedures

(1.1) Environment (2.1) Accounting

(3) Monitoring information system

(1.2) Entity’s risk (2.2) Control activities/

20
assessment process procedures
COMPONENT DEFINITION

Control environment  integrity & ethical values The attitude, awareness & actions
of owners, directors & management
 commitment to competence in respect of the importance of the
internal control system.
 participation of those charged with
governance This sets the tone in the
organization – it influences the
 management’s philosophy & employees’ awareness. This is the
operating style foundation for all other
controlcomponents.
 organizational structure

 assigning authority & responsibility

 human resource policies & practices

Risk assessment  define the objectives of the entity, its The process management follows in
departments &functions identifying, analyzingand
responding to risks that are
 identify & assess risks relevant to the preparation of
- operational risks financial statements that are a
- financial reporting risks reasonable reflection of the financial
- compliance risks position and results of the operations
and cash flow of the entity.
 respond to risk This forms the basis for the
- information system determination of controlactivities.
- control activities
Accounting information  valid, accurate & complete This comprises the functions
system (computerized and manual) by
 procedures to deal with transactions means of which the entity gathers,
- initiating processes and accounts for
- recording information.
- processing
- correcting
- posting (to ledgers)

 related accounting records

- documents used
- document design

 capturing events & conditions other

than transactions

 journal entries
Control activities /  actions, procedures supported by These comprise techniques,
procedures policies methods and principles that are
- approval, authorisation necessary for the application of
- segregation of duties internal control. These are the policy
- isolation of responsibility measures and procedures that the
- access/custody (security) management has instituted in
- comparison & reconciliation response to internal and external
- performance reviews risks.

 preventive, detective

 general & application

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Monitoring  assessment over time Management should consider on a
 are objectives being met? regular basis whether the control
 Assessment at all levels measures are functioning as they
- directors were intended to do, for example
- management management supervision and
- department heads oversight.
 independent assessment
- internal audit
- external bodies
- customers
 remedial action

Component 1: the control environment

A good control environment will be characterised by:

- communication & enforcement of integrity & ethical values throughout the organization;

- a commitment by management to competent performance throughout the organization;

- a positive influence by those charged with governance (are they independent, do they display
integrity and ethical commitment, and are their actions & decisions appropriate?);

- a management philosophy & operating style which encompasses leadership, sound judgment,
ethical behavior, etc.;

- an organisational structure which provides a clear framework within which proper planning,
execution, control and review can take place;

- policies, procedures and an organizational structure which clearly define authority, responsibility
and reporting relationships throughout the entity;

- sound human resource policies and practices which result in the employment of competent ethical
staff, provide training and development as well as fair compensation and benefits, promotion
opportunities, etc.

Gathering of evidence relating to the control environment can be achieved by observation of

management and employees “in action”, including how they interact, inquiry of management and
employees, e.g. union officials, and inspection of documents, e.g. codes of conduct, organograms, staff
communications, records of dismissals, etc.

Component 2: the entity’s risk assessment process

This is the process which the company has in place for, i.e.:

 identifying business risks relevant to financial reporting objectives;

 estimating the significance of each risk;

22
  assessing the likelihood of its occurrence;
 responding to the risk

Information about the client’s risk assessment process will be gathered mainly by inquiry, e.g. Risk
Officer, Compliance Officer, and inspection of documentation where it is available, e.g. minutes of
designated committee meetings, inter-office memo’s.

Component 3: the information system

The auditor is required to obtain an understanding of the information system relevant to financial
reporting & communication. The accounting system is part of the information system. The auditor must
obtain a thorough understanding of:

 the classes of transactions in the client’s operations that are significant to the financial
statements, e.g. sales, wages

 the procedures within both IT and manual systems, by which those transactions are initiated,
recorded, processed, corrected as necessary, transferred to the general ledger and reported in
the financial statements

 the related accounting records, supporting information & specific accounts in the financial
statements in respect of initiating, recording, processing and reporting transactions

 how the information system captures events & conditions, other than transactions that are
significant to the financial statements, e.g. contingent liabilities

 the financial reporting process used to prepare the entity’s financial statements, including
significant accounting estimates and disclosures

 controls over the passing of non-standard journal entries used to record non-recurring, unusual
transactions or adjusments

 the manner in which financial information is conveyed to management , the Board, the audit
committee & external bodies, e.g. the JSE in the case of a listed company

The chart below provides a breakdown of matters which the auditor might consider when obtaining
information about a computerised information system.

FACTOR MATTERS TO CONSIDER

Computerised applications a) which applications are computerized, e.g.
 payroll – not computerized
 acquisitions and payments – computerized
b) computer environment
 micro, network, centralized
 use of bureau
c) the application software
 purchased or in-house software
 key processing functions
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  nature and source of inputs
 output produced
 important materfiles and tables
 interface between applications
 new or established
Hardware a) makes and capacities of CPU’s, drives, printers,
servers, terminals (important for establishing
compatibility with the auditors hardware &
software and for understanding the system)
b) physical location (branches, factory, etc)
Software a) details of all software which is used for
managing the functions of the hardware and
data
 operating systems
 database management systems
 utilities
 access control software
 programme change control software
Organisation and control a) general and application controls
b) communication and reporting lines
c) IT personnel and their job descriptions
d) steering committee details
e) internal audit involvements in IT
Complexities of the system a) the presence of:
 networks (LANS, WANS)
 electronic data interchange (EDI)
 electronic funds transfer (EFT)
 real time systems
 the Internet
 high levels of system integration
 complex databases, communication networks
The level of dependence (of the client on its a) degree of disruption which would occur if the
normal system) system was not functional for a lengthy period
b) the dependence of a particular functional area
on timely, accurate computing, e.g. wages in a
large labour intensive industry

The auditor should be mindful that computerized (IT) systems pose specific risks to an entity’s internal
control. These risks include the following:

a) A computer will process what is input and will do so in the manner in which it is programmed. If for
example there is an error in programming, that error will be repeated every time the relevant
transaction is processed, e.g. a programming error results in the VAT on sales being calculated on
the selling price plus VAT e.g. 14% of 114%. If 5000 invoices are processed the computer will make
the mistake 5000 times.

b) Unauthorised access to data can result in instant and huge destruction or contamination of data
e.g. deletion of the debtors masterfile.

c) IT personnel gaining access privileges they should not have, resulting in a breakdown of segregation
of duties e.g. a systems analyst gains access to the salaries masterfile & alters his salary.

d) Unauthorised changes to data in masterfiles, systems or programmes.

24
e) Processing of fraudulent transactions instantaneously e.g. unauthorised funds transfer which
almost instantaneously moves money out of the company’s bank account.

f) Potential denial of access to electronic data e.g. can’t get into the database because of system
failure.

The auditor should also be mindful that the information system as a whole, or part thereof, can be
placed at risk, by for example:

a) New employees who have a different understanding of, or attitude to internal control;
b) Rapid growth in the company which places severe strain on the controls;
c) New technology which can lead to disruption of internal controls;
d) Introducing new business models which may result in the existing internal controls being
rendered inadequate;
e) Corporate restructuring which may result in staff reductions, new lines of authority, etc.,
thereby jeopardizing for example, division of duties and authorisation controls.

Details of the information system (including the accounting system) can be gathered by:

1. Inspection (or creation) of flowcharts of the system

2. Observation of the system in action, e.g. what happens when goods are delivered by a supplier
3. Inquiry of client staff & the completion of internal control questionnaires
4. Discussions with prior year audit staff, management & possibly outsiders, e.g. application
software suppliers
5. Discussions with internal audit staff &review of internal audit workpapers
6. Tracing transactions through the information system, sometimes called “walk through” tests

Component 4: control activities

Control activities are the policies and procedures that are implemented to ensure that management’s
objectives are carried out. Control activities essentially include such things as:

 authorisation of transactions (which is a form of isolating responsibility);

 segregation of duties, e.g. separating custody of inventory from keeping of inventory records;
 physical control over assets, e.g. restricting access to the warehouse;
 comparison and reconciliation, e.g. reconciling the bank account monthly;
 access controls, e.g. access tables, user profiles, Ids and passwords in a computerized
environment;
 custody controls over blank / unused documents, e.g. cheque books, order forms;
 good document design (to achieve accuracy & completeness of information);
 sound general and application controls in IT systems

Component 5: monitoring of controls

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Monitoring of the system tells management how well the internal control process is doing.
Management (and the Board) wish to know if controls are operating as intended and monitoring assists
in providing this information.

Information about monitoring can be obtained by the auditor by inquiry of management and staff
working with internal audit and inspecting documentation relating to a monitoring process or
performance reviews.

INHERENT LIMITATIONS OF INTERNAL CONTROLS

LIMITATION REASON FOR EXISTENCE
1) Cost of internal control A control may be inefficient because the cost of
implementing it exceeds any benefit that could be
derived from it
2) Human error Generally arises from carelessness, interruptions,
bad judgement on the part of an employee or
misunderstanding of instructions
3) Problems with non-routine transactions Internal controls are usually designed to deal with
routine transactions
4) Collusion A person (or more than one person) could be in
collusion with parties inside or outside the entity to
circumvent certain internal controls
5) Controls may become inadequate Controls may become inadequate because
conditions change continually, the internal controls
are not always adjusted accordingly and
compliance with procedures sometimes becomes
lax over time
6) Abuse of responsibility A responsible officer could abuse his position

INTERNAL CONTROLS PRINCIPLES (CHARACTERISTICS OF GOOD INTERNAL CONTROL)

The auditor focuses mainly on those aspects that ensure that valid, accurate and complete financial
information is provided.

To be able to evaluate internal controls and make recommendations on possible weaknesses in and
improvements to internal control systems, the auditor requires a thorough knowledge of control
activities.

Management institutes internal controls on the basis of these principles of internal control.

The auditor is not responsible for the internal controls of an enterprise. His task is to evaluate the
effectiveness of the controls to determine the appropriate nature, extent and timing of substantive
procedures.

Activity:
ABC Stores is a general dealer with branches throughout South Africa. Their head office is in
Johannesburg. Once a month the branches receive inventory from head office. The branches
are only permitted to buy inventory for cash.

One of the aspects of control activities is proper control over the storage of inventory. To verify
26
that proper control over the storage of inventory is being carried out, the auditor must make
certain that adequate physical security measures and access controls are in place for all the
assets of the enterprise.

Required:
Describe the internal controls that would ensure that proper control over the storage of inventory
and assets is exercised at all the branches of ABC Stores.

Feedback:
1. Management should prohibit any unauthorized access to the premises and buildings.
2. An appointed person should be given responsibility for authorizing access to fixed and other
assets of the entity.
3. Lockable storage facilities should be available and somebody should be appointed to
exercise adequate control over the keys.
4. If goods have to be delivered, there should be only one exit from the business premises,
and that exit should be guarded by gate guards so that no goods can leave the premises
without the necessary delivery note / invoice.
5. If goods are sold directly to the public, there should be adequate controls over the use of
cash registers. The number of exits should be limited, and security staff should make
certain that customers have paid for the goods that leave the premises.
6. Customers should not have direct access to items with a high value.
7. Large sums of cash should never be kept in cash registers. Cash should be removed
regularly by a responsible person and deposited.
8. Cash that is not banked in time should be locked up in a safe until it can be banked.
9. An appointed person should regularly compare the financial records and physical assets
(fixed and other assets). Explanations should be sought for any shortfalls and deviations.

27
 Study Unit 2.5
Concepts in computer information systems (CISs)

THE COMPONENTS OF INTERNAL CONTROL AND INFORMATION TECHNOLOGY

SYSTEMS (IT)
Internal controls can be defined as the process designed, implemented and maintained by those
charged with governance, management and other personnel to provide reasonable assurance about the
achievement of an entity’s objectives with regard to:

 the reliability of the entity’s financial reporting;

 the effectiveness and efficiency of its operations; and
 its compliance with applicable laws and regulations

In terms of ISA 315, the auditor is required to gain an understanding of the company’s internal control
system and this understanding can be best obtained by considering the 5 components of internal
control. These components are:

1) the control environment;

2) the company’s risk assessment procedures;
3) the information system, including relating business processes relevant to financial reporting;
4) control activities;
5) monitoring of controls

When considering each component, the auditor will need to consider the effect of the company’s IT
(computerization) on that component.

1) THE CONTROL ENVIRONMENT

This is about management’s attitude to and awareness of the need for controls. Because of the
potential major consequences of poor control in a computerized system, a strong control environment is
very important. The evaluation of the control environment will be far more intense in a large, highly
computerized company (bank) than in a smaller business.

2) THE COMPANY’S RISK ASSESSMENT PROCEDURES

The King III report on corporate governance recognizes information technology (IT) risk as one of the
major risks facing a company. Whilst managing IT risk is the responsibility of the board, it is likely that
the board will delegate its responsibility to a risk committee. The IT structure may include a steering
committee and a chief information officer. Part of this internal control component’s function will be to
focus on the assessment of (and response to) the IT risks facing the company e.g. data security and
privacy, business continuity, data recovery and keeping up with technology, etc.

3) THE INFORMATION SYSTEM, INCLUDING BUSINESS PROCESSES RELEVANT TO FINANCIAL

REPORTING

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The information system is described (by ISA 315) as “consisting of infrastructure (physical and hardware
components) software, people, procedures and data. When the auditor is gathering information about
this component he will need to familiarize himself with each of the above and how they interact. ISA
315 also explains that the information system relevant to financial reporting objectives, which includes
the accounting system, consists of the procedures and records designed and established to:

 initiate, record, process and report entity transactions, events and conditions and to maintain
accountability for the related assets, liabilities and equity;
 resolve incorrect processing of transactions;
 process and account for system overrides, e.g. by the creation of audit trails in the form of a log
of overrides;
 transfer information from transaction processing systems to the general ledger e.g. where the
revenue application software is not integrated with the general ledger, a journal entry will have
to be passed to get sales and debtors totals into the general ledger;
 capture information other than transactions, such as depreciation and allowances for bad debts;
 ensure information required for disclosure is accumulated, recorded, processed, summarized
and appropriately reported in the financial statements;
 authorise and process journal entries

4) CONTROL ACTIVITIES

This is the component of internal control which will probably interest the auditor the most because
these control activities (policies and procedures) have a big influence on whether the financial
information records and processes only authorized transactions which are authorized and have already
actually occurred, and has done so accurately and completely.
It is important to remember that control activities in a computerized system will be a combination of
manual and automated (programmed) controls.

5) MONITORING OF CONTROLS

This component concerns management’s responsibility to assess whether the internal control system is
meeting its objectives over time. It is not just about monitoring whether the control activities are taking
place, it is also about assessing whether they are affective. Monitoring is also not about assessing
control activities; it is also about evaluating the other components of the internal control system, e.g.
the control environment and the risk assessment process. In a computerised environment the amount
and variety of information which can be quickly and accurately obtained from the system enhances the
ability of management, those charged with governance as well as various bodies such as the internal
audit department as well as audit and risk committees, to conduct effective monitoring over time.

29
DIFFERENT TYPES OF COMPUTER SYSTEMS

The following table describes and illustrates the different types of computer systems with reference to
examples.

Computer system Definition Example

Online input with real-time Transactions are captured at If someone books an air
processing a terminal, automatically ticket, the seats available
authorized & the computer masterfile for the flight in
files are updated immediately. question is captured online
As a result, the transaction & and immediately processed.
masterfiles are immediately Can you see the necessity for
up to date. this processing method in the
given example? If the
masterfile is not updated in
real time, there is a risk that a
seat could be booked more
than once.

Online input with batch Transactions are captured via Orders for hair products are
processing a terminal, authorized and placed by the public. An input
written to a transaction file. operator inputs the orders on
The transactions are added to a terminal as soon as the
the masterfiles later. The order form has been received.
result of this is that the The order forms are written to
masterfiles are not updated a separate transaction file.
immediately. Later on the order forms on
the transaction file are
processed to the masterfile in
a batch.

Batch input with batch Data are captured manually Time cards are updated daily
processing on purpose-generated source by 100 factory workers. At the
documents. The source end of the week the time
documents are then cards are submitted to the
assembled in batches (the factory foreman. They are
number of source documents then sent to the input
per batch is determined in operator, who makes up the
advance). They are then time cards into batches of 20.
inputted into the computer in a The time cards are
computer-readable format, sequentially read into the
after which they are stored on computer by the input

30
 the computer system in a operator and each batch is
transaction file. At a given stored in a transaction file on
time the relevant masterfile is the computer system. Two
updated with the new data days before the payment of
from the transaction files. wages, the payroll masterfile
is updated from the various
transaction files.

CONTROL TECHNIQUES AND APPLICATION CONTROLS

1.1 Batch entry, batch processing / update

 Transaction data is captured initially onto manually prepared source documents e.g. sales
invoices.
 These source documents are then collected into batches usually after manual checks have been
performed and entered via the keyboard with control totals in these batches. Relevant
programme checks take place as the information is keyed in e.g. validation check on employee
number. The transaction information is converted into machine readable form and held on a
transactions file on the computer system.
 These transactions are then processed as a batch when it is efficient / convenient to do so and
the relevant masterfiles are updated to reflect the effect of the entire batch on affected
masterfile balances. Control totals before and after processing are compared.
 Not common, particularly as it is slow and information is not up to date.

1.2 On-line entry, batch processing / update (also referred to as on line entry with delayed
processing)

 Transaction data is entered, via a keyboard immediately as each transactions occurs e.g. a sales
order is placed by telephone and the operator keys in the details as the conversation with the
customer takes place. Relevant programme checks take place as information is keyed in (for
simplicity sake, assume an invoice is created immediately and not only after goods have been
dispatched).
 The transaction information is converted into machine readable form as each transaction occurs
and is held on a transactions file on the computer system.
 Control totals are created by the computer on the batch for the transaction file.
 The transactions are then processed as a batch and the relevant masterfiles are updated to
reflect the effect of each transaction in the batch on affected masterfile balances, e.g. they
could be processed at the end of each day (daily batch update).
 Entry of the transaction is efficient, but information is not immediately up to date. The longer
the period that the batch of transactions is not processed, the less up to date the information.

1.3 On-line entry, real-time processing / updated

31
  Transaction data is entered, via a keyboard, immediately as each transaction occurs. Relevant
programme checks take place as information is keyed in.
 The relevant masterfiles are also updated immediately to reflect the effect of each individual
transaction on affected masterfile balances, e.g. a seat booked on an air craft will instantly
update the “seats available masterfile” which is really an inventory masterfile, for that particular
flight. Obviously this could not be done in batch mode as the same seat could be booked
numerous times before the masterfile is updated.
 Entry of the transaction is efficient (access controls are very important) and information is right
up to date.

CIS INTERNAL CONTROLS (CATEGORIES)

Internal control in a computer environment is achieved by implementing and maintaining general

controls and application controls (each category probably consists of user (manual) and programmed
(computerised) controls.

The object of such controls is to ensure that:

a) the computer system is properly developed, implemented and maintained (general controls);
b) proper controls are in place to ensure the validity, completeness and accuracy of transactions and
data (application controls)

Certain controls fall under both general and application controls. Access controls apply to both
categories, as illustrated below.

 General controls: to control access to data and programs

 Application controls: to control access to specific program functions to ensure the validity of
input, processing and output.

ELEMENTS OF A COMPUTERISED DATA PROCESSING SYSTEM

The following are the elements of a data processing system:

 hardware
 systems software
 application software
 procedures
 staff

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HARDWARE
The term “hardware” collectively describes all the equipment necessary to perform a data
processing function. This equipment includes the following:
Central processing unit (CPU) This consists of the primary storage unit where the output of
the computer is stored, the mathematical unit which performs
the calculations and the control unit which controls functions
such as the keyboard.
Input devices These consist of the keyboard, the disk drives & the
scanners. For example, the prices of items at a supermarket
are read from the barcodes by means of a scanner.
Output devices These consist of the printer and the computer screen.
Data preparation equipment Such equipment is used for an offline function, in other
words the function can be performed while the device is not
linked to the computer. For example, batch information (time
cards) can be read in, converted to computer language, and
then stored on a compact disk (CD). The CD is later used to
read the time card information into the computer.

SYSTEMS SOFTWARE
Systems software is a set of programs (instructions) that coordinate the use of the hardware &
supports the running of computer programs. It includes the following:
Operating system Examples of operating systems are Windows or DOS
Database management This is the program used to create & store the data &
system (DBMS) manage the database. Along with the operating system, the
DBMS facilitates the storage of data, defines the relationships
between data and makes data available for use by the
application programs.

APPLICATION SOFTWARE
Application software refers to programs designed to meet specific data processing needs, such
as the processing of wages and creditors.

PROCEDURES
Even if the computer hardware & software works automatically, it is still necessary for personnel
to follow proper procedures to operate the computer effectively. These procedures relate to
data preparation, the use of the computer, etc.

PERSONNEL
To get an electronic data processing system working properly requires personnel with sufficient
training & experience to perform the various specialised tasks.

Activity:
Credit sales transactions are recorded by means of a manual system, as described below:

A sales invoice is made out by hand in triplicate by the sales clerk. At the end of the day the
debtors’ ledger & the sales and inventory records are updated from copies of the sales invoices.

Briefly indicate how the above transaction would be recorded if the transaction were processed
by each of the following kinds of computer systems:

33
 (1) batch input/batch processing
(2) online input/batch processing
(3) online input/real-time processing

Feedback:
(1) Batch input/batch processing
 A credit sales invoice is made out by hand in triplicate by the sales clerk.
 At the end of the day the invoices are batched & captured on computer.
 After the input of the batch invoices, the batch is processed by the computer & the
debtors’ file and the sales and inventory records are updated.

(2) Online input/batch processing

 A credit sales transaction is captured directly on the computer by the sales clerk & is
then stored by the computer.
 A sales invoice is prepared and printed by the computer.
 At the end of the day the whole day’s credit sales transcations are processed by the
computer and the debtors’ file and sales and inventory records are updated.

(3) Online input/real-time processing

 A credit sales transaction is captured directly on the computer by the sales clerk.
 The transaction is immediately processed by the computer and the debtors’ file and
sales and inventory records are then updated.
 The computer then prints the sales invoice immediately.

34
 Study Unit 2.6
Corporate governance

KING III – CODE OF GOVERNANCE PRINCIPLES (effective March 2010)

The primary reasons for King III were:
- The promulgation of the Companies Act 2008 and
- Changes in international trends

The King III Code identifies two bases as “comply or else” or “comply or explain” and describes a
variation of the latter, i.e. “apply or explain”.

 “comply or else” conveys that companies must adhere to the rules and if they don’t, they will be
punished.
 “comply or explain” conveys that the principles and practices recommended by the Code should be
the focus of the company’s corporate governance. However, if the directors consider that
compliance with a particular recommendation is not in the best interests of the company then the
directors are at liberty not to comply but must explain the reason behind their decision.
 “apply or explain”. The word “comply” is too strong and inflexible. Using the word “apply” suggests
a more accommodating approach. Thus King III is on the “apply or explain” basis.

“APPLY OR EXPLAIN” AND THE LAW

The “apply or explain” basis does not mean that corporate governance and the law can be separated.
As the term suggests, corporate governance is about governing companies. This is achieved by the
directors of the company putting in structures, processes and procedures which achieve the objectives
of the company but within the framework of the law. The directors themselves have legal duties:

 They are obliged to act with a duty of care, skill and diligence in managing the business; and
 They have a fiduciary duty to act in the best interests of the company, to avoid conflicts, and not
to make secret profits.

If they fail in these fundamental duties they can be found guilty of gross negligence, misconduct or
breach of trust.

The Companies Act 2008 requires that public companies & state owned enterprises be audited and that
they appoint audit committees. In fulfilling their duties, the directors must ensure that this happens.

The Act also makes certain individuals ineligible for appointment as a director such as a person
convicted & imprisoned for theft, forgery or fraud; directors must declare their financial interest in any
matter to be considered at a meeting of the board and as a final example, directors must produce
financial statements to stakeholders. These legal requirements, all related to governance, must be
complied with.

35
KEY ASPECTS OF THE KING III REPORT
a) Leadership – good governance is about effective leadership. Leadership is characterized by the
ethical values of responsibility, accountability, fairness and transparency & is based on moral duties
that find expression in the concept of Ubuntu (humaneness, mutual support and respect,
interdependence, unity, collective work and responsibility).

b) Sustainability – companies are part and parcel of society and must address, and be part of the
social, ethical and environmental issues which arise out of society. Should a company fail to
understand and react to its position in society, the implication is that it will not survive i.e. it is not
sustainable. There is no sustainability or future for companies which ravage the environment or
exploit their constituency.

c) Corporate citizenship – the concept of corporate citizenship flows from the fact that the company
is a person and should operate in a sustainable manner. Companies have rights but also legal and
moral obligations in respect of their economic, social and natural environments.

