Nkonki Technical News

The Independent Review – A New Skill Set for South African Accounting Professionals

2011-02-11T11:09:00.000+02:00

On 1 April, 2011 Companies Act 2008 (“Act”) will replace both the Companies Act 1973 and Corporate Laws Amendment Act 2006. The Act introduces the concept of an “Independent Review” as an alternative form of external independent assurance of financial statements. Private companies in South Africa will be able to replace the annual audit with an Independent Review. The work effort in an independent review engagement is limited to inquiry, analytical procedures and discussions related to the information that the client supplies. Consequently, an independent review does not require the gathering of supporting or independent evidence or an assessment of internal control as would be required in an audit. Management's responses to inquiries are acceptable as long as they appear plausible in the circumstances. The word plausible is often defined in terms such as the information being credible, appearing worthy of belief, or seemingly or apparently valid, likely or acceptable. The draft regulations to the Act make provision that allows the registered auditor in terms of the Auditing Professions Act and an accounting officer in terms of the Close Corporations Act to conduct the independent review. The independent review requires different skills from those possessed by auditors or accounting officers. An auditor and accounting officer are only skilled in conducting various specialised procedures based on the objective of their engagement. However they are not skilled with an ability to ask penetrating questions an essential ingredient of an independent reviewer. This is because the independent reviewer not only has to ask the right questions and analyse the responses given to spot implausibilities but to have the strength to stand up to implausibilities and press for further explanation. An auditor has to corroborate all management representations while the accounting officer does not have to inquire anything of management as part of their duties. Therefore the acceptance of management representations without corroboration is a new skill for the auditor while making management inquiries will be a newly acquired skill for the accounting officer. An ability to read body language would be advantageous. Conducting an analytical review of the financial statements is not the primary source of audit evidence required by an auditor. Accounting officers are not obliged at all to conduct analytical reviews. An analytical review in an audit is used as a planning tool and to corroborate any primary audit evidence obtained. In an independent review the analytical review is a primary source of evidence in assessing the plausibility of management’s representations. Auditors and accounting officers will have to acquire sufficient analytical skills that would enable them to use analytical reviews as a primary tool rather than just a secondary one. This would entail additional training and practice to ensure this new skills set is obtained. The accounting officer would be at a disadvantage when it comes to the conducting of independent reviews as compared to the auditor. The accepted view is that the ability to perform an independent review is greatly facilitated by the fact that an auditor had previous audit experience with the clients. The accounting officer will need to obtain additional skill sets that an auditor already has. For example: the ability to plan the review and document the review procedures conducted, something that has been part of the auditor’s DNA for almost time in memorial. The draft regulations to the Act recognises the differences in skills between the registered auditor and accounting officer. The regulations allow only the registered auditor to conduct the independent review of the larger private company while the Accounting Officer can only conduct the independent review for the smaller private company.

Commenting on the defintion of control - IAS 27

2010-09-06T14:56:00.000+02:00

IAS 27 GUIDANCE ON CONTROL

Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. [IAS 27(2008).4]. Financial and operating policies are not defined in IAS 27. Operating policies generally would include those policies that guide activities such as sales, marketing, manufacturing, human resources, and acquisitions and disposals of investments. Financial policies generally would be those policies that guide dividend policies, budget approvals, credit terms, issue of debt, cash management, capital expenditures and accounting policies.

Policies and benefits

The definition of control encompasses both the notion of governance and the economic consequences of that governance (i.e. benefits and risks). Governance relates to the power to make decisions. In the definition of control, the phrase ‘power to control’ implies having the capacity or ability to accomplish something – in this case, to govern the decision-making process through the selection of financial and operating policies. This does not require active participation or ownership of shares. In situations where one entity has the power to govern another entity’s policies, but derives no benefits from its activities, there is a presumption that control does not exist.

Presumption of control

Control is generally presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity. In exceptional circumstances, however, it may be possible to clearly demonstrate that such ownership does not constitute control. Control also exists when the parent owns half or less of the voting power of an entity when there is:

[IAS 27(2008).13]

a) power over more than half of the voting rights by virtue of an agreement with other investors;

b) power to govern the financial and operating policies of the entity under a statute or an agreement;

c) power to appoint or remove the majority of the members of the board of directors or equivalent governing body and control of the entity is by that board or body; or (d) power to cast the majority of votes at meetings of the board of directors or equivalent governing body and control of the entity is by that board or body.

The definition and guidance on control is intended to identify whether an entity has sole control over one or more other entities. Where two entities have joint control under a contractual agreement (i.e. they are able to exercise control by cooperating, but neither can unilaterally exercise control without the agreement of the other), then the arrangement will not fall within the scope of either IAS 27 or IFRS 3, but will fall within the scope of IAS 31.

Potential voting rights

An entity may own instruments (e.g. share warrants, share call options, debt or equity instruments that are convertible into ordinary shares) that have the potential (if exercised or converted) to give the entity voting power or reduce another party’s voting power over the financial and operating policies of another entity (potential voting rights).

a) Where potential voting rights are currently exercisable or convertible, they are considered when assessing whether an entity has the power to govern another entity’s financial and operating policies. [IAS 27(2008).14]

b) Where potential voting rights are not exercisable or convertible until a future date or until the occurrence of a future event, they are not considered in making that assessment. [IAS 27(2008).14]

c) However, the proportions of profit or loss and changes in equity allocated to the parent and non-controlling interests are determined on the basis of present ownership, and do not reflect any exercise or conversion of potential voting rights. [IAS 27(2008).19]

In assessing whether potential voting rights contribute to control, all of the facts and circumstances that affect those rights should be considered (including the terms of exercise of the rights and any other contractual arrangements), except the intention of management and the financial ability to exercise or convert such rights. [IAS 27(2008).15]

The effect of these requirements is that where one entity, by using the threat of exercise or conversion of potential voting rights, is able to ensure that its wishes are followed, then it has the power to direct the actions of others who are affected by a change in voting power.

I am convinced based on the above notes that even if a company has a share certificate reflecting ownership of 51 shares out of 100 but is unable exercise their majority rights as contemplated by such a percentage ownership they do not have the “POWER’” as discussed above and it would not be able to consolidate the investment in which the 51% investment is held. The owners of the 51% are what could commonly called “lame duck” and have no capacity to influence the board of directors of the investee in any manner. It is the directors who run the company on behalf of the shareholders. Directors can make various decisions by themselves without shareholder approval however every time shareholder approval would be legally needed the 51% shareholder cannot exclusively authorise the directors to conduct operations whether economically or financially. Every shareholder approval requires approval from 24% of the remaining shareholders. This in essence means that the 51% shareholder does not control the company by virtue of not controlling the board.

My research proposal that has now been approved - Masters in Law 100% by research

2010-08-27T04:18:00.000+02:00

1. Objective of the research proposal

This research proposal provides a coherent and concise outline of the intended research. This will allow selectors to assess the originality of the proposed topic, its viability as a research project, as well as potential supervisors if the application is accepted.

2. Academic and practical reasons for choosing the topic

The responsibilities of an auditor are influenced by a combination of relevant professional and legal requirements. While the determination of what is appropriate professional audit guidance and practice is generated by the expertise knowledge and experience to be found in the auditing profession, auditors are required to take legal responsibility for their examinations and the reports they render. As a result the law has become a significant factor to be considered in the development of professional auditing guidance and the practice of auditing.

The Independent Regulatory Board for Auditors (IRBA) in addition to developing and maintaining Statements of Auditing Standards however does not initiate research on audit issues. IRBA do not recognise that the discussion of the duties and responsibilities of auditors is influenced by the examination of legal cases. This study of the law is aimed at providing IRBA with a comprehensive examination of the judicial decisions in respect of an auditor’s legal duties and liabilities in South Africa.

This research study covers relevant judicial decisions reported in Australia, the United Kingdom, Ireland, Canada, the United States, South Africa and New Zealand.

The major objectives of this research study are:

1. To draw together and analyse historical and recent decisions from the relevant common law jurisdictions to identify the basic principles and legal precedents concerned with the civil and criminal liabilities of auditors.

2. To provide the IRBA with a legal framework for reviewing existing professional statements and developing future guidance.

3. To provide legal and auditing practitioners and other interested parties in auditing with a comprehensive reference service about the contemporary law concerning the civil and criminal liability of auditors in South Africa.

Litigation against auditors is argued to be having an adverse effect. Firms are retreating from serving high-risk clients, and some smaller firms are shying away from audits — a trend that is counter to the public interest. It is also argued that intense competition for fees accelerated the breakdown of traditionally stable relationships between firms and their accountants. Furthermore, the litigation crisis is causing professional staff to question their continued association with audit firms, and deterring new graduates from entering into public practice.

The damages awarded against the auditors can be far in excess of their ability to pay, either from their own resources, or through their professional indemnity cover. The possible collapse of an accounting firm as a result of litigation is a reality — it has already happened to Levanthal & Horwath, and Spicer & Oppenheim in the United States. The well capitalised and well managed firms may survive, but they and their partners are increasingly at risk. The liability system is regarded as a risk transfer mechanism and the auditors are the prime transferees.

