CHAPTER 14: FINANCE AND INVENTMENT CYCLE

14.1 THE ACCOUNTING SYSTEM AND CONTROL ACTIVITIES

14.1.1 INTRODUCTION

FINANCE CYCLE
Covers how to raise finance, for example, by issuing shares, or borrowing money from a bank or
investment company

INVESTMENT CYCLE
The cycle also deals with the investments the company makes, whether it be in property, plant and
equipment, making long-term loans or investing surplus funds.

The transactions in this cycle will usually result in the creation or alternation of an account balance,
for example, investment in property, plant and equipment may also result in cash inflows and
outflows, that are written off at the end of the financial year, for example, interest or dividends
received on investments or interest paid on borrowings.
In a general sense the audit of the capital employed section of the statement of financial position is
linked to the finance side of the cycle, and the audit of non-current assets to the investment side of
the cycle.

14.1.2 CHARACTERISTICS OF THE CYCLE

14.1.2.1 FREQUENCY OF TRANSACTIONS
The number of transactions in this cycle is considerably smaller than for “everyday” transaction, such
as purchases and sales, salaries and wages, etc.

14.1.2.2 SIZE OF TRANSACTIONS

Transaction in this cycle are usually material. Generally, when a company raises finance or purchases
non-current assets, the amounts are large.

14.1.2.3 LEGAL AND REGULATORY REQUIREMENTS

Transaction in this cycle are frequently governed by statute and by the company’s Memorandum of
Incorporate (MOI).
For example, if the company chooses to issue shares, it must comply with the requirements of the
Companies Act. If the directors wish to declare a dividend to shareholders, they must comply with the
company’s MOI and with section 46 of the Companies Act, which deals with distributions (as defined)
to shareholders.

14.1.2.4 NON ROUTINE INTERNAL CONTROLS

Due mainly to the three characteristics identified above, transactions in the cycle will not be subjected
to the routine everyday controls relating to transactions. However, it is still very important that strict
controls are exercised over these transactions and what might be termed “compensating” controls
should be put in place. These are discussed below (para 3).

14.1.2.5 NON-STANDARD DOCUMENTATION

Because of the “uniqueness” of transactions in this cycle, it is unlikely that the documentation relating
to them will be the standard everyday documentation, for example, goods received notes, invoices,
etc. Certainly, there will be occasion when these documents are used but more often than not,
documents specific to a particular type of transaction will be used, such as contracts and lease
agreements.
14.1.2.6 MAJOR RISKS WITHIN THE CYCLE
Although the risk of material misstatement must always be evaluated in terms of the specific
circumstances at the client, generally the major risks would be that the client understates
completeness of the long-term liabilities or overstates existence and valuation of the investments that
have been made whether these are investments in plant and equipment, etc., or in other private or
public companies. Due to the legal and regulatory requirements, there is also risk that invalid
transactions have occurred, for example, long-term loans raised in contravention of the MOI, or the
issue of shares to a director without the appropriate approval in terms of the companies Act.

14.1.3 COMPENSATING CONTROLS

14.1.3.1 PLANNING
Transaction in this cycle, for example, investment in plant and equipment, should be carefully planned
by senior experienced management. This normally involves:
• The formation of specific committees, for example, a capital expenditure committee, that will
evaluate the need for their capital expenditures and how they will be financed, or an
investment committee, that may look at alternative forms of investments for surplus funds.
• The preparation of capital expenditure budgets and cash flows, for example, is adequate
funding available to settle the purchase consideration
• Exhaustive consideration of alternatives, for examples best method of raising finance, and
• Regular comparison of actual performance to budget performances to assist in ongoing
planning.
Note: Decisions will often be prompted by strategies adopted by these committees to respond to risk.
Controls over the purchasing of these items should be in place, such as obtaining multiple quotes from
pre-approved suppliers.

14.1.3.2 AUTHORISATION
• Authorisation of material finance and investment transactions should be at the highest level.
This could be by way of resolutions of a fixed asset committee, a steering committee, an
investment committee or the board of directors.
• The resolutions should be minute.
➢ The company’s MOI
➢ The company’s policies, and
➢ The company’s Act where applicable.
• Legal advice should be obtained to consider the implications for the entity before concluding
any material agreement.
• Signed agreements should be entered into and should include all relevant terms and
conditions.

14.1.3.3 Implementation
Where the implementation of the transaction is other than straightforward, it should be carried out
by competent staff and properly controlled. For example, the installation of a new production line
should be regarded as a project and sound project controls must be implemented. If a public share
issue is to be undertaken, merchant bankers, lawyers and other experts should be involved.

14.1.3.4 REVIEW AND APPROVAL

Transaction in this cycle should be subjected to:
• Progress reporting
• Comparison to plans and budgets, and
• Independent scrutiny by internal audit particular for compliance with legal and regulatory
requirements.
14.1.3.5 CONTROLS AFTER ASSETS IS ON HAND
Once the asset is on hand, it can be lost, stolen or damaged and therefore inappropriately recorded
in financial statements.

Security
• All material tangible assets should be physically secured to avoid theft of assets and loss to
the entity.
• A detailed fixed assets register should be kept and at least once a year a physical count should
be performed where the physical condition is assessed for any indication if impairment.
• The assets should be serviced regularly in order to maintain their functionality.

14.3 THE AUDIT OF THE CYCLE

14.3.1 INTRODUCTION
As for all other cycles, ISA 315 (revised) requires that the auditor identify and assess the risk of material
misstatement at the financial statement level and at the assertion level for classes of transactions,
account balances and disclosures. The risk assessment procedures will be those that are carried out
in any cycle and will hinge around the auditor gaining a thorough understanding of the entity and its
environment. In the context of this cycle, the auditor will need to evaluate whether there is anything
in the assessment of the risk at financial statement level that may filter down into down into the audit
of the cycle and whether there are any specific risks pertaining to the various balances and
transactions in the cycle.