SUSTAINABILITY

The important aspects of sustainability are:

1. Inclusivity of stakeholders: to achieve sustainability, the legitimate interests and expectations of all
stakeholders must be taken into account in decision making and strategy. Stakeholders will include,
employees, suppliers, the community in which the company operates, investors, customers, etc.

2. Innovation, fairness and collaboration: these are key aspects in achieving sustainability. Innovation
provides new ways of achieving sustainability, fairness is vital because social injustice is unsustainable
and collaboration (and co-operation) is required if business at large is going to embrace the principles
of sound corporate governance proposed by King III.

3. Social transformation: to achieve sustainability, social transformation must be part and parcel of a
company’s performance.

IMPORTANT ISSUES INCORPORATED INTO THE KING III REPORT

1. Alternative dispute resolution (ADR) – where disputes arise in business dealings,

mediation/arbitration as opposed to going to court is an acceptable way of resolving the dispute.
From a governance perspective, where a dispute arises, it is a duty of the directors to resolve the
dispute timeously, efficiently and effectively. ADR clauses are now frequently included in contracts
and mediation and arbitration should be regarded as “good governance”.

2. Risk-based internal audit – King III favours risk based internal audit over compliance based internal
audit. The compliance based approach has internal audit checking that the company has complied
with its internal controls, legislation, etc. The risk-based approach places more emphasis on internal
audit understanding the risks associated with the strategic direction of the company and determining
whether internal controls, processes and procedures, adequately address these risks.

36
3. IT governance – if you think about the international banking system, electronic banking, use of the
internet by businesses, it is very easy to understand that issues such as confidentiality, integrity,
functionality of the system are of paramount importance in the management of the company.

4. Business rescue – rescuing a business means that the business has been sustained, and is clearly in
the interests of all the business’s stakeholders.

APPLICATION OF THE CODE

King III applies to all entities regardless of the manner and form of incorporation. The size and nature of
the company will determine how the entity applies the recommendations, and it is recommended by
King III that all entities disclose which principles and / or practices they have decided not to apply and
explain why.

The King Code of Corporate Governance (King III) deals with the following aspects:
 Ethical leadership and corporate citizenship
 Boards and directors
 Audit committees
 The governance of risk
 The governance of information technology
 Compliance with laws, rules, codes and standards
 Internal audit
 Governing stakeholder relationships
 Integrated reporting and disclosure

ETHICAL LEADERSHIP AND CORPORATE CITIZENSHIP

Principle 1.1: The board should provide effective leadership based on an ethical foundation
Principle 1.2: The board should ensure that the company is, and is seen to be, a responsible corporate
citizen
Principle 1.3: the board should ensure that the company’s ethics are managed effectively

Principle 1.1: The board should provide effective leadership based on an ethical foundation
a) The company’s strategy must take into account the economy, society and the environment.
b) The board is answerable to all of the stakeholders of the company.
c) All aspects of corporate governance are based on ethical values and standards, and the ethics of
governance require that all decisions and actions of the board be based on four ethical values:

 Responsibility– the board should assume responsibility for the assets and actions of the
company and should take corrective action to keep the company on its correct path.

 Accountability – the board should be able to justify its decisions and actions to all
stakeholders.

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  Fairness – in its decisions and actions, the board should ensure it gives fair consideration to
the interests of all stakeholders.

 Transparency – the board should disclose information in a manner that enables all
stakeholders to make informed analysis of the company’s performance.

With regard to a director, the ethics of governance require that each director adhere to these five basic
ethical values and that each director exercise the following moral duties:

1. Conscience – a director should act with intellectual honesty, in the best interest of the company,
avoid conflicts of interest and remain independent in mind and action.

2. Care – a director should pay careful attention to the affairs of the company, a carefree or careless
attitude is not acceptable.

3. Competence – a director should have the necessary knowledge and skills to exercise his / her duties
and should continuously “upgrade” knowledge, e.g. keep abreast with IT development.

4. Commitment – a director should be diligent and prepared to put in the necessary time & effort.

5. Courage– a director should have the courage to take the risks associated with “directing &
controlling” a company and should have the courage to act with integrity, even when there is
pressure on him to act otherwise, or be unpopular.

Principle 1.2: The board should ensure that the company is, and is seen to be, a responsible corporate
citizen

a) A very important aspect is “stakeholder interaction” and a significant part of this is the concept of
the company reporting on its triple bottom line, that is, the company’s economic, social and
environmental performance
 the economic aspect relates to the financial and non-financial information relevant to the
company’s business
 the environmental aspect includes the effect of the company’s activities, products and
services on the environment
 thesocial aspect embraces the values, ethics and relationships with the stakeholders of the
company which the company promotes.

b) Being a good corporate citizen is far more than projecting an image & getting public relations right.
It is about genuine commitment and leadership in the company, not a series of publicity stunts or a
passing phase.

Principle 1.3: The board should ensure that the company’s ethics are managed effectively

1. The board is responsible for creating & sustaining ethical corporate culture in the company. An
ethical corporate culture requires that:
 ethical practice for directors is a non-negotiable requirement;

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  sound moral values & ethics are propagated by the conduct of individuals (throughout the
company);
 business activity is directed by people with integrity, fairness, responsibility & vision;
 laws & regulations are obeyed; unfair practices, abuse of economic power (unfair treatment of
suppliers) and collusion (e.g. price fixing) are avoided;
 “having to be ethical” cannot be used as an excuse for poor business performance;
 the directors duty is firstly to his company and shareholders, but the interests of all
stakeholders must be considered.

2. Creating an ethical corporate culture requires that the company has a well-designed & properly
implemented ethics management process consisting of the following four aspects:
 Compilation of an ethics, risks and opportunity profile. An ethical risk would be doing
business in a country / sector where bribery is rife. An ethical opportunity would be entering
a business arrangement with a company with a well-known reputation for ethical conduct.
 Development of a Code of Ethics which lays down ethical values, standards and specific
guidelines for the company in its dealing with internal and external stakeholders.
 Integration of ethicsinto the company’s strategies and operations. This will include , ethical
leadership, education and training for employees, communication of ethical requirements and
advice on ethical issues which may arise, and the prevention and detection of misconduct e.g.
by whistle blowing.
 Ethics performance reporting and disclosure. The board should assess the company’s ethical
performance & disclose findings to internal and external stakeholders, in the integrated
report.

Activity:
List four (4) aspects of a properly implemented ethics management process.

Feedback:
A well designed & properly implemented ethics management process consists of the following
four aspects:

1. Compilation of an ethics, risk and opportunity profile.

2. Development of a Code of Ethics.
3. Integration of ethics into the company’s strategies and operations.
4. Ethics performance reporting and disclosure.

BOARDS AND DIRECTORS

ELEMENT: Role and Function of the Board

1. The board should act as the focal point for and custodian of corporate governance
2. The board should appreciate that strategy, risk, performance and sustainability are inseparable
3. The board should provide effective leadership based on an ethical foundation
4. The board should ensure that the company is, and is seen to be, a responsible corporate citizen
5. The board should ensure that the company’s ethics are managed effectively
6. The board should ensure the company has as effective and independent audit committee
7. The board should be responsible for the governance of risk
8. The board should be responsible for information technology (IT) governance

39
9. The board should ensure that the company complies with applicable laws and considers adherence
to non-binding rules, codes & standards
10. The board should ensure that there is effective risk-based internal audit
11. The board should appreciate that stakeholders’ perceptions affect the company’s reputation
12. The board should ensure the integrity of the company’s integrated report
13. The board should report on the effectiveness of the company’s system of internal controls
14. The board and its directors should act in the best interests of the company
15. The board should consider business rescue proceedings or other turnaround mechanisms as soon as
the company is financially distressed
16. The board should elect a chairman who is an independent non-executive director. The CEO of the
company should not also fulfill the role of chairman of the board
17. The board should appoint the chief executive officer and establish a framework for the delegation of
authority
18. The board should comprise a balance of power with a majority of non-executive directors. The
majority of non-executive directors should be independent
19. Directors should be appointed through a formal process
20. The induction of and ongoing training & development of directors should be conducted through
formal processes
21. The board should be assisted by a competent, suitably qualified & experienced company secretary
22. The evaluation of the board, its committees and the individual directors should be performed every
year
23. The board should delegate certain functions to well-structured committees but without abdicating
its own responsibilities
24. A governance framework should be agreed between the group and its subsidiary boards
25. Companies should remunerate directors and executives fairly and responsibly
26. Companies should disclose the remuneration of each individual director and certain senior
executives
27. Shareholders should approve the company’s remuneration policy

Principle 14: The board and its directors should act in the best interests of the company
a) A director:
 must not use his position to gain an advantage for himself, or knowingly cause harm to the
company;
 must exercise his powers in good faith and for a proper purpose in the best interests of the
company;
 must act with a degree of care, skill and diligence that is reasonably expected of a person
b) The personal interests of a director should not take precedence over those of the company. He
needs to disclose any financial interest he may have at a meeting of the board.

Principle 16: The board should elect a chairman who is an independent non-executive director. The
CEO of the company should not also fulfill the role of chairman of the board
a) The chairman should be:
 appointed on an annual basis;
 independent and not conflicted

b) The role of the chairman must be formalized, and his ability to add value, and his performance
against what is expected of his role and function should be assessed annually.

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c) The chairman should focus on social, sustainability and transformation issues including employment
equity, diversity management and social investment.

d) The board should have a succession plan in place for the position of chairman. Any former CEO of
the company should not be eligible for appointment as chairman until three years have lapsed.

e) The chairman should:

 not be a member of the audit committee;
 not chair the remuneration committee (may be a member);
 not chair the risk committee (may be a member);
 be a member of the nomination committee and may chair it

Principle 17: The board should appoint the chief executive officer and establish a framework for the
delegation of authority

a) The CEO should:

 play a critical and strategic role in the operation of the company;
 ensure the long-term strategy and vision of the company is developed and implemented;
 ensure a positive and ethical work climate is maintained;
 foster a corporate culture that promotes sustainable ethical practices, encourages individual
integrity and fulfills social responsibility objectives

b) The CEO should:

 not be the chairman;
 not be a member of the remuneration, audit or nomination committees, but should attend by
invitation, recusing himself when matters of personal interest arise;
 not take on the chairmanship of other companies (outside the group);
 consider carefully the appropriateness of taking on non-executive directorships in other
companies outside the group

Principle 18: The board should comprise a balance of power with a majority of non-executive
directors. The majority of non-executive directors should be independent

Executive director:
 a director who is involved in the management of the company and / or is a full-time salaried
employee of the company;
 may also be a non-executive director of another company

Non-executive director:
 is not involved in the management of the company;
 his role is to provide independent judgment and advice / opinion on issues facing the company;
 has a duty of care, skill and diligence and should not take on more directorships than necessary

Independent non-executive director:

 is not a representative of shareholder who has the ability to control or influence management;
 does not have a direct or indirect interest in the company;

41
  has not been employed by the company in any executive capacity for the preceding three (3)
financial years;
 is not a member of the immediate family of an individual who is, or has been during the
previous three (3) financial years, employed by the company in an executive capacity;
 is not a professional advisor to the company;
 is free from any business or other relationship which could be seen to interfere materially with
the individual’s capacity to act independently;
 does not receive remuneration contingent upon the performance of the company

The board should:

 ensure that there is appropriate balance of power on the board i.e. it should not be dominated
by an individual or grouping of individuals;
 consist of individuals of integrity and courage;
 have a suitable diversity of academic qualifications, technical expertise, industry knowledge,
experience, nationality, age, race and gender to conduct the business of the board and make it
effective;
 have a CEO and a financial director;
 have a structured program to rotate non-executive directors without losing necessary skills. At
least one third of the non-executive directors should rotate every year.

Principle 19: Directors should be appointed through a formal process

a) The procedure for appointing directors to the board should be formal and transparent.
b) The board should thoroughly investigate the background of a proposed director before appointing
or recommending an individual for appointment.
c) In the Companies Act 2008, careful attention must be paid to “Ineligibility and disqualification of
persons to be a director”.
d) It is also important to ensure that the proposed director has not been declared delinquent

Principle 20: The induction of and ongoing training & development of directors should be conducted
through formal processes

The board should:

 establish a formal induction program to familiarize the new director with the company’s
business & his responsibilities & fiduciary duties;
 ensure new directors with limited experience are mentored;
 ensure that formal processes (continuing professional development programmes) are in place to
keep directors abreast of important matters such as changes in laws and regulations, accounting
standards, etc., on an ongoing basis.

Principle 21: The board should be assisted by a competent, suitably qualified & experienced company
secretary

a) The Companies Act 2008 makes it mandatory for a public company or state owned enterprise to
appoint a company secretary.

42
b) The board should appoint and remove the company secretary, but the company secretary should
have a direct channel of communication to the chairman.

c) The company secretary should:

 have an arms-length relationship with the board;
 not be a director of the company;
 assist the nominations committee with the appointment of directors;
 assist with the director induction and training programmes;
 provide guidance to the board on the duties of the directors and good governance;
 ensure board and committee charters are kept up to date;
 prepare and circulate board papers;
 elicit responses, input, feedback, from board and board committee meetings;
 assist in drafting yearly work plans;
 ensure preparation and circulation of minutes of board and board committee meetings;
 assist with the evaluation of the board, committees and individual directors

Principle 23: The board should delegate certain functions to well-structured committees but without
abdicating its own responsibilities
a) A committee may include persons who are not directors of the company, but that such persons
 Must not be ineligible to be or disqualified from being a director and may not vote on any matter
decided by the committee.

b) King III recommends four standing committees, namely, audit, risk, remuneration and nomination
committees.

 Audit committee: chairman should be an independent non-executive director

 Remuneration committee: chairman should be an independent non-executive director

all members should be non-executive directors, majority of
which should be independent

 Nomination committee: chairman should be the chairman of the board

All members should be non-executive directors, majority of
which should be independent

 Risk committee: chairman should be a non-executive director

Members should include executive and non-executive directors,
senior management and independent risk management experts
where necessary

c) A director who is not a member of a specific committee may attend meetings of that committee,
but may not participate in the proceedings without the consent of the chairman and will not have a
vote.

Principle 25: Companies should remunerate directors and executives fairly and responsibly

a) The remuneration of directors is a very contentious issue, fuelled by frequent “scandals” reported in
the press relating to huge bonuses paid to directors (even where the company has performed
43
 poorly), the granting of stock options to directors, etc. King III has addressed the issue
comprehensively.

b) Companies should have a remuneration committee which should recommend remuneration policies
for all levels in the company but especially senior executives and non-executive directors.

c) Non-executive director’s fees should consist of a retainer and meeting attendance fee, and should
be approved by the shareholders in advance. Non-executive directors should not receive incentive
awards e.g. fees based on company performance.

d) Base pay and bonuses:

 remuneration should reflect the contribution of the executive measured against appropriate
& defined criteria;
 annual bonuses should relate to performance against annual performance objectives;
 performance targets should be reviewed regularly and should be both financial and non-
financial
 in measuring performance, multiple performance measures should be used to avoid
manipulation of results or poor business decisions

e) Contracts and severance:

 employment contracts with executives should not commit companies to pay out large sums of
money where the executive has been dismissed due to poor performance/failure;
 early termination of the contract (for other reasons) should not entitle executives to bonuses
or share based payments in their severance pay

f) Share based and other long-term incentive schemes:

 shareholders should approve in advance, all long-term share based and other incentive
schemes;
 incentive schemes should contribute to shareholder value & should be reviewed regularly to
determine whether they fulfill this objective;
 participation in share incentive schemes should be restricted to genuine employees and
executive directors and should be subject to appropriate limits for individual participation;
 the chairman and non-executive directors should not receive incentive rewards geared to share
price or corporate performance;
 non-executive directors should not receive share options;
 share option awards should not be backdated and should not be exercisable within three years
of the date of grant of later than ten years from the date of the grant

The table below is a summary of the composition of the board

Board of directors
Chairman Independent non-executive director
CEO of the company should not also fulfill the role of chairman of the board
Membership The board should comprise a balance of power, with a majority of non-
executive directors. The majority of non-executive directors should be
independent
Members Minimum of two executive directors of which one should be the CEO and the
other the director responsible for finance
Meetings Meet at least four times a year
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Board committees constitute an important element of the governance process. The table below sets out the composition of the different committees

Audit Committee Remuneration Committee Nomination Committee Risk Committee

Chairman Independent non-executive Independent non-executive Independent non-executive Independent non-executive

director director director director
Chairman of the board should
not be the chairman or member
of the Audit committee
Membership All members should be Majority should be non- Majority should be non- Executive and non-
independent non-executive executive directors of which executive directors of which executive directors
directors majority should be majority should be independent
independent The chairman of the board
should be a member and may
also be chairman
Members Minimum of three members Not specified in King III Not specified in King III Minimum of three members

Meetings Meet at least twice a year Not specified in King III Not specified in King III Meet at least twice a year
Should meet with internal &
external auditors at least once a
year without management being
present

Activity:
List the responsibilities of the board regarding the induction of, ongoing training and development of directors.

Feedback:
The board should
 establish a formal induction programme to familiarize the new director with the company’s business, his responsibilities & fiduciary duties;
 ensure new directors with limited experience are mentored;
 ensure that formal processes are in place to keep directors abreast of important matters such as changes in laws & regulations,
accounting standards etc., on an ongoing basis

45
Activity:
What is an independent non-executive director? Describe the requirements which such
adirector must satisfy to be regarded as independent.

Feedback:
A non-executive director is a director who is independent of management and does not
deriveany remuneration for services rendered to the company (other than a director’s fee).

Essentially it is a director who is not involved in the day to day running of the company, but in
addition, is free of any of the following relationships with the company which could impair his
independence:
 Is not a representative of a shareholder who has the ability to control or significantly
influence management;
 Does not have a direct or indirect interest in the company which is material to the
directoror the company;
 Has not been employed by the company in any executive capacity for the preceding
threefinancial years;
 Is not a member of the immediate family of any person described in the sentence
above;
 Is not a professional advisor to the company;
 Is free from any business or other relationship which could be seen to interfere
materiallywith the individuals capacity to act independently;
 Does not receive remuneration contingent upon the performance of the company

Activity:
The directors of School Projects (Pty) Limited are aware of the board’s duty to present an
integrated report which should include a remuneration report with certain disclosure.
Uncertainty exists with regard to the disclosure that should be included in this remuneration
report.

List the disclosure which should be included in the remuneration report as specified in the
King III Report.

Feedback:
This report should be issued annually as part of the integrated report and should
disclose/explain:
 The remuneration policies followed, the strategic objectives and the implementation
of policies;
 The policy on base pay;
 Incentive schemes;
 Share incentive schemes;
 The salaries of the three most highly paid employees who are not directors;
 Material “ex-gratia” payments;
 The use of benchmarks;
 The remuneration of non-executive directors and committee fees

46
Activity:
Recently, whilst scanning through the annual report of Stadium Ltd, a company listed on the
Johannesburg Stock Exchange (JSE), you came across the company's schedule of
directors and committees.

These appeared as follows:

1. Board of Directors

Chief Executive Officer - Donald Winthrop

Managing Director – Administration - Charles Tree
Financial Director - Monty Mann
Operations Director - Christo Wells
Human Resources Director - Jerry German
Marketing Director - KoosKatswinkel
Non-executive Director - CazKallim
Independent non-executive Director - Mary Maswai

The company has not appointed a chairman. The most senior director who arrives at the
directors’ meeting acts as chairman.

2. Committees
2.1 Directors Appointment Committee - Donald Winthrop
- Charles Tree

This committee recommends to the shareholders who should be appointed as directors. If

thetwo directors disagree, Donald Winthrop has the casting vote.

2.2 Remuneration Committee - Donald Winthrop

- Monty Mann
- KoosKatswinkel

2.3 Audit Committee - Monty Mann

- Christo Wells
- Mitchell Street (Internal Audit)
- External Audit
- Fred Carver (Financial manager)

All committees meet as and when required. The Board meets every six months.

3. Risk Committee
The Risk Committee was disbanded at the start of the year. The directors know the
businessand the risks involved.

Required
Comment on the information presented above in relation to the requirements of King III.

Feedback:
Stadium Ltd's adherence to King III appears to be lacking.

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1. Board of Directors
1.1 The Board does not have a balance of executive and non-executive directors. At
present, the Board consists of six executive directors, and two non-executive directors.

1.2 The majority of the non-executive directors are not independent.

1.3 The company has no chairman. King III recommends that a board should elect a
chairman who is an independent, non-executive director.

1.4 The board of directors is the most important component of corporate governance and
important decisions must be taken at board meetings. This requires that meetings be
knowledgeably and efficiently run which, in turn, requires careful preparation for a
meeting. At present, this does not happen and a meeting is simply run by the most
senior director who arrives at the meeting. This also suggests that not all directors
arrive for meetings.

1.5 The Board should meet at least four times a year. At present, the board meets every
six months.

1.6 The Board appears not to reflect the diversity or demographics of South Africa (race
and gender).

2. Committees
2.1 King III recommends that a company such as Stadium Ltd should have a Nominations
Committee (it can be called the directors’ appointment committee). This committee
should be chaired by the chairman of the board, and all members should be non-
executive directors, the majority of whom should be independent. At present Stadium
Ltd doesn’t have a chairman, neither Donald Winthrop nor Charles Tree are non-
executive directors.

2.2 The recommendations for appointments as director should be made by the Board as a
whole and not a select committee. A Nominations Committee will only assist in the
process.

2.3 The Remuneration Committee should be chaired by an independent non-executive

director and consist of a majority of non-executive directors of which the majority
should be independent. At present, this committee has no independent, non-executive
directors.
Donald Winthrop is again likely to carry the major influence. This committee will
probably be seen to be looking after the interests of the directors, to the detriment of
the company, by deciding on excessive remuneration packages for directors.

2.4 In terms of King III, the Audit Committee should be chaired by an independent, non-
executive director, which Monty Mann is not, and it should be made up only of
independent, non-executive members, which it is not.

2.5 Fred Carver, the financial manager, nor Mitchell Street, the internal audit manager, and
the external auditor should not be committee members. These three groups should
work closely with the committee at various times, but they should not be part of the
committee.

48
2.6 All committees should schedule meetings properly and the audit committee should
meet at least twice per year, not just on a random, “as and when” basis.

3. Risk Committee
3.1 Risk is an ever-present factor in any large company, and risks change. It is unrealistic
for Stadium Ltd to think otherwise, and irresponsible to have disbanded the Risk
Committee because the directors “know the business and the risks involved”.

3.2 Furthermore, it is an important part of integrated reporting that the company report on
its sustainability to all stakeholders.

4. General
4.1 On balance, this company appears to be dominated by the chief executive officer
(CEO), Donald Winthrop.

AUDIT COMMITTEES

ELEMENT: Existence of Audit Committees

1. The board should ensure that the company has an effective and independent audit committee.
2. Audit committee members should be suitably skilled & experienced independent non-executive
directors.
3. The audit committee should be chaired by an independent non-executive director.
4. The audit committee should oversee integrated reporting.
5. The audit committee should ensure that a combined assurance model is applied to provide a co-
ordinated approach to all assurance activities.
6. The audit committee should satisfy itself of the expertise, resources and experience of the finance
function.
7. The audit committee should be responsible for overseeing of internal audit.
8. The audit committee should be an integral component of the risk management process
9. The audit committee is responsible for recommending the appointment of the external auditor and
overseeing the external audit process.
10. The audit committee should report to the board and shareholders on how it has discharged its
duties.

Principle 1: The board should ensure that the company has an effective and independent audit
committee
a) The Companies Act 2008 makes it compulsory for a public company and a state owned company to
have an audit committee.

49
b) Meetings:
 the audit committee should meet as often as is necessary but at least twice a year;
 the audit committee should meet with internal & external audit (without management being
present) at least once a year.

Principle 2: Audit committee members should be suitably skilled & experienced independent non-
executive directors
a) All members should be independent non-executive directors & there should be at least three
(3)members.

b) The committee should collectively have sufficient financial knowledge, a good knowledge of
financial risks.

c) At least one third of the members of the audit committee must have academic qualifications, or
experience in economics, law, corporate governance, finance, accounting, commerce, industry,
public affairs or human resource management.

Principle 3: The audit committee should be chaired by an independent non-executive director

The chairman of the board should not be the chairman of the audit committee.