The heavy burden on auditors in South Africa is mainly due to the legal principle of joint and several liability. For commercial reasons, the auditor is held liable if the plaintiff is of the opinion that he can recover his losses from the auditor. Owing to the enormous costs involved, the plaintiff seldom turns to other defendants, who usually have nothing like the same financial resources available to auditors via insurance, and for the same reason the auditor does not recover his losses from potential co-defendants. The trend to sue has not been the result of deterioration in professional competence, but rather a strong tendency to regard the opinion of the auditor as an assurance against risk. The activities of companies are becoming increasingly complex, and the business world does not realise that the auditor’s report is based on reasonable enquiries and auditing procedures and that it is not a guarantee that the financial statements are correct in all respects and is not an absolute reflection of the state of affairs.

It is quite clear that there is a growing body of opinion worldwide that supports the principle that auditors should not pay for others’ mistakes merely because they are the only ones left standing after a financial collapse. Common sense and a sense of fairness demand such a reform as there are many instances where the question of fault is not clear and resolving such issues automatically in the favour of the plaintiff causes grave injustice to the defendants. Very often, through inappropriate action or lack of action, the directors have played a significant role in causing the losses sustained. However, the auditor is often required to compensate for all the losses incurred. It is this exposure to the risk of having to pay for damages far in excess of their proportionate share of responsibility and to the cost of defending such claims, that causes auditors to succumb to threats to settle actions out of court, even where they are confident that they have good defenses or did not cause the damages claimed.

In light of the above discussion and in addition to the main objectives of this research study this research will provide a framework for regulators in South Africa on how to achieve a fairer liability risk exposure for statutory auditors.

This research study will be conscious of the fact in the increasing litigious environment in which auditors work there is always the possibility that existing judicial decisions and interpretations will be subject to refinement through the judicial system. Nevertheless it is essential that comprehensive research of this type would be timely and provide a valuable resource by explaining the evolution of the current legal responsibilities of auditors in South Africa.

IRBA should develop professional audit guidance on a pro-active basis not as it currently done based on IFAC standards. This research study will provide a necessary background for and encourage a pro-active basis for developing professional audit guidance. It should also reinforce for individual auditors the importance of their professional responsibility to ensure that their audit practices are kept at a professionally acceptable level as it is in this context that the law will assess whether an auditor has acted reasonably.

I believe that this research study will focus the attention of the profession and individual audit practitioners on the legal environment within which their work may be judged and also encourage debate as to the legal issues facing auditors.

3. Outline of research topic and key questions to be answered

As stated in Section 1 the objectives of this research study are to describe the legal rights, duties and liabilities of auditors practicing in South Africa and to describe the reform rationale for auditor liability. The research study will embrace six main aspects:

1. The need to regulate of the Accountancy Profession and the nature of professional negligence and the auditor’s duty to exercise reasonable skill and care which is owed to the client company.

2. The circumstances under which the duty to exercise reasonable skill and care is owed to shareholders and to external parties having an interest in the financial affairs of the client company.

3. The standards of professional skill and care which are legally required of auditors.

4. Auditor’s legal duties and liabilities in relation to client fraud and other irregularities.

5. The circumstances under which auditors may incur criminal liability in relation to the affairs of their clients.

6. In addition to the above the following research question will be addressed:

a. Should audit professionals in South Africa (World Wide) be permitted to limit their liability with their clients, and if so, what form should this limitation take?

b. If a statutory cap on liability was implemented, at what level should liability be capped?

4. Broad Problems and issues to be investigated

Litigation has had a significant impact on the public accounting profession and it seems reasonable to expect that it will continue to do so in the foreseeable future. To avoid litigation, it is vital that the auditor comply fully with professional pronouncements in completing each audit engagement and use sound professional judgement during the audit and at the time of issuing the audit report.

This research study describes the current legal environment faced by audit firms, and introduces the detailed development of court decisions on auditor liability. The issue of auditor liability is very much an unresolved matter. Auditors are liable under statute to their clients for breach of duty under Corporations Law. However, the interpretation of the laws has been largely dependent on court cases.

The concept of due professional care has been used in the Kingston Cotton Mill case and in the London and General Bank case , and was further defined in the Pacific Acceptance case — a landmark case in determining what are acceptable Auditing Standards and approaches.

The research study also examines the concepts of negligence, privity of contract, causal relationship, and contributory negligence. These concepts provide a framework for understanding how and when a duty of care arises, and to what extent liability is incurred. The AWA case was the first to establish the application of contributory negligence, and helps to define in more exact terms the extent of liability or damages attributable to the auditor's negligence. The case laws concerning auditors' liability to third parties are inconsistent, however.

The key cases of Caparo and Esanda refer to auditor liability being based on the premise that (1) the auditor's report is prepared on the understanding that it will be provided to and used by a third party for a financial decision, (2) that it will be relied on for that decision by such third party, and (3) that the third party consequently suffers loss because of the auditor's negligence in preparing the report. The application of the tests for proximity and reasonable foreseeability have been inconclusive.

Finally, this research study looks at the development of legal reforms in South Africa and inter-nationally. So far, reforms affecting auditor liability have been slow, and to some extent ineffective.

5. Principle theories upon which the dissertation will be based

This research study seeks to integrate the statutory and common law framework within which an auditor’s duties and legal liability exists in South Africa. This objective is achieved by giving orderly formulation to the laws surrounding an auditor’s duties and legal liability. The formulation the law in respect of an auditor’s legal liability is based on the legal realism theory of jurisprudence which argues that the real world practice of law is what determines what law is; the law has the force that it does because of what legislators, judges, and executives do with it. This research study does not seek to test a prior hypothesis; rather is seeks to theorise through the critical analysis of the legal concepts which have been derived from judicial decisions, legal opinions and statutory enactments in an inductive manner.

6. Research methodology

As stated in Section 5 this research study seeks to theorise through the critical analysis of the legal concepts which have been derived from judicial decisions, legal opinions and statutory enactments. The central aim of this method is to construct theory, rather than theory testing by grounding the theory in a rigorous analysis of the judicial decisions, legal opinions and statutory enactments. Each judicial decision will be analysed in the following format:

1. Facts of the case.

2. Judgement

3. Analysis

4. Impact auditor’s duties and legal liability.

7. Conclusion and Contribution to the Literature

This research paper makes a valuable contribution to the compilation and critical discussion of the regulatory developments in respect of corporate law reform currently taking place South Africa and internationally. It is useful and beneficial for all legal practitioners, auditors and accountants as it brings together the various components of an auditor’s statutory duties and legal liability. In addition this paper will help regulators and policy makers to adopt appropriate strategies for improving audit quality. The South African experience may serve to encourage other developed and developing countries to adopt effective policies for financial reporting practices.

It is submitted that it is essential and necessary to critically examine the legal and institutional framework for auditor oversight in a regulatory environment where South Africa is considered to be a virtual microcosm of the world in terms of its ethnic diversity, level of economic development, standard of living and economic infrastructure and race. This paper broadens research into auditor regulation by providing an examination of the legal and institutional framework for auditor oversight in South Africa, an emerging economy, where auditing has been under researched compared to Europe and other industrialized countries, especially in examining the legal and institutional framework for an auditor’s duties and liability. Given the significance of the emerging economies to the overall well-being and balance of the global economy, it is important to establish and understanding of the development of auditing regulation in different socio-political and economic settings.

Auditor’s Lose 3-2 after Extra Time

2010-08-27T04:03:00.000+02:00

In recent years considerable evidence has emerged concerning a rather alarming phenomenon which has come to be known as the audit expectation gap. The audit expectation gap consists of differences between the perceptions of the duties and responsibilities of auditors held by the business community and the public generally as compared to the legal duties and responsibilities of auditors.

Given the above perception if it should happen suddenly or without any obvious warning that a company is in serious financial difficulty then it is likely to be presumed that the auditors are at fault in some way. Such perceptions have been heightened by adverse media publicity concerning auditors to the extent that public confidence in the auditing profession appears to be at an historically low ebb.

In recent years the reputation of the auditing profession has been further damaged by considerable media publicity concerning law suites against a number of audit firms and by the finings of a number of official inquiries into recent corporate collapses.

Although some recent criticisms of auditors may well be justified it also appears that the media and various interest groups have lost sight of the fact that the primary responsibility for every aspect of management of company’s affairs rests with its directors. The soon to be effective Companies Act 71 of 2008 legally ensures that the fiduciary responsibility of all company directors is to conduct the company’s affairs with care and integrity on behalf of all stakeholders and to take responsibility for the detection, investigation and prevention of fraud and error.

The unfortunate fact for auditors is that when directors abrogate their duties and companies fail or incur losses then in the eyes of society and even the courts auditors are convenient and vulnerable scapegoats. This could be likened to suing the fire brigade for arson or blaming the police for the levels of crime.

Many actions against auditors cry out for a defence of contributory negligence (on the grounds that that management have been negligent) but the courts have denied this defence to auditors. The primary cause of most corporate failures rests with inept or imprudent decisions made by management.

In 1987 Justice Rogers (an Australian Judge) stated that directors should bear their share of responsibility with respect to losses suffered by their company. He posited the view that it was socially and commercially unjust and inappropriate that directors should escape liability completely and that the full burden of responsibility should rest on the auditors.

This view was shared by a brave and visionary South African Judge who understood the potentially damaging effects of the audit expectations gap. Justice Ezra Goldstein’s ruling in the Thoroughbred Breeders Association v Price Waterhouse almost shut the audit expectation gap by upholding the view that the auditor should not be held liable for the negligence of directors.