For example:
• At financial statements level: if the auditor has concerns about the “accounting” competence
of management, there may be a risk of material misstatement in a number of balances
relating to the cycle, for example, management may not even be aware of matters such as
impairment requirements to establish fair value, or how intangible assets should be
measured.
• At account balance level: risk assessment procedures may have revealed that a number of
machines may have become technically obsolete.
• At transaction level: risk assessment procedures may reveal that long-term loans are being
made to directors and other related persons without considering the requirements of the
Companies Act.

14.3.2 FRAUD IN THE CYCLE

14.3.2.1 FRAUDULENT FINANCIAL REPORTING
This cycle presents the directors with a fair number of opportunities for fraudulent reporting, as there
are numerous account heading that can be manipulated. Of particular concern for the auditors would
be the manipulation of allowances, provisions, impairments, and fair values. Working on the
assumption that the directors’ motives would be to improve the financial statements through fraud,
the following methods could be adopted:
• Creating unjustified reserves with a corresponding increase in fixed assets (valuation), for
example, obtaining an inflated property valuation from an estate agent.
• Omitting long-term liabilities (completeness), for example, failing to record a new loan and
disguising the inflow of cash as income, or failing to capitalise leases.
• Undervaluing long-term liabilities (valuation), for example, failing to amortise debentures
redeemable at a premium.
• Overstating property, plant and including fictitious assets or assets that the company does
not own (existence and rights), for example, including the assets of a related party.
 • Overstating plant and equipment, understating depreciation allowances and impairments
(valuation), for example, failing to write down obsolete/impaired machinery.
• Overstating investments in listed and/ or private companies, for example, failing to write
down the cost of investments in private companies, where the fair value of the investment
has fallen.
• Understating or omitting provisions/allowances, for example, not providing for long-term
environmental damage that the company has an obligation to rectify.
• Omitting or inadequately disclosing contingent liabilities, for example, the company makes
no mention in the notes of a pending lawsuit that may have grave consequences for the
company.
Note that any manipulation of the statement of comprehensive income by the directors will also affect
the capital section of the statement of financial position.

14.3.2.2 MISAPPROPRIATION OF ASSETS

This cycle does not present any unique opportunities to management or employees to misappropriate
assets, other than:
• Making unauthorised use of the company’s assets for personal use, for example, using the
company’s computer processing facilities to run private accounting jobs, taking company
vehicles or equipment for weekends for private use, using company assets as security personal
loans, or the directors making (unauthorised) long-term loans to themselves.

14.3.3 OVERALL RESPONSES TO RISK OF MATERIAL MISSTATEMENT AT FINANCIAL STATEMENT

LEVEL
In terms of ISA 330, the auditor must implement overall responses to address the risk of material
misstatement at the financial statement level.
For example:
• Assigning more experienced staff to the audit team, for example, in response to an assessed
risk that management may lack “accounting” competence. The auditors will assign staff who
have high level of technical competence relating to the account heading in this cycle.
• Providing more supervision of audit work as well as more frequent and comprehensive review
• The engagement of an expert to assist with the audit of complex transactions.

14.3.4 RESPONDING TO RISK AT ASSERTION LEVEL

There is no change in principle here. The auditor will still need to decide on the nature, timing and
extent of tests that will reduce audit risk to an acceptable level. As was explained in chapter 6, the
best mix of tests of controls and substantive tests, that is, observation, re-performance, inspection,
etc., must be decided upon and executed. Particular considerations for these cycles include:

14.3.4.1 NATURE OF SUBSTANTIVE PROCEDURES

• As there are normally only a few transactions (relatively) in this cycle, the auditor may limits
tests of controls (not ignore them!) and concentrate on performing substantive tests of
details, often on each of the transactions that have occurred, and the account as a whole.
• A common approach is to verify the opening balance on the account, vouch the transactions
that make up the movement on the account including adjusting journal entries, and verify
that the closing balance agrees with and is appropriately reflected in the financial statements.
For example:
SpendIt Ltd has raised two long-term loans and repaid one. Broadly it will be audited as follows:

Opening balance: Compare to prior years’ closing balance in working papers

Two new loans: Vouch as transactions (occurrence, accuracy, cut-off, classification and
completeness)
 Repayment: Vouch as transaction (occurrence, accuracy, cut-off classification and
completeness)
Closing balance: Cast account and confirm that appropriate presentation and disclosure have
been achieved (presentation)

Where a subsequent measurement adjustment has been passed, for example, for the amortisation of
a debenture redeemable at a premium, the adjusting journal entry will be vouched.
If there are numerous and frequent transactions in this cycle, for example, lots of purchases of
machinery and other equipment, then tests of controls would be carried out as with any other cycles.
The same board approach would be adopted, but the extent of substantive testing would be
influenced by the outcome of the tests of controls, and samples of transactions relating to the account
heading would be extracted for audit.

14.3.4.2 EXTENT OF SUBSTANTIVE PROCEDURES

As indicated, there are frequently few transactions in the cycle and each one can be audited
individually. When there are numerous transactions, for example, in very large organisations, the
normal principles of sampling would be adopted, and the extent of substantive testing would be
influenced by the risk assessment and effectiveness of controls.

14.3.4.3 TIMING OF SUBSTANTIVE PROCEDURES

There is nothing about the cycle itself that makes the timing of tests particularly critical so they may
be conducted at the interim or final stage. Quite often the external auditor may be asked for input at
the time the transactions are taking place, for example, the auditor may be consulted on Companies
Act or JSE listing requirements for a share issue and some audit work may be done at this stage. Where
a tight audit deadline is in place, early verification and roll forward procedures can take place quite
conveniently, for example, physical asset inspections, statutory work, and scrutiny of finance leases
raised at an interim date two months prior to year-end.