Principle 4: The audit committee should oversee integrated reporting

a) The board of a company may delegate its responsibility for reporting & internal control to the audit
committee; the audit committee will make recommendations to the board which will, after
evaluation, approve or reject them.

b) The audit committee will be responsible for monitoring the integrity and completeness of the
company’s financial reporting. This will include:
 evaluating judgments & reporting decisions e.g. changes in accounting policies, treatment &
disclosure of significant or unusual transactions, compliance with IRFS and SA GAAP;
 considering whether there are any conditions which may tempt management to “manipulate”
the financial statements, e.g. bonuses for management linked to reported financial
performance;
 dealing with complaints & queries relating to previously published financial information;
 acting as arbiter / referee between management and the external auditors when there is a
disagreement on accounting matters;
 confirming that other regulatory or enforcement requirements pertaining to the company’s
financial information is complied with e.g. JSE regulations for listed companies;
 reviewing management’s assessment of the company’s going concern ability

c) The audit committees responsibility extends to the integrity & completeness of all price sensitive
financial information including:
 the integrated report & financial statements;
 interim reports;
 preliminary & provisional result announcements;
 summarized financial information;
 prospectuses

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Principle 7: The audit committee should be responsible for overseeing of internal audit
The audit committee should:
 be responsible for the appointment/dismissal, performance assessment of the CAE;
 approve the audit plan;
 ensure that internal audit is independent, and has the necessary resources, standing & authority
to discharge its functions;
 oversee co-operation between internal & external audit;
 evaluate the effectiveness of internal audit by independent quality review;
 report to the board on internal audit’s assessment of the company’s internal controls

Principle 8: The audit committee should be an integral component of the risk management process
The audit committee should have oversight of:
 financial reporting risk;
 internal financial control;
 fraud risk (as it relates to financial reporting);
 information technology risk (as it relates to financial reporting)

Financial reporting / internal financial controls

1. Although the board is responsible for the design, implementation and maintenance of a sound
system of internal control, the audit committee should be responsible for overseeing risk
management and controls.

2. The audit committee must understand the environment in which the company operates and the
challenges it faces, to be in a position to assess the appropriateness of the company’s risk
management programme.

3. The audit committee should report annually to the board on the effectiveness of the company’s
internal financial controls. The report should include any financial control inadequacies which
resulted in actual material financial loss.

4. To be in a position to make this report, the audit committee should determine the nature and extent
of a formal review of the design implementation & effectiveness of internal controls to be carried
out (annually) by management or internal audit.

Fraud risks
1. The audit committee should consider matters which may result in material misstatements in the
financial statements due to fraud.

2. The audit committee should:

- review the arrangements made to enable employees and outside whistle blowers to report
concerns about improprieties in matters of financial reporting or compliance with laws &
regulations which may affect financial reporting;
- ensure that there is a suitable system in place for an independent and balanced investigation
into matters reported by whistle blowers

Information technology risks

1. In most companies IT, internal control & risk are intertwined. In addition, IT has inherent risks which
will need to be closely addressed.

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2. It is very likely that the audit committee will need expert IT advice to meet their responsibilities with
regard to the management of the company’s exposure to IT risk.

3. As a minimum, the audit committee should play an oversight role regarding:

- IT risks and controls;
- business continuity & data recovery;
- data security and privacy

Principle 9: The audit committee is responsible for recommending the appointment of the external
auditor and overseeing the external audit process
With regard to the external auditors, the audit committee should:
 recommend the appointment, re-appointment and removal of the external auditors;
 before making this recommendation (annually), assess the audit firm’s & the designated
auditor’s qualifications, expertise & resources, effectiveness & independence;
 approve the terms of the external auditor’s engagement & remuneration;
 oversee the planning & execution of the annual external audit;
 define & implement a policy for the nature, extent & terms under which the external auditor
may perform non-audit services;
 review any accounting & auditing concerns arising from the internal or external audit;
 develop a procedure for receiving, considering & resolving reportable irregularities;
 at the end of the annual audit, review the quality & effectiveness of the audit process, by
discussion with the external auditor, head of internal audit, finance directors, etc.; deviations
from the original audit plan should be discussed

Principle 10: The audit committee should report to the board and shareholders on how it has
discharged its duties
1. The report should provide, as a minimum:
 a summary of the role of the committee;
 whether the audit committee has adopted formal terms of reference, and whether it has
complied with its terms of reference;
 names and qualifications of all members of the audit committee & the period for which they
served;
 the number of audit committee meetings held & who attended;
 a description of how the audit committee carried out its functions;
 a statement as to whether the audit committee is satisfied with the independence of the
external auditor;
 commentary on the financial statements, accounting practices & financial control of the
company;
 information on other roles assigned to the audit committee by the board;
 recommend the integrated report for approval by the board

2. The report by the audit committee to the shareholders should be included in the integrated report.

Activity:
List the responsibilities of the Audit Committee regarding the appointment of external auditors
and overseeing the external audit process.

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Feedback:
The Audit Committee should:
a. Recommend the appointment, re-appointment and removal of the external auditors;
b. Before making this recommendation (annually), assess the audit firm’s and the
designated auditor’s qualifications, expertise and resources, effectiveness&
independence;
c. Approve the terms of the external auditor’s engagement and remuneration;
d. Oversee the planning and execution of the annual external audit;
e. Define & implement a policy for the nature, extent and terms under which the
externalauditor may perform non-audit services;
f. Review any accounting and auditing concerns arising from the internal & external audit;
g. Develop a procedure for receiving, considering and resolving reportable irregularities;
h. At the end of the annual audit, review the quality and effectiveness of the audit process
by discussion with the external auditor, head of the internal audit, finance directors, etc;
and discuss deviations from the original audit plan

Activity:
The following is a summary of the composition of and certain functions of the Audit Committee
of Mineco Ltd, a JSE-listed company in the mining sector of South Africa:

Audit Committee

Violet Mguni - Operations Director

William Smith - Government official (only attends Board meetings)
Bob Cilliers - Financial Director

The Audit Committee meets annually.

The Audit Committee evaluates the Board's performance. During a recent meeting of the Audit
Committee, it was decided that Mineco Ltd would acquire shares in Africa Coal, a coal mining
company listed on the JSE. A detailed analysis of the coal-mining sector supported thisdecision.

Required
Comment in terms of the requirements of King III on the information presented.

Feedback:
1. In terms of King III, the Audit Committee should comprise at least three members. Mineco
Ltd has three members and therefore complies with King III.

2. All members should be independent non-executive directors. Two members of the

committee are not independent non-executive directors, as they are involved in the day-
today running of the business.

3. The Audit Committee should meet as often as necessary, but at least twice a year.

4. The board should be evaluated by the chairman or by an independent party, not by the
Audit Committee.

5. As part of risk management, the Audit Committee cannot make decisions on theacquisition
of shares in Africa Coal. This should be the responsibility of the Board (with the approval
of the shareholders).
THE GOVERNANCE OF RISK
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ELEMENT: The board’s responsibility for risk governance
1. The board should be responsible for the governance of risk
2. The board should determine the levels of risk tolerance
3. The risk committee or audit committee should assist the board in carrying out its risk responsibilities

ELEMENT: Management’s responsibility for risk management

4. The board should delegate to management the responsibility to design, implement & monitor the
risk management plan

ELEMENT: Risk assessment

5. The board should ensure that risk assessments are performed on a continual basis
6. The board should ensure that frameworks & methodologies are implemented to increase the
probability of anticipating unpredictable risks

ELEMENT: Risk response

7. The board should ensure that management considers & implements appropriate risk responses

ELEMENT: Risk monitoring

8. The board should ensure continual risk monitoring by management

ELEMENT: Risk assurance

9. The board should receive assurance regarding the effectiveness of the risk management process

ELEMENT: Risk disclosure

10. The board should ensure that there are processes in place enabling complete, timely, relevant,
accurate and accessible risk disclosure to stakeholders

Principle 1: The board should be responsible for the governance of risk

1. The board should have the responsibility to ensure that the company has implemented an effective
ongoing process to identify risk, measure its potential outcome & activate what is necessary to
manage the risks

Principle 3: The risk committee or audit committee should assist the board in carrying out its risk
responsibilities
a) The board may appoint a risk committee to deal with risk management;
b) If a risk committee is appointed, it should:
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  be chaired by a non-executive director;
 have a minimum of three (3) members (no limit);
 consist of a mix of executive directors & non-executive directors, members of senior
management & if necessary, independent risk management experts (who will not have a vote);
 convene at least twice a year;
 consist of members who have the qualifications, experience & skills to meet the responsibility of
risk management, e.g. IT skills
c) The risk committee should:
 specifically consider the risks which may affect the sustainability of the company and it may be
appropriate to name the committee “the risk & sustainability committee”;
 review the risk management maturity of the company;
 consider the risk management strategy & policies;
 monitor the risk management process

Principle 4: The board should delegate to management the responsibility to design, implement &
monitor the risk management plan
a) Management is accountable to the board for designing, implementing&monitoring the process of
managing risk & integrating it into the day to day activities of the company.
b) Risks are very diverse, but it remains the responsibility of management, led by the chief executive
officer, to manage those risks.
c) In larger companies, a chief risk officer (CRO) may be appointed to assist in managing risk.

Principle 5: The board should ensure that risk assessments are performed on a continual basis
1. In assessing risk, the board (risk committee) should take into account:
 stakeholder risks: e.g. what risks will a proposed expansion of the company pose for the
community in which the expanded business operation will take place? Increase in pollution,
crime? Loss of recreational land?

 reputational risks: e.g. will the company suffer a loss to its reputation if it fails to support a
particular cause or does not take appropriate action against a director convicted of fraud?

 compliance risk: in relation to legislation which significantly affects the company, e.g. what risks
arise for the company if it does not implement the new Companies Act requirements
adequately? Does an agreement with a competitor in the same business amount to price fixing?

 ethics risk: e.g. will the introduction of a bonus scheme for sales employees based on sales,
increase the risk of unethical selling practices by sales personnel?

 sustainability issues: e.g. is the risk of loss of employees through HIV/AIDS on the increase?

 corporate social investment, employee equity, BEE, skills development & retention: e.g. is
there a risk that valuable skills will be lost because of poor remuneration packages? Is there a
risk that a new promotion strategy will fail to satisfy employee equity requirements?

 human& financial capital: e.g. is there a risk that a new venture will not generate sufficient cash
flow to sustain itself? Will there be sufficient human skills available?

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2. Another framework for risk assessment may be to consider risk in the following categories:
 strategic risks: e.g. the risks associated with adopting or changing company strategy, such as
expansion of the manufacturing facility, entering a new market in a foreign country, acquiring
another company
 operating risks: e.g. risks relating to health and safety, and the environment for a chemical
manufacturer
 financial risks: e.g. the effect on cash flows should a company decide to move from a cash sales
basis to a credit sales basis, or the risk associated with committing the company to long-term
borrowing to finance an expansion
 information risks: e.g. the risks associated with introducing electronic funds transfer for
payment of creditors, or a retail company deciding to introduce on-line trading
 compliance risks: e.g. the risk that a business decision may result in significant breaches of
legislation, relating to pollution, the environment, taxation, price fixing, foreign exchange, fraud,
etc.

Principle 7: The board should ensure that management considers & implements appropriate risk
responses
Once risks have been identified, the board, risk committee and management, should consider the
possible risk response options. The options include:

a) avoid or terminate the risk by not commencing or ceasing the activity which creates the
exposure to the risk, e.g. if the company can no longer tolerate the risk of doing business in a
foreign country, then close that business down

b) treat, reduce or mitigate the risk, e.g. exposure to the risk of foreign exchange losses may be
treated, reduced or mitigated by taking forward cover

c) transfer the risk to a third party, e.g. if the company consider that the proper maintenance of its
computer system, database, etc., is at risk, it may decide to outsource this responsibility. Taking
out insurance is a common method of transferring risk

d) accept the risk, e.g. if a transport company’s risk assessment reveals that a 100% increase in the
cost of diesel to say R 15 a litre will seriously jeopardize its going concern ability, but that the
risk of this occurring is low, the company may simply decide to accept the risk, rather than
perhaps replacing its fleet of vehicles with more fuel efficient vehicles

e) exploit the risk, e.g. where a retailer of expensive clothing anticipates loss of market share due
to the economic downturn, it may decide to introduce a range of cheaper clothing to regain its
market share

f) integrate a number of options given above

Principle 10: The board should ensure that there are processes in place enabling complete, timely,
relevant, accurate and accessible risk disclosure to stakeholders
1. The board should report on how the company has dealt with risk management in a statement in the
integrated report. The board should:
 include a statement that the board is responsible for the total process of risk management
as well as forming an opinion on its effectiveness;
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  disclose the system that is in place to evaluate the effectiveness of the process, e.g.
independent reviews by internal audit;
 confirm that the board maintained a system to monitor changes in the company’s risk
profile;
 make a statement that key risks are being managed and that the board is not aware of any
key risk, current, imminent or forecast, that may threaten the sustainability of the company;
 disclose any material losses (causes, quantity & effect) and steps which have been taken to
prevent a recurrence.

Who is responsible for what? The table below sets out the responsibilities for the governance of risk.

WHAT WHO
Governance of risk The board
Design, implementing & monitoring the risk The board should delegate to management
management plan
Monitor risk management process The board, Risk Committee, Audit Committee
Perform an objective assessment of the Internal audit
effectiveness of risk management

Activity:
Who is responsible for the governance of risk?

Feedback:
The board

THE GOVERNANCE OF INFORMATION TECHNOLOGY

1. The board should be responsible for IT governance

2. The board should ensure that IT is aligned with the performance and sustainability of the company
3. The board should delegate to management, the responsibility for the implementation of an IT
governance framework
4. The board should monitor & evaluate significant IT investments and expenditures
5. IT should form an integral part of the company’s risk management & the board should ensure that
information assets are managed effectively
6. A risk committee and the audit committee should assist the board in carrying out its IT
responsibilities
Principle 1: The board should be responsible for IT governance

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IT governance is the responsibility of the board, either directly or through the risk committee or some
other specifically formed “IT committee”
 board members should play an active role in IT strategy and governance
 the CEO should provide organization structures to support the implementation of the strategy
 the senior members of the IT division must be business orientated & must provide the link
between IT and the business
 all executives should become involved in IT steering or similar committees such as an IT strategy
committee
 IT matters should be a regular & significant part of the board’s agenda
 board members should challenge the IT department’s activities with the objective of uncovering
issues, and problems, etc. are revealed
 the board should encourage management & IT to work together & should ensure that
management understands the effect on the business of IT related risks
 the board should insist that IT performance be measured & reported to the board

Principle 2: The board should ensure that IT is aligned with the performance and sustainability of the
company
IT governance should focus on:
 strategic alignment with the business & collaborative solutions, including the focus on
sustainability. It is imperative that IT supports the objectives of the business & that IT and
business managers collaborate in solving problems & developing both IT and the business itself
 value delivery, optimizing expenditure & proving the value of IT. The board should not approve
IT projects before a thorough cost /benefit analysis has been done. Once a project is up and
running, it should be regularly evaluated to determine whether the expected “return on
investment” is being achieved
 risk management, safeguarding IT assets, disaster recovery & continuity of operations
 resource management, optimizing knowledge & IT infrastructure. This means that part of IT
governance is ensuring that maximum (optimal) benefit is gained from the use of the IT
resources which the company has as its disposal

Principle 3: The board should delegate to management, the responsibility for the implementation of
an IT governance framework
a) Management should be primarily responsible for the implementation of the IT governance
framework (structures, processes, mechanisms)

b) An IT steering committee may be formed & a chief information officer (CIO) appointed by the CEO

c) The CIO must have access to the board & should interact regularly with it on strategic IT matters

Principle 4: The board should monitor & evaluate significant IT investments and expenditures

a) Whilst the investigation / feasibility studies relating to significant IT expenditures will be conducted
by the IT steering committee, approval for the expenditure should come from the board

b) The board should monitor the return on investment of major IT projects

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c) Intellectual property contained in the information system (e.g. unique software) should be
protected

d) Independent assurance on the governance of outsourced IT services should be regularly obtained

Principle 5: IT should form an integral part of the company’s risk management & the board should
ensure that information assets are managed effectively

a) IT management must be able to demonstrate that:

 Effective disaster recovery plans are in place;
 The company is complying with relevant IT laws, rules, codes, etc.;
 Information is secure & protected from unauthorized access, contamination, destruction, etc.;
 Equipment is adequately safeguarded, e.g. from theft, damage, etc.

b) Information security has three components:

 Confidentiality: information should be accessible only to those authorized to have access
 Integrity: the accuracy & completeness of information & processing must be safeguarded
 Availability: authorized users have access to information when required

c) Sound IT security contributes for example, to:

 Building trust between the company & its business partners, customers & employees. Without
this trust, new business strategies attempted are unlikely to succeed

 Sustaining normal business operations, e.g. if a company’s system “crashes” frequently & users
cannot get information, the company will lose business

 Avoiding unnecessary costs brought about by failure in IT security

 Meeting compliance requirements. Companies are required to comply with the law in
numerous ways. E.g.: a company must pay VAT. If the process of recording VAT is not secure &
the database on which the VAT information is stored is not safeguarded, the amount of VAT
indicated as payable may be inaccurate & incomplete or may not be available at all.

Activity:
1. To whom should the board delegate the responsibility of implementing the information
technology (IT) governance framework?
2. Who should assist the board in carrying out its information technology (IT) responsibilities?

Feedback:
1. Management is responsible for the implementation of the structures, processes &
mechanisms for the IT goverenace framework. This could be achieved by appointing an
IT steering committee. The CEO should also appoint a CIO who should be responsible
for the management of IT.
2. The Risk Committee & the Audit Committee

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COMPLIANCE WITH LAWS, RULES, CODES AND STANDARDS

1. The board should ensure that the company complies with applicable laws and considers adherence
to non-binding rules, codes and standards
2. The board & each individual director should have a working understanding of the effect of the
applicable laws, rules, codes & standards on the company & its business
3. Compliance risk should form an integral part of the risk management process
4. The board should delegate to management the implementation of an effective compliance
framework & processes

Principle 1: The board should ensure that the company complies with applicable laws and considers
adherence to non-binding rules, codes and standards

a) Where there are (legally) non-binding rules or standards which would enhance the company’s
corporate governance, the company should adhere to them. The company should disclose the
applicable non-binding rules and standards to which it adheres on a voluntary basis in its reporting
to stakeholders, e.g. there are numerous safety, environmental & industry standards which are
recommended but are not “law”.

b) Exceptions, shortcomings and “loop holes” in the law should be handled ethically, & the company
should not seek questionable ways of getting around the law; compliance should be an ethical
imperative.

c) The board should monitor the company’s compliance with applicable laws, rules, etc. & the
compliance should be a regular item on the agenda of the board.

d) The integrated report should disclose details of how the board discharged its compliance
responsibilities.

Principle 2: The board & each individual director should have a working understanding of the effect
of the applicable laws, rules, codes & standards on the company & its business

1. The board has a duty to identify the laws, rules, etc., applicable to the company, and part of the
induction & ongoing training of directors should be familiarization with applicable laws, rules, etc.

2. Not all directors need to have an in-depth knowledge of all the laws etc., applicable to the company.
E.g. the production director is unlikely to have an in-depth knowledge of the Income Tax Act, but
collectively the board must have in-depth knowledge & individual directors should have a sound
knowledge of laws etc. applicable to their portfolios & at least an awareness of other laws, etc.

60
3. The company secretary has a duty to assist the board / directors in fulfilling their duties with regard
to laws, regulations, etc.

Principle 3: Compliance risk should form an integral part of the risk management process

a) Compliance risk is the risk of damage arising from non-adherence to laws and regulations. Damage
may be financial (e.g. losses from penalties, lost contracts), to the company’s reputation (e.g.
reports in the media about the company evading taxation), to stakeholder relationships (e.g. oil
refinery breaches health regulations, and resultant pollution affects the local community) or
sustainability e.g. bus company ignores roadworthy requirements placing its operations license in
jeopardy.

b) Like any category of risk, compliance risk should be identified, assessed and responded to through
the company’s risk management process.

c) A compliance function may be established. It should:

 be independent
 provide assistance to the board & management in complying with laws, regulations, etc.
 be managed by a qualified & experienced person (compliance officer)
 report on its activities to the board / executive management
 be adequately resourced to fulfill its duties

Principle 4: The board should delegate to management the implementation of an effective

compliance framework & processes

a) There should be a legal compliance policy, approved by the board & implemented by management.

b) Compliance with laws, rules, codes & standards should be included in the code of conduct and
management should inform & educate employees in respect of matters pertaining to compliance.

c) A compliance officer may be appointed, and should be afforded access to the board to interact on
compliance matters, e.g. the implementation of a new Act which affects the company and its
employees.

Activity:
State, with an explanation, whether the following statement is true or false:

The board and each individual director should have a working understanding of the effect of the
applicable laws, rules, codes & standards on the company and its business.

Feedback:
True. The induction and ongoing training programmes of directors should incorporate an
overview and any changes to applicable laws, rules, codes & standards.

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INTERNAL AUDIT

1. The board should ensure that there is an effective risk based internal audit
2. Internal audit should follow a risk-based approach to its plan
3. Internal audit should provide a written assessment of the effectiveness of the company’s system of
internal control & risk management
4. The audit committee should be responsible for overseeing internal audit
5. Internal audit should be strategically positioned to achieve its objectives

Principle 1: The board should ensure that there is an effective risk based internal audit

a) Where a board decides not to establish an internal audit function, full reasons must be given in the
integrated report. An explanation of how the company has obtained adequate assurance as to
whether effective governance, risk management and internal controls have been maintained must
also be given.

b) Internal audit services may be provided by a department within the company or may be outsourced.

c) Internal audit’s key responsibility is to the board. It assists the board in discharging its governance
responsibilities by:
 performing reviews of the company’s governance process including ethics;
 performing an objective assessment of the adequacy & effectiveness of risk management
&internal controls;
 systematically analyzing and evaluating business processes & associated controls;
 providing a source of information regarding fraud, corruption, unethical behavior and
irregularities

d) An internal audit charter should be formally defined, documented and approved by the board (audit
committee)

e) The internal audit function should adhere to the Institute of Internal Auditors Standards for the
Professional Practice of Internal Auditing and Code of Ethics.

Principle 2: Internal audit should follow a risk-based approach to its plan

1. A compliance based approach to internal audit sets out to determine whether or not the company is
complying sufficiently with internal controls & other rules and regulations. This is not regarded as
sufficient by King III & the recommendation is that internal audit be risk based, i.e. the internal audit
function gains a thorough understanding of the risks which the business faces as well as considering

62
 whether there are risks which have not been identified, and then conducts tests to determine that
an appropriate risk management process is in place & being properly conducted.

2. A risk based audit approach to internal audit (as opposed to a compliance based approach) should
be adopted. An audit plan should be developed & discussed with the audit committee. The plan
should:
 Address the full range of risks facing the company, e.g. strategic, operational, financial, ethics,
fraud, IT, human & environmental
 Identify areas of high priority, greatest threat to the company, risk frequency & potential change
 Indicate how assurance will be provided on the risk management process & how the plan
reflects the level of maturity of the risk management process
 Have any changes to it, timeously, approved / ratified by the audit committee

Principle 4: The audit committee should be responsible for overseeing internal audit

a) Internal audit is the agent of the audit committee, the party which gets out & gathers the
information which the audit committee requires to fulfill its responsibilities with regard to risk
management.

b) The internal audit plan should be agreed & approved by the audit committee.

c) The audit committee should evaluate the performance of internal audit & ensure that it is subjected
to an independent quality review.

d) The audit committee should be responsible for the appointment, performance, assessment of the
chief audit executive.

e) The chief audit executive should report to the audit committee chairman.

f) The audit committee should ensure that the internal audit department is appropriately resourced &
funded.

g) Internal audit should report at all audit committee meetings.

Principle 5: Internal audit should be strategically positioned to achieve its objectives

1. The key elements in the success of the internal audit function are independence and objectivity.

2. It is important that the board ensures that internal audit is provided with the necessary “conditions”
to attain & retain the status it requires to fulfill its role. For example:
 The board and management should defend and promote the independence of internal audit;
 Properly qualified & experienced staff with high ethical standards should be appointed to
internal audit;
 The directors and management should regard internal audit as an integral part of the assurance
framework & an indispensable control mechanism in the risk management process;
 Designating the head of internal audit as a senior member of the company, e.g. Chief Audit
Executive (CAE);
 Having the CAE report to the audit committee & administratively to the CEO;

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  Giving the CAE direct access to the chairman;
 Supporting and being seen to support the recommendations of internal audit;
 Ensuring that internal audit is sufficiently resourced and has an appropriate budget

3. If internal audit is to be granted the respect it deserves, its members must be competent,
independent & objective as well as ethically sound.

4. Some of the tasks undertaken by internal auditors are complex and will require a thorough
understanding of the latest tools & audit techniques, particularly in the information technology
field.

5. Internal auditors require appropriate business skills to enable them to understand the business &
organizational dynamics of the company.

6. The CAE will set the tone of the internal audit function & should have at least the following
attributes:
 strong leadership;
 command respect for his competence & ethical standards;
 be a strong communicator, facilitator, influencer, networker & innovator;
 have a practical approach;
 be able to think strategically & have strong business analysis skills

Activity:
List the responsibilities of the Audit Committee regarding the internal audit function.