The Supreme Court of Appeal like many goalkeepers in the 2010 world cup did not keep their eye on the ball and reversed the ruling made by Judge Goldstein and placed the entire blame for management’s negligence on the auditor’s. Little did the Supreme Court of Appeal realise that their judgement would place the future of the entire auditing profession in jeopardy.

In 2005 the Supreme Court of Appeal only by a 3-2 decision extended auditor liability in to a new age where auditors could become a different species. In 1896 the auditor was said to be a watchdog, in 1991 they become bloodhounds and it appears that if the Supreme Court of Appeals have their way auditors will become clairvoyants with the ability to disclose to their clients when they are negligent even when they have no idea that were negligent.

Three out of the five Judges of the Supreme Court of appeals ruled that Deloitte and Touché failed to warn the companies to whom they owed a duty of care that they were negligent. In other words negligence by silence.

The winning team of judges (three of them) explained in defence of their ruling that it must be remembered that we are dealing with a situation where the legal convictions of the community could well consider it unacceptable that an auditing firm which issued a seriously negligent report should escape the legal duty to speak with care concerning that report simply because it was, possibly even negligently, ignorant of the negligence of its report.

The losing team of judges (two of them) in the defence of their opinion asked of the winning judges the following: How can one disclose what one does not know?

The Supreme Court of Appeal was not unanimous and in fact the decision went into extra time and the entire future of the auditing profession in South Africa was decided by an odd goal. This split decision by equally learned judges clearly implies that the liability of an auditor is unresolved and is need of reform. The split decision indicates that the case law is complex and ill defined making it difficult for a court of law to give due consideration to the issues and sensitivities involved.

So where to now. In any business activity if the financial risks are perceived to outweigh the rewards the practice ceases to be regarded as viable. If auditors are to be judged on performance of their clients and any other persons the courts deem the auditors owe a duty of care this may well result in the demise of the profession and the ultimate losers will of course be the entire business and investor communities.

It may well be in the public interest to impose limitations on the liability of auditors and to limit the persons to whom they owe a duty of care so as to ensure that there is not a wholesale exodus from the ranks of the auditing profession and burden society even more. There needs to be a replay the decision made in extra time reversed. Judge Goldstein’s ability as a clairvoyant should passed on to the ultimate referee - the government. The law needs to be changed.

ACCOUNTING FOR CONTRACTS OVER HUGE GROUP LIMITED’S OWN EQUITY INSTRUMENTS: AN ETHNOGRAPHIC CASE STUDY

2010-05-09T23:36:00.001+02:00

Introduction

Whether I shall turn out to be ultimately accurate in my counsel offered to the Board of Directors of Huge Group Limited (Huge) and their auditors Horwath Leveton Boner (HLB) will in the end be determined by the JSE Limited (JSE), the GAAP Monitoring Panel (GMP) and by the users of financial information disclosed in their annual financial statements. The purpose of this ethnographic case study was to explore and describe the process in respect of the accounting for financial instruments in respect of contracts for difference and single stock futures with the underlying security being its own share entered into by and to examine the problems and obstacles that occurred when implementing their preferred accounting treatment.

The study also makes a contribution towards the need for accounting research to become more explanatory of accounting wherein theory is both informed, and is developed by observation. This is achieved by developing grounded theory from the data. Only a few years ago, the last thing on a structured financier’s list of worries was how to ensure the structure complied with accounting standards. The accounting rules were ‘flexible’ to say the least, if in fact any rules existed at all. Not many structured finance, specialised funding or treasury professionals had ever entertained the idea that accounting would affect economic bottom-line business decisions. There has been a revolution in accounting, especially in the financial instruments field. More complex rules have replaced the long-established accounting principles; prudence has been replaced by neutrality; the income statement has now become volatile ground; and, accounting significantly influences economic decisions.

The input from technical accountants has significantly increased and accounting risk management has become a specific part of the product development process. It is useless spending hundreds of hours on a deal only to find out later that the accounting does not work and that major changes are necessary. The accounting procedure needs to be considered at every step and it needs to become an integral part of structuring the deal.

Background

Huge entered into a single stock future contract with the underlying security being its own shares. The first transaction of its kind to take place in South Africa. The JSE rules and regulations made provision for one method of settlement of Huge’s SSF contract which is – by physical delivery. As a result Huge have only one option under this contract and that is to repurchase their own shares on expiry of the SSF contract. The question of how to account for this type of transaction is not specifically dealt with by IFRS. It must be noted that it is a contravention of South African company law not to comply with IFRS.

The purpose of this ethnographic case study was to explore and describe the process in respect of the accounting for financial instruments adopted by Huge Group Limited and to examine the problems and obstacles that occurred when implementing their chosen accounting treatment.

The research is predicated on the belief that a sound appreciation of the role and potential impact of accounting can only be developed by reference to the particular setting within which it is embedded (Hopwood, 1983). This kind of research, in general, does not seek to test a prior hypothesis. Rather, it seeks to theorise through the data in an inductive manner.

The paper commences with a brief review of the existing literature on culture and accounting practices and accounting in religious organisations. The paper then explains the use of ethnography and grounded theory as the interpretive research methodology. An overview of the organisations selected for the in-depth case studies is provided followed by a discussion of the findings from the study and the theoretical perspectives that have emerged.

The Actors

The Regulator

The JSE was established in 1887, and is the only stock exchange in South Africa. The JSE is registered in terms of the Securities Services Act, 2004, which is the general controlling Act in this regard. The GMP’s role is to advise the JSE about alleged cases of non-compliance International Financial Reporting Standards (IFRS), the JSE Listings Requirements and the Companies Act for listed companies.

The Client

Huge Group is listed on the Johannesburg Securities Exchange on the Alt-x (Alternative Exchange). The company listed on the Alt-X on 08 August 2007. This is the second year of financial results. The company is listed in the Technology Equipment and Hardware sector of the Alt-X. The company carries on business as a provider of least cost routing services in the telecoms industry in South and Southern Africa (AWP, 2009). Huge Group Limited has two wholly owned subsidiary companies namely Huge Telecoms (Pty) Ltd and Centracell (Pty) Ltd as well two unlisted investments one a joint venture and the other an Associate. The company has a joint venture investment and an Associate investment.

The company is owned by a wide number of shareholders due to its listing in the JSE. Major shareholders are James Herbst, Anton Potgieter, Vincent Mokholo (BEE) and B Morel's all executive directors of the company (AWP, 2009).

The Researcher

I am the IFRS advisor to the Huge Group Limited. To begin my life as an IFRS Advisor I record that I was accredited by the JSE Limited in October 2008 having provided the JSE with adequate information to demonstrate I had spent at least 800 hours performing practical and interpretive IFRS consulting over the past 12 months and I had a comprehensive working knowledge of IFRS (BULLETIN 3 of 2008 – Rule 15.4 [JSE Listing Requirements]).

The IFRS consulting must include a combination of review of financial statements before being issued, advising internal and external clients on the interpretation or application of IFRS, providing practical training on IFRS and other practical matters (Amoils, 2008).

It has been remarked (Amoils, 2008) that these new requirements are being introduced to enhance market protection. Several factors precipitated this, such as the increasing complexity of International Financial Reporting Standards (IFRS), the introduction of an alternative reporting framework for privately held companies (IFRS for SMEs) and difficulties experienced in the quality of work performed by auditors - evident from GAAP Monitoring Panel cases. I need to say nothing here other than to emphasise that IFRS advisors are subject to the JSE’s powers for censure and penalties. The maximum fine is R5million (JSE, Listing Requirements – Rule 1.20 (c)).

Justification

There is no shortage of guidance on how to account for financial instruments. The style of this guidance varies; some paraphrase the paragraphs in the standards while others go into more detail with practical examples. However, not all of the practical examples, even those produced by the standard setters themselves, follow a transparent logic – they are therefore difficult to understand, let alone implement. Furthermore, the complexity and variety of financial instruments also means that not every situation is covered by the pages of guidance issued by the standard setters. This case study is largely aimed at structured finance, specialised funding and liquidity, and treasury specialists, as well as accountants in these fields.

The case study aims to extract from the two thousand or so pages of the accounting rules and regulations the essential parts that would be most relevant to structured deals and present the issues and solutions in a way that the practitioner can easily understand. This case study has not been written to provide an exhaustive list of accounting rules and regulations, which in most cases would be irrelevant. However, it has been written to provide a practical guide for a specialist who needs to understand the most important accounting risks within a proposed transaction as the transaction is structured.

Research Methodology

Methodology - The Ethnographic Research Design

This study will utilize the ethnographic research tradition. This design emerged from the field of anthropology, primarily from the contributions of Bronislaw Malinowski, Robert Park and Franz Boas (Jacob, 1987; Kirk & Miller, 1986). The intent of ethnographic research is to obtain a holistic picture of the subject of study with emphasis on portraying the everyday experiences of Individuals by observing them (Fraenkel & Wallen, 1990). The role of the researcher as the primary data collection instrument necessitates the identification of personal values, assumptions and biases at the outset of the study. The investigator's contribution to the research setting can be useful and positive rather than detrimental (Locke 1987).

Interpretive methodology using ethnographic methods of inquiry enables an understanding of the accounting treatment for financial instruments in its proper context. Ethnography attempts an explanation or a `thick' description of meanings (Geertz, 1973) and in this case the meanings of accounting practices (Power, 1993).

An ethnographic study of accounting practices for financial instruments should therefore consider the subjective nature of human understanding and the complexity of human relationships in applying International Financial Reporting Standards.