14.4 ISA 540 AUDITING ACCOUNTING ESTIMATES AND RELATED DISCLOSURES

It is quite possible that in this cycle “fair values” will be used extensively. In some cases, for example,
for investments in listed shares, auditing fair value is straightforward. The auditor can use share price
listings that are widely available, but for other account headings relating to this cycle, establishing fair
value may be more complex. Complex accounting estimates have become more prevalent in financial
statements as businesses themselves become more complex, and need the auditor to consider
management’s estimate of financial statement item based on various factors.
ISA 540- Auditing accounting estimates, including fair value accounting estimates and related
disclosures: Accounting estimates vary from amounts arising from depreciation (useful lives),
contingent events, warranties, provisions, to allowances, etc.
Fair value accounting estimates are those estimates relating specifically to “fair values” such as
estimating the “fair values” of shares that are not in a listed company. Accounting estimates also
include the disclosures made in the financial statements, if any, related to the monetary estimate
made. There are inherent risks in the estimation of a financial statement item. ISA 540 requires that
inherent risk factors be identified and addressed. Because the shares are not traded in an active
market, the estimation of the fair value will have an inherent degree of imprecision because they
cannot be precisely measured. This type of inherent risk, where no instrument will measure an item
precisely, is called estimation uncertainty. Secondly, the complexity of the estimate will need to be
considered. The estimation of the useful life of typical property, plant and equipment will be less
complex than the estimation of a pension plan liability for a pension fund, that will require actuarial
knowledge, an actuarial valuation model that uses probabilities to predict outcomes, and needs to use
appropriate internal and external data that may be difficult to attain or understand. Such complexities
can increase the risk of misstatement with varying degrees, and may require management to engage
a management expert. Thirdly, the subjectivity of the accounting estimates relates to the judgements
that management are required to make in the estimate. These can include management deciding what
information to disclose, which valuation techniques to use, the assumptions used in the estimate, the
data used (management using their judgement on whether internal or external data should be used
and where are the various sources of data and management determines the source), where are
various possible outcomes to be measured in the estimate and management decisions on the
weighting of those outcomes. Although these inherent risk factors are required to be addressed by
the auditor, any relevant inherent risk factors in an estimate should be identified and addressed. Other
inherent risk factors can be the susceptibility of the estimate to management bias or fraud, and a
change in the nature of the financial statement line item necessitating a change in the estimation
process. The impact of ISA 540 on the process is described below, based on the stages of the audit
illustrated in chapter 6 of this textbook. A diagram representing the process to the audit of an estimate
is shown at the end of this section.

In the planning stage, when conducting risk assessment procedures and planning further audit
procedures, the auditor will perform the following at an assertion level:
• Obtain an understanding of the entity and its environment as follows:
➢ The transactions or events that gives rise to the estimate
➢ The requirements of IFRS in relation to the estimate
➢ The requirements of regulations related to the estimate, for example, in the financial
services industry, the actuarial valuation of a pension fund is required at least once every
three years by the Pension Funds Act of 1956, and
➢ The disclosures made in the financial statements regarding the estimates.
• Obtain an understanding of the IFRS requirements for the fair value measurements and
disclosure of the accounting estimate. Accounting estimates will be audited at the assertion
level.
• Obtain an understanding of the entity’s internal control as follows:
➢ The nature and extent of supervision over management’s process for accounting
estimates
➢ How management identifies and addresses risks related to accounting estimates,
including the need to use a management expert.
➢ How risk related to accounting estimates are addressed by the entity, and
➢ How management reviews previous accounting estimates made.

Where information technologies or systems are used, an understanding of the following is necessary:
➢ The financial statement items that related to the information systems
➢ How management determines the methods, assumptions and sources of data used in
the information system
➢ Identify if any changes to the method, assumptions and sources of data is necessary
➢ How management understands and addresses estimation uncertainty for the estimate
➢ Control activities covering the process to make an estimation by management.

• Perform analytical procedures and inquire with management about prior year accounting
estimates as compared to the related current actual amounts (or “outcome” as it is referred
to in the Standard). Where there are differences between the estimate and the outcome or
actual amount, the guidance of the financial reporting framework will determine whether
there is a misstatement. For example, the difference between what is paid to a pensioner, and
the amount that was expected to be paid to a pensioner (the estimate), is an actual gain or
 loss per IAS 19. Where the difference arises from information that was reasonably obtainable
as at the prior year reporting date, this could indicate a misstatement.
• Determine whether specialised skills or knowledge is required to perform these risk
assessment procedure, in which case an expert may be engaged.

14.4.1 ASSESSMENT OF INHERENT RISK

Based on the above, the auditor will identify the risks of material misstatement at an assertion level
and assess them. This assessment must be done separately for inherent risk and control risk. For the
principles relating to the assessment of control risk, refer to chapter 7. The assessment of inherent
risk depends on the extent to which the inherent risk factor affect the likelihood of misstatement and
varies on a scale that is referred to by ISA 540 as the spectrum of inherent risk.
For example:

A warranty liability estimate could have a high degree of subjectivity (where management chooses
which data it is to be based on, among various sources, and determines how to measure the liability)
but a low degree of complexity (where an entity uses the number of goods per year multiplied by a
specified percentage, and no specialised skills are needed in order to calculate it).
However, there are no rules for inherent risk factors; they have to be assessed based on information
obtained in understanding the entity. It is therefore possible to have a warranty liability with a higher
degree of subjectivity and a high degree of complexity, depending on the inherent risks of an entity.
There could also be other inherent risk factors that need to be taken into account, such as the
susceptibility of the estimate to management bias or even fraud, and changes in the nature of the
estimate (such as a big change in how the estimate was made in prior years compared to the current
year).