Feedback:
The Audit Committee should:
 agree to and approve the internal audit plan;
 evaluate the performance of the internal audit function;
 ensure that the internal audit function is subjected to an independent quality review;
 ensure that the Chief Audit Executive (CAE) reports to the Audit Committee
chairman;
 appoint, assess the performance and dismiss the CAE if required;
 ensure that the internal audit function is well resourced and has an appropriate
budget allocated to the function;
 ensure that the internal audit function reports at the Audit Committee meetings

Activity:
Stapleking Ltd is a large manufacturer & wholesaler selling a wide range of fasteners, such as
staples, tacks & drawing pins. The company has a number of divisions, for example the
commercial fasteners & domestic fasteners divisions. Controls are sound & include an internal
audit department which is staffed by competent internal auditors. Internal audit activities are
scheduled at the start of each financial year, but, during the year, numerous requests are
received from within the company for “internal audit” to carry out various assignments. The
following request have been received:

1. Lindsay Haffejee, the chief audit executive, has been asked by the human resources director
to serve on a Selection Committee for the appointment of a new company secretary.

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2. The financial director has asked the internal audit department to design & implement a
costing system for a new type of product which is to be manufactured.

3. The information technology manager has asked internal audit to conduct a post
implementation review of a recently introduced telesales ordering system.

4. The warehouse manager has requested internal audit to perform an audit to determine
whether the company is complying with all necessary safety regulations, for example fire
protection & ventilation regulations.

5. The financial director has requested internal audit to schedule an investigation into the payroll
& personnel cycle to determine whether there are fictitious employees on the payroll.

6. The production director has requested internal audit to conduct inventory cycle counts in the
finished goods warehouse on an ongoing basis.

7. The external auditors have requested internal audit to assist them with the verification of the
existence of plant & equipment at an interim audit.

8. The board of directors has requested internal audit to assist in identifying, evaluating and
assessing significant organizational risks.

9. The financial director has requested internal audit to perform an analysis of the monthly
management accounts & to make a presentation to the board on a quarterly basis.

Required:
1. Explain how the board of directors can promote the status of the internal audit department

2. Indicate, giving reasons, how Lindsay Haffejee, as the chief audit executive, should respond
to the above requests

Feedback:
1. The board can promote the status of internal audit by:
1.1 Appointing well-qualified staff in internal audit

1.2 Designating the head of internal audit as a senior member of the company, for
example chief audit executive

1.3 Having internal audit report to the Audit Committee if there is one, or to the board itself
(internal audit should report to the CEO in respect of administrative matters)

1.4 Having internal audit (the head or representative) attend Audit Committee meetings

1.5 Giving internal audit direct access to the chairman

1.6 Supporting and being seen to support the recommendations of internal audit

1.7 Developing a culture among the directors & management of viewing internal audit as
an important & useful control mechanism which directly benefits them

1.8 Ensuring that internal audit is properly staffed & resourced

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2. Feedback on Lindsay Haffejee’s requests:

2.1 This request could be acceded to. The appointment of a company secretary is an
important aspect from the point of view of corporate governance. In a sense the
company secretary position is similar to that of internal audit, in that both are “control
mechanisms”.

2.2 This request should be refused. The design & installation of systems are an operational
responsibility from which the internal audit department should be independent. Internal
audit may review the proposed system &be part of the post-implementation review, but
should not take responsibility for the system.

2.3 This request should be acceded to. Part of internal audit’s basic function is to perform
objective assessments of the adequacy & effectiveness of risk management & internal
controls & post-implementation reviews are part of this.

2.4 This assignment can be accepted. Although internal audit should follow a risk based
approach to internal audit activities, compliance audits (evaluating whether the company
is complying with relevant laws & regulations) are part of what internal auditors do.
Ensuring compliance with laws & regulations is part of risk management.

2.5 This assignment can be accepted. The board has direct responsibility for risk
management, and for implementing & monitoring controls which, inter alia, safeguard
the assets of the company (in this case, cash). Internal audit is part of the directors’
means of obtaining information relating to fraud & corruption.

2.6 This request should be refused. Inventory control is an operational activity & is the
responsibility of the inventory controller / production department. Internal audit could be
used to review & evaluate cycle counts from time to time.

2.7 This request can be acceded to. External & internal audit should cooperate in this kind
of exercise which, in effect is an independent verification procedure.

2.8 This request could be acceded to, but internal audit must not assume the functions,
systems & processes of risk management in other words, become part of the
operational internal controls. It is intended that internal audit assist & support the board
in fulfilling its responsibilities, one of which is to identify risk. This request is in line with
the risk based approach to internal audit.

2.9 This assignment can probably be accepted. Internal audit is again fulfilling an
independent evaluation role, as long as it does not become “responsible” for producing
(part of) the management accounts, the assignment would be beneficial in assisting the
Board to fulfill its duties. However, this does look a little like a financial/accounting
section responsibility in the long run, but if it is the “independence” aspect which the
financial director is after, it is probably acceptable.
NOTE: if there is an audit committee all requests for internal audit services would be
discussed/accepted/rejected with & by the audit committee.

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GOVERNING STAKEHOLDER RELATIONSHIPS

1. The board should appreciate that stakeholders’ perceptions affect a company’s reputation
2. The company should proactively manage the relationship with its stakeholders
3. The board should strive to achieve the correct balance between its various stakeholder groupings, in
the best interests of the company
4. Companies should ensure the equitable treatment of shareholders
5. Transparent & effective communication with stakeholders is important for building and maintaining
their trust & confidence
6. The board should ensure disputes are resolved as effectively, efficiently and expediously as possible

Principle 2: The company should proactively manage the relationship with its stakeholders

1. The board should identify stakeholders relevant to the company’s sustainability to ensure that they
are accommodated in the reporting process.

2. Managing stakeholder relations should be proactive. It is mainly about communication, both formal
(AGM, meetings with regulators), but can also be through informal processes such as social
functions, websites, media, etc.

3. The major stakeholders and the underlying factors on which the relationships with these
stakeholders should be built, are as follows:

 Suppliers
- It is in the interest of the company to have stable suppliers who supply products or services of
the necessary quality at an acceptable price, when required.

- This is important for suppliers of strategic products or services e.g. a sugar milling company is
entirely reliant on its transport supplier to deliver sugar cane to the mill if it has outsourced
this function. Equally, the transport company will have invested heavily in capital expenditure
& needs the contract with the sugar milling company to remain in business.

- A mutually beneficial relationship contributes to the sustainability of both companies.

 Creditors
- The company should be mindful of the fact that creditors, if not paid, have the power to have
business rescue processes imposed on the company & in more serious situations, have the
company liquidated.

- Creditors should be managed accordingly, paid on time at the correct amount. Payment
terms should be fair to both parties.

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 - Creditors are usually suppliers either of goods, services or finance and a mutually beneficial
relationship should be developed. For example, a large supermarket chain should not push its
payment terms for smaller suppliers to 120 days when they should be 60 days, just because
they have the power to do so, knowing that the smaller supplier depends on the large
supermarket chain.

 Employees
- Companies should engage their employees in improving the business ensuring that employees
at all levels benefit from the improvement, e.g. incentive schemes, bonuses, etc.

- The company should also ensure that employees have the chance to develop their potential &
capabilities by providing training, a healthy & safe working environment & the opportunity for
employees to advance in the company.

- Proper leadership which includes strong communication with employees is essential. Failing
to manage employees properly may result in low morale, poor productivity and work quality,
strikes, “go-slows”, or even sabotage.

 Government
- A company should abide by the laws of the land & pay taxes due by it.

- All employees who deal with government should:

 act in a manner which promotes mutual respect & co-operation;
 not engage in an form of corruption

- Companies should not give “major gifts” to politicians or other government officials & should
consider carefully whether it is appropriate to make financial contributions to political parties
or similar groupings

 External Auditors
- The company should not view the external audit function as an unnecessary cost or as a threat

- A properly conducted external audit will add immense value to a company. It adds significant
credibility to the financial statements & is an integral independent element of the combined
assurance model.

- External audit is appointed by & accountable to the shareholders.

- External audit works mainly with management & the audit committee, and company policy
should promote co-operation between the parties, a free flow of information & appreciation
of the independence requirements of external audit.

 Consumers / customers
- For customers to respect the company, the company:
 should market responsibility e.g. not glorify products which can be harmful to health
such as cigarettes, alcohol, certain food products;
 should communicate production information e.g. content breakdown on foodstuffs,
safety precautions for electrical products;

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  should not sell products which, e.g. are harmful to the environment, customers’ health
or which have been manufactured in labour “sweat shops” or under other adverse
situations

 Industry
- A company’s sustainability is dependent on other entities within its sphere of operations. A
company should therefore acknowledge its responsibility to its industry as a whole.

- To achieve this, a company should participate in or facilitate forums to address industry risks
& opportunities.

- Companies should not engage in anti-competitive practices / price fixing.

 Local communities
- Every company operates in a community to some degree or another. A community may be
totally dependent on the company and in fact may have been created by the company, e.g.
remote mine or forestry operation.

- Looking after its community, amounts to a company being a good corporate citizen, & should
be geared to enhance the lives of local communities by health programmes, schooling,
sporting opportunities, etc.

 Media
- It is important that a mutual relationship of trust be developed between the company & the
media. If this is to be achieved, the company should be:
 open to communication with the media;
 accurate & truthful with the information it provides to the media;
 professional in its approach e.g. not aggressive or condescending;
 objective when assessing reporting by the media e.g. not overreacting with a journalist
criticizes the company;

- Likewise, the reporting journalist should:

 be knowledgeable & experienced;
 report accurately & fairly without sensationalism;
 as with all forms of communication, the company is not expected to compromise its
confidentiality standards or its competitive edge

 Regulators
- The relationship between a company & its regulators is similar to that between a company &
government. The company should comply with regulations, pay any fees due, deal with the
regulators employees with professionalism & not engage in dubious practices to circumvent a
regulation, e.g. attempt to bribe an official who is carrying out a regulatory health inspection.

 Potential investors
- Potential investors, i.e. those who may be seeking to invest as opposed to existing
shareholders, will expect high standards of corporate governance, board integrity &
confidence in the sustainability of the business of the company.

- To enable potential investors to evaluate these aspects, clear and transparent disclosure
should be available to them, e.g. on a website, contained in media releases, etc. Frequently
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 large companies will meet with financial journalists & potential institutional investors (e.g.
pension funds) to communicate this information.

Principle 3: The board should strive to achieve the correct balance between its various stakeholder
groupings, in the best interests of the company

1. It is often perceived that the most important stakeholders in the company are the shareholders and
that the board’s major responsibility is to this body, e.g. profits must be made, share prices
maintained, etc.

2. However, the interests of different stakeholders may well clash & it is in these situations that the
board should attempt to satisfy the needs of all shareholders. This provides a better chance of
sustaining the company. For example, a fertilizer company may want to expand its operations. It
has a choice of two sites. Transport & construction costs on site A will be much cheaper & the
company will earn a far greater return on investment if it expands to site A. However, expansion on
site A will also negatively affect the local fruit farming community. Site B will be expensive for the
company to develop and return on investment will be lower, but there will be no negative affect on
local business, and job opportunities will be created for the local community. Does the board go for
site A or site B?

Principle 4: Companies should ensure the equitable treatment of shareholders

1. Not all shareholders are equal. There are different classes of share with different rights. There are
majority shareholders & minority shareholders, and controlling shareholders & non-controlling
shareholders.

2. Despite this, shareholders must be treated fairly. For example, minority shareholders should be
protected against the abusive actions of majority or controlling shareholders.

3. The Companies Act 2008, Chapter 7 provides remedies for aggrieved parties (including
shareholders), but wherever possible the board should set up processes which allow for
constructive engagement to minimize the costs & time taken up by the more formal remedies.

Principle 5: Transparent & effective communication with stakeholders is important for building and
maintaining their trust & confidence

1. If stakeholders do not receive information which is sufficient, relevant, accurate, honest & timeous,
the communication of the information is unlikely to contribute to meaningful stakeholder
involvement in the corporate governance process.

2. Information should be provided on both the negative & positive aspects of the company’s
performance, & attention should be paid to the wording of negative situations. The negatives
should not be hidden behind complex / technical language designed to confuse stakeholders.

3. Whilst transparency is important, what is disclosed must be considered in the light of:
 legal requirements including those applicable to access of information and

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  the maintenance of the company’s competitive advantage

4. The board should also consider the suitability of the method used to communicate, e.g. an
information website may be a cheap and effective method but stakeholders, such as a local labour
community, may not have easy access to computers.

Principle 6: The board should ensure disputes are resolved as effectively, efficiently and expediously
as possible
1. In terms of their duty of care, directors are required to resolve disputes effectively, efficiently and as
quickly as possible.

2. It is the board’s duty to set up mechanisms / processes to resolve disputes, e.g. where a dispute
arises with an employee, there must be a laid down procedure for that employee & the company to
follow. Where there is a dispute (e.g. unlawful strike) with a labour union, there is an established
legal procedure which must be followed; the company must have processes in place to adhere to
the legal procedure.

3. Disputes can be internal (e.g. with an employee or shareholder) or external (e.g. with a supplier,
customer, local community), and are simply a part of “doing business”. Obviously disputes can be
taken to court but this is generally costly and time consuming.

4. Alternative dispute resolution (ADR) is now a widely accepted practice which involves the parties to
the dispute taking the matter to arbitration, adjudication or mediation. This essentially amounts to
a party independent of the disputing parties, hearing both sides of the dispute and “presenting a
finding or solution”.

5. The company should select a dispute resolution method that best serves the interests of the
company. For example, going to court, arbitration or adjudication results in a judgment, whereas
mediation or conciliation allows the dispute parties and an impartial and neutral third party to work
together to negotiate a resolution to their dispute. (A settlement agreement rather than a handed
down judgment).

6. In deciding on which dispute resolution method to follow, the board should consider at least the
following factors:
 time available to resolve the dispute – court proceedings can continue for years with
postponements, appeals, etc. ADR can be concluded much quicker. It is usually in the interests
of the disputing parties to resolve the matter promptly.

 principle and precedent – where the company wants a binding decision on an important matter
of principle, which will result in a precedent for any future disputes, a court action is likely to be
more suitable.

 business relationships – ADR, especially mediation/conciliation is normally far more “friendly”

than court proceedings. It is important to maintain good business relationships (sustainability)
and mediation / conciliation is more likely to contribute to the continuation of good business
relationships.

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  expert recommendations – where the parties do not wish to go to court, but do not have the
necessary expertise to devise a solution, an expert may be required to facilitate a solution (this
is conciliation).

 confidentiality – where confidentiality for the dispute parties is very important, ADR may be
more suitable as dispute resolution proceedings may be conducted in confidence.

 Rights and interests – court proceedings, arbitration and adjudication results in the decision
maker imposing a resolution on the parties based on the principles and rights applicable to the
dispute. Mediation and conciliation allow the parties a level of flexibility in fashioning a
mutually beneficial solution.

 empowerment of participants – if mediation or conciliation is to be promptly & successfully

concluded, the personnel involved must be given the necessary powers to act.

7. The success of ADR is largely dependent on the willingness of the parties to resolve the dispute.
Obviously presentation skills, a thorough knowledge of the subject matter of the dispute & a
professional approach are pre-requisites. Those who fall short of the “will and capacity” to resolve
the dispute, should be excluded. Thus the board should select the appropriate individuals to
represent the company in ADR.

Activity:
State, with an explanation, whether the following statement is true or false:

The stakeholders of the company consist of only the shareholders and the employees.

Feedback:
The statement is false. Stakeholders are any group which can affect, or be affected by the
company, such as shareholders, employees, creditors, lenders, suppliers, customers,
regulators, the media, analysts, the community in which the company may operate, etc.

INTEGRATED REPORTING AND DISCLOSURE

1. The board should ensure the integrity of the company’s integrated report.
2. Sustainability reporting & disclosure should be integrated with the company’s financial reporting.
3. Sustainability reporting & disclosure should be independently assured.

Principle 1: The board should ensure the integrity of the company’s integrated report
a) For the company to be transparent& accountable to all of its stakeholders, effective communication
is essential. This means that reporting by the company should be:

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 proactive
relevant and transparent
cover all material matters affecting the company
integrated across all areas of performance and
include reporting on economic, social&environmental issues (triple bottom line)

b) There should be controls in place e.g. verification & review of data, to ensure the integrity of the
integrated report.

c) The audit committee should evaluate sustainability disclosures.

d) Transparency in reporting sustainability information is critical if the trust and confidence of the
stakeholders in the company is to be maintained.

e) Transparency requires that both the positive & negative be reported on, and where negative
matters are reported, the company’s plans to reduce the effect of this should be disclosed.

f) Sustainability reporting should address the needs & expectations of both internal stakeholders (e.g.
employees) and external stakeholders (e.g. the local community)

g) Although transparency is a key requirement for sustainability reporting, confidential information

should not be disclosed. Obviously, non-stakeholders will have access to what is reported and
should not be provided with an easy opportunity of acting in a manner which may harm the
company.

h) The integrated report should be prepared every year.

Principle 2: Sustainability reporting & disclosure should be integrated with the company’s financial
reporting
a) If a company decides to report on its HIV/AIDS prevention activities, the reporting system should be
able to provide the information necessary to make the report meaningful for stakeholders.

b) The integrated report should contain commentary on the financial results, going concern, and how
profits have been made (or losses suffered).

c) Reporting to stakeholders is not just a matter of compiling the annual report and making it available
to stakeholders.

d) Each company will have different stakeholders & stakeholders will have different information needs,
so each company should decide on the frequency and method of reporting to its stakeholders.

e) The method of reporting may include meetings, e.g. feedback sessions on pollution to the
community in which a company has its manufacturing operations, written reports, e.g. the annual
report, or posting information on the company’s website. There a number of standards to assist
companies in deciding on what is most suitable for their circumstances.

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Principle 3: Sustainability reporting & disclosure should be independently assured
a) General oversight for sustainability reporting should be delegated to the audit committee.

b) The audit committee should review the integrated report to ensure that information is reliable,
relevant, understandable & complete.

c) The audit committee may seek the provision of independent assurance.

Activity:
Briefly explain the term “triple bottom line” reporting.

Feedback:
It refers to the practice of a company reporting not only on a single bottom line, i.e. profits,
but rather on its economic, social and environmental activities.

Activity:
Treelines Ltd is a large forestry company which grows and harvests trees & transports them to
its mills where the timber is pulped (an operation which uses a great deal of water & produces
unusable waste) for the manufacture of pulp based products. Demand for pulp based products
is declining worldwide, but demand for other timber products is stable.

The company’s forests are spread over numerous regions of the country, and the majority are in
remote areas. A key element of the location of forests for both replanting (once trees have been
harvested) and new forests is the level of local rainfall as forests are not irrigated.

Treelines Ltd employs a reasonably large workforce at its forest locations – a workforce ranging
from unskilled to skilled logging machine operators all of whom are vital to the operation. It also
has a large administration, financial, marketing & support staff of mixed gender and race at its
head office.

The Board of Treelines Ltd adopts sound corporate governance in how it conducts its business
& in how it reports to its stakeholders. Integrated sustainability reporting & disclosure are
regarded as an important part of keeping stakeholders informed, and of building & maintaining
relationships & promoting respect between the company and the stakeholders.

Required:
1. Discuss how frequently a company like Treelines Ltd should report to its stakeholders on
sustainability & other issues.
2. Identify the main stakeholders, other than shareholders, with whom Treelines Ltd should be
“building & maintaining relationships and promoting respect”, and indicate briefly, in respect
of each, why you consider them to be stakeholders.
3. Identify & briefly discuss, based on the information about Treelines Ltd given in the question,
the sustainability issues which the company should report on in its integrated report.

Feedback:
1. King III states that effective reporting should take place at least once a year, but there is
no fixed number of times it should take place. The objective is to keep all stakeholders
informed to the extent that satisfies each stakeholder group’s needs.

2. TreelinesLtd’s main stakeholders are:

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2.1 Suppliers of goods and services without whom the company cannot operate effectively.

2.2 Creditors arising from the supply of goods, services & finance, e.g. loan providers.
These parties are owed money & therefore have a direct stake in the company.

2.3 Employees at all levels and in all activities, skilled, unskilled & administrative.

2.4 Government and important parties responsible for relevant legislation, e.g. governing
the granting of forestry licences.

2.5 External auditors, who require cooperation and respect to fulfill their legislated
function.

2.6 Customers who may range from individual to large corporations to government and
who are the lifeblood of the company.

2.7 Industry at large – Treelines Ltd does not operate within a vacuum. It is part of the
greater economic community & of the forestry / milling / pulp / paper industry specifically.
Cooperation & participation are key to the sustainability of the industry as a whole.

2.8 Local communities – companies are part of a wider society & as in the case of
Treelines Ltd of numerous local communities. The company depends on these
communities & vice versa.

2.9 The media – financial, industrial and human interest journalists write about companies
& can enhance or damage a company’s reputation & its image as a good corporate
citizen. They have a “stake” in the company & the company needs to manage
relationships accordingly.

2.10 Regulators – Treelines Ltd will probably be regulated by a number of bodies that
require compliance with rules, regulations or a code, e.g. the Forest Stewardship
Council regulations and code. A sound working relationship between the company and
regulator must be promoted.

3. Sustainability issues which should be reported on:

3.1 The declining demand for pulp based products & its anticipated effect on TreelinesLtd’s
business:
 Whether mills will be temporarily closed or shut down permanently
 Whether retrenchments are likely
 Whether replanting or new forests are intended

3.2 The board’s response to the decline in pulp based products, including any plans to
diversify into other timber products.

3.3 How environmental issues are being addressed:

 Reduction of water usage at the mills
 Reduction of CO2 and other harmful emissions
 Reduction of unusable waste

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3.4 Incidents of fire in plantations & the prevention thereof.

3.5 Monitoring of weather patterns and trends in forestry areas with regard to replanting &
new forests.

3.6 How employees throughout the company have been enhanced:

 Ongoing training of all levels
 Development of gender and race at management level

3.7 Relations with remote local communities;

 Training of locals in essential forestry skills;
 Provision of decent living conditions, transport and education
 Health programmes, e.g. provision of HIV / AIDS drugs & counseling
 Prevention of injury to forest workers

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 Study Unit 3.1
Control environment

1. Communication and enforcement of integrity and ethical values

 In terms of King III, ethical IT governance must be cultivated & promoted & should align with the
ethical culture of the organization.
 A strong ethical culture is important in an IT department, particularly as IT personnel will have
access to confidential & sensitive information, and may also have the opportunity to cause
disruption to operations & destruction & unauthorized alteration of data.
 IT management should communicate a code of ethical behavior, comply with it themselves, and
take strong remedial action which may include dismissal where integrity & ethical behavior have
been lacking.

2. Commitment to competence
 The demands of the IT department with regards to skill and knowledge can be considerable.
 IT management should be committed to matching these attributes to an individual’s job
description. Again the consequences of an individual not being able to do his job could be
immense. Performance reviews & regular discussions with employees assist in achieving this.

3. Participation by those charged with governance

 IT governance is the overall responsibility of the board and it should provide the required
leadership & direction to ensure that IT achieves, sustains and enhances the company’s strategic
objectives.
 There should be defined mechanisms for the IT department to communicate with the board and
report regularly to it.
 The board should appoint an IT steering committee to assist with the governance of IT. A
steering committee is a group of people knowledgeable about computers, to whom major issues
are referred, e.g. policies, future strategy, IT risk, acquisitions of hardware & software
 The IT department should not be seen as a “separate entity” only answerable to itself.

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4. IT management’s philosophy and operating style
 IT’s actions set the tone of the department and as they lead, so will the employees follow. Their
management philosophy and management style must demonstrate, communicate and enforce
sound control.
 Very often IT personnel are seen as technical specialist who are more interested in IT and the
excitement of its capabilities, than they are in the financial side. This can lead to a level of
disharmony within management.

5. Organisational structure and assignment of authority and responsibility

5.1 The organizational structure should achieve two major objectives:

 It should establish clear reporting lines / levels of authority; and
 It should lay the foundation for segregation of duties so that no staff perform incompatible
functions

5.2 The organizational structure should address segregation of IT and user departments & segregation
of duties within the IT department.

5.3 In terms of King III the chief executive officer should appoint a chief information officer (CIO) who is
suitably qualified and experienced. This individual should interact on a regular basis with:
 the board;
 steering committee and audit committee
 executive management

5.4 Overall the functions of supervision, execution and review within the department should be
segregated as far as possible.