Russell (1996) describes an interpretive methodology as a research process which is iterative, involving ongoing analysis and reflection through stages of exploration of an initial problem focus. The researcher gradually discovers the issues and questions of centrality to the informants and develops an emergent theoretical perspective. Through further reflection and data analysis the researcher eventually develops a theoretical understanding of the problem being studied.

Method – Case Study

The central aim of this method is to construct theory, rather than theory testing, by grounding the theory in a rigorous observation of the phenomenon. Analysis of the data is itself an emergent process. The researcher seeks gradually to develop empathy with the data, to understand how to interpret the various data sources. Case studies inevitably encounter problems of generalisability, but if the research methodology is sufficiently rigorous, these problems may be, at least partially, overcome. A well-constructed grounded theory should meet the criteria of generality in judging the applicability of the theory to a phenomenon. If the data upon which the theory is based is comprehensive and the interpretations conceptual and broad, then the theory should be abstract enough and include sufficient variation to make it applicable to a variety of contexts related to that phenomenon (Strauss and Corbin, 1990).

The Research Process

The research findings are presented using an adapted version of Russell’s (1996) model of the interpretive research process.

Initial Problem Focus

Around June 2008, the price of Huge Group Limited’s (Huge) ordinary share was trading around 395 cents per share. It was noted that the forward earnings yield (or return on investment) in a Huge Group ordinary share exceeded the forward cost of debt capital. At the time Huge’s problem was raising traditional debt to fund the repurchases own their own shares. So Huge decided to make use of the JSE's SAFEX-guaranteed single stock futures (“SSF”) mechanism, and general contracts for difference (“CFD”) mechanisms available in the market. Herbst, and Executive Chairman Anton Potgieter, therefore agreed to effectively bond their existing shares in Huge Group via SSF contracts, in order to provide the company with the means of repurchasing its own shares and making other capital investments.

Their decision to gain exposure to the ordinary shares in the company was an intelligent way to hedge the cash-flow risk of the repurchase of the company's share some time in the future. SSFs also provided Huge Group with a quick way of getting access to very cheap funding, funding that was effectively provided at a rate of prime less 3% with no guarantees or surety-ships required, and with limited security requirements. In a nutshell, Huge Group's use of SSFs ensured that the future repurchase of ordinary shares is pegged at a known price, and as such, Huge Group has hedged itself against the cash-flow risk of a rising stock price and a continually shifting goal post.

IAS 32.33 explains that the cost of an entity's own equity instruments that it has reacquired ('treasury shares') is deducted from equity. Gain or loss is not recognised on the purchase, sale, issue, or cancellation of treasury shares. This statement embodies the essence of the issue surrounding the accounting treatment of the SSFs that have been entered into by Huge Group Limited. The JSE have declared that upon expiry of the SSF contracts entered into by Huge may only be settled on a gross physical basis.

In terms of the above discussion the question that needs to be resolved is whether the SSF contracts entered into by Huge have the characteristics to indicate that these contracts should be treated as an equity instrument and reflected in the financial statements as an imitation share repurchase or should the SSFs be treated as a financial asset as held for trading and measured at fair value through profit or loss. The financial asset as held for trading versus equity distinction is important. Put simply: If an instrument is a financial asset as held for trading the accounting will impact on the profits for the period. If an instrument is equity: the proceeds received are credited directly to equity and are not remeasured - it is not subject to IAS 39 accounting by the issuer and there will be no impact on profit or loss for the period.

Initial Data

The collection of the data for this study took place during the annual audit of Huge Group Limited for the financial year end 28 February 2009. The researcher’s involvement was that of the IFRS advisor to Huge Group Limited and the Engagement Quality Control Reviewer (EQCR) to their auditors Horwath Leveton Boner (HLB). International Standard on Quality Control (ISQC) 1 “Quality Control for Firms that Perform Audits and Reviews of Financial Statements and Other Assurance and Related Services Engagements” P 35 states that the audit firm shall establish policies and procedures requiring, for appropriate engagements, an engagement quality control review that provides an objective evaluation of the significant judgments made by the engagement team. P39 states that the audit firm shall establish policies and procedures to address the appointment of an engagement quality control reviewer. The accounting treatment of Huge Group’s SSF contracts over their own shares would constitute complex and controversial that would require not only the services of an quality control reviewer but in addition the services of an IFRS expert in form of the IFRS advisor. I was requested by the management of Huge Group and HLB to act in both capacities. I was therefore entrusted to oversee the entire audit of Huge Group Limited and ensure that accounting treatment was in compliance with company law. I was in a unique position to be able to observe and sign off on the entire audit process and the accounting treatment of the SSF contracts.

Contracts for Difference

CFDs are a leveraged product requiring a deposit of cash collateral rather than the payment of the full value of the underlying position. Effectively cash is being borrowed by the long counterparty and lent by the short counterparty to finance the purchase or short sale of the underlying security. Although CFDs replicate the economic movements of the underlying securities they convey no right or interest in the securities nor entitle holders to any voting rights or STC credits associated with them. A Contract for Differences is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. In substance the contract is between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.)

For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares. CFD on a company's shares will specify the price of the shares when the contract was started. The contract is an agreement to pay out cash on the difference between the starting share price and when the contract is closed. CFDs can be used to gamble on shares falling (going short) as well as rising (going long). CFD on a company's shares will specify the price of the shares when the contract was started. The contract is an agreement to pay out cash on the difference between the starting share price and when the contract is closed. CFDs can be used to gamble on shares falling (going short) as well as rising (going long).

In consequence of the above discussion there can be no doubt that a contract for difference is a derivative financial instrument that is held for trading and therefore the accounting for a Contract of Differences is relatively simple. IAS 39 defines held for trading as: held for the purpose of selling in the short term or for which there is a recent pattern of short-term profit taking are held for trading. IAS 39.55 states that a gain or loss arising from a change in the fair value of a financial asset or financial liability that is not part of a hedging relationship shall be recognised shall be recognised in profit or loss. In simple terms all contracts for difference must be recognized at fair value on the reporting date.

The gain or loss on the contract is recognized in income as it occurs. This loss appears in the financial statements in the amount of R 7,686.704.

Single Stock Futures

Standard Bank has acquired a certain number of Huge Group Shares. As Huge Group Huge were expecting an increase in their own share price in the near future it was decided to investment their own ordinary shares by repurchasing them from Standard Bank.

To hedge its position Huge purchased 84,055 SSF contracts in their own shares via SAFEX. In terms of the contract, the futures will be purchased at a level of 3.62 per share. At year-end, (27 Feb 09), the mark-to-market account stood at R17,881,162 debit. This debit represented a fair value write down of the SSFs. This loss appears in the financial statements in the amount of R17,881,162.

To date: The company has indicated an intention to repurchase shares at some point in the future. No indication has been made as to when the contracts will be finally settled or how many times the contracts will be rolled over before being settled. The SSFs have rolled three times. On the 18th Of December, 18th of March and 18th of June - They will continue to roll every three months. Huge Group is exposed to 80 455 Single Stock Futures Contracts (i.e. each contract represents 100 shares) (100:1). The yearend of Huge is 28 February. At year there had only been one rollover.

The rollover day for a futures contract is one of the most misunderstood features in trading these contracts. The expiration day is easily understood. That day is when the futures contract must be settled. On expiry the underlying SSF contracts would require a physical delivery of Huge; own shares to them. To date and also at financial year end settlement on a gross physical basis had yet been effected. To affect this the normal process is to roll the SSF contract over into the next quarterly period to keep the trade open. Standard Bank has to buy back their contracts and sell a new one to Huge with a longer term but the same strike price and the same number of shares. If the roll over does not change the terms substantially then derecognition of the SSF contracts in Huge’s accounting records does not occur. The question arises as to why Huge decided not settle on a gross physical basis, but rather to extend their SSF contracts by affecting a rollover? At year end there had only been one rollover. If the sole reason for entering into the SSFs was to repurchase their own shares then why have they not done so at the first expiry date?

Due the impact of the global financial crisis and event not foreseen by the global business community the SSFs are well out of the money. The share price dropped to a level well beyond the strike price of R3.62. This meant that Huge could re-purchase their own share on the JSE for an amount well below the strike price and this would have a severe cash flow implications. Huge were legally bound on expiry to pay a huge premium for their own shares. Huge were probably speculating the share price would improve in relation to the strike price hence the rollover. In addition Huge may have been able to afford to take possession of their own shares just yet due to cash flow problems.

Huge at 18 December had not yet complied with Section 85 of the Companies Act, so legally they could not take delivery of their own shares. It is submitted that these conditions existed at each of the following rollovers. In discussions with the directors the rollovers of the SSF contracts would continue indefinitely until the above conditions were improved.

On Thursday, 19 March 2009 a public announcement stated the Huge board acted without the required JSE shareholder approval in entering the SSF contracts. If this is the case Huge were unable to take possession of their own share on any of the expiry dates and therefore had no alternative but to roll the SSFs contracts over. Whatever the reasons by rolling over their future positions in my opinion Huge have entered into a scheme to improve their position and delay the physical delivery of their own shares. This is trading and therefore the SSFs are held for trading.