14.4.2 RESPONDING TO THE ASSESSED RISK

An auditor may respond to the assessed risk of an estimate in three ways, as will be explained by
means of the following example: a company buys a building and start renting it out for rental income,
and therefore meets the requirements of IAS 40 for investments property. In accordance with IAS 40,
a fair value estimate is required at initial measurements. Because of investment property not being
an observed price, the fair value will need estimation. In this example, the value that the investment
property is sold for can be a good estimation of its fair value. If it is sold soon after the year-end of the
entity, ISA 540 paragraph 21 may apply, as that provides strong evidence of its estimated fair value at
year-end- this is the first alternative. In the case where management does not want to sell the building
(more likely), it may decide to value the investment property itself. ISA 540 paragraph 22-27 require
that the auditor tests how management made the accounting estimate in the following manner (this
is the second alternative):

Selection Methods
Assumptions
Application Data
Influenced by inherent risk factors

The auditor would need to address the selection of the valuation method, the assumption implied in
the method and the selection of data. The auditor would also be required to assess the application of
methods, assumptions and data used in the valuation. If management had used an expert in the
valuation, the auditor would need to comply with both ISA 540 and the requirements of ISA 500 in
order to rely on a management expert. The third alternative is for the auditor to estimate an amount
or a range of amounts. For this, the auditor could use a variety of acceptable methods.
For example:
The auditor could use recent selling prices of investment property in the immediate area around the
building to calculate a “selling price per square metre” (selling price of property divided by the number
of square metres of the property), then use this estimated selling price per square metre multiplied
by the square metres of the property being valued. The auditor has therefore calculated a point
estimate. In estimating range, the auditor may take the lowest selling price per square metre of a
recently sold investment property in the area, and the highest selling price per square metre of a
recently sold investment property in the area, and use that as a reasonable range for estimating the
investment property’s selling price per square meter.

(Refer to diagram on page 14/11)

14.5 AUDIT PROCEDURES – THE FINANCE CYCLE

14.5.1 INTRODUCTION

Note 1: The audit of the finance and investment cycle can be very difficult and will require a technically
proficient and experienced member of the audit team to be responsible for it. This is due mainly to
the fact that virtually all aspects of the cycle are strongly influenced by extensive and complicated
financial reporting statements that substantially increase the risk of material misstatement with
regard to relevant transactions and events, balances and disclosures.

What has been included in this text is a considerably simplified version of auditing in this cycle
designed to give you a general idea of what is required.

Note 2: The procedures for auditing presentation and disclosure follow a general pattern. By
inspection of the financial statements including the notes, reference to the applicable financial
reporting standards and current audit documentation, the auditor confirms that:
1. Amounts are presented and positioned in the statement of financial position/ statement of
comprehensive income as required by the applicable financial reporting standard, for
example, trade receivables under current assets.
2. The disclosure relevant to the accounting heading
2.1 Are accurate in terms if amounts, facts and details
2.2 Include specific disclosures required by the applicable financial reporting standards for that
account heading.
3. Any disaggregation or aggregation in the notes, the statements of financial position or
statement of comprehensive income, is accurate and relevant.
4. The wording of disclosures is clear and understandable.
5. All required disclosures have been made.

Simplified examples have been provided for share capital, finance lease liabilities, provisions,
contingent liabilities and contingent assets, property, plant and equipment.

14.5.2 SHARE CAPITAL

We will only consider the issue of share capital by private companies, as the statutory and JSE
requirement relating to public and listed companies are fairly onerous and a description of these
requirements is beyond the scope of this text.

14.5.2.2 OPENING BALANCE

Inspect prior year work papers and prior financial statements to confirm that the opening balance
agrees with the prior year closing balance.
14.5.2.2 OCCURANCE
• Insect the MOI and any relevant shareholders resolutions:
➢ For any conditions with which the issue must comply,
➢ To establish that the company has the necessary authorised (but unissued) share capital
to make the issue (note, the board may resolve to issue shares at any time, but they must
be authorised shared and the MOI may include conditions).

• If any shares were issued to the directors (or person related to the director or a nominee of
such director), inspect, the minutes of meetings of shareholders for a special resolution
approving the issue to the director. Note that in certain circumstances this authority is not
required, for example:
➢ Where the director is exercising a pre-emptive right
➢ The issue is made in proportion to existing holdings on the same terms and conditions as
has been offered to all shareholders of the company or to all shareholders of the class of
shares being issued.

• Confirm by inspection of the minutes of the meetings of shareholders, communications with

the shareholders, or inquiry of the directors that the requirements relating to any pre-emptive
rights (to the new shares) were satisfied.
• Inspect the minutes of meetings of directors to confirm that:
➢ The resolution to issue shares was approved
➢ The issue price of the shares was for an “adequate consideration” determine by the board
(s 40).
Note: In terms of the companies Act 2008 par value shares cannot be issued.
Note: Meetings must be quorate and approval must be in terms of the Companies Act 2008 (and MOI)
for ordinary and special resolutions.

• Inspect the register of shareholders and agree details to the share capital account in the
general ledger/statement of financial position, nothing that the addition of new shareholders
and changes to existing shareholdings agree with the minutes.
• Trace the receipt of payment for the shares to the cash receipts journal and bank statement
or inspect appropriate evidence of value received by the company if the consideration
received for shares was other than cash.

14.5.2.3 COMPLETENESS
Confirm with the directors that no other share issues have taken place during the current year.

14.5.2.4 ACCURACY, CUT-OFF, CLASSIFICATION

• Re-perform the calculations to verify that the consideration received for the shares is in
accordance with the issue price as authorised (accuracy).
• Confirm by inspection of dates on the supporting documentation that the issue took place
during the accounting period under audit (cut-off).
• Cast the capital account and all related documentation.

14.5.2.5 CLOSING BALANCE

Agree the closing balance on the share capital account to the financial statements (balances will be
reflected in the statement of financial position and “changes in equity” note).
14.5.2.6 PRESENTATION
• The auditor must inspect the financial statements to confirm that:
➢ Share capital appears as a separate line item on the face of the statement of financial
position
➢ The disclosure in the notes include, for example, for each class of share:
o Its description, number of shares authorised and issued
o The rights preferences and restrictions attaching to that class of share
o Details of authorised but unclassified shares, and
o Movements in the share capital balance (statement of changes in equity)
• By inspection of the annual financial statements (AFS) and reference to the application
financial reporting standards and the audit documentation, confirm that:
➢ Disclosures are consistent with the evidence gathered (amounts, facts, details)
➢ Any disaggregation of the balance reflected in the statement of financial position is
relevant and accurate, for example, A shares and B shares, and
➢ The wording of disclosures is clear and understandable, and all required disclosures have
been included.

• 14.5.3 DEBENTURES
The audit of dentures, which are regarded as loan capital, attracts a mix of procedures similar to
the audit of shares and long-term liabilities. Again, we deal only with the issue of debentures in a
private company. If debentures are offered to the general public, they are almost like shares issues
and are controlled by the relevant Companies Acts sections, including the issuing of a prospectus.