5.5 Job descriptions, levels of authority and responsibilities assigned to IT personnel should be
documented.

Sound Organizational Structure for an Information Technology Department

Board of Directors
IT risk committee

Steering Committee

Chief Information Officer

Software manager Infrastructure manager

Webmaster Application development Technical / administration Help desk Security

& programming operations

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 Application development and programming
 Business / systems analysts – are responsible for liaising with users to understand their needs &
documenting functional specifications for new applications & programme enhancements.
 Programmers – write the programme code based on the specifications supplied by the business
analysts, document the technical specification & debug programmes.
 Webmaster – a webmaster should be appointed. Responsibilities will be to:
design, develop and maintain the company’s website;
regulate and manage the access rights of the users of the site;
set up and maintain website navigation;
deal with complaints and other feedback about the site
 Technical / Administration
(a) Database administrators – have the specialized skills to develop, maintain and manage the
database (the store of information);
(b) Operating system administrators – have the specialised skills to implement, maintain &
manage the operating system & hardware;
(c) Network administrators – have the specialised skills to implement, maintain & manage the
company’s LAN/WAN, etc
 HelpDesk / Operations
Helpdesk operators receive calls from users & log their problems / requests on the HelpDesk
System as well as performing routine operational duties e.g. checking backups have been
completed successfully & managing rotation of backup tapes.
 Security personnel lay down control procedures for access to all computer facilities, monitor
security violations (e.g. logs) and follow these up, issue passwords.
 The IT department should be entirely separate from user departments
No transactions should be authorized or executed by any member of the IT department,
e.g. placing a purchase order or authorizing a wage rate increase
No member of the IT staff should have access to, or custody of, the physical assets of
the company, e.g. inventory, or uncontrolled access to the non-physical assets, e.g. the
debtors masterfile
IT staff should only be responsible for correcting errors which arise from operating or
processing problems; unless in response to authorized requests from user departments
for assistance with corrections

6. Human resource policies and practices

The characteristics of honesty, competence and trustworthiness are paramount in a computerized

environment & management should institute the following policies and practices:
 Proper recruiting policies which include careful checks on an applicant’s background &
competence.
 Immediate exclusion from computer facilities if an employee is dismissed (password and user
privileges should be cancelled).

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  Compulsory leave – employees who are involved in unauthorised activity will often be
uncovered when they are not present to cover their tracks.
 Training and development to keep staff up to date & able to fulfill their functions efficiently &
effectively.
 Written formalization of human resource policies to provide employees with terms of reference
or guidelines.
 Rotation of duties – moving employees between functions, is a useful practice as it helps avoid
undue reliance on any individuals by ensuring that each employee has a backup. It may also
relieve boredom as well as encourage employees to develop new expertise & skills. Rotation of
duties should not be implemented to the extent that segregation of duties is compromised, e.g.
the computer operator should not be trained as an application programmer & then be placed
temporarily in the programming section.
 Strict policies pertaining to the private use of computer facilities by IT personnel (and other
employees) should be in place, e.g. internet use and running private jobs.

The following example indicates that an effective control environment is present:

• Management takes computer information processing seriously.

• Aspects pertaining to computer information processing are effectively managed and anyrisks are
immediately dealt with.

It is clear that the functions of the user department should be completely separated from thefunctions
of the information technology department. This is illustrated by the followingexamples:

• The information technology department should not initiate or authorise transactions;

• The information technology department may not authorise amendments to a masterfile;
• The user department must check all amendments to a masterfile;
• Personnel in the IT department should not be permitted to correcterrors made by the user
department.

Further, certain functions in the electronic data processing section should also be segregatedto promote
internal control.

Activity:
Indicate, in each of the following cases, whether or not the internal controls were undermined.

1. Transactions rejected during data processing are corrected and re-entered by the ClS
department.
2. Payroll operators have to sign when they take over the payroll masterfile from the
programmer. The programmer should in turn ensure that the files are in safekeeping.
3. All members of staff are fully trained in the operation of all programs and are able to operate
all programs.

Feedback:
1. The principles are not being undermined. The CIS department should correct its own
errors.
2. The principles are being undermined. Masterfiles should be kept under the supervision
of an independent person.
3. The principles are being undermined. All members of staff may be fully trained, but
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 particular tasks and responsibilities must be reserved for specific people. Access to
functions could be restricted by means of passwords.

Management should introduce controls to ensure the following:

 That the staff appointed are honest and competent;
 That the staff are satisfied;
 That the work produced by staff is of a high standard

To achieve the above aims, it is necessary to develop a policy that includes the following aspects of
personnel practice:

Personnel practices Explanation of the principle with reference to

an example
Proper recruiting policies Background checks should be carried out:
referees on a CV must be contacted and proof of
qualifications requested before a person is
appointed.

lmmediate exclusion from computer facilities if Mr X reaches retiring age and leaves the service
an employee is dismissed or leaves the service of the company. On the last day of his service
of the company for any other reason. Computer Services must cancel Mr X’s access to
all systems and programs.

Compulsory vacation leave/staff must take Mrs Y has taken no leave in the last year. She is
vacation leave regularly. contravening the management policy that
requires employees to use their leave allocation
for a particular year in that year. Management
should compel Mrs Y to take her annual leave in
the following month.

Training and development Management must identify courses and

seminars on a regular basis and request certain
members of staff to attend the courses since this
will make them more efficient in carrying out their
duties and expand their skills.

Formalisation of personnel practices All the personnel practices must be formalised in

a written procedural manual that codifies the
policies regulating personnel practices. This
manual must be freely available and must be
regularly revised and updated.

Rotation of duties Staff must be rotated so that cross-training can

take place. lfMr R goes on leave Mr V is
available to do his work successfully. This
practice prevents boredom, because if someone
stays in the same job for years errors can easily
creep in.

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Strict policies pertaining to the private use of Certain websites should be blocked during office
computer facilities hours, for example, facebook.

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 Study Unit 3.2
Systems Development and Implementation Controls

New systems are continually being developed, but often without adequate systemsdevelopment
procedures and documentation. As a result a system might generate inaccurate orincomplete records
that could increase the possibility of fraud.

Why do you think systems development and implementation controls are important?

Systems change because the business world changes and the need for quicker, different, additional and
better quality information increase. Business related systems are said to have a “life cycle”, they start,
develop, mature & decline. Changes in the company’s information system may arise because of changes
in the company’s business activities, growth, a need to maintain a competitive advantage or just to
improve it all round performance by having better information. Unless the designing of a system is
carefully controlled, the following might occur:

 costs of development may get out of control;

 the system design may not suit user requirements properly;
 programs within the system may contain errors and bugs;
 important financial reporting requirements are not incorporated into the system or are
incorrectly understood by the business analyst / programmer;
 the new system may not incorporate enough controls to ensure the integrity of its programs &
data, e.g. the design of access privileges may give employees write access to programmes they
should not have any access to;
 an excellently designed system may be rendered virtually useless because no-one knows how to
use it;
 the information transferred from the old system to the new may be erroneous, invalid or
incomplete

If proper systems development and implementation controls are put in place, the risks mentioned above
can be avoided.

1. For in-house development and implementation of systems

1.1 Standards
 All systems development should be carried out in accordance with pre-defined standards which
have been set for each of the phases described below, e.g. components of the ISO 9000 series of
standards.
 Compliance with these standards should be strictly monitored and any deviations strictly
followed up by management.

1.2 Project approval

 Projects for systems development may arise out of user requests or as a result of strategic
planning.
 A feasibility study should be carried out:
- a system specification for an in-house development proposal;
- a proposal which involves the purchase of off-the-shelf software;
- rejection of the project
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 The feasibility study should include a cost / benefit analysis which lists and puts a money value to:
- all requirements for the project such as personnel, hardware, software & running costs;
- all benefits arising e.g. increased revenue, reduced costs, improved controls
 The steering committee should give its approval prior to commencement of the project

1.3 Project management

 A project team should be formed by the steering committee to manage the project & should
include IT & appropriate user personnel, including accounting and internal audit personnel.
 The development project should be planned in stages, each stage detailing the specific tasks
which must be completed.
 Responsibility for each task must be allocated to appropriate staff members.
 Deadlines should be set for completion of each stage and each task.
 Progress should be monitored at regular intervals to identify any problems which may affect
achievement of goals set.
 Regular progress reports should be submitted to the steering committee.

1.4 User requirements

 Business Analysts should carefully determine and document all user requirements relating to
the system e.g. input, procedures, calculations, output, reports, financial reporting
requirements, audit trails.
 Special care should be taken to consult both internal and external auditors as to their
requirements & their recommendations concerning internal controls e.g. access controls,
validation checks.
 Management of each user department should sign their approval of the specifications recorded
to satisfy the needs of their individual departments.

1.5 Systems specifications and programming

 Program specifications should be clearly documented.
 Programming should take place in accordance with standard programming conventions &
procedures e.g. for coding, flow charting, program routines.
 Programmers should carry out all program development in a development environment &
should have no access to the live environment.

1.6 Testing
 Program coding of individual programs should be tested by the programmers using standard
debugging procedures like program code checking and running the program with test data.
 The system should also be tested as a whole to ensure that all programs are integrating
properly.
 The system should also be tested on an output level by management, users and auditors to
establish whether the system is satisfying the requirements of its users.

1.7 Final approval

 Results of testing should be reviewed by all involved to ensure that necessary changes have
been made and errors corrected.
 The project team should then obtain final approval from the board, users, internal audit and IT
personnel before going ahead with conversion procedures.

1.8 Training

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  A formal programme should be devised setting out in detail all personnel to be trained, dates &
times for their training & allocating responsibility for training to specific, capable staff.
 User procedure manuals & updated, clearly defined job descriptions should be compiled & used
in the training exercise.

1.9 Conversion
Controls are necessary at this stage to ensure that programs & information taken onto the new
system are complete, accurate and valid:

 Conversion project: the conversion should be considered as a project in its own right.
 Data cleanup: data to be converted must be thoroughly checked & discrepancies
resolved prior to conversion. For example, if a new inventory
application is being introduced; physical inventory should be counted
so that correct quantities can be entered onto the system.
 Conversion method: the conversion method must be selected:
 parallel processing of the old & new systems for a limited period; or
 immediate shut-down of the old system on implementation of the
new system; or
 conversion of the entire system at one time; or
 phasing in different aspects over a set period
 Preparation & entry: controls over preparation & entry of data onto the new system should
include the use of a data control group to:
 perform file comparisons between old & new files & resolve
discrepancies;
 reconcile from original to new files using record counts and control
totals, e.g. if there were 300 employees on the old payroll, there
must be 300 employees on the new payroll;
 follow up exception reports of any problems identified through use
of programmed checks e.g. no employee identity number;
 obtain user approval for data converted in respect of each user
department;
 obtain direct information from customers or suppliers of balances
reflected on the new system

1.10 Post-implementation review

Users, IT personnel & auditors should review the system several months after implementation
to determine whether:
 the system is operating as intended;
 the systems development exercise was effective;
 all aspects of the new system are adequately documented in accordance with
predetermined standards of documentation.

1.11 Documentation
 The project itself and all the activities which took place in the planning & execution of the
project should be documented.
 Documentation relating to the system itself, must also be prepared, e.g. systems analysis,
flowcharts, programming specifications, etc.
 Documentation should be backed up on an ongoing basis and stored offsite.

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The following table provides examples of all the types of controls that should be put into operation for
the in-house development & implementation of systems:

Controls for the in-house Explanation of the principle with reference to an example
development
and implementation
of systems
Standards Systems development must be subject to the lSO 9000 standards.
lSO 9000 is a series of standards for quality management systems
that is maintained by the lnternational Organization for
Standardization

Project approval A cost versus benefits study must be carried out, for example:
Option 1: Cost of an existing system purchased directly from the
developer: R5 000.
Option 2: Cost of developing the system in house: R10 000.
lf the benefits offered by the different options are the same, it would
be best to choose option 1.
Project management A project management team responsible for drawing up a project
plan should be formed. This project plan should include the following:
objectives, responsible persons, deadlines etc. The project
management team is responsible for planning and controlling the
project, and monitoring progress.
User requirements Multi-level involvement is necessary. All persons responsible for the
system (e.g. users) should provide input.

Systems specifications There must be agreement on the specifications before a system is

and programming developed. A computer language should be chosen, for example, as
well as the symbols and abbreviations that will be used. This is
followed by the programming, in other words, the physical writing of
the programs.

Testing lt is important that system development should precede the

implementation of the system. The following kinds of tests could be
carried out:
 Program test: Tests the processing logic of a single program, in
other
 Words it tests whether the program could deal with every
possiblesituation.
 String test: A series of related programs is tested in order to
determinewhether the data is being correctly transmitted from one
program to thenext
 Systems test: This test determines whether all the programmes in
thesystem are interacting correctly. Test data is entered on the
system totest whether the system handles it correctly
 User acceptance test: The system is tested at an output level
bymanagement, the users and the auditors.
Final approval All the parties involved in the testing should finally approve the
system before it is implemented. It is important that the system
should be adapted and corrected to deal with the errors that showed
up during testing.
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Training A training programme that gives details of the people to be trained,
the dates and times of training etc should be devised. Procedure
manuals for users should be updated and used during the training
sessions.

Conversion There are several steps that should be followed when converting a
system:
Development of a conversion project, cleaning of data, choice of a
conversion method and lastly the preparation and physical entry of
data. Controls over the preparation and input of data into the new
system involve the following:
 Compare old and new files – when a debtors’ system is
converted, for example, it is necessary to ensure that the same
number of debtors’ files exist before and after the conversion.
 Reconcile original files with the new files with the aid of control
totals – eg the sum of the outstanding debtors before and after
conversion should be R50 890.
 Print exception reports if certain conditions are not complied with
– eg the number of inventory items transferred to the new system
may not contain a negative value. If a negative value occurs, it
would appear on an exception report.
 User approval must be obtained from each department involved
in data conversion eg the creditors section would give their
consent if they were satisfied with the accurate, valid and
complete transfer of creditors information and balances from the
old to the new system.
 Obtain direct evidence from customers and suppliers eg all
customers and suppliers could be contacted to determine whether
the outstanding balance as reflected on the new system is
correct.
Post-implementation A few months after the new system has been adopted, a post-
review implementation review should be carried out to measure the
satisfaction of users, information technology personnel and auditors.

Documentation The project and all related activities should be documented. In

addition, documentation relating to the system should also be
prepared. This documentation should be regularly backed up and
stored offsite.

Activity:
Systems testing, which takes place during the systems development phase, is an
importantmeasure for both the management of the entity and the auditors because it affords the
lastopportunity to test the system before it is implemented.
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Write down (in point form) the objectives of system testing during the systems development
phase.

Feedback:
The objectives of system testing during the systems development phase are to:
 Determine whether the system is operating in accordance with its design specifications
 Determine whether the operation of the system complies with user requirements
 Determine whether all application controls are operating as they were designed to do
 Demonstrate that correct input leads to correct output
 Demonstrate that incorrect input, processing or output will be detected

Activity:
During the systems development phase, when conversion takes place from one system to
another, controls are required since errors can arise when master and transaction files are
converted to a new system. Such errors can arise when data in a record is accidentally
changed or lost, or when records are omitted.

Describe the conversion controls applied during systems development that should detect or
prevent errors during systems development when conversion to a new system takes place.

Feedback:
Conversion controls:
 Approval for the conversion of files should be given before the conversion process
begins. The purpose of this approval is to ensure that the files that are converted have
been thoroughly checked.
 The original and the new files must be reconciled by means of record counts, hash
totals and financial totals.
 Sections of the records from the original files can be compared with the corresponding
sections of the records in the new files to make certain that there are no differences.
 Requests for confirmation can be sent to third parties such as customers and users, who
can be asked to check the information in the documents and correct it if necessary.
 Exception reports can be used to detect and correct irregularities.
 Operating approval must be obtained from the users after they have used the system a
few times. Approval indicates that they are satisfied with the way the system is
operating.

2. Systems development and implementation based on packaged software

When a company decides that it needs a new system, one of the options it has, is to purchase packaged
software as opposed to developing the software itself (in-house). This is not just a matter of buying a
package, installing it & away you go – the majority of the systems development & implementation
controls will apply. The major difference between in-house developed and packaged software is that for
purchased packages, the company will have no control over the specifications & development, e.g.
writing the programs, or testing of the software. Purchased packages are designed to meet the generic
requirements for lots of users with similar needs & although current packages contain hundreds of
features & capabilities, the user basically gets what the package offers, nothing more and nothing less.
This means that from the company’s perspective, the emphasis will be deciding whether the package
offers features and capabilities which match with what the company’s users want.
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 2.1 The advantages of packaged software:
 lower cost;
 the entire software development project is completed far quicker because development &
testing have been done on the software by the developers;
 the package can be demonstrated up front, so IT personnel & users can see what the
package “can do”. Sample reports can be examined & the computer capabilities required by
the software can be determined & tested;
 technical support (by phone or over the internet) is usually available from individuals who
are very skilled & knowledgeable about the specific package, and comprehensive manuals
are supplied;
 software companies usually upgrade the packages on an ongoing basis

2.2 The disadvantages of packaged software:

 the package may not meet the company’s requirements exactly
 excellent software developed overseas may, for example, not satisfy South African tax or
financial reporting requirements;
 changes can’t be made by a purchaser of the software

2.3 Summary of controls for the acquisition and implementation of packaged software
 Project management – the entire exercise should be run as a project by a team appointed by
the steering committee
 Project approval – a feasibility study must still be conducted to determine:
 user needs
 specifications (capabilities, functions, controls) of packages available in the market;
 costs and benefits;
 technical support & reliability of the supplier
 Approval – for the package chosen should be obtained from users, internal audit & the steering
committee, and authorization for its purchase should be obtained from the CIO and the board.
 Training – all affected IT personnel & users should be trained in the use of the new software.
 Conversion – moving data onto the new system should be controlled.
 Post implementation review – again IT personnel, users, internal audit, should review the new
software several months after implementation to determine whether it is operating as
intended.
 Documentation – the systems documentation, user manuals, etc., will come from the supplier
but the planning & execution of the project itself should be documented.

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 Study Unit 3.3
Access Controls

It is essential to control access in order to prevent damage to and the theft of equipment, aswell as the
manipulation, destruction or theft of data. Access controls should be designed toensure that
onlyauthorised users obtain access to the computer facilities and data.

Access to all aspects of the system must be controlled:

a) hardware
b) computer functions at system level (accessing the computer system itself)
c) computer functions at application level (accessing a specific application or module)
d) data files / databases
e) utilities
f) documentation (electronic or hard copy)
g) communication channels

Security policy

1. Least privilege: employees should only be given access to only those aspects of the system which
are necessary for the proper performance of their duties, e.g. a clerk in the wages department
should not be given access to inventory records as he does not “need to know” what is contained in
the inventory records.

2. Fail safe: if a control “fails”, whatever is being protected by that control, should remain “safe”, e.g. if
logical access control software malfunctions, the system should shut down completely, rather than
allowing uncontrolled access.

3. Defense in depth: this means that protection is not left up to one control only, but rather to a
combination of controls

4. Logging: the computer’s ability to log (record) activity which takes place on it, should be extensively
incorporated, e.g. unsuccessful attempts to access the system should be logged & followed up.
Logging is not an effective control activity, unless the logs are regularly and frequently reviewed and
follow up action taken where control violations are identified.

The following table illustrates the principles of a security policy by means of examples:
Principle Explanation of the principle with reference
to an example
Least privilege The foreman of the store should not
haveaccess to the debtors system sincehis
duties do not include any aspects of the use of
the debtors system.
Fail safe lf the internal controls detect irregular access to
the inventory system, the system should be
locked and no further functions/changes to the
inventory system should be allowed.

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Defense in depth A number of controls rather than a single control
should be implemented to protect the inventory
system. For example: access to the inventory
system can only be obtained from computers
situated in the inventory section; only certain
users can gain access to the system by means
of passwords and, lastly, various modules of the
computer system can be restricted by giving
certain users reading rights only.
Logging At the end of every week management should
study the logging register. All unsuccessful
attempts to gain access to the inventory system
should be studied and followed up.

Physical access control

A combination of the following physical controls can be implemented to prevent unauthorized entry to
an IT data centre. For example, the IT department as a whole could be contained in a separate building
or wing of a building. All IT personnel would have their offices in this building. The building would also
have a dedicated room in which all the equipment which runs the system would be housed, e.g. CPU,
servers, routers, to run the company’s systems. This dedicated room would be the data centre. Access
to the IT building may be controlled & further access to the data centre itself would be far more strictly
controlled. Only a limited number of personnel need access to the data centre itself whilst many more
need access to the IT department.

 Visitors from outside the company to the IT building should:

- be required to have an official appointment to visit IT personnel working in the IT department, e.g.
external maintenance personnel;
- on arrival, be cleared at the entrance to the company’s premises e.g. by a phone call to the IT
department;
- be given an ID tag & possibly escorted to the department;
- not be able to gain access through the locked door (must “buzz”);
- wait in reception for whoever they have come to see;
- be escorted out of the department at the conclusion of their business

 Company personnel other than IT personnel

- there should be no need for other personnel to enter the data centre& access to the IT
department should be controlled in a practical manner as there will be contact between the IT
department staff & users on a regular basis

 Physical entry to the data centre

- only individuals who need access to the data centre should be able to gain entry ;
- access points should be limited to one;
- access should be through a door which is locked other than when people are entering or exiting;
- the locking device should be de-activated only by swipe card, entry of a PIN number, scanning of
biometric data, e.g. thumbprint;
- entry/exit point may be under closed circuit TV

 Remote workstations / terminals

- terminals can be locked and secured to the desk;
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 - terminals must be placed where they are visible & not near a window;
- offices should be locked at night & at weekends

Logical access controls

Logical access controls will be primarily preventive, i.e. designed to prevent unauthorized access via
terminals, but these will be supported by logs which are detective.

The following controls in various forms can be implemented through the access control software &
other programs:

 identification:
- user identification (user IDs)
- magnetic card or tag
- biometric data (e.g. thumbprint, facial recognition)
- terminal identification (system recognizes terminal ID number or name)

 authentication:
- entering a unique password;
- entering a piece of information which an unauthorized individual would not know about the
genuine user, e.g. great grandmother’s first name;
- connecting a device to the USB port of the terminal (e.g.: dongle). A one-time password can be
generated on a server & sent by SMS to the user. A combination of the above techniques is
called multi-factor authentication & is used where very strict access control is required. The
dongle will only work on a terminal on which the bank’s specific software has been loaded, this is
a form of terminal authentication

 authorization (this is defining the levels of access to be granted to users and computer resources)
- once the system has authenticated the user, access will only be given to those programmes to
which the user is authorized to have access
- a user may be granted read only; or
- read & write
- although modern software concentrates access privileges around the user, specific terminals can
be linked to specific applications e.g. warehouse terminal not linked to the wage application, or
to the EFT facility;
- restricted hours of operation, e.g. terminal shuts down at 4pm and comes on at 7am

 logging
- this is recording access and access violations for later investigation. Logging and follow up is a
detective control.

 Access tables
The computer cannot perform logical access control unless a large number of details are defined in
tables to which the system can refer. These tables identify all “objects” and “conditions” which the
computer has to “know” in order to be able to control access. These objects include:
- all authorized PCs (PC IDs);
- all authorized users (user IDs);
- all passwords;
- all programs;
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 - all possible modes of access (no access, read-only, read and write), time of day

Access profiles are usually set up for “user groups” rather than for individual users, as this is a more
efficient way of controlling access.

 Controls over passwords

The strict control of passwords is fundamental to successful, logical access controls:
- passwords should be unique to each individual;

- passwords should consist of at least six characters, be random not obvious, and a mix of letters,
numbers, upper/lower case and symbols;

- passwords / user-ID’s for terminated or transferred personnel should be removed /disabled at the
time of termination or transfer;

- passwords should be changed regularly & users should be forced by the system, to change their
password;

- the first time a new employee accesses the system, he / she should be prompted to change his
initial password;

- passwords should not be displayed on PCs at any time, be printed on any reports or logged in
transaction logs;

- password files should be subject to strict access controls to protect them from unauthorized read
and write access. Encryption of password files is essential;

- personnel should be prohibited from disclosing their passwords to others and subjected to
disciplinary measures should they do so;

- passwords should be changed if confidentiality has been violated, or violation is expected;

- passwords should not be obvious, e.g. birthdays, names, name backwards, common words, and
should not be the same as the user ID

Other access control considerations

1. Data communication
Data communication relates to the transmission of information from a sender to a receiver in electronic
form. Information must be sent down a link which may be a fixed line, e.g. a public telephone network,
or a dedicated line linking two computers, or a fibre optic cable, or by wireless technology, e.g. satellite
transmission, cellular telephones or even cordless computer devices, such as a cordless mouse.