Data and emergent research questions

As the research proceeded it became evident that the regulator has become increasingly insistent that Huge in some form should disclose the SSF contracts as an imitation share repurchase. However at a meeting with the regulator I submitted the following technical opinion and stated that under no circumstances was this opinion going to be changed. The following discussion outlines this opinion and the resultant regulator’s response.

The IFRS Advisor’s Opinion

IAS 39.AG14 states that trading generally reflects active and frequent buying and selling, of financial instruments. Trading is not investing; it’s speculating. Speculating is defined as assuming a business risk with the hope of profiting from market fluctuations. Successful speculating requires analyzing situations, predicting outcomes, and putting your money on the side of the trade on which way you think the market is going to go, up or down. Huge’s conduct clearly satisfies the definition of speculating. These conditions in my opinion suggest overwhelmingly that the single stock futures entered into by Huge to repurchase their own shares at an uncertain date in the future cannot and should not be classified as equity instruments until such date that Huge de facto take delivery of their shares after complying with Section 85 of the Companies Act and the requirements of the JSE.

A contract is not an equity instrument solely because it may result in the receipt or delivery of the entity's own equity instruments. IAS 32 emphasizes that a contractual obligation, including one arising from a derivative financial instrument, that will or may result in the future receipt or delivery of the issuer's own equity instruments, but does not meet the certain conditions is not an equity instrument. IAS 32 does not deal directly with SSFs however there is adequate discussion in IAS 32 as to whether a financial instrument should be classified as held for trading or as an equity instruments. The rule in IAS 32 for classification of items as held for trading or equity is essentially simple. A holder of a financial instrument must classify the instrument (or its component parts) on initial recognition in accordance with the substance of the contractual arrangement. It is conceded that substance and form are 'commonly', but not always, the same. In reality the substance is determined, if not by the legal form, then certainly by the precise legal rights of the holder of the financial instrument concerned. Ultimately, the key determinant of whether an instrument is held for trading or an equity instrument is whether the financial instrument displays the characteristics of an equity instrument as indicated by the substance of the futures contract.

It is important to note the emphasis of IAS 32 is on the contractual rights and obligations arising from the terms of an instrument, rather than on the probability of those rights and obligations leading to an outflow of cash or other resources from the entity.

The discussion in the above paragraph requires a detailed understanding of contractual rights and obligations arising from the terms of the SSF contracts entered into by Huge. According to the JSE’s own guidelines on SSFs one can exit a futures contract before the expiry date. At 14:00 two business days prior to the expiry of an SSF contract if the holder hasn’t elected to roll the SSF into a longer-dated contract. This is exactly what Huge has done. Single Stock Futures Contract Specifications of the JSE state that single stock futures contracts may be physically settled as contemplated in paragraph (a) of the definition of “futures contract” in rule 2.10 and, in terms of rule 8.40.7, at the expiry date and time referred to in clause 6 or that Single stock futures contracts may be cash settled as contemplated in paragraph (b) of the definition of “futures contract” in rule 2.10 and at the expiry date and time referred to in clause 6. Simply put physically settled in terms of Rule 8.40.7 and cash settled in terms of Rule 8.40.3. However as the SSFs have deemed to be physically delivered this feature constitutes the only mode of settlement on expiry.

Whatever the rights and obligations under the SSF contracts, these contracts have been extended and rolled over three times to date. The SSFs are alive and are being traded by Huge, if this was not the case they would have expired and Huge would have had to take delivery of their own shares. This has de facto not happened.

By rolling over the futures position Huge are waiting for the market to improve and reduce the differential between the strike price and share price, and this is trading. Sometimes a derivative financial instrument gives one party a choice about how the instrument is to be settled (either the issuer or the holder may decide whether it wants to settle net in cash or by exchanging shares for cash) (IAS 39 (AC 125).26–.27).

If this is the case, it is a financial asset or liability (not an equity instrument) unless settlement of all the alternatives would result in it being an equity instrument. The underlying contract for a futures trade would require a physical delivery, and to avoid this the normal process is to close out the contract, which basically means make a financial settlement, in advance of the designated expiration date. An alternative to closing the contract is to roll it over into the next quarterly period if you want to keep the trade open. The expiring contract can be traded. In other words when the substance of the contract includes various provisions as described that one party has a choice to request a settlement option, this results in a derivative, regardless whether the holder or issuer has the choice over settlement. Such derivatives accounted for as such under IAS 39. In respect of SSF purchased via SAFEX, SSF contracts can be traded before expiry closed out using equal and opposite trades, and rolled over. These various forms of settlement can all be affected before expiry and are available for choosing by the holder (Huge). Hence there is clearly a choice on how the SSFs are settled. One must understand the designation by the JSE that Huge’s SSFs are physically delivered can only be enforced on expiry. That’s the date the parties to the transaction agree to effect delivery and terminate the contract. This agreement to date has not yet taken place and it appears based on the evidence that is not going to take place in the near future.

Contract and contractual refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. The evidence as presented suggests that there many mechanisms which allow for an indefinite delay or in never taking delivery of their own shares before expiry.

As such the SSFs in applying the substance of the overall SAFEX and JSE contract specifications and derivative rules cannot be classified as an equity instrument. As stated previously Huge may never take delivery of their own shares under the SSFs. There is persuasive evidence of this. First there are the three rollovers to date. If Huge’s intention was to repurchase their own shares why was thus not done on the first expiry? This suggests speculation. Cash flow problems which are clearly a problem at Huge has ensured that Huge delays physical delivery until the share price approximates the strike price. Legally, as discussed they were unable to take delivery of the own shares. The Companies Act requires the annual financial statements to fairly present. The term “fairly present” is a rather subjective one, and therefore difficult to apply in practice. It is therefore submitted that fair presentation should be assessed against the Framework of accounting. It means that the information that is disclosed in the financial statements will give a faithful representation of the events it purports to represent (or would reasonably be expected to represent). All items that impact on the financial position and/or results of an entity should therefore be represented in the financial statements in an appropriate manner. Financial states should provide relevant information to ensure fair presentation.

Relevant information is information that is useful and can therefore influence the economic decisions of users by helping them to evaluate past, present or future events, or confirming or correcting their past evaluations. Such information can enable users to make more accurate forecasts regarding specific events, or can supply feedback on previous expectations. Relevant information, therefore, has one or both of the characteristics of feedback value or predictive value.

To fairly present the financial impact of the SSF contracts entered into by Huge the question that needs to be addressed is whether by accounting for the SSF contracts as held for trading fair value through profit and loss faithful representation and relevance have not been achieved. This in my opinion can only materialize if the SSFs display the characteristics of an equity instrument and there is absolute certainty via the substance of the SSF contracts that Huge would in fact take delivery of their own shares and could not be therefore held under any circumstances held for trading.

IAS 32 defines an equity instrument as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. The notion of a residual is literally meaningful only in the event of corporate liquidation, when the firm would cash out its assets and distribute them to satisfy all claims. This raises the questions of whether Huge as a result of their SSF contracts could be classified as a claimholder. Is there sufficient evidence in terms of the SSF contracts to establish Huge as a claimholder? Do the SSF contracts serve in any way as legally enforceable evidence of the right of ownership in Huge, to enable Huge to reflect a share repurchase?

In my professional opinion the answer to these questions is no, and consequently the SSF contracts do not display any characteristics of equity sufficient to suggest that they could be classified as an equity instrument. To classify Huge group’s SSF contracts would be not faithfully represent the substance of the contract specifications that apply to a Huge SSF.

Emerging theoretical perspectives

The interpretive methodology which informs this research (Russell, 1996) requires an iterative approach to theory development whereby initial theoretical perspectives are tested by reference back to the research site. In this way a deep theoretical understanding, or grounded theory, of the phenomenon is constructed. The emergent theoretical perspective is an important stage in this construction as it brings together theory and empirical data to develop a theoretical understanding which can be tested and further developed. The following section outlines the emergent theoretical perspective of the relationship the application of International Financial Reporting Standards and South African company law.

South African company law makes provision that the financial statements of company’s must comply with financial reporting standards, and fairly present its financial position and the results of its operations. The main premise of financial reporting standards is that their application with additional disclosure when necessary is presumed to result in financial statements that achieve a fair presentation. This presumption raises the question as to why the Companies Act requires separate compliance with financial reporting standards and fair presentation.

The intention of the legislation is clear: only by preparing financial statements in compliance with financial reporting standards and ensuring that they fairly present the effects of transactions can they comply with the provisions of the Companies Act.

The requirement to prepare financial statements in conformity the provisions of the Companies Act is not apparent from a plain reading of the legislation as confusion exists as to which provision is dominant in respect of preparing financial statements: financial reporting standards or fair presentation.

This research paper attempts to reconcile the apparent contradictory and duplication of the legal provisions for preparing financial statements by detailing the principles of the law regarding the preparation of financial statements.

The preparation of financial statements has been the domain of auditors and accountants who are interpreting whether financial statements comply with financial reporting standards with little or no concern whether the financial statements are legally compliant. As a result financial reporting standards have become the overriding provision upon which financial statements are being prepared; with absolute no regard as to whether fair presentation has been achieved. Financial reporting standards have not eliminated the one basic limitation of the financial reporting system, i.e. the possibility of different accounting treatments being applied to essentially the same facts and can lead to significant variations in reported profits. This flexibility of financial reporting standards and the auditor and accountant’s unwillingness to consider fair presentation and the faithful representation of the effects of transactions potentially creates liabilities for directors which never existed before.