• 14.5.3.1 IMPORTANT ACCOUNTING ASPECTS

IFRS 9 –Financial Instruments: IFRS 9 requires that debentures are held at amortised cost. An
auditor should bear this in mind when, for example, auditing a debenture that is redeemable at a
premium. IFRS 9 requires the use of an effective interest rate in order to correctly reflect the value
of the debenture at each reporting date and the finance cost associated with it.
In terms of IFRS 9, the effective interest rate is the rate that “exactly discounts estimated future
cash payments through the life of the financial instrument”. Transaction costs may be included in
this calculation. In effect the true finance cost (interest plus premium) is calculated and spread
over the life of the debenture.

Basic example: compulsory redeemable debentures

An entity issues 100 R10 par value debentures on 1 January 0001
Coupon rate 10% redeemable at R12 on 1 January 0004
Effective interest rate is 15.72% (given)

Working Effective int. INTEREST PAYMENT CAPTIAL

R R R
1 Jan 0001 1000
31 Dec 0001 157 (100) 1057
31 Dec 0002 166 (100) 1123
31 Dec 0003 176 (100) 1200

Based on this workings:

• At 31 December 0001, the debenture will be reflected at R1057 and the journal entry to record
the finance charges would be:
Dr Finance Costs R57
Cr Debenture account R57
• At 31 December 0002 the debenture would be reflected at R1123, and
 • At 31 December 0003 at R1 200 (the amount to be repaid the next day).

Note 1: The interest payment of R100 and premium will give a total finance cost of R157 in year 1,
R166 in year 2 and R176 in year 3.

Note 2: This example is kept simple for the purposes of explaining the principles of auditing a
straightforward compulsory redeemable debenture (see below). An auditor may be required to audit
more advanced transaction/account heading been audited must be tested for compliance with all
relevant financial reporting standards. However, conventional auditing procedures, for example,
inquiry, recalculations and inspection will still be used.

14.5.3.2 OPENING BALANCE

Inspect prior year working papers and prior year financial statements to confirm that the opening
balance agrees with the prior year closing balance.

14.5.3.3 OCCURANCE EXISTENCE

• Inspect the MOI to determine whether:
➢ The company is authorised to issue debentures
➢ The issue has in any way contravened the company’s borrowing powers, for example,
authority requirements.
• Inspect the minutes of the meeting of directors at which the decision to issue debentures was
made and note:
➢ To whom the issue was to be made
➢ The number and amount of the debentures to be issued
➢ The interest rate, date and manner of payment, and
➢ Any particular characteristic of the debenture, for example, repayable at a premium,
convertible to shares.

Note: The directors do not need shareholder approval to issue debentures, except where the directors
intend to issue debentures convertible in to shares, to themselves. If this is the case, section 41 of the
Companies Act will apply (basically special resolution from shareholders unless exceptions apply).
• Inspect the register of debentures holders to confirm that the addition of new debentures
holders and adjustments to the holdings of existing debenture holders have been made
according to the authority granted for the issue.
• Inspect the cash receipts journal, deposit slip/bank statements for evidence of the receipt of
the correct amount.

14.5.3.4 ACCURACY, CUT-OFF, CLASSIFICATION

(a) Initial recognition (on issue)
• Re-perform the calculations and casts to confirm that the cash received from the issue of the
debentures is in accordance with the debenture agreement, for example, 100 debentures of
R1 000= R100 000 received (accuracy).
• Trace the receipt of cash from the cash receipts journal to the general ledger to confirm that
it was posted to the debenture liability account (classification).
• Inspect the dates on all documentations to confirm that they fall within the accounting period
under audit (cut-off).
(b) SUBSEQUENT MEASUREMENT
• Recalculated the effective interest rate based on the terms of the debenture agreement and
compare to the effective interest rate used by the client in the amortisation calculation.
• Inspect the journal entry raising the finance cost and increasing the debenture liability account
and agree the amounts to amortisation calculation.

14.5.3.5 COMPLETENESS
Confirm by inquiry of the directors and scrutiny of the minutes that no other debenture issues have
taken place during the year.

14.5.3.6 CLOSING BALANCE

• Agree the closing balance on the debenture account (after the finance charge/amortisation
adjustment) to the trail balance.
• If necessary, obtain a third-party confirmation from the debenture holders (confirm amount
of debenture, interest rates, redemption premium and condition of redemption). This relates
to all assertions.

14.5.3.7 PRESENTATION
See notes 1 and 2 on page 14/12.

14.5.4 LONG-TERM LOANS

Borrowing long term is common form of financing. The audit plan will be to audit substantively the
opening balance, movement on the account including any adjusting journal entries, and the closing
balance. Ultimately the auditor see evidence about the assertions relating to the balance on the long-
term liabilities account and its related disclosures (i.e. obligations, existence, accuracy valuation and
allocation, classification and completeness as well as presentation). This is achieved by auditing the
transactions making up the account for accuracy, cut-off, classification, completeness and occurrence,
and supplementing these with procedures relating to the final balance. Generally speaking the
dominant risk is completeness so the auditor will be concerned about any long-term loans not
recorded.

14.5.4.1 IMPORTANT ACCOUNTING ASPECTS- LONG-TERM LOANS

Long-term loans should be reflected at amortised cost using the effective interest rate. For a normal
long-term loan, for example, fixed term, no premium on repayment, etc., the effective rate will be the
annual interest rate charged per the agreement. There may be a situation where the company raises
a long-term loan that has a low annual interest rate (to assist with cash flow) but must be repaid at a
premium at the end of the loan term. Such a loan would have to be amortised at the effective interest
rate to spread the full cost of the loan over the term of the loan (very similar to a debenture
redeemable at a premium).