Control is achieved by:

a) The implementation of specialized software which is responsible for:
o controlling access to the network;
o network management;

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 o data & file transmission;
o error detection and control;
o data security
b) encryption (converting data into a secret code)
c) the protection of physical cabling

2. Firewalls
Once a company’s network is connected to an external network such as the internet there is an
increased risk of unauthorised access to the company’s network. A firewall is a combination of
hardware & software that sits between the company’s network & the external network, and is access
control gateways which restrict what traffic can flow in and out.

3. Libraries
In a computer environment, libraries may be both in electronic form and in physical form. Library
software will protect backup copies of programmes from unauthorised changes being made, record (log)
any authorized access, audit changes and monitor user.

4. Root access / system wide access / super-user privileges

This level of privilege gives the user virtually unlimited powers to access and change, without trace, all
programs & data, bypassing normal access controls and therefore should only be given to a very limited
number of IT personnel.

5. Utility programs / Database access

Access to utility programmes & high level access directly to the database provides the potential to
change / delete data & programs without leaving an audit trail.

Two categories of access controls are involved, namely physical and logical access controls.The
distinction between these two categories is as follows:

Physical access controls are controls that are visible. For example, you
can see a security guard standing in front of the gate of the electronic data
processing section and you know that he will only allow you to enter if you
sign a register.

Logical access controls are controls that are built into the computer.
When you log onto the computer, the system tests to see whether you are
a registered user.

Activity:
Explain what you understand by the encryption of data.

Feedback:
Encryption is the coding of data to disguise its meaning. The original data can only be
recovered by the person or device that has the key required for decoding.

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 Study Unit 3.4
Continuity of Operations

These controls are aimed at protecting computer facilities from natural disasters (e.g. flooding or fire),
as well as from acts of destruction, attack or abuse by unauthorised people. Our high crime rate and
general unrest, places businesses at risk of armed robbery & damage from explosion.

1. Risk assessment

The dependence by large companies on their IT systems is huge & failure to assess & address IT risk
threatens the continuity of operations. The auditor will evaluate whether:
 assessing IT risk is an integral part of the company’s risk assessment procedures;
 there is an appropriate level of experience & knowledge with regard to IT risk on the risk
assessment committee;
 the risk committee meets regularly but is available to deal with the threat of unexpected IT risk
on an ongoing basis;
 the risk assessment committee recognizes & assesses all types of threat relating to IT which
could disrupt operations including, e.g.:
- fraud & theft perpetrated through the IT system;
- physical and infrastructure damage;
- hacking & viruses;
- non-compliance with IT laws, rules, standards & best practice
 accepted risk assessment protocols (way of doing things) are followed;
 assessments are documented & reported to the board;
 responses to risks are recorded, implemented and monitored

2. Physical security

These controls are designed to protect facilities against natural & environmental hazards & attack or
abuse by unauthorized people. The following pertain more specifically to the data centre:
 Physical location (site selection)
 the data centre (and obviously the building in which it is housed), should be placed away
from obvious hazards e.g. river banks, main traffic areas, the factory, stores of hazardous
materials;
 the facility should be located within a secure area within a building i.e. no outside walls &
windows;
 there should be a secure door & access control devices
 Fire and flood
 automatic gas release (e.g. CO2), smoke detectors, fire extinguishers, no smoking allowed;
 situated above ground level and away from water mains;
 raised flooring in the computer room
 Power surges
 use of “uninterrupted power supply” equipment & backup generators, particularly if
continuity is critical (normally is)
 Heat and humidity
 air-conditioning preferably on its own electrical circuit
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  Physical access controls

The following table provides examples of continuity of operations controls:

Continuity of operations Explanation of the control with reference to an example

controls
Physical location As a result of large-scale expansion, management is currently building
other facilities. Despite the high cost implications, management has
decided not to locate the building in an industrial area. The reason is
that the increase in the emission of smoke and exhaust gases in
industrial areas can damage the computer equipment.

Fire and flood Management has decided to install fire detection equipment in the
building. The sensors are sensitive to smoke and heat and would
activate an alarm immediately if a fire were to break out.

Power surges Large-scale power failures have a negative effect on the productivity of
computer operators. Management was therefore compelled to buy
back-up generators.

Heat and humidity The life of computer equipment can be shortened if it is placed in an
area that gets very hot. Management therefore decided to install air-
conditioning units to maintain a constant temperature in the computer
room.

Access controls See study unit 3.3

3. Disasterrecovery

There are controls implemented to minimize disruption as a result of some disaster which prevents
processing & destroys / corrupts programmes & data.

a) A disaster recovery plan:

 a written document which lists the procedures which should be carried out by each employee in
the event of a disaster;
 the plan should be widely available so that there is no frantic searching if a disaster occurs. Time is
usually precious;
 the plan should address priorities i.e. the order in which files or programmes should be
reconstructed, with the most important being allocated the highest priority, as well as where
backup data, programmes, hardware, etc. may be obtained;
 the plan should be tested;

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  the plan should be detail alternative processing arrangements which have been agreed upon in the
event of a disaster, e.g. using a bureau

b) Backup strategies:
 backups are copies of all or parts of files, databases, programmes taken to assist in
reconstructing systems or information, should they be lost or damaged;
 backup of all significant accounting and operational data and programme files should be carried
out frequently and regularly;
 at least three generations of backups should be maintained (grandfather, father, son);
 the most recently backed up information should be stored off-site;
 all backup should be maintained in fireproof safes & on-site backups should be stored away
from the computer facilities;
 critical data and programs can be copied in real time to a “mirror site”, so that it is possible to
switch processing to the mirror site in the event of a disaster e.g. a large refinery in CPT
duplicates its processing on a second computer installation housed in a separate, very secure
(bomb proof as well) site on the premises;
 copies of all user and operations documentation should be kept off-site

An example of an effective disaster recovery plan (of ABC (Pty) Ltd) is given below.

 The disaster recovery plan was documented during the establishment of ABC (Pty) Ltd. This plan
sets out detailed procedures and is revised and updated annually.
 The updated disaster recovery plan is issued to all members of staff annually. lt is also stored at a
central point on the network.
 The disaster recovery plan covers the following areas:
- sequence in which files and programs should be reconstructed
- staff responsible for the reconstruction procedures
- location of the back-up data
- names and telephone numbers of suppliers who could provide assistance
- alternative processing methods such as the manual processing of transactions
 After the annual updating of the disaster recovery plan it is tested to ensure that it is feasible

Activity:
Explain what you understand by the concept “mirror site”.

Feedback:
During the updating and processing of critical data and programs they are automatically
copied to a “mirror site”. If there is a disaster - suppose a fire has wiped out all critical data
and programs - it would be possible to continue with data processing on the “mirror site.”

4. Other measures

There are a number of other control measures that can be taken which will assist in preventing or
alleviating disaster:
 applying the concept of redundancy;
 regular maintenance and servicing of equipment to prevent failure;

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  adequate insurance cover to provide funds to replace equipment;
 avoidance of undue reliance on key personnel by maintaining complete and appropriate
documentation & by training of understudy staff, e.g. the disaster recovery plan should not
revolve around one staff member;
 arrangements for support to be provided by suppliers of equipment & software, who may even
provide alternate processing facilities;
 the use of fire walls & use of anti-virus software

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 Study Unit 3.5
System Software and Operating Controls

System software controls are aimed at monitoring the system. Operating controls are thepolicies and
procedures which should be in place to work with the system software controls tomake sure the
computer system run like a “well-oiled machine”.

System software is made up of various kinds of software including, i.e:

1. Operating system software which:

 controls the use of the hardware
 tests critical components of the hardware & software where the computer is started
 controls the input and output of data
 schedules the use of resources and programmes
 monitors the activities of the computer and keeps track of each programme & the users of the
system
 provides the interface with the user, e.g. how the user communicates with the computer

2. Network management software:

 which enables computer systems to communicate with each other

3. Database management software:

 which enables the user to create, maintain & use data files in an efficient & effective manner

4. System development software:

 which is used to develop new software, e.g. assemblers, compilers

5. System support programmes:

 such as anti-virus software, data compression software, etc

Controls include:
 Operating policies & procedures which are fully documented, regularly reviewed and updated
 System software which maintains a log of activity on the system detailing all activity which has
taken place, including:
- Hardware malfunction
- Intervention by personnel during processing
 Skilled technicians who can resolve operating problems for users
 Adherence to international system software control protocols (how things are properly done)
 Follow up on access violations, attempted violations
 Follow up of potential virus infection
 Adherence to manufacturers’ equipment, maintenance & usage guidelines
 Strict supervision and review of IT employees (IT manager needs to know what his staff are
doing)

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The following table provides two examples of kinds of operating controls that should beinstituted:

Operating control Explanation of the control with reference to an example

Equipment operation and Hardware must be operated and maintained according to the
maintenance manufacturer’s instructions. For example, computers should not
be switched off at the plug.

Machine servicing Like motor cars, machines must be serviced regularly. A

photocopier must be serviced every 3 months, for instance.

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 Study Unit 3.6
Documentation Controls

Documentation
Sound document policies are essential, because documentation can be critically important in:
 improving overall operating efficiency;
 providing audit evidence in respect of computer related controls;
 improving communication at all levels;
 avoiding undue reliance on key personnel;
 training of users when systems are initially implemented

There are two major objectives to bear in mind regarding documentation:

 all aspects of the computer system should be clearly documented;
 access to documentation should be restricted to authorized personnel

Documentation standards
Pre-determined standards should exist for documentation and adherence thereto should be enforced.
These standards should require at least:
 general systems descriptions;
 detailed descriptions of program logic;
 operator and user instructions including error recovery procedures;
 back-up & disaster recovery procedures;
 security procedures / policy;
 user training;
 implementation and conversion of new systems

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 Study Unit 4
Internal Control Structures – Application Controls

Application controls are user and programmed controls and are embedded in each of the data
processing functions, namely input, processing and output.

Application controls must ensure the following:

 only valid transactions are processed, and they are completely and accurately processed and
recorded
 data in accounting and supporting files are kept properly up to date
 assets are protected against physical loss or theft

Controls Definition Example

User controls Controls performed manually by  checking of exception reports
the users  authorization of transactions
Programmed controls Controls embedded in the  limit tests
application program code and  alphanumeric tests
applied by the computer

The place of application controls in an internal control system can be schematically represented as
follows:

Exposure as a result of errors and

irregularities

Management control objectives

System control objectives

General controls

Application controls

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Systems objectives are achieved by using general and applications controls that prevent, detect and
correct errors in every phase of the transaction cycle. Application controls are specifically instituted for
each individual accounting application. General controls create the environment within which the
application controls operate.

Auditors approach:
a) if general controls & application controls cannot be relied upon – substantive testing
b) if general controlscannot be relied upon but application controls can be relied upon –
substantive testing
c) if general controls can be relied upon but application controls cannot be relied upon –
substantive testing
d) if general controls & application controls can be relied upon – control testing

The relationship between controls and systems objects is characterised by the prevention, detection and
correction of errors.
Preventive measures prevent errors.
Detection measures were designed to pick up unavoidable errors (errors that occur in spite of effective
preventive measures).
Corrective measures ensure that errors that are detected can be properly corrected and the data
resubmitted for input and processing.

Application Controls

1.1 An application is a set of procedures and programmes designed to satisfy all users associated with a
specific task, e.g.: the payroll cycle. Other examples include making sales, placing orders with
suppliers & receiving or paying money.

1.2 An application control is any control within an application which contributes to the accurate &
complete recording and processing of transactions which have actually occurred, and have been
authorized (valid, accurate and complete information)

1.3 The stages through which a transaction flows through the system can be described as input,
processing and output and application controls can be described in terms of these activities, e.g. an
application control relating to input.

1.4 Controls must be implemented over masterfiles. A masterfile is a file which is used to store only
standing information and balances

1.5 The objective of controls in a computerized accounting environment is generally regarded as being
centred around the occurrence, authorization, accuracy and completeness of data and information
processed b y and stored on the computer.

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 Occurrence and authorization is concerned with ensuring that transactions and data:
 are not fictitious (they have occurred) or fraudulent in nature, and
 are in accordance with the activities of the business and have been properly authorized by
management

Accuracy is concerned with minimizing errors by ensuring that data and transactions are correctly
captured, processed and allocated.

Completeness is concerned with ensuring that data and transactions are not omitted or incomplete.

Understanding control activities in a computerized accounting system

2.1 Introduction
User controls are also called manual controls and they include all the controls which people carry
out, e.g. signing a cheque.

2.2 Segregation of duties

Segregation of duties in a computerized environment is achieved by controlling access which
employees have to the system itself, the application on it, and the modules or functions within the
application. This is achieved by setting up user profiles on the system for each employee which
detail exactly what that employee must be given access to and what he can do when he has access,
e.g. read a file, write to a file, make an enquiry, authorize a transaction, etc.

2.3 Isolation of responsibilities

In a manual system, this is achieved by making a specific employee responsible for each function or
procedure and requiring that the employee sign a document to acknowledge having carried out the
procedure.

A computerized system can enhance isolation of responsibility by programming the computer to

produce a log of who did what and when they did it. Access controls also contribute to isolation of
responsibility. Passwords can also restrict (isolate) access.

2.4 Approval and authorization

Approval and authorization can be a user (manual) procedure, e.g. signing a document, or an
automated (programmed) control. In a computerized system the authorization and approval of a
transaction can be carried out far more effectively and efficiently than in a manual system. For
example:
 an order clerk who wants to place a purchase order with a supplier who is not approved by
the company, will be prevented from doing so because the system will not allow an order to

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 be initiated on the system if the supplier is not on the approved supplier (creditors)
masterfile.

A computerized system is very effective at preventing unauthorized transactions from taking place. It is
certainly true that these kinds of controls can be overridden, but overrides will be logged by the
computer and should be followed up. Logging and follow up is a detective control.

Another advantage or approval on the system is that the parties involved do not have to be
geographically close.

One potential risk with regard to approval / authorization in a computerized system is that the initiation
and execution of transactions may be automatic with no visible or actual authorization of the
transaction, e.g. the rate of interest paid on a savings account at a bank, or the rate of interest charged
on a debtor’s account by a company, may automatically increase when the savings balance reaches a
specified amount or the debt has been outstanding for a specified period of time.

2.5 Custody
In the case of cash in the bank, the company does not have physical control over the cash, but must
control unauthorized removals from its bank account. In a manual system, this will be done by
controlling the company cheque book itself, limiting signing powers to senior officials (preventive
controls) and reconciling the company’s cash book with the bank statement (detective controls). In
a computerized payment system, e.g. EFT for the payment of creditors and employees, far stricter
controls must be implemented over access to the EFT facility and authorizing and releasing of funds.

2.6 Access controls

Access violations can have extremely serious consequences for the business. These include:
 destruction of data;
 “theft” of data;
 Improper changes to data;
 Recording of unauthorized or non-existent transactions

 Access to particular applications can be restricted to particular terminals, e.g. the ability to affect an
EFT transfer can be restricted to the terminal of the financial manager.
 Access is restricted in terms of user profiles at both systems level and applications level, e.g.:
- at systems level, access to a particular application may be restricted to particular users,
- at application level, access to specific program functions may be restricted to particular users on
the “least privilege” basis e.g. sales order entry is limited to telesales operator
 PC time out or automatic shutdown will prevent continued attempts to access the system, as well as
the threat of employees leaving their terminals unattended.

The “least privilege” principle may be implemented in a number of ways:

a) restrictions on access to a module or program function e.g. masterfile amendments;
b) restrictions in terms of mode (type) of access, e.g. read-only;

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 c) restrictions in terms of time of day (e.g. working hours only as in a bank or telesales call centre);
d) extent of access to data (e.g. allowing only restricted views of certain data so that sensitive data
fields are hidden to users of lower privilege levels)

In effect a user:
 must identify himself to the system with a valid user ID;
 must authenticate himself to the system with a valid password;
 will only be given access to those programmes and data files to which he is authorized to have
access to

2.7 Comparisons and reconciliation

A reconciliation is a comparison of two different sets of recorded information or of recorded
information and a physical test. In a manual system this is done by employees laboriously
comparing the two sets of information to identify differences. In a computerized system this
reconciliation can be completed accurately, comprehensively and in no time at all.

Along with the ability for a good computerized system to produce any number of reports, including
those which can be printed out and used for physical comparisons, its ability to instantly compare
any data on the system makes comparison and reconciliation a valuable and effective control
activity.

2.8 Performance reviews

These control activities include reviews and analysis of actual performance versus budgets, forecasts
& prior period performance as well as relating different sets of data to one another. The huge
advantage which a computerized system has is its ability to produce numerous useful reports,
including comparisons, reconciliations and reasons for differences. For example, provided the
necessary data is in the database, sales can be extensively analysed, reports can be generated to
show what quantities or products are selling, which specific models or colours or sizes are most
popular or are not selling, what gross profit is being generated from each sale, the region in which
the products were sold, etc.

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 Study Unit 4.1
Batching

1. Batching
1.1 batch entry, batch processing / update
1.2 on-line entry, batch processing / update
1.3 on-line entry, real time processing / input

1. Batching
Batching is a technique which assists in controlling an activity which will be carried out on a batch of
transactions with the intention of making sure that all the transactions in a batch are subjected to the
activity.

Batching still has a place, for example in a wage system where up to date information is only needed at
weekly intervals. The daily hours worked by each employee will be accumulated and then entered
individually as items in a batch & processed in a batch. The following description of batching illustrates
the principle of batching at the input stage:

 Source documents are grouped into separate batches of say 50, and the following control totals
manually computed:
 financial totals: totals of any fields holding monetary amounts;
 hash totals: totals of any numeric field e.g. invoice number;
 record counts: totals of the number of records in the batch e.g.50

 A batch control sheet should be prepared and attached to each batch. The batch control sheet
should contain:
 a unique batch number e.g. batch 3 of 6, week ending 31/7/14;
 control totals for the batch;
 identification of transaction type e.g. invoices;
 spaces for signatures of all people who deal with the batch e.g. prepared by:…., checked
by:…., reviewed by:…..

 A batch register should be used to record physical movement of batches; the register should be
signed by the recipient of the batch after checking what is being signed for, e.g. transfer of the
clock cards to the payroll department.

Note: Batching assists with the following:

- Identifying data transcription errors (e.g. incorrect values keyed due to transposition errors);
- Detection of data captured into incorrect fields;
- Detection of invalid (e.g. duplicate) or omitted transactions, e.g. if a clock card is entered twice

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1.1 Batch entry, batch processing / update
 Data is captured initially onto manually prepared source documents e.g. sales invoice.

 These source documents are then collected into batches & entered via the keyboard with
control totals in these batches. Relevant program checks take place as the information is keyed
in e.g. validation check on employee number. The information is converted into machine
readable form and held on a transaction file.

 These transactions are then processed as a batch when it is convenient to do so and the
relevant masterfiles are updated to reflect the effect of the entire batch on affected masterfile
balances. Control totals before and after processing are compared.

 Not common, particularly as it is slow and information is not up to date.

1.2 On-line entry, batch processing / update

 Data is entered via a keyboard immediately as each transaction occurs, e.g. a sales order is
placed by telephone & the operator keys in the details as the conversation with the customer
takes place. Relevant program checks take place as information is keyed in.

 The information is converted into machine readable form and held on a transaction file.

 Control totals are created by the computer on the batch for the transaction file.

 The transactions are then processed as a batch and the relevant masterfiles are updated to
reflect the effect of each transaction in the batch on affected masterfile balances, e.g. they
could be processed at the end of each day

 Entry of the transaction is efficient, but information is not immediately up to date. The longer
the period that the batch of transactions is not processed, the less up to date the information.

1.3 On-line entry, real-time processing / update

 Data is entered via a keyboard immediately as each transaction occurs. Relevant program
checks take place as information is keyed in.

 The relevant masterfiles are updated immediately to reflect the effect of each individual
transaction on affected masterfile balances, e.g. a seat booked on an airplane will instantly
update the “seats available masterfile”.

 Entry of the transaction is efficient & information is right up to date.

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Activity:
The purpose of control totals in a CIS environment is to detect the loss of or non-processing
of input documentation or data, or errors in data preparation.

Using examples, describe and illustrate three (3) different kinds of control totals that comply
with the above requirements.

Feedback:

Explanation of control total Example

Financial total: the total of a field containing a Rand value of the sales represented by all the
monetary value sales invoices in a batch
Hash total: a total calculated on any numerical Total of all the debtors’ numbers of all the sales
field invoices in a batch
Record counts: the total of the number of The number of sales invoices in a batch, eg 50
physical records keyed in during data
preparation

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 Study Unit 4.2
Screen Aids and Related Features
Screen aids have been classified as all the features, procedures and controls which are built in to the
application software & reflected on the screen to assist a user to capture information accurately and
completely, and to link the user’s access privileges to the screen in front of him.

1. Minimum keying in of information

The principle is that the less information that has to be keyed in, the less errors are likely to occur &
the less time it takes, e.g.:
- in a telesales system, the customer should be required to give only his account number or name
which, when keyed in, will automatically retrieve all other standing details, provided the account
number is valid.
- techniques such as “drop down” lists which simply require the user to “select and click” the
option they require from the options provided on the dropdown list.

2. The screen should be formatted

The screen should be formatted in terms of what hardcopy would look like e.g. when entering an
order from a customer the screen should look like the sales order, and should have easily
recognizable fields into which data is entered such as a box with the letters QTY above it.

3. Extensive use of screen dialogue and prompts

These are messages sent to the user to guide him, e.g. a prompt may appear on the screen
reminding the user to confirm and re-enter a field.

4. Mandatory fields
Keying in will not continue until a particular field or all fields have been entered. Such fields may be
hi-lighted in red or identified by a star or there may even be a prompt if the user misses out that
field & moves on to the next field.

5. Shading of fields
Which will not react if “clicked on”, e.g. an on-screen sales order may have the customer’s account
number & details shaded, the user completing the sales order will not be able to change these
fields.

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 Study Unit 4.3
Programme Controls – Input and Processing
It is essential to design and implement controls around the input of data to ensure that the datathat is
entered to update masterfiles occurred and is authorised, complete and accurate.

If management neglects to design and implement controls for the input of data, the followingerrors are
possible:
 Unauthorised data could be entered
 Input errors could occur;
 Data could be lost during input;
 Data could be added or modified during input;
 Errors could occur when rejected data is corrected and re-entered.

It is also necessary to implement controls during data processing to ensure that only occurredand
authorised, complete and accurate data is processed.

If management omits to design and implement controls for the processing of data, the followingare
among the errors that could occur:
 Data could be lost during processing
 Invalid data could be added during processing
 Data could be modified during processing
 Computational or accounting errors could occur

Programming controls – input and processing

Programme checks are controls which are built into the application software, with the intention of
validating/editing information / data which is entered or processed. Validation can take place at the
input and / or processing stages. Vast quantities of transactions can be subjected to a range of
programmed controls to consistently produce reliable information. Errors are reduced and information
is provided timeously.

1. Programme checks - input

a) Existence / validity checks
 validation checks validate data keyed in against the masterfile e.g. a customer’s account
number will be checked against the debtors masterfile
 matching checks amount to input being matched against data that is already in the database
 data approval / authorization checks test input against a preset condition e.g. to make a sale on
credit, a liquor store requires that the customer’s identity number be entered on a computer
generated invoice. If the customer is under 18 (which the identity number will indicate), a sales
invoice cannot be generated (the sale is not authorized).

b) Reasonableness and limit checks

 limit checks detect when a field entered does not satisfy a limit which has been set, e.g. the
normal hours worked by an employee in a week cannot be entered at a quantity greater than 40
hours
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  reasonableness checks to accept the data being entered, must fall within reasonable limits
when compared to other data, e.g. if a normal order from a customer for an inventory item is
100 units, and a clerk enters 1,000, the screen will display a message querying the entry,
although there is no limit on the quantity ordered.

c) Dependency checks
An entry in a field will only be accepted depending on what has been entered in another field, e.g.
the acceptability of entering a credit limit of R 100 000 on a debtors account will depend on the
status allocated to the debtor. If the debtor’s credit status rating is A+ (very good), the credit limit
of R 100 000 will be acceptable. If the status is only B+ then the credit limit will not be acceptable.

d) Format checks
 alpha-numeric checks prevent / detect numeric fields which have been entered as alphabetic &
vice versa, e.g. when entering an employee’s identity number, all digits must be numeric
 size checks detect when a field does not conform to pre-set size limits, e.g. an identity number
entered must have 13 digits
 mandatory field / missing data checks detect blanks where none should exist, if a quantity is
not entered in a quantity field on an internal sales order, data capture cannot continue
 valid character and sign checks, the letters, digits or signs entered in a field are checked against
valid characters or signs for that field, e.g. a minus sign (-) could not be entered in a quantity
order field

e) Check digits
A check digit is a redundant (extra) character added to an account number, part number, etc. the
character is generated by manipulating the other numerical characters in the account number.
When the account number is keyed in, the computer performs the same manipulation on the
numerical characters in the account number and if it has been entered (keyed in) correctly, the
computer will come up with the same check digit which was added to the account number
originally. If it does not match, the computer sends a screen message to inform the operator that
the account number has been incorrectly entered. Check digits use up processing resources &
therefore are limited to critical fields. They cannot be used on financial fields.

f) Sequence checks
Detect gaps or duplications in a sequence of numbers as they are entered, e.g. if numbered
masterfile amendment forms are being keyed in, a sequence check will alert the user if there is a
gap or duplication in the numerical sequence.