Faithful representation refers to the nature of the information contained in the financial reports. It means that the information that is disclosed in the financial statements will give a faithful representation of the events it purports to represent (or would reasonably be expected to represent). All items that impact on the financial position and/or results of an entity should therefore be represented in the financial statements in an appropriate manner. It is stated in paragraph 34 of the Framework that most financial information is subject to the risk of not being entirely faithfully representative in that it does not necessarily portray what it purports to portray.

The accounting treatment of liabilities (such as loans or bonds) and equity instruments (such as shares, stock or warrants) by their issuer was not historically regarded as presenting significant problems. Essentially the accounting was dictated by the legal form of the instrument, since the traditional distinction between equity and liabilities is clear.

The issue of equity creates an ownership interest in a company, remunerated by dividends, which are accounted for as a distribution of retained profit, not a charge made in arriving at the result for a particular period.

Liabilities, such as loan finance, on the other hand, are remunerated by interest, which is charged in the income statement as an expense. In general, lenders rank before shareholders in priority of claims over the assets of the company, although in practice there may also be differential rights between different categories of lenders and classes of shareholders. The two forms of finance often have different tax implications, both for the investor and the investee.

In economic terms, however, the distinction between share and loan capital can be far less clear-cut than the legal categorisation would suggest. For example, a redeemable preference share could be considered to be, in substance, much more like a liability than equity. Conversely, many would argue that a bond which can never be repaid but which will be mandatorily converted into ordinary shares deserves to be thought of as being more in the nature of equity than of debt, even before conversion has occurred.

The accounting profession has not always found it easy to decide how to balance competing considerations of substance and form in accounting for these instruments, especially since the fundamental distinction between debt and equity is rooted in form to begin with.

The rule in IAS 32 for classification of items as financial liabilities or equity is essentially simple. An issuer of a financial instrument must classify the instrument (or its component parts) on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument. The application of this principle in practice, however, is often far from straightforward. IAS 32 requires the issuer of a financial instrument to classify a financial instrument by reference to its substance rather than its legal form, although it is conceded that substance and form are 'commonly', but not always, the same. Typical examples of instruments that are equity in legal form but liabilities in substance are certain types of preference share and units in open-ended funds, unit trusts and similar entities. Conversely, a number of entities have issued instruments which behave in all practical respects as perpetual (or even redeemable) debt, but which IAS 32 requires to be classified as equity.

Ultimately, the classification of preference shares redeemable only at the holder's option or not redeemable according to their terms must be determined by the other rights that attach to them. IAS 32 requires the classification to be based on an assessment of the substance of the contractual arrangements and the definitions of a financial liability and an equity instrument.' If the share establishes a contractual right to a dividend, subject only to restrictions on payment of dividends in the relevant jurisdiction, it contains a financial liability in respect of the dividends.

This would lead to a 'split accounting' treatment whereby the net present value of the right to receive dividends would be shown as a liability and the balance of the issue proceeds as equity. In such a case, it is quite likely that the issue proceeds would be equivalent to the fair value (at the date of issue) of dividends payable in perpetuity, such that the entire proceeds would be classified as a financial liability.

IAS 32 restricts the role of 'substance' to consideration of the contractual terms of an instrument, and that anything outside the contractual terms is not considered for the purpose of assessing whether an instrument should be classified as a liability under IAS 32.

Coleman J stated in Novick v Comair Holdings Ltd – “The first point to be made is that accountancy is not an exact science. It is a system of recording the transactions of business enterprises, and of presenting accounts or financial statements relating to those transactions, and to the affairs of the enterprises, in accordance with certain conventions which are professionally recognised, and reasonably well known in the world of commerce, although they undergo evolutionary change from time to time. Those conventions, although they require strict adherence to the literal truth in respect of some items reflected in accounts, do not require it in relation to others; it is indeed an accounting convention that, in respect of some items in a balance sheet, a reflection of the literal truth is neither expected nor sanctioned”.

Thus, in relation to a set of accounts it is seldom meaningful to ask whether what they reflect is true. That was recognised by the framers of the Companies Act 61 of 1973, who have provided in s 286(3) a standard to which the annual financial statements of a company must conform. It is not therefore required that the financial statements be 'true' or "accurate'.

In South Africa the common perception amongst auditors and preparers of financial statements that they must be prepared in terms of IFRS without due consideration to fair presentation and faithful representation is in essence a contravention of South African company law.

Conclusion

Derivatives are here to stay. It is difficult to imagine managing finances or conducting business without them these days. But they are not to be trifled with. Many are highly complex and behave in sometimes unpredictable ways. And new architectures are being developed continually. Yesterday’s derivatives have advanced through many generations of innovation so that, today, a request that would once have produced the financial equivalent of a slingshot will now beget a nuclear device.

Populating the derivatives world are a band of risk takers who, oddly enough, frequently trade to transfer risk to others. But most people are risk-averse, and this includes nearly the entire spectrum of management within companies that use derivatives. Their aim is to avoid becoming a casualty of that process. Despite best efforts, that aspiration may be defeated. The best defense against this career risk is effective supervision of the derivatives activity so that calamities do not occur.

This case study has sought to provide some guidance toward that end. If any further reinforcement is needed, the Huge Group’s debacle that was detailed in this case study should dispel any illusions that derivatives disasters cannot happen to nice people who think they are good managers.

The Audit Exemption: Its Role and Impact on the Quality of Accountability of Private Limited Liability Companies

2010-05-09T23:31:00.001+02:00

INTRODUCTION

Corporate accountability can be defined as the ability of those affected by a corporation to control that corporation’s operations. The discharge of corporate accountability traditionally relied on the preparation and audit of accountability reports (financial statements). For over 100 years an audit arguably has provided a high level of assurance from an independent professional (auditor) that financial statements comply with an identified financial reporting framework and helped to enforce the obligations which are placed on companies and their directors in return for limited liability.

The financial statements of a company provide information on the financial position of a company and give an account of the stewardship of management. Such information is useful to the owners of that enterprise (the shareholders). Obviously, reliable and relevant financial statements may also provide a useful starting point for the information needs of others, such as potential investors, actual or potential creditors, lenders, employees, regulators and government. But this is debatably only ‘secondary’ in nature. It would be rare for any decision to be taken solely on the basis of information contained in financial statements.

The obligation for a statutory audit in South Africa stems from the Companies Acts, 1973 and the amendments to the Companies Act which includes Phase 1 of Corporate Law reform in South Africa – The Corporate Laws Amendment Act 2006 which requires an independent auditor to give an opinion to the members (shareholders) as to whether the financial statements “are presented fairly, in all material respects,” in accordance with an applicable financial reporting framework. The auditor does not normally assume any duty of care other than to the client’s shareholders as a body. However, secondary benefits of the statutory audit may include; Increasing confidence that filed information meets statutory requirements; Allows professional accountants to identify issues of relevance to management which can be useful in decision making; Assists companies in meeting their compliance and regulatory requirements; Can help deter fraud as the audit process is designed to give reasonable assurance that fraud and errors that may be material to the financial statements will be detected.

However, audited financial statements do not provide a ‘one size fits all’ solution to information needs. Nor are they meant to. This is particularly the case for small, owner managed, businesses (Private Companies) with little or no apparent public accountability, where the detail of financial information on the public record is quite limited due to the small company filing exemptions available under the Companies Act. While shareholders, the primary beneficiaries of audited financial statements, receive ‘full’ audited accounts, others have access only to limited information placed on the public record, and often after considerable time has elapsed between the financial period to which the information relates and when it is actually placed on the public record. While the audit adds value, there are, of course, associated costs, most obviously the cost of the audit itself. Typically, these costs are higher, proportionately for smaller companies. Such an outcome needs to be avoided not only for the sake of good public administration but for the sake of business confidence in the whole system of financial reporting. These public interest implications suggest that the interests of a company’s shareholders alone are not the only valid criteria to take into account in considering the future of the statutory audit.

This cost issue has been exacerbated with the application of a revised set of International Auditing Standards (ISAs) which registered auditors are legally obligated to comply with when conducting an audit in the manner required by the Companies Act.

This obligation stems from the newly enacted Auditing Professions Act 2006. These standards, which have been developed primarily with large, capital market companies in mind, contain a lot more detailed and prescriptive procedures than in the previous applicable South African Auditing Standards. Unlike International Financial Reporting standards which have been introduced on a compulsory basis only for listed companies in South Africa, no distinction is made as to the type and size of entity to which these ISAs apply.

During May 2004 the South African Department of Trade and Industry issued a Policy Paper indicating their intention to review South African corporate laws. The review was to include amongst others the Companies Act, and Close Corporation act, non-profit organisations and cooperatives. The reasons for the review have been stated as a need to bring South African company law in line with international trends as some of the major commonwealth countries, including the United Kingdom which recently undertook major reforms. The review was also made necessary by recent and spectacular corporate governance failures not only internationally but also in South Africa. Globalisation also influenced the decision to undertake the review. The reform was set out in two phases. The second phase of the reform takes the form of the new Companies Act that was signed by the President on the 8th April 2009 and gazetted in Gazette No. 32121 (Notice No. 421). The Act comes into operation on a date still to be fixed by the President by proclamation in the Gazette, which may not be earlier than one year following the date on which the President assented to this Act. It is anticipated a commencement date of 1 July 2010.