14.5.4.3 AUDIT PROCEDURES

As the audit procedures are so similar to those for debentures, as discussed above, they have not been
repeated here. However, additional procedures pertaining to the completeness assertion have been
included below as this is an assertion for which there is potential for material misstatement, i.e.
understatement of liabilities.
14.5.3.4 COMPLETENESS OF LONG-TERM LOANS PROCEDURES
• Obtain specific representations from management that all long-term loans have been include.
• Review financial records, minutes of directors, audit committee and capital expenditure
committee meetings and correspondence for evidence of unrecorded loans.
• Obtain third-party confirmations from all long-term loan creditors from the prior year, who
are no longer reflected as long-term liabilities, or whose balances are significantly lower in
the current year.
• Enquire and confirm as to the source of funding for any major acquisitions identified during
the audit of non-current assets.
• Match interest payments to long-term loans to confirm the loan to which the interest
payment relates has been raised.
• Perform analytical review, for example, compare current year balances on loan accounts and
interest paid to the prior year.

14.5.5 LEASES
Leasing is another very common form of “acquiring” an asset. The distinction between operating and
finance leases is eliminated for lessees (previous IAS 17 standard), and a new lease asset (representing
the right to use the leased item for the lease term) and lease liability (representing the obligation to
pay rentals) are recognised for all leases. A lessee should initially recognise a right-of-use asset and
lease liability based on the discounted payments required under the lease, taking into account the
lease terms as determined according to the new standards. The audit of a lease if therefore difficult
and requires that both the asset raised and the corresponding liability be audited. The assertions that
pertain to assets and liabilities as well as to transactions all apply, sometimes overlapping with each
other.

14.5.5.1 IMPORTANT ACCOUNTING ASPECTS

• The auditor must be aware of the guidance contained in IFRS 16 – Leases.
The core of the new requirements means that lessees have to take almost all leases, with
some cost benefit driven exceptions on balance. The lessee has to recognise a right-of-use
asset, measured at the lease liability at initial recognition. The lease ability is measured by
discounting the future lease payments with the rate “implicit” in the lease, if that rate can be
readily determined or by using the lessee’s incremental borrowing rate. The future lease
payments are the fixed lease payments (including in-substance fixed payments) over the lease
term. The lease term has to be determined considering extension and termination options if
the lessee is reasonably certain to exercise that option.
• Where a lease is to be capitalised as lease, an asset and corresponding liability must be
recognised in the statement of financial position.

INITIAL RECOGNITION AND MEASUREMENT

LEASE LIABILITY
Lessees are required to initially recognise a lease liability for the obligation to make lease payments
and a right-of-use asset for the right to use the underlying asset for the lease term.

The lease liability is measured at the present value of the lease payments to be made over the lease
term.

The lease payments shall be discounted using the interest rate implicit in the lease, if the rate can be
readily determined. If that rate cannot be readily determine, the lessee shall use the lessee’s
incremental borrowing rate.

LEASE ASSET
The right-of-use asset is initially measured at the amount of the lease liability, adjusted for lease
prepayments, lease incentives received, the lessee’s initial direct costs (e.g. commissions) and an
estimate of restoration, removal and dismantling costs.

Lessees are permitted to make an accounting policy election, by class of underlying asset, to apply a
method like IAS 17’s operating lease accounting and not recognise lease assets and lease liabilities for
leases with a lease term of 12 months or less (i.e. , short-term leases). Leases also are permitted to
make an election, on a lease-by-lease basis, to apply a method similar to current operating lease
accounting to lease for which the underlying asset is of low value (i.e. , low-value assets).

The lessee shall recognise the lease payments associated with the “short term” and “low-value assets”
leases as an expense on either a straight-line basis over the lease term or another systematic basis.
The lessee shall apply another systematic basis if that basis is more representative of the pattern of
the lessee’s benefit.

SUBSEQUENT MEASUREMENT
LEASE LIABILITY
• Lessees accumulate (accrete) the lease liability to reflect interest and reduce the liability to
reflect lease payments made.
• Lessees remeasure the lease modification (i.e., a change in the scope of a lease, or the
consideration for lease that was not part of the original terms and conditions of the lease)
that is not accounted for as a separate contract, that is generally recognised as an adjustment
to the right-of-use asset.
• Lessees are also required to the remeasure lease payments upon a change in any of the
following, which is generally recognised as an adjustment to the right-of-use asset:
➢ The lease term
➢ The assessment of whether the lessee is reasonably certain to exercise an option to
purchase the underlying asset
➢ The amounts expected to be payable under residual value guarantees, and
➢ Future lease payments resulting from a change in an index or rate.

LEASE ASSET
• The related right-of-use asset is depreciated in accordance with the depreciation
requirements of IAS 16 Property, Plant and Equipment.
➢ If the lease transfers ownership of the underlying asset to the lessee by the end of the
lease term, or if the cost of the right-of-use asset reflects that the lessee will exercise a
purchase option, the lessee depreciates the right-of-use asset from the commencement
date to the end of the useful life of the underlying asset. Otherwise, the lessee depreciates
the right-of-use asset from the commencement date to the earlier of the useful life of the
right-of-use asset or the end of the lease term.
➢ Lessees apply alternative subsequent measurement bases for the right-of-use asset under
certain circumstances in accordance with IAS 16 and IAS 40 Investment Property.
➢ Right-of-use assets are subject to impairment testing under IAS 36 Impairment of Assets.
PRESENTATION
• Right-of-use assets are either presented separately from other assets on the balance sheet or
disclosed separately in the notes. Similarly, lease liabilities are either presented separately
from other liabilities on the balance sheet or disclosed separately in the notes.
• Depreciation expense and interest expense cannot be combined in the income statement.
• In the cash-flow statement, principal payments on the lease liability are presented within
financing activities, interest payments are presented based on the accounting policy election
in accordance with the IAS 7 Statement of Cash Flows.

Lessor accounting is substantially unchanged from the current accounting. Lessors will classify all
leases using the same classification principle as in IAS 17 and distinguish between operating and
finance leases.