Where information is entered off a source document, the source document should be:
 Pre-printed, in a format which leaves the minimum amount of information to be manually filled in;
 Pre-numbered, sequencing facilitates identification of any missing documents;
 Designed in a manner which is logical and simple to complete & subsequently enter into the
computer, e.g key pieces of information should have a prominent position on the document;
 Should be designed to obtain blank blocks which can be used for authorizing or approving the
document;
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 Unused source documents should be kept under lock and key by an independent person and a
register of receipt and issue of the document kept.

2. Programme checks – Processing

Processing controls assist in ensuring that data is processed accurately and completely.
Processing will not normally stop if an error is discovered. The error will be written to an exception
report.

a) Programme edit checks

 Sequence test the sequence of documents processed is checked for gaps, e.g. after processing
credit notes, the computer may identify missing credit note numbers
 Arithmetic accuracy check e.g. reverse multiplication
 Reasonableness / consistency / range tests after processing of a transaction has taken place,
the result is compared by the computer itself to other information for reasonableness e.g. a
wage of R 5000 is not reasonable for a grade 3 employee or compared to his prior week’s
earnings
 Limit test identifies amounts which fall outside a predetermined limit after processing, e.g.
credit sales to a customer have pushed the debtor’s balance owing beyond the customer’s
credit limit
 Accuracy test, where amounts are allocated to columns & the columns are independently cast
(added up), the totals of the columns can be cross cast (added across) and compared to the total
amount allocated e.g. net pay + paye + medical aid deduction = gross pay
 Matching in the context of processing is about comparing data which has been processed,
against data which is already in the database, e.g. a matching control may match clock cards
processed with the employee masterfile to identify employees for whom there was no clock
card information. The reason there is no clock card may be perfectly valid, e.g. the employee
was on holiday for the week, but it could also be a processing error.

b) Programme reconciliation checks

 Control totals, e.g. record counts, hash totals from input are compared to record count and
hash totals after processing
 Run-to-run totals, a final balance arrived at after processing is compared to the opening balance
and individual totals of transactions e.g. the closing balance on debtors (31 May) is compared to
the opening balance on debtors (30 April) plus the total of May sales (debits) less the total of
May receipts (credits)

The reliability of hardware also plays an important part in processing. Modern computer equipment is
very reliable, and the hardware will have its own range of hardware controls, e.g.:
 Parity checks: a redundant bit is added to data to make the sum of the bits in the data
concerned, even (even parity) or odd (odd parity). Changes in parity detected as a result of this
check indicate that an error has occurred in transmission or processing.

 Valid operation code: the processor checks if the instruction it is executing is one of a valid set
of instructions.
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  Echo check: the processor sends an activation signal to an input / output device – that device
returns a signal showing it was activated. Echo checks can also be used to detect corruption of
messages in transit by bouncing the signal back from the recipient of the message to the sender
so that the sender can compare it against the original message for any errors, which may have
occurred during transmission.

 Equipment check: input / output devices are activated prior to a read / write operation to
ensure they work correctly.

Activity:
Name and describe four types of built-in hardware controls with reference to suitable
examples.

Feedback:

Built-in hardware controls Description

Parity check The computer adds a redundant bit to a field on the basis of the
logical relationship between the characters that make up the
field. lf the field is sent from the computer to a printer, the printer
recomputes the bit and compares it with the original bit attached
to the field during processing. This ensures that the processed
information is not altered during transmission to a printer.
Valid operation code This test ensures that a computer will only carry out valid actions.
During the processing of clock cards this test ensures that the
number of hours is multiplied and not divided by the hourly wage
rate.
Echo test This is a test that ensures that information is correctly transmitted
from one component to another. lf the computer is processing
wage cards, for example, and the information is sent to the
printer, the printer will echo the information to the computer. The
computer will then compare the information received from the
printer with the information that was originally sent over.
Equipment test This is a test carried out by the computer when it is switched on.
This test determines whether all the components of the computer
are present and are functioning correctly. For example, the
computer would perform a test to determine whether the disc
driver is functioning correctly.

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 Study Unit 4.4
Output Controls
The output of a data processing system can be stored in machine-readable form, visuallydisplayed or
printed on paper. Output controls mainly pertain to printed output, although controlover visual display
is also important.

The objective of output controls is to ensure that output is accurate and complete and that its
distribution is strictly controlled, for example, confidential output does not go to the wrong individuals.
Output does not have to be hardcopy; it can be “on screen”.

Controls over distribution will include preventive controls such as:

 clear report identification
o name of report
o time and production number of report
o processing period covered
o sequenced pages and “end of report” messages

 a distribution matrix of who is to receive which output and when. This should be aligned to the user
profiles & access privileges so that individuals who do not need access to the report, etc, cannot
access them on the system

 if output is hardcopy & printed out at a certain point and distributed to users, its movement should
be controlled by the distribution list (who gets what and when)

 output which is confidential should be designed to promote confidentiality, e.g. “sealed envelope”
salary slips

 confidential information for employees which is emailed to them (such as payslips) should not be
emailed to their work PC’s

 output which is printed out, especially more sensitive information, should be printed out only in the
departments which require the output, and if it is confidential, under the supervision of authorized
personnel

 input which is not required should be shredded, not just left about or thrown away as a complete
document

User controls will include (all detective controls):

 review of output for completeness e.g. numerical sequence check

 reconciliation of input to output e.g. foreman of each cost centre reconciles overtime worked with
his factory overtime records

 review of output for reasonableness e.g. financial manager reviews, week-to-week wage
reconciliations (payroll manager will conduct detailed tests on the week to week wage reconciliation
produced by the system)

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 review and follow up of any exception reports produced during processing e.g. individual wage
payments which failed “reasonableness test” during processing

Activity:
1. Describe how the “occurrence and authorisation” objective for output controls differs
from the “occurrence and authorisation” objective for input and processing controls.
2. Describe the output controls over the distribution of documentation to users.

Feedback:

1. The “occurrence and authorisation” objective is changed to "correct and confidential

distribution” because an important part of output control is to ensure that output is
distributed to an authorised user.

2. Controls to achieve the “occurrence and authorisation” objective for

outputcontrols:
 Clear report identification practices must be implemented, for example:
- the name of the report
- the time and production number of the report
- the processing period covered
- sequenced pages

 Compilation of a distribution checklist, which identifies all the items of output and
indicates who the authorised recipient of the output is.

 Recording of output in a distribution register to control movement. The recipient ofthe

output must be asked to sign for receipt of the output.

 The print function for the printing of confidential information should be restricted to
printers that are under the control of suitable officials.

 The design of stationery must promote confidentiality, for example salary slips
should be of the “sealed envelope type”.

 Shredding of all output that is not required, such as by-products of the printing of
confidential information, for example carbon paper.

 Confidential information for employees which is e-mailed to them should not be

emailed to their work PCs.

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 Study Unit 4.5
Logs & Reports
Various logs and reports can be produced by the computer and either printed or accessed onscreen.
Access can be restricted to read-only and should be for all logs of computer activity which form part of
the audit trail.

Types of logs and reports used may include:

 audit trails – provide listings of transactions and summaries and lists of tables or factors used in
processing

 run-to-run balancing reports – which provide evidence that the opening balances which have been
updated by a series of transactions have resulted in correctly calculated closing balances

 override reports – which provide a record of computer controls which have been overridden by
employees using supervisory or management privileges. Abuse of such privileges is a threat to the
objective of validity

 exception reports – which provide a summary listing of any activities, conditions or transactions
which fall outside of parameters which have been set for control purposes, e.g. employees whose
remuneration for the week falls outside the reasonableness parameters set for employees of that
grade

 activity reports – which provide a record for a particular resource, of all activity concerning that
resource, e.g. names of users, usage times & duration of usage

 access / access violation reports – particularly important in relation to sensitive applications such as
electronic funds transfer and payroll

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 Study Unit 4.6
Masterfile Amendments (Masterfile Maintenance)
Masterfiles (which contain standing data and the latest balances) are an integral part ofprocessing. If
these files are not protected against unauthorised amendments, there is apossibility that the
information generated by the processing may be invalid. The following areexamples of masterfile
amendments:

 A supplier is added to or deleted from the list of authorised suppliers

 The particulars of a member of staff are added to or deleted from the salaries masterfile

The application controls over masterfile amendments are very important. The objective will be that:

a) only valid (authorised) amendments are made to masterfiles

b) the details of the amendment are captured & processed accurately & completely
c) all masterfile amendments are captured & processed

Below is an example of the controls over a debtor’s masterfile amendments:

Procedure Application control and related comments

1. Record all masterfile 1.1 All amendments to be recorded on hardcopy masterfile

amendments on a source amendment forms MAFs (no verbal instructions)
document
1.2 MAFs to be pre-printed, sequenced & designed in term of
sound document design principles

2. Authorise MAF 2.1 The MAFs should be:

 Signed by two reasonably senior debtors personnel
 Cross referenced to the supporting documentation

3. Enter only authorised masterfile 3.1 Restrict write access to a specific member of the debtors
amendments onto the system section by the use of user ID & passwords
accurately and completely
3.2 All masterfile amendments should be automatically logged
by the computer on sequenced logs and there should be no
write access to the logs

3.3 To enhance the accuracy & completeness of the keying in of

masterfile amendments and to detect invalid conditions,
screen aids & programme checks will be implemented

Screen aids and related features

 minimum keying in of information. For example when
amending existing debtors records, the user will only key in
the debtors account number to bring up all the details of
the debtor

 screen formatting, screen looks like MAF, screen dialogue

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  new debtors account number automatically generated by
the system

Programme checks e.g.

 verification / matching checks to validate a debtor account
number against the debtors masterfile (invalid account
number, no amendment)
 alpha numeric checks
 range and / or limit / data approval checks on terms and
credit limit field, e.g. credit limit must be between R 5000
and R 75000 (range) or cannot exceed R 75000 (limit), and
terms can only be 30 days or 60 days (data approval)
 field size check & mandatory / missing data checks, e.g.
credit limit & terms must be entered
 sequence check on MAFs entered
 dependency checks e.g. the credit limit granted may
depend upon the credit terms granted, e.g. a debtor
granted payment terms of 90 days may only be granted
credit up to a limit of R 2000

4. Review masterfile amendments 4.1 The logs should be reviewed regularly by a senior staff
to ensure they occurred, were member e.g. financial manager
authorised & were accurately  the sequence of the logs should be checked (for any
and completely processed missing logs)
4.2 Each logged amendment should be checked to confirm
that it is supported by a properly authorised MAF and
4.3 That the detail, e.g. debtor account number, amounts,
etc. are correct
4.4 The MAFs themselves should be sequence checked
against the log to confirm that all MAFs were entered

Can you recall that input of data can be either: batch input or on-line input?
These two methods can be described as follows:

Batch input
Batch input depend on two steps: data preparation and the keystroke entry of data.

Data preparation is an off-line process in batch entry systems by means of which:

 Data is manually captured, which includes initiating, recommending, authorising and preparing
documentation for the transaction.
 Data is collected into batches for input into the computer.

The keystroke entry of data is a process where data is keyed in, converted and encoded inmachine
readable form and held in a transaction file on the computer system. During thisprocess a series of
programmed application controls are applied to make certain that the data isreliable and correct before
it is processed.

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On-line input
Transaction data is entered, via a keyboard, immediately as each transaction occurs. With onlineinput,
batch data preparation is not required and the control approach required differs fromthe approach
required for batch input. The on-line input approach involves immediate datavalidity testing and batch
controls that operate after (instead of before) input. This approachrelies heavily on general controls.

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123
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Instruction for using table 2
Certain of the application controls are applicable to a combination of masterfile amendments,input,
processing and output. For example, the screen aid that requires the minimum keying ofinformation is
applicable to masterfile amendments, the keystroke entry of data and onlineinput. This is illustrated by
the following extract from table 1:

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 Study Unit 5.1
Methods of obtaining & documenting an understanding of internal
control systems
REMEMBER: An understanding of a client’s internal control system assists the auditor in identifying
types of potential misstatement and factors that affect the risks of material misstatement, and in
designing the nature, timing and extent of further audit procedures.

NB: Components of internal control

1. The control environment
2. The entity’s risk assessment process
3. The information system
4. Control activities
5. Monitoring of controls

1. Component: the control environment

The control environment sets the tone of the organization & influences the control consciousness of its
staff. The directors and managers should, by their actions and behavior, promote an environment in
which adherence to controls is regarded as very important. If managers set a bad example, ignoring
controls & generally projecting a “slack” attitude, employees will soon adopt the same attitude. For
example, a creditors clerk whose function it is to reconcile the creditors ledger accounts to the creditors
statements, and then take the reconciliation to the financial accountant to be checked before payment
is made, will soon not bother to reconcile properly, if at all, if she knows that the financial accountant
does not check the reconciliation before authorizing the payment.

A good control environment will be characterized by:

1.1 communication and enforcement of integrity and ethical values throughout the organization;

1.2 a commitment by management to competent performance throughout the organization;

1.3 a positive influence generated by those charged with governance of the entity, e.g. non-executive
directors, the chairperson (i.e. do these individuals display integrity & ethical commitment, are they
independent, and are their actions and decisions appropriate?);

1.4 a management philosophy and operating style which encompasses leadership, sound judgment,
ethical behavior,etc;

1.5 an organizational structure which provides a clear framework within which proper planning,
execution, control and review can take place;

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1.6 policies, procedures & an organizational structure which clearly define authority, responsibility and
reporting relationships throughout the entity;

1.7 sound human resource policies and practices which result in the employment of competent ethical
staff, provide training and development as well as fair compensation and benefits, promotion
opportunities, etc

Gathering of evidence relating to the control environment can be achieved by observation of

management and employees “in action”, including how they interact, inquiry of management and
employees, e.g. union officials, and inspection of documents, e.g. codes of conduct, organograms, staff
communications, records of dismissals, etc.

Generally a strong control environment will be a positive factor when the auditor assesses the risk of
material misstatement. For example, the risk of fraud may be significantly reduced. A poor control
environment, or elements of the control environment which are poor, will have the opposite effect, e.g.
the company may have excellent human resource policies, but may lack leadership & organizational
skills. Employees may be competent but management may have a “slack” attitude towards controls.

2. Component:the entity’s risk assessment process

This is the process which the company has in place for, inter alia,
 identifying business risks relevant to financial reporting objectives;
 estimating the significance of each risk;
 assessing the likelihood of its occurrence;
 responding to the risk

This process of assessment of risk may be formal or informal. Larger organizations are more likely to
have a formal plan, e.g. specific committees who hold regular meetings, the appointment of a Chief Risk
Officer (CRO) and / or a Compliance Officer, but generally risk assessment is part of “managing”. In
doing their jobs, managers will identify and respond to risk.

Information about the client’s risk assessment process will be gathered mainly by inquiry, e.g. Risk
Officer, Compliance Officer, Chief Executive Officer, and inspection of documentation where it is
available, e.g. minutes of designated committee meetings, inter-office memo’s, on rectifying problems
(responding to risk). An effective risk assessment process is advantageous for the auditor because the
results produced by the in-house process provide the auditor with a platform to work from in assessing
risk.

3. Component: the information system

The auditor is required to obtain an understanding of the information system relevant to financial
reporting and communication. The accounting system is part of the information system. The auditor
must obtain a thorough understanding of:
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  the classes of transactions in the client’s operations that are significant to the financial
statements, e.g. sales, wages

 the procedures within both IT and manual systems, by which those transactions are initiated,
recorded, processed, corrected as necessary, transferred to the general ledger and reported in
the financial statements

 the related accounting records, supporting information and specific accounts in the financial
statements in respect of initiating, recording, processing and reporting transactions

 how the information system captures events and conditions, other than transactions that are
significant to the financial statements, e.g. contingent liabilities

 the financial reporting process used to prepare the entity’s financial statements, including
significant accounting estimates and disclosures

 controls over the passing of non-standard journal entries used to record non-recurring, unusual
transactions or adjustments

 the manner in which financial information is conveyed to management, the Board, the audit
committee and external bodies, e.g. the JSE in the case of a listed company

The chart below provides a breakdown of matters which the auditor might consider when obtaining
information about a computerized information system.

Factor Matters to consider

Computerised applications  which applications are computerised, e.g.

- payroll – not computerized
- acquisitions and payments – computerized
 computer environment
- micro, network, centralized
- use of bureau
 the application software
- purchased or in-house software
- key processing functions
- nature and scope of inputs
- output produced
- important masterfiles and tables
- interface between applications
- new or established

Hardware  makes and capacities of CPU’s, drives, printers,

servers, terminals
 physical location (branches, factory, etc)

Software  details of all software which is used for managing the

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 functions of the hardware and data
- operating systems
- database management systems
- utilities
- access control software
- programme change control software

Organisation and control  general and application controls

 communication and reporting lines
 IT personnel & their job descriptions
 steering committee details
 internal audit involvement in IT

Complexities of the system  the presence of:

- networks (LANS, WANS)
- electronic data interchange (EDI)
- electronic funds transfer (EFT)
- real time systems
- the Internet
- high levels of system integration
- complex databases, communication networks

The level of dependence (of the  degree of disruption which would occur if the system
client on its normal system) was not functioning for a lengthy period
 the dependence of a particular functional area on
timely, accurate computing, e.g. wages in a large
labour intensive industry

The auditor should be mindful that computerised (IT) systems pose specific risks to an entity’s internal
control. These risks include the following:

1. A computer will process what is input & will do so in a manner in which it is programmed. If for
example, there is an error in programming, that error will be repeated every time the relevant
transaction is processed, e.g. a programming error results in the VAT on sales being calculated on
the selling price plus VAT e.g. 14% of 114%. If 5000 invoices are processed the computer will make
the mistake 5000 times.

2. Unauthorised access to data can result in instant and huge destruction or contamination of data e.g.
deletion of the debtors masterfile.

3. IT personnel gaining access privileges they should not have, resulting in a breakdown of segregation
of duties e.g. a systems analyst gains access to the salaries masterfile and alters his salary.

4. Unauthorised changes to data in masterfiles, systems or programmes.

5. Processing of fraudulent transactions instantaneously, e.g. unauthorized funds transfer which

almost instantaneously moves money out of the company’s bank account.

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6. Potential denial of access to electronic data e.g. can’t get into the database because of system
failure.

The auditor should also be mindful that the information system as a whole, or elements of it, can be
placed at risk, by for example:

 New employees who have a different understanding of, or attitude to internal control, e.g. a newly
appointed IT manager has a less strict attitude to access controls than his predecessor;

 Rapid growth in the company which places severe strain on the controls, e.g. a significant increase
in the demand for the company’s products has resulted in the company letting its creditworthiness
checks lapse (so as not to lose sales) due to a lack of time and staff to carry out the checks.
Automated (programmed) controls relating to creditworthiness may be overridden permanently or
disabled;

 New technology which can lead to disruption of internal controls – introducing a network system
may result in data being lost or corrupted;

 Introducing new business models which may result in the existing internal controls being rendered
inadequate, e.g. introducing sales over the Internet to a long established (physical) retail business
may introduce problems in controls over banking, receipt and dispatch of goods, etc.;

 Corporate restructuring which may result in staff reductions, new lines of authority etc., thereby
jeopardizing for example, division of duties and authorisation controls

Details of the information system (including the accounting system) can be gathered by:

1. Inspection (or creation) of flowcharts of the system;

2. Observation of the system in action, e.g. what happens when goods are delivered by a supplier;
3. Inquiry of client staff and the completion of internal control questionnaires;
4. Discussions with prior year audit staff, management and possibly outsiders, e.g. application
software suppliers;
5. Discussions with internal audit staff and review of internal audit workpapers;
6. Tracing transactions through the information system, sometimes called “walk through” tests

4. Component: control activities

Control activities are the policies and procedures that are implemented to ensure that management’s
objectives are carried out.
Control activities include things such as:

 authorisation of transactions (which is a form of isolating responsibility);

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  segregation of duties .g. separating custody of inventory from keeping of inventory;

 physical control over assets, e.g. restricting access to the warehouse;

 comparison and reconciliation, e.g. reconciling the bank account monthly;

 access controls, e.g. access tables, user profiles, IDs and passwords in a computerised
environment;

 custody controls over blank / unused documents, e.g. cheque books, order books;

 good document design (to achieve accuracy and completeness of information);

 sound general and application controls in IT systems

Information about control activities will usually be gathered in the same way as information about the
information system as a whole is gathered, e.g. inspection of control procedures, manuals, observation
of controls in action, inquiry of employees as to the procedures they carry out and the completion of
internal control questionnaires.

5. Component: monitoring of controls

Monitoring of the system tells management how well the internal control process is doing over time.
Management (and the board) wishes to know if controls are operating as intended and monitoring
assists in providing this information. Monitoring as a component of the internal control process looks at
all of the components of the process not only at the control activity component.

In larger companies, internal audit usually contribute to the effective monitoring of control activities,
and the external auditor will frequently rely on work carried out by the internal auditor. Information
from outside the company can also provide meaningful insight into whether the “system is working”,
e.g. monitoring complaints from customers will often give a good indication of aspects of the business
which are not functioning as required.

Information about monitoring can be obtained by the auditor by inquiry of management and staff
working with internal audit and inspecting documentation relating to a monitoring process or
performance reviews.

The methods of obtaining information and knowledge comprise the following:

 Walk-through tests of the system
 Enquiries and discussions
 Inspection of documentation
 Observation of internal controls and processes
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 Internal control questionnaires

The following table describes the various methods use dto form an understanding of the components of
internal control. Each method is explained with reference to an example.

Methods of obtaining an Description of method Example

understanding of the various
components of internal
control

System walk-through tests This is the process where an The auditor chooses a
auditor selects a number of purchase order for
documents by which a certain ordering stock &
transaction type is initiated & determines by means of a
then follows the trail through walk-through test whether
the entire accounting process it is made out in triplicate &
that the first copy is sent to
the creditor, the second to
the accounts department&
the third to the warehouse.
The auditor does the same
for all the transaction
classes

Enquiries and discussions Meetings can be scheduled The scheduling of a

with management & the staff meeting with the managing
so that they can give the director to discuss the risk
auditor information on the assessment process
internal controls in the various
transaction cycles.

Information on the system can

also be obtained by holding
discussions with the previous
year’s audit personnel, third
parties and the internal
auditors

Inspection of documentation The auditor could study various The study of systems
documents in order to obtain flowcharts (prepared by
an understanding of the the client), systems
internal controls present in the descriptions (prepared by
various transaction cysles the client), operating
procedure manuals and
the previous year’s audit
working papers

Observation of internal Internal controls and processes The auditor can determine
controls and processes can be observed by the auditor through physical
inspection what happens
when goods are delivered
by the supplier
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Internal control Since internal control
questionnaires objectives and the way they
are achieved are largely the
same from one system to the
next, most auditors find that
both efficiency & effectiveness
are greatly increased by
designing an internal control
questionnaire (ICQ) to identify
the expected internal controls.
The ICQ is then used to
document the internal control
system. The ICQ is usually
divided into transaction cycles
covering the main transaction
flows in a typical company.
The ICQ can be classified on
the basis of the internal control
objectives that should be
achieved by the client’s internal
controls at every stage of the
transaction processing. The
ICQ is also a convenient way
of documenting the specific
internal controls that the
auditor wants to test for
compliance. The questions in
the ICQ are usually worded in
such a way that only a “yes” or
“no” answer is required to
indicate the presence of
absence of internal controls.
An ICQ contributes to an
auditor’s understanding of the
design and functioning of the
internal control structure, but it
does not contribute to an
understanding of its
effectiveness

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Activity:
Your firm has recently been appointed as the auditors of Echo Ltd, a company in the tourist
industry. You are of the opinion that the use of internal control questionnaires would have
many advantages for you as an auditor and that a questionnaire could be quickly compiled
at the beginning of the audit.

Compile an internal control questionnaire that will enable you to evaluate Echo Ltd’s internal
control over their investments.