Despite the vital role that statutory auditing plays in enhancing trust and credibility over the financial statements of business entities, one of the most far reaching changes in Phase 2 of South Africa’s corporate law reform is the removal of the audit requirement for Private Limited Liability companies. Government’s reason for this change is the elimination of bureaucracy and unnecessary administrative requirements for small companies. Much attention has been given to removing the administrative burdens of small companies globally, as development of this sector will help grow developing economies and reduce unemployment.

Government-mandated audit requirements are believed to result in a greater level of acquisition of audit services than would occur in a free market. This may be desirable because of the nature of audit services as a public good. Without government intervention, such services may be under produced due to disagreement among ﬁnancial statement users as to who ought to bear the cost of providing the service. Deregulation of a government-mandated audit requirement provides a rare opportunity to study the shift from a mandatory audit regime to a market regime. The suggestion that the increasing complexity of accounting, auditing and associated ethical standards has imposed disproportionate burdens on smaller entities and the effects of this on the cost and quality of their financial management and reporting are not clear from existing research.

Some people agree that not all companies should require an audit and are of the view that it does not make sense to require small companies to be subject to an audit where the cost of the audit outweighs any benefits. The challenge is to decide where the cut-off point should be. Others argue that all companies should be audited because there are other structures available for trading that do not require an audit.

This research paper provides a critical perspective in respect of the circumstances surrounding the deregulation of the mandatory audit for South African private companies and whether it would be beneficial for these firms to still maintain an audit of their business after the abolishment. Of particular interest is the justiﬁcation for this change, the impact on the corporate accountability of private companies and whether company law regulators in South Africa have sacrificed the promoting of the public interest in favour of economic efficiency when they incorporated the audit exemption into South African company law.

A critical synthesis of the of legal and economic literature will be conducted to provide an objective discourse on the audit abolition in South Africa and what it impact it will have on the global corporate governance debate for small private limited liability companies. This research contributes to the literature on the regulation of audit services by examining the issues surrounding deregulation and the possible consequences of deregulation of such services. This critical perspective is not an effort to refute or approve the important role of Corporate Reform in South Africa; rather, it aims to illustrate various potential and unintentional effects it may have on markets, business activity, and the corporate governance debate.

The remainder of the paper is organized as follows. The next section provides a historical background for the study. This is followed by sections on the method, justiﬁcation and criticism of the proposed deregulation, the impact of deregulation and the conclusion.

BACKGROUND

Background and History to South Africa’s Company Law Legislation

Company law has existed in South Africa since 1861, beginning with the Joint Stock Companies Limited Liabilities Act No 23 of 1861 of the Cape Colony, which, along with other provincial company legislation, was a carbon copy of equivalent English legislation. The first national company law was introduced in 1926 with the Union Companies Act, which was amended from time to time along the lines of the latest English legislation. The 1926 Act was replaced in 1973 with the Companies Act No 61 of 1973, which, despite efforts to innovate and develop a direction more appropriate for South Africa, remains much in the mould of English law.

The current framework of company law in South Africa is therefore essentially built on foundations, which were put in place by the British in the middle of the 19th century. The 1973 Act, hailed as cutting the umbilical cord between the South African and English company law, however, adopted many of the principles and provisions of the 1926 Act. It is therefore still based on the framework and general principles of the English law. Most amendments to the Companies Act, with the exception of the establishment in 1989 of the Securities Regulation Panel to regulate takeovers and changes of control in a company, have been of a technical nature. Thus, the last extensive reform of company law occurred in South Africa in 1973 with the enactment of the existing company law, and even then the model remained that of the 1926 Act.

When the ANC came to power it was critical of the existing legislation since it did not address the problem the major difficulties with the South African company law regime as it was highly formalistic, making it burdensome and costly to form and manage an enterprise and creating artificial preferences for certain structures.

As a result, negotiations for a new legislation commenced in 2004. During the course of the drafting of the Companies Act 71 of 2008 took place, the ANC took cognizance of the problems associated with the old Act. There was much interaction between business, labour and the government prior to the drafting of the legislation. The Companies Act 71 of 2008 has heralded a new era of corporation’s jurisprudence for South Africa.

Since the Companies Act was enacted in 1973, fundamental legal developments have taken place in South Africa. The most important change was the adoption of the Constitution in 1996. No area of South African law can be analyzed or evaluated without recourse to the Constitution, which is the supreme law of the country. The Bill of Rights, as provided for in Chapter 2 of the Constitution, constitutes a cornerstone of democracy in South Africa.

It enshrines the rights of all people in the country and affirms the democratic values of human dignity, equality and freedom. It also regulates the relationship between economic citizens and thus may have fundamental implications for company law. New company law should therefore be consistent not only with the Constitution of South Africa and the principles of equality and fairness that it enshrines, but also with other laws that have been enacted.

METHODOLOGY

Conceptual Framework

McCandless (2002) defines public accountability as the obligation to answer publicly, to report to an acceptable standard of answering, for the discharge of responsibilities that affect the public in important ways. Based on this definition McCandless (2002) developed the public accountability principle. This principal states that every responsibility that affects the public in important ways carries with it the obligation to answer publicly for the discharge of the responsibility.

It makes no sense to assign important responsibilities to corporations whether public or private and then allow them to act without attaching an obligation of answering to the public. Without answering, one is left with only fighting to stop something and/or blaming after the fact. The obligation to answer is simply an obligation in fairness - one that is reasonable to expect. The question arises as to whether this obligation to answer to the public should be a self-regulating or legal obligation.

In this respect, Singh (2007) suggests that there needs to be a robust, transparent, and efficient regulatory framework to oversee the implementation of corporate accountability. Furthermore, Singh (2007) maintains that given that there is often a considerable discrepancy between a corporations’s undertaking to act in the public’s best interest and its actual business conduct, it is essential therefore that the state assume the primary responsibility of regulating corporate behavior.

Method

This critique offers institutional critique as an activist methodology for changing perceptions. Institutional Critique is a term that describes the systematic inquiry into the workings of institutions such as the auditing profession and the investing and financial community. Since institutions are rhetorical entities, rhetoric can be deployed to change them. In an effort to counter oppressive institutional perceptions such as the audit expectations gap and audit regulation, the focus of this critique shifts from the scene of action and argument to professional writing and to public discourse using a narrative and illustrative research method. Institutional critique is a way to supplement the practice of auditing’s current efforts and to extend the field into broader interrogations of discourse in society.

This institutional critique is written in the narrative mode. The narrative point-of-view is meant to be the related experiences of the actual author. The narrative mode encompasses not only who tells the story, but also how the story is described or expressed. In this context this critique uses perspective in theory of cognition which is the choice of a context or a reference from which to sense, categorize, measure or codify experience, cohesively forming a coherent belief, typically for comparing with another. This perspective is contextual, interpretive and interdisciplinary, aiming at a more holistic understanding of audit regulation. This contrasts with much accounting research, which is influenced by an approach to economics abstracting from much of the socio-political context. The critique approach emphasizes the auditing constructs, as well as reflects individual, organizational and social reality. The aim is to contribute to an imminent critique of on the issues facing the auditing profession and their contribution to society.

DEREGULATION OF A MANDATORYAUDIT: JUSTIFICATION AND CRITICISM

Advocates of the public interest theory of regulation see its purpose as achieving certain publicly desired results which, if left to the market, would not be obtained. The regulation is provided in response to the demand from the public for corrections to inefficient and inequitable markets. Thus, regulation is pursued for public, as opposed to private, interest related objectives (Gaffikin, 2005). Davis and Ward (2008) posit the view that the public interest school holds that government actions can improve efficiency and welfare outcomes in society. South African Company Law for the 21st Century Guidelines for Corporate Law Reform (2004) was a policy paper that set out the framework and guidelines that provided the foundation for the drafting of the Companies Act, 71 of 2008. The policy paper states that socio-political and economic change in South Africa has underscored the need for social responsiveness, transparency and accountability of enterprises and that corporate law reform has been fundamental to the future of South Africa and is driven both by the new democratic dispensation. Mpahlwa (2004) argued that it was time that South Africa reviewed their regulatory framework to ensure that it was relevant for the present and the future and that it includes all South Africans by promoting economic opportunity for black businesses and small businesses.

Makatiani (2006) posits the view that the South African small and medium enterprises (SMEs) face the challenge of increasing their skills base and productivity if they want to grow into sustainable and globally competitive companies. A lack of capital and skills restricts most small local business from expanding into the export market, which results in the saturation of the local market with cheap, low quality goods and services from a range of survivalist sme-businesses. It is crucial that SMEs have systems and people in place that are efficient and productive if they want to effectively compete against larger businesses and multinationals for these opportunities. Running a small business and transforming it into a sustainable and globally competitive company is a complex undertaking in this environment.

South African entrepreneurs need to tighten corporate governance; put in financial systems and processes in place; upgrade manufacturing systems, technologies and processes; and introduce quality assurance.

The growth of the Small, Medium and Sme-Enterprise (SMME) sector is critical to the social and economic advancement of South Africa (Thabethe, 2008). Thabethe (2008) added that the development of SMMEs will continue to play a major role in empowering those who were previously economically excluded, particularly in the South African context. “Small businesses are an integral part of any healthy economy.

They enhance competitiveness of the kind that many economies sorely needs. They help to mobilise the savings from communities for productive purposes. Creating a regulatory environment in which SMMEs can thrive is crucial to long-run growth, especially in an emerging economy in which the role of SMEs is ever more vital (Davis and Ward, 2008). Irwin (2004) stated that a shift to a regulatory environment that reduces the administrative burden for SMMEs would be a positive investment in South Africa’s future. Booysen (2008) asserts that smaller companies are often eliminated from the supply chain due to the lack of funding, and corporate governance.

In public interest theory regulation is assumed to benefit society. This research contends that in terms of the legislation as set out in the Companies Act, 71 of 2008, SMEs appear to be the forgotten stakeholders in the fair and efficient management of South African corporate governance because the Companies legislation perpetuates the myth that the corporate governance market is essentially aimed at listed and other public companies. It can be speculated that rules, norms and best practice in corporate governance for SMEs will somehow magically trickle down to SMEs. The Companies Act, 71 of 2008 offers neither resources nor practical guidance on corporate governance for SMEs.

An alternative view could be that that the South African government does not consider that corporate governance should apply to SMEs due to the cost associated with implementing corporate governance e.g. appointment of independent directors, developing internal control systems and external audits. The statutory audit for an SME provides no added value for a company and the sooner it is abolished the better. There is a risk that a message will be sent out to small companies that the authorities will not be concerned about the quality and reliability of the accounts that they prepare.

The limited liability company is an important business entity in a modern economy. Under this structure, entrepreneurs can conduct business with limited risk to their personal assets in the event that the business proves unsuccessful and does not generate sufficient funds to meet all its liabilities. The limited liability structure represents a major concession by society generally to entrepreneurs, because it enables them to take risks that they might not otherwise be prepared to accept. The reason society is prepared to convey this concession is because it facilitates greater economic activity, which in turn increases the wealth of society generally.

However, the operation of limited liability companies carries an increased risk of default for anybody dealing with such companies, because once the resources of the company itself are exhausted, there is no further recourse for any debts owed.

Thus, society does not allow unfettered use of the so-called "corporate veil" and prescribes rules under which those wishing to avail of it must operate. In South Africa’s case, these rules are set out in the Companies Acts and elsewhere and are designed to ensure that the owners of companies behave in a responsible manner and do not attempt to take advantage of the privileged position which limited liability status affords them.

The primary purpose of regulation in any economic sector is to provide, for reasons of public interest, a counterweight to free market forces and to counteract market failure. If allowed to operate unchecked, these forces may merely serve to benefit individuals in society to the disadvantage of society as a whole. Reports by auditors on financial statements are widely used for decision-making in our economic lives. Reliable and respected financial reporting and audit are fundamental elements in supporting the reputation of South African business, in avoiding financial losses, in encouraging trade and ensuring the efficient operation of the South Africa financial markets and more generally, in enhancing the attractiveness of South Africa as a location of business development.

This process of simplifying company law in South Africa will result in private limited liability companies not being required to prepare financial statements or to appoint an auditor. The impact of the company law “simplification process” guarantees that small closely-held private companies have been overlooked in the fair and efficient management of South African corporate governance. The adoption of limited liability status by individual companies must be counterbalanced by a proportionate requirement for public accountability and transparency on the part of the companies concerned, and the new corporate law regime will provided a little or no confidence to employees, shareholders, creditors and prospective suppliers that a company is operating in accordance with corporate governance rules, norms and best practice.

For the privilege, of limited liability an entity must ‘pay’ by making information available to its stakeholders in a responsible, transparent and unbiased manner. Gone are the days that a company is only accountable to its shareholders. No company is an island. It is part of a complex infrastructure and as a corporate citizen, is accountable to the community, employees and others. The owners and directors of private limited liability companies must be made accountable in law for their actions. The law should ensure that external stakeholders, such as shareholders, minorities, employees, creditors, suppliers, consumers and the general public, are protected.

The question arises – if there is no corporate governance function in private companies how are the stakeholders protected from irregularities committed by the company? There are many of laws that define what a company may do and may not do. These laws are framed to control company behaviour so that they behave in a way that is consistent with the public good or at least that is the theory.

The whole nature of the law is to provide checks and balances to try and keep the behaviour of companies under control so that it does not disadvantage any other group in society. There is a particular problem with financial matters as many members of the public do not understand how the financial world works but need to be able to invest in financial products with confidence without having to spend all their time checking up on the companies.

Company law should therefore contain a minimum of mandatory rules and clear and enforceable prohibitions, limited to those aspects of corporate structure, governance, administration and management which must be complied with by all companies so as to ensure transparency, disclosure, the protection of legitimate interest and the prevention of fraud and improper and oppressive conduct (South African Company Law for the 21st Century Guidelines for Corporate Law Reform, 2004).

This raises the question as to why a certain group of companies should not be required to be audited. The audit of small companies is a very important element of corporate governance (Williams, 2008). With the benefits of trading in a corporate structure, for example limited liability comes with certain responsibilities.

The obligation to provide reliable information that has been audited by an independent professional is one of those responsibilities. An audit provides a high level of assurance from an independent professional (auditor) that financial statements comply with an identified financial reporting framework. It therefore adds to the credibility of financial reporting (Rezaee, 2004).

An audit performed on the financial statements of an SME benefits the SME in many ways. For any organisation to prosper, it is essential that proper and reliable financial information and sound corporate governance are in place. An audit helps protect the interest of stakeholders and provides a level of comfort to key decision makers, allowing them to know that the financial information they are using for their business decisions are reliable and comply in all material aspects with the relevant accounting framework. With good corporate governance and sound financial reporting processes, corporate accountability is enhanced, which eventually leads to the creation of wealth for stakeholders.

Audited financial statements prepared in compliance with accounting standards provide more transparency to investors, suppliers and financial institutions on a company's financial position. In some situations, financial institutions or investors may see businesses that have not been subject to external audits as having higher a default risk, hence restricting their access to credit, which may impede expansion.

The benefits for SMEs of having their financial statements audited so that these are properly prepared in compliance with the relevant accounting framework are tremendous. Such financial statements, if used appropriately as the basis for tax computation and tax filing purposes, will minimise the likelihood of the companies filing inappropriate tax returns that could result in unnecessary tax penalties and interest.

It is common for SMEs to be family-managed companies, with key management positions held by family members. Sibling rivalry and conflict of interest are common in family-managed companies where management and control are ineffective. An independent auditor could be engaged to highlight whether financial information and controls are credible and reliable. This could also act as a deterrent against fraud and misappropriation of funds in family-managed set-ups. Recommendations by external auditors, if properly implemented by management, can improve internal controls, leading to a stronger controlled financial structure that reduces the opportunities for fraud.

Consequently, an audit provides a platform, both financial and non-financial, for SMEs to build on to meet future challenges. Having an audit performed on its financial statements will prepare an SME for greater challenges as it grows and develops into a more complex organisation, especially if it is a potential candidate for expansion or a listing.

The advantages of engaging an external auditor to audit financial statements far outweigh the cost of not having one, since auditors play an important role in the success and growth of a company - more so for an SME that is expanding rapidly. An objective assessment by qualified professionals of an entity's accounting and internal control systems will prevent unforeseen problems.

Business and their stakeholders need to rely on credible information to make effective economic decisions and for business relationships to work effectively. For information to be credible, it needs to be objective, of good quality and fit for purpose. Trust and integrity are important factors that underpin credible information flows. It is however, difficult to build trust in a complex and dynamic business world where there are new technology and business practices, changing expectations of stakeholders and demands for further information and a stream of new regulations which require increasing levels of expertise and experience.

Business and their stakeholders need suitable solutions to help address these issues and meet their information needs. One of these solutions might be external assurance. External assurance may be described as the provision of an independent opinion provided by an expert practitioner on information prepared by business for the benefit of stakeholders. It is important to emphasise the point that the opinion comes from an independent source. Stakeholders want credible information that they can trust. Objectivity and independence are therefore essential characteristics of external assurance.

Reducing compliance costs for the company can only become a convincing argument for deregulation if the reduction in compliance is not to the detriment of those who stand to benefit from the compliance work and for whose benefit the accountability measures are intended in the first place. Thus, the merits of the Companies Act 71 of 2008 must be assessed by reference to the damage that they could incur to the interests of stakeholders. One question raised in this discussion is whether the level of assurance provided an audit should be the same for all types and sizes of clients, or should the concept of reasonable assurance mean that an auditor can provide a lower level of assurance for non-public interest entities such as SMEs.

The Companies Act 71 of 2008 provides that certain private companies, for example non-owner managed companies, may choose to either have their financial statements audited by a registered auditor or have their financial statements independently reviewed. This would result in two levels of assurance: reasonable and limited. Only a limited level of assurance would be given by the review that the financial information subject to review is free material misstatement. The assurance report would provide negative form of assurance.

Tabone and Baldacchino (2003) findings indicate that in the context of owner-managed companies, the statutory audit fulfils two important roles. First, it is relevant to outside third parties who have no direct ownership interest in the company but who nonetheless contribute to the viability of the enterprise. Second, it has a positive effect on the owner-manager and staff. The auditor may also fulfil a behavioural role, acting as an influence on the directors, management and staff. The auditor may assist the directors in maintaining a company's reporting standards and grant the directors access to financial expertise to improve their existing systems and controls. Thus, the question arises as to whether a mandatory annual statutory audit requirement is justified in such circumstances, where the auditor is merely reporting information already known to the same person acting in a different role.

Crous (2008) argues that one of the biggest questions currently facing South African companies is whether the audit of financial statements is a necessity