14.5.5.2 ASSERTION- OCCURRENCE/OBLIGATION AND EXISTENCE

• Inspect the lease agreements for pertinent details:
➢ Name of lessor and lessee (i.e. client)
➢ Amount of minimum lease payments
➢ Term of lease, and
➢ Other salient conditions, for example, penalties for late payments of lease rental.
• Inspect the minutes of directors and capital expenditure committee’s meetings authorising
the lease agreement.
• Before the resolution is passed, the following should be done:
➢ Specific consideration must be given to the statutory requirement as the Companies Act
➢ Inspect the MOI to confirm that it has been compiled with, in particular that the borrowing
powers/conditions have not been breached, and
➢ Specific consideration must be given to the projected cash requirements of the entity, as
evident from entity budgets and necessary cash-flow forecasts.
• Enquire of management and refer to prior working papers to confirm that new finance will
not breach contracts in respect of existing finance agreements.
• Properly signed agreements should be entered into.

14.5.5.3 ASSERTION- COMPLETENESS

• Obtain specific representations from management that all leases have been included.
• Review financial records, minutes of directors, audit committee and capital expenditure
committee meetings and correspondence for evidence of unrecorded liabilities, for example,
use of leases to provide “off-balance sheet finance”, when in fact they should be classified and
treated as leases.
• Enquire and confirm as to the source of funding for any major acquisitions identified during
the audit of fixed assets.
• Obtain a schedule of all leased assets and by inspection and enquiry, determine whether any
leases that have not been recognised as a lease asset and lease liabilities are for either:
➢ Leases with a lease term of 12 months or less (i.e. , short-term leases), and
➢ Leases for which the underlying asset is of low value.
• Obtain a schedule of all lease payments, and match to lease agreements to confirm that all
leases have been identified. Confirm by scrutiny of the agreements that all leases have been
identified and capitalised.
• Perform analytical procedures, for example, compare current year balances on lease accounts
and lease payments paid to the prior year.
14.5.5.4 ASSERTION- ACCURACY, CUT-OFF, CLASIFICATION
(a) INITIAL RECOGNITION
• Obtain independent confirmation of the fair value of the right-of0use asset that has been
leased by enquiry of the supplier, inspection of trade journals, etc. (the fair value is unlikely to
appear in the lease agreement).
• If any direct lease costs have been capitalised, confirm by enquiry and inspection of the
supporting documentation that the costs are valid lease costs applicable to the leased asset
and were incurred by the lessee.

(b) DEPRECIATION – LEASED ASSET

• By enquiry of management and evaluation of the terms of the lease agreement, determine
whether the right-to-use asset should be depreciated over its useful life or the term of the
lease.
• Determine by enquiry of the directors whether the residual value applicable to the leased
asset, is reasonable.
• Determine by enquiry of the directors whether the “significant part” method of depreciation
is applicable and if so, whether the allocation of costs of the components is appropriate
(independent enquiry of the supplier may be required).
• Enquire of the directors as to whether the depreciation method, for example, straight line,
units produced, is appropriate, and confirm by reference to the minutes that the method has
been reviewed by the directors (must be done annually).
• Re-perform the depreciation calculation.
• Enquire of production directors as to whether any impairment of the right-to-use asset is
required.

(c) LEASE PAYMENTS

• Re-perform the implicit interest rate calculation.
• Re-perform the apportionment calculation of the leased payments and trace the posting
of the amounts apportioned to the liability account (and finance cost account).
• Re-perform the “current portion of the lease liability calculation” and trace the
reclassification to the general ledger/trail balance/financial statements.

(d) GENERAL
• Cast the lease liability account.
• By scrutiny of dates on documentation confirm that the leases, repayments, etc., relate to the
accounting period under audit.
14.5.5.5 ASSERTION- PRESENTATION
• The auditor must inspect the financial statements to confirm that:
➢ The non-current portion of the lease liability is reflected on the face of the statement of
financial position under non-current liabilities, and
➢ The current portion of the lease liability is reflected under current liabilities.

• By inspection of the AFS and reference to the applicable reporting standards IFRS 16 and the
audit documentation, confirm that:
➢ Disclosures are consistent with the evidence gathered (amounts, facts, details)
➢ All required disclosures have been included, for example:
o Accounting policy
o Encumbrances on any right-to-use assets, and
o Reconciliation between the total of the future minimum lease payments at the end of
the reporting period, and their present value, and
➢ The wording of the disclosures is clear and understandable, for example, accounting note.
14.5.6 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
To achieve fair presentation, companies are obliged to make adjustments for certain anticipated
events or to disclose them. The former is termed a provision and the latter is termed a contingent
liability/asset.

In common accounting language, the term “provision” is frequently used in connection with bad debts,
inventory obsolescence and depreciation, for example, provision for bad debts. This is not
theoretically the correct terminology as these “provisions” do not fit the provision definition in IAS 37.
The term that is being used more and more is “allowance” for bad debts or impairment allowance for
accounts receivable, or allowance for inventory obsolescence. Situation that might give rise to
provisions (should the definition be satisfied) include a provision for:
• The cleaning up of environmental damage caused by the company
• Refunds to dissatisfied customers, and
• Damages arising out of a court case.

Contingent liabilities are similar to provisions but not as “certain”. Provisions and contingent liabilities
(and contingent gains) are, however, treated differently in the financial statements. Provisions are
recognised as liabilities provided the amount can be measured with sufficient reliability. They are
included in the statement of financial position whereas contingent liabilities are only disclosed in the
notes.

14.5.6.1 IMPORTANT ACCOUNTING ASPECTS

(a) DEFINITONS (IAS 37)
• PROVISIONS- a liability of uncertain timing or amount.
• LIABILITY- a present obligation of an entity arising from past events, the settlements of which
is expected to result in an outflow of resources from the entity.
• CONTINGENT LIABILITY- a possible obligation that arise from past event, and the existence of
which will be confirm only by the occurrence or non-occurrence of an uncertain future events
not wholly in the control of the entity.

(b) RECOGNITION OF PROVISIONS AND CONTINGENT LIABILITIES

• PROVISIONS- a provision must be recognised when:
➢ The company has a present obligation as a result of a past event
➢ It is probable that an outflow of resources will be required to settle the obligation, and
➢ A reliable estimate can be made of the amount of the obligation
If these conditions are not met, no provisions shall be recognised but the matter will still be disclosed
in the notes as a contingent liability.
• CONTINGENT LIABILITIES- contingent liabilities are not recognised but must be disclosed.

(c) CONTINGENT ASSETS

A contingent asset is a possible asset that arise from past events and whose existence will be
confirmed by the occurrence or non-occurrence of an uncertain future event not wholly within the
control of the entity, for example, successful outcome of a court case where the company is awarded
damages.
Contingent assets are not recognised in the financial statements but, where the inflow of economic
benefit is probable, are disclosed. If the economic benefit is “virtually certain”, the asset is not
regarded as “contingent” and should be recognised. The auditor should satisfy himself on the basis of
all the evidence available whether a contingent asset exist at reporting date, and whether the
economic inflow is probable (disclosure) or virtually certain (recognition).
(d) COMMITMENTS
Companies are also required to make disclosures pertaining to “commitments”. To identify any
commitments that should be disclosed, the auditor will perform very similar procedures to those
conducted for provisions and contingents liabilities, for example enquiry of the directors and scrutiny
of the minutes of directors’ meetings may reveal commitments for capital expenditure, contracted
and approved, that must be disclosed. The assertions applicable to presentation and disclosure will
apply to commitments.

14.5.6.2 IMPLICATIONS FOR THE AUDITOR

As indicted earlier, the provisions and contingent liabilities that are being discussed here are not as
straightforward as the normal allowances for bad debts, inventory obsolescence, etc. They may varied
in nature and may be unique to particular industries.
Provisions are recognised and therefore there will be a “provisions” account in the general ledger, the
assertions applicable to which will be:
Completeness All provisions have been included in the account balance
Existence The provisions included are not fictitious
Accuracy valuation The provisions are included at an appropriate amount
Obligation The provisions represent an obligation of the entity, and
Classification Provisions have been recorded in the proper accounts, for example, correctly
classified as a provision, not a liability.

In addition the auditor must satisfy himself that the provisions are appropriately presented and
described in the financial statements and that related disclosures in the notes are clearly expressed,
accurate and understandable.

Contingent liabilities are not recognised in the statement of financial position but are disclosed in the
notes. The applicable assertions relating to this disclosure are:
Completeness All contingent liabilities have been included in the notes
Obligation The contingent liabilities disclosed pertain to the entity
Occurrence The event giving rise to the contingent liability has actually occurred (it is not
fictitious)
Presentation The disclosures pertaining to the contingent liabilities are appropriately
described, understandable and clearly expressed in the context of the
applicable financial reporting framework, for example, IFRS, and
Accuracy valuation Information provided in the disclosure is fair and accurate and values
included are appropriate.

14.5.6.3 AUDIT PROCEDURES- PROVISIONS AND CONTINGENT LIABILITIES

The audit procedures for provisions and contingent liabilities are very similar as they are themselves,
very similar in nature.

14.5.6.4 EXISTENCE/CLASSIFICATION
Under normal circumstances a company will not wish to include provisions and contingent liabilities
that are fictitious. However, there is the possibility that provisions that do not meet the definition
criteria are included in the account heading, or that the directors wish to manipulate the financial
statements by the inclusion of fictitious provisions or contingent liabilities. Procedures to test the
existence of provisions and contingent liabilities are as follows:
• Evaluate the company’s procedures for identifying provisions and contingent liabilities.
 • Inspect the supporting documentation that management provides for each provision
recognised, and
➢ Evaluate whether there is a legal or constructive present obligation arising out of a past
event that actually occurred.
➢ Evaluate the probability that an outflow of resources will be required to settle the
obligation, and
➢ Evaluate the basis on which the amount of the obligation was determine to decide
whether a reliable estimate could be made
• Inspect the documentation that management supplies in support of contingent liabilities
disclosed and evaluate whether there is a possible obligation whose existence will only be
confirmed by the occurrence or non-occurrence of an uncertain future event.
• Consider the progress used to authorised the recognition/disclosure of provisions and
contingent liabilities (authority minuted by the Board may reduce the risk of invalid
provisions).
• Discuss any uncertainties or concerns arising out of the above evaluations with the directors.
• If necessary, seek legal counsel or the advice of an expert (e.g. in industry-specific matters,
such as provisions for environmental damage).

14.5.6.5 VALUATION
The value at which the provision is recognised is the “reliable estimate of the amount of the
obligation”. The auditor is thus auditing an estimate. ISA 540- Auditing accounting estimates, including
fair value accounting estimates and related disclosures, provides guidance. The auditor should assess
the risk of material misstatement of the entity’s accounting estimates (in the normal manner) and
design and perform further audit procedures to obtain sufficient appropriate evidence as to whether
the accounting estimates are reasonable in the circumstances and, where necessary, appropriately
disclosed.
The statement requires the following:
• The auditor must identify and assess the risk of material misstatement of accounting
estimates.
• When performing risk assessment procedures (at the understanding the entity phase), the
auditor should obtain an understanding of:
➢ The requirements of the applicable accounting framework relevant to accounting
estimates (e.g. IFRS/IAS 37)
➢ How management identifies transactions, events and conditions that may give rise to the
need for accounting estimates, and
➢ How management makes the estimates, for example, use of a model, use of an expert,
the assumptions underlying the estimate and the effect of estimation uncertainty (this is
defined as “the susceptibility of an accounting estimates and related disclosures to an
inherent lack of precision in its measurement”).
• The auditor must review the outcome of prior year accounting estimates (in effect this
provides information as to the effectiveness of the company’s estimate setting procedures).
The auditor should
• Review and test the process used by management to develop the estimate including the
approval/authorisation procedure (internal controls over the procedure)
• Evaluate the data on which the estimate is based for accuracy, completeness and relevance
• Evaluate the reasonableness and consistency of any assumptions that have been used in
developing the estimate:
➢ Reasonable in the light if actual prior performance, and
➢ Consistent with the assumptions used for other similar estimates
• Re-perform an calculations pertaining to the estimate
• Compare the amount of the estimate