Feedback:

Internal control questionnaire:

Question Yes No Comments
1. Are all the investment documents under the control of a
custodian
2. Are investment documents kept in a safe or in a safe-
deposit box at the bank?
3. Is the presence of more than one person required
before the safe or safe-deposit box is opened?
4. Are investment documents periodically inspected &
reconciled with the accounting records?
5. Does the securities custodian also have access to the
accounting records?
6. Are registered securities held in the name of Echo Ltd?
7. If registered securities are not held in the name of the
auditee, are they properly endorsed in blank, or in the
name of an authorized agent or in the name of a
nominee, or is a power of attorney attached?
8. Are securities held as collateral or securities held for
safekeeping for other parties properly segregated, both
in the records and physically?
9. Does the accounting department maintain an
independent record of each investment security?
10. Is all investment income properly accounted for?
11. Are purchases and sales of investments properly
authorized?
12. Do the minutes of the board of directors authorize the
acquisition of the securities of other companies?

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Activity:
Your firm has recently been appointed as the auditors of Local Architects (Pty) Ltd. The
company uses information technology systems for their financial reporting and for operating
purposes. They contacted you to discuss the specific risks that information technology
involves for their internal control. You are of the opinion that the use of an internal control
questionnaire enables you to obtain an understanding of the design and operation of the
company’s internal controls.

Draw up an internal control questionnaire that will enable you to obtain an understanding of
the design and operation of Local Architects (Pty) Ltd’s internal controls over unclaimed
wages.

Feedback:

Internal control questionnaire:

Question Yes No Comments
1. Do the paymaster & the foreman record the particulars
of unclaimed wages in an unclaimed wages register?
2. Does the paymaster keep the unclaimed wage
envelopes & wages, and are they stored in a locked
area?
3. Do employees identify themselves to the paymaster
when they collect unclaimed wages?
4. When they collect unclaimed wages, do employees
acknowledge receipt of their wage envelopes by
signing the unclaimed wages register?
5. Are periodical independent reconciliations between the
unclaimed wage envelopes on hand and the unclaimed
wages register carried out?
6. Is the unclaimed wages register inspected for any
unusual events?
7. Are any wages that remain unclaimed after two weeks
banked?
8. Is a copy of the deposit slip with cross-references to
the relevant entries attached to the register?

Methods of documenting the understanding of an internal control system that

has been obtained

It is essential that an auditor record his understanding and knowledge of an entity’s internal control
system in audit working papers. There are several methods that the auditor could use to document the
internal control processes of an entity. These methods include:

 Systems descriptions
 Representation of systems and programs on flowcharts
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These methods are described below:
Methods of documenting the Description
understanding of an internal
control system obtained by
the auditor

A description of the system A description consists of the auditor’s written comments on

an auditee’s internal control structure. These comments can
be used to supplement other forms of documentation,
because they are a summary of the auditor’s general
understanding of the internal control structure, individual
elements of the internal control structure or other specific
internal controls that are related to a specific control
objective.

For an audit of a small business, a description could serve as

the onlhy documentation of the auditor’s understanding of the
internal control structure. In this case the description would
indicate the sources of the knowledge that was obtained, and
identify aspects of the internal control structure that are of
importance for audit planning.
Systems and program flowcharts are used by auditors to
Flowcharts represent the flow of information through the accounting
system in visual terms. Systems flowcharts represent the
broad flow of documents and data graphically, and program
flowcharts illustrate the processing logic of computer
programs in detail. There are numerous conventions for the
preparation and use of systems and program flowcharts.
These conventions cover aspects such as the flow of
information and standardised symbols.

Over the years audit firms have developed a variety of

specialised techniques for compiling flowcharts. Flowcharts
facilitate the overview and documentation of internal control
systems.

To understand or prepare a flowchart, an auditor must know

the meaning of the specialised symbols that are used.

Internal control flowcharts are usually prepared for

accounting sub-systems such as cash receipts, wages, etc. If
a system is too comprehensive, flowcharts can be compiled
for a single class of transactions.

Internal control flowcharts are usually divided into vertical

columns, where each column represents a separate
functional department (or an individual employee) responsible
for the internal control activities for the processing of the
relevant transactions. Flowcharts are usually arranged in
such a way that processing begins either in the top right-hand
corner or in the tope left-hand corner. Arrows and flow lines
indicate the sequence of processing.

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 The location and arrangement of files and multicopy
documents in the department are shown by means of
symbols. Important internal checkpoints can be identified
and described by means of brief narrative descriptions.

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 Study Unit 5.2
The design of internal control systems
Basic functions for any revenue and receipts cycle:

(Insert photocopied pages into this section)

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Framework that can be used in designing an internal control system for manual
systems

1. Divide the system into phases on the basis of the flow of information:

 Typically a purchase or sales system would be divided into orders, deliveries, invoicing, recording
in the accounting records and processing in the general & subsidiary ledgers.

 Similarly a wages system is divided into appointments and discharges, hours worked, preparation
of the payroll, wage disbursements and unclaimed wages.

2. Identify the key documents or records for each phase of the flow of information.

3. For each document, identify the key information that should be recorded. This information is
usually related to:
 Person: the person with whom the client has entered into a transaction
 Price: the price at which the transaction was entered into
 Quantity and description: the quantity of the transaction entered into and the description of the
goods and services

4. The following specific internal control objectives must be applied to all information in every
document:

 Validity
- Must the information be authorised? If so, how and by whom?
- Does the information represent an actual (valid) transaction with a bona fide third party? If so,
who checks it, against what and how? - This is usually achieved by comparing the information
with other documentation.
- You need to indicate which information should be processed, by whom and whether a manual is
required.

 Accuracy
- Should the information be checked to see whether the amount is accurate? If so, how and by
whom?
- Should the information be processed to a specific account? If so, how does the client ensure that
this is done?
- You need to indicate which information or documents should be processed, by whom and
whether a manual is required.

 Completeness
- Are sequential documents used?
- Who checks the numerical sequence?

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 - Remember to state who the document should be sent to, who should check the numerical
sequence and who should handle the missing items.

We shall illustrate steps 1-4 with the aid of an example before proceeding to step 5.

The following example relates to credit sales:

Step Respective steps as set out in the Example relating to credit sales
above framework
1 Divide the system into phases on the Phase 1 of the credit sales cycle: Client
basis of the flow of information commits himself to a sales transaction
2 Identify the key documents or records Order forms
for each phase of the flow of information
3 Identify the key information that should be The client’s name, the selling price,
recorded for each document discount, quantity and description of the
goods
4 Apply specific control objectives for each Validity: The credit section must give
piece of information on each document permission on the basis of the client’s
credit-worthiness. The price must be
compared with the price list. The
document given must be agreed to the
discount terms. Once all the above steps
have been completed, the credit section
would grant authorisation.

Accuracy: The order form must be

checked for accuracy by a senior person,
in other words the selling price must be
recalculated by multiplying the price with
the quantity.

Completeness: The inventory section

must check the numerical sequence of the
order forms and follow up any missing
numbers.

5. In the recommended system you should always indicate who is responsible for carrying out the
internal control, how the internal control should be carried out, when the internal control should be
carried out, what internal control should be carried out and on what documentation the internal
control should be carried out.

6. Remember that in all cases the document must be signed as evvidence that the internal control has
been carried out.

7. Conclude by making certain that all the types of control activities in the entire system have been
covered.
 The approval / authorisation of transactions;
 Segregation of duties, in other words, the distribution of core functions to different members
of staff;

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  Isolation of responsibility. Always remember to mention that a document must be signed as
evidence that the internal controls have been carried out;
 Access and custody controls. For example, internal controls are required to ensure the
safekeeping of assets and unused stationery;
 Comparison and reconciliation – for example, the comparison of a creditors’ statement with
the creditors’ account, and the performing of key reconciliations which are subject to
management review;
 Performance reviews – for example, review of the company’s performance against the budget

Framework that can be used to design an internal

control system for computerized systems
 Systems modification controls are methods of ensuring that authorisation takes place, in other
words, whether requests for systems modification are evaluated and authorised in advance by the
user department and the information technology manager

 Batch controls are implemented mainly to ensure accuracy, although they also affect validity and
completeness

 Regarding completeness, a computerised system usually assigns unique sequential numbers to

transactions and carries out sequence checks to ensure that all transactions have been processed

General pitfalls in the design of an internal control system

The following shortcomings are often found in the design of an internal control system:

 Obvious principles of internal control are often omitted, such as that there must be adequate
segregation of duties between the person who receives payments and the person who does the
daily banking of cash.

 Information supplied with the question is often not used. Always remember that the
information given must be applied in your anwer.

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  Students often fail to give a full description of the necessary internal controls. Read the
following two internal controls:

- Statement 1: At the beginning of each week, the clerk must prepare a clock card for each
employee from the permanent files, and issue these cards to the factory.

- Statement 2: A clerk must prepare a clock card for each employee and issue it to the factory.

There is an obvious difference between these two statements. Statement 2 does not contain sufficient
detail. As stated above, it is always necessary to indicate who should carry out the internal control, how
the internal control should be carried out, when the internal control should be carried out, what
internal control should be carried out, and on what documentation the internal control should be
carried out. See the following table for a further explanation:

Requirements Statement 1 Statement 2

Who carries out the internal The clerk The clerk

control?
How is the internal control From the permanent files Missing – clearly
carried out? indicates a lack of
sufficient detail
When is the internal control At the beginning of each Missing – clearly
carried out? week indicates a lack of
sufficient detail
What internal control is carried Preparation of a clock card Preparation of a clock card
out? for each employee and issue for each employee and
of the cards to the factory issue of the cards to the
factory
On what documentation is the Clock cards Clock cards
internal control carried out?

Note that these questions (who, how, when, what and on what) cannot always be answered and
included in your answer. Nevertheless it is a good idea to test each internal control that you write down
against these questions, to see whether you have left out important details. Let us examine the
followinng internal controls and test them against the requirements:

Unused cheque books must always be kept in a safe place by the cashiers

Requirements Feedback
Who carries out the internal control? The cashiers
How is the internal control carried out? This information is not provided & therefore this
question cannot be answered
When is the internal control carried out? Always
What internal control is carried out? Safekeeping
On what documentation is the internal Unused cheque books
control carried out?
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Design of Internal Control Systems
The desing of internal control systems is illustrated by the following two activities.

Manual Systems
Activity

Your firm has been appointed the auditors of a primary school. An amount of R 1,5 million has been
donated to the school by a well-known listed company in the engineering sector for the establishment
of a sports centre on the school’s premises. The sports centre includes two squash courts, two tennis
courts, a swimming pool and a shooting range. The directors of the listed company have stipulated,
however, that the project must be audited and that an appropriate auditor’s report must be submitted
to the directors upon completion of the project.

The headmaster is concerned about the required audit and wants to make sure that everything goes
according to plan. He approaches you, as the partner in charge of the primary school’s audit, and asks
you to put together a plan showing how the project should be handled.

List the most important internal controls that the headmaster should implement regarding the
establishment of the sports centre.

Feedback

1. A committee, and possible sub-comittee as well, should be appointed to take charge of the project

2. A separate bank account should be opened and the R 1,5 million deposited into it. This account
should be used exclusively for transactions relating to the project

3. Two persons, one being the headmaster, should be authorised to sign cheques on this account

4. An administrative official should be appointed by the committee. This person will be responsible for
all the accounting and administrative functions

5. Separate accounting records must be kept for the project. The most important record is the
cashbook. The columns in the cashbook should make provision for the various sub-projects

6. A bank reconciliation should be prepared monthly and submitted to the committee

7. A detailed time schedule for the completion of the project should be drafted by the committee

8. All meetings of the committee and sub-committees should be minuted

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9. Tenders for each project should be advertised in the local newspapers and in tender bulletins

10. Only tenders from companies with a strong financial background and a good reputation should be
considered.

11. A tender may only be accepted after the committee has considered all the tenders received

12. The acceptance of a tender should be accepted at a committee meeting. Committee members who
have an interest in a particular tender should disclose such interest and should not take part in the
voting on the tender in question

13. Contracts with approved tenderers should be drawn up by a legal advisor appointed by the
committee

14. All documents should be placed in safekeeping by a responsible officer

15. Each payment should be approved in writing by either the committee or the sub-committee,
depending on the amount involved

16. All relevant documentation and the written approval of the committee should be submitted to the
headmaster before he signs a cheque

17. The documents should be stamped “Paid” by the financial officer after payment has been made

18. All cheques should be crossed

19. Unused cheque books should be kept in a safe place by a responsible person

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Computerised Systems
Activity

You are engaged in auditing the wages system at one of your clients. After extensive enquiries and
observations, you have compiled the following simplified system flowchart:

Note:
(a) Process takes place in the wages department
(b) Process takes place in the EDP department

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The following specimen of a clock card used by the client was also supplied:

Discuss the application control measures that would ensure the valid, complete and accurate capturing
of wage data in the electronic data processing department

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Feedback

Application controls within the EDP department to ensure the valid, complete and accurate input of
wages data:

Data preparation

1. The EDP department acknowledges receipt of each batch by signing for it and recording the
particulars of each batch in the batch register.

2. The data input clerk receives the batches from the wages section and checks them as follows:

 He checks the particulars of the batch against the information on the batch control sheet;

 The numerical sequence of the clock cards is checked by test sampling and the data input clerk
determines whether all the details on the clock cards have been completely and accurately
filled in and whether the clock cards have been duly authorised;

 The data input clerk checks compliance with batch standards, namely that standard batch
sizes have been used, a unique number has been allocated to each batch and control totals
(both financial and hash totals) have been calculated;

3. Control totals must be recalculateed and must be agreed to the control totals recorded on the batch
control sheet;

4. Error handling: If any errors are detected as a result of the above checks & comparisons, the batch
must be returned to the payroll section for rectification;

5. The screen format must be standard and must be designed to make it easier to input information
and reduce the possibility that mistakes will be made, e.g. the screen format could be made similar
to that of a standard clock card;

6. By means of on-screen dialogue, the computer must guide the input clerk through every stage of the
input process;

7. The computer must perform the following logical tests on the input fields during the input of data:

 Alphanumeric test: to determine whether the input fields consist of the correct combination of
alphabetical and/or numerical characters. The name of an employee can only consist of
alphabetical characters, e.g. and the employee number can only consist of numerical characters

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  Valid code test: a code, such as the departmental code, is compared with a programmed list of
valid codes for the payroll application
 Field size check: to test whether each field contains the correct number of characters, for
example that the employee number consists of six characters
 Sign test: certain fields may only be positive & many not contain negative values, e.g. the
number of hours worked per day and the total number of hours worked per week
 Limit test: to make certain that certain input fields fall within predetermined limits, for example
the total number of ordinary hours worked in a week may not exceed 40

A limit must also be placed on the total number of overtime hours worked. When this limit is
exceeded, approval must be obtained in advance from a senior person, such as the manager of
the wages section of a foreman.

8. During data preparation a check digit should be calculated for each field by the program and
attached to the field.

9. Error handling: the computer must display an error message as soon as an error is made during
input. Errors must be corrected immediately. The system must be programmed to block further
input until the error has been corrected.

10. Computer-generated control totals must be agreed to the control totals in the batch register, after
the input has been done for the conversion.

Batch input from the magnetic tape

1. The computer compares point-of-input control totals, which are balanced by the program after the
input of each batch, with control totals calculated during data preparation.

2. The system must recalculate the check digit for each field and compare it with the check digit
attached to the field during data preparation.

3. Logical tests must be performed on all the input fields.

4. A sequence test must be carried out on fields and records during batch input to ensure that all fields
and records are read in the correct sequence.

5. Error handling: any errors that have been detected must be recorded by the computer in an error
log. Error reports must be printed after each input run, but before processing has taken place.
These reports must be checked and any errors corrected before a batch is processed.

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 Study Unit 5.3
The evaluation of internal control systems

General pitfalls relating to the evaluation of an internal control system

The following is a summary of the shortcomings generally encountered:

 Obvious weaknesses are often left out. For example, management’s failure to check calculations is
often left out.

 In questions that require students to describe the weakness and suggest a corrective measure,
students do not properly explain how the weakness and the corrective measure are connected. For
example, students state that order forms are not properly authorized before the order is placed
with the supplier, but then as corrective measures for this weakness students sketch scenarios that
bear no relation to the weakness. For example, they might say the following: ensure that there is
sufficient separation of duties between the person who places the order and the person who
approves it. It should be clear to you that the improvement suggested is not connected in any way
to the identified weakness.

 The above corrective measures for identified weaknesses often reveal a lack of detail, that is,
students do not give a full description of the required internal controls. For example:

Study the following two internal controls:

- Statement 1: At the beginning of each week the clerk must prepare a clock card for each
employee from the permanent files, and issue these cards to the factory.
- Statement 2: A clerk must prepare a clock card for each employee and issue it to the factory

There is an obvious difference between these two statements. Statement 2 does not contain sufficient
detail. As stated above, it is always necessary to indicate who should carry out the internal control, how
the internal control should be carried out, when the internal control should be carried out, what
internal control should be carried out, and on what documentation the internal control should be
carried out.

Requirements Statement 1 Statement 2

Who carries out the internal The clerk The clerk

control?
How is the internal control From the permanent files Missing – clearly
carried out? indicates a lack of
sufficient detail
When is the internal control At the beginning of each Missing – clearly
carried out? week indicates a lack of
sufficient detail
What internal control is carried Preparation of a clock card Preparation of a clock card
out? for each employee and issue for each employee and

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 of the cards to the factory issue of the cards to the
factory
On what documentation is the Clock cards Clock cards
internal control carried out?

Basic guidelines that you may find useful in evaluating internal control system

The following guideline may be helpful if you find it difficult to evaluate the internal controls in the
various transaction cycles:

Put yourself in the shoes of the owner of the business & then
develop the internal controls that you would like to implement in your capacity as the
owner.

As the owner of a business it would be important to you to introduce controls for dealing with risks.
Suppose one of the risks in your business is that cheques received by post are not banked on account of
theft. An essential control would therefore be that the post should be opened by two people, and the
cheques recorded in a register. Unless this is done there is likelihood that a cheque could be stolen by a
member of staff for personal gain. The result would be that you, the owner, would suffer a PERSONAL
loss.

Evaluation of the internal control systems

The evaluation of internal control systems is illustrated by the following two activities:

MANUAL SYSTEMS
You are engaged in auditing the financial statements of Kasper de Bruyn, a large independent
contractor. All his employees, most of whom are unskilled labourers, are paid in cash because Mr De
Bruyn believes that this arrangement reduces administrative expenses and is preferred by the
employees.

During the audit of the undertaking’s petty cash, you discover that the petty cash box contains almost
R3000. You are informed that R 2500 of the amount represents unclaimed wages. On investigating this
matter further you ascertain that Mr De Bruyn has ordered that any unclaimed wages be placed in the
petty cash box so that the cash is available for future petty cash disbursements. When an employee
appears to claim unpad wages he is immediately paid from the petty cash.
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Mr De Bruyn informs you that this measure reduces the number of cheques drawn to replenish the
petty cash fund. This also ensures that all the responsibility for cash on hand is vested in one person
because the petty cash custodian always distributes the wage envelopes.

Required
Make a list of the internal controls that you would recommend to the client to improve internal control
over both the wages and the unclaimed wages.

Feedback

1. Specific accounting procedures should be introduced for wages and unclaimed wages. A separate
payroll bank account should be opened.

2. Each wage envelope provided by the wages department should bear the employee’s name and
other relevant personal information about the employee.

3. The wage envelope should be prepared by a person other than the person computing the payroll.

4. Wage envelopes should be compared with the payroll records.

5. Wages should be dealt with independently of petty cash or other cash receipts.

6. The distribution of wage envelopes to employees should take place in the presence of a third,
independent person.

7. Every employee should sign for the receipt of his wage envelope.

8. All unclaimed wages should immediately be handed to Mr De Bruyn or another independent person
should be held in safekeeping until they are claimed.

9. The unclaimed wages should be depositeed in the payroll bank account at regular intervals & the
bank account should be reconciled regularly.

10. The unclaimed wages account should be disclosed as a current liability on the balance sheet.

11. The payment of any unclaimed wages from this bank account should be duly authorised.

12. After a specified period, the unclaimed wages should be declared unclaimed and credited to wages.

13. The petty cash should be maintained on an imprest basis, independent of any unclaimed wages.

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14. From time to time, on a surprise basis, Mr De Bruyn or any other supervisor should witness a payroll
distribution.

COMPUTERISED SYSTEMS
Mrs De Beer has been working for BBP (Pty) Ltd for the past 12 years and is responsible for the salaries
and debtors of the company. Mrs De Beer & the managing director, Mr Nel, have been personal friends
for years and regularly go gambling at a casino near the offices of the company. They regularly use Mrs
De Beer’s computer password as their lucky number when they gamble. The board of directors have
implicit trust in her because of her friendship with the managing director.

The annual salary increases are approved by the board of directors in March. After the meeting, a list
prepared manually and showing all the approved salary increases is handed to Mrs De Beer, who
captures the data on the computer. No employee of the company earns more than R 20 000 per month.
After completing the changes on the computer, Mrs De Beer herself compares the information on the
computer with the handwritten list. The list is then filed in Mr Nel’s office.

The newly approved monthly salaries are as follows:

Mr Nel R 19 500
Mr Roos R 12 500
Mrs De Beer R 9 500
Mrs Smit R 4 500
Two other directors R 19 500 each

The other 23 employees all earn a salary of between R 4 500 and R 7 500 per month.

At the end of each month Mrs De Beer prepares a payroll printout, but she does not check it. She gives
the salary cheques, which are also printed by computer, and the payroll printout to Mr Roos, the
accountant. Mr Roos totals the individual cheques and compares the total with that of the printout,
unless he thinks the amount is more or less the same as that of the previous month. He then signs all
the cheques, initials the printout and returns it to Mrs De Beer along with all the signed cheques. She
deposits the cheques in the staff banka accounts.

Mrs Smit, who used to be responsible for all incoming post, resigned in May. Her work is now being
done by Mrs De Beer.

At the end of June Mrs De Beer increased her own salary by R 4 500 and entered Mrs Smit’s salary as a
negative R 4 500 into the computer. Mrs De Beer printed two cheques for herself. They bore the same
number, the one was for R 9 500 and the other for R 4 500.

In June Mr Nel used Mrs De Beer’s password to gain access to the computer without her knowledge. He
increased his salary to R 24 000 and also changed Mrs Smit’s salary by minus R 4 500. Mrs De Beer tore

166
up Mrs Smit’s cheque for minus R 9 000 without looking at it and handed all the cheques to Mr Roos.
The result was that the net amount of the salaries remained more or less the same.

Mrs De Beer did not realise that Mr Nel had made a change, because she printed the list of salaries &
cheques and handed it to Mr Roos without checking it. Mr Roos did not notice the changes either,
because the total of the salaries was more or less the same as for the previous month.

When Mr Nel tried to change his salary cheque back to R 19 500, he accidentally erased the debtors’
masterfile. It took the company four months to reconstruct the debtors’ masterfile.

Required
Identify the weaknesses in BBP (Pty) Ltd’s internal control system and describe the internal controls that
would eliminate these shortcomings.

Feedback

No Weakness Internal controls

1 No segregation of duties after Mrs Smit Two people, other than Mrs De Beer, should
resigned. Mrs De Beer now opens all the open the incoming post to ensure proper
incoming post and she is also segregation of duties
responsible for debtors
2 The changes in the salary masterfile An independent person like the accountant
were not reviewed by an independent should check the salary increases by
person after Mrs De Beer did the comparing the handwritten list drawn up by
changes for the annual salary increases the directors with the payroll masterfile.
There should be proper segregation of duties
3 The use of Mrs De Beer’s password as a Passwords should always be kept
lucky number when she and Mr Nel were confidential and not revealed to other
gambling was a striking weakness people. Passwords should be changed
regularly
4 Mr Roos does not compare each Mr Roos should compare each individual
individual cheque with the payroll cheque with the payroll prinout, or examine
printout or examine the printout for the printout for abnormal items. It would
abnormal items have been apparent that Mrs De Beer and
Mr Nel had made out cheques for negative
amounts
5 There are inadequate controls with Any change in the payroll masterfile should
regard to salary changes appear on the audit trail and should be
approved by the directors
6 Mrs De Beer made out two cheques with The making out of two cheques with the
the same number to herself same number would have been prevented if
the following controls had been in operation:

 Sequence check
 Control totals
7 Mrs De Beer and Mr Nel were able to A sign test would have made it impossible to
make out a cheque for a negative make out a cheque for a negative amount

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 amount
8 Mr Nel increased his salary to R 24 000. A limit check would have prevented Mr Nel
The maximum salary that anyone can from increasing his salary to R 24 000
earn is R 20 000
9 It took four months to reconstruct the Proper backups and a proper plan would
debtors’ masterfile have reduced this period considerably
10. There is no access control to the The computer room should be locked &
computer access should be controlled by means of
keys and logs
11 The debtors’ masterfile was erased Boundary protection would have prevented
the erasure. It would have prevented the
payroll program interfering with the debtors’
program
12 This company is not applying proper Personnel and their activities should be
personnel practices properly supervised to ensure that they are
doing their work properly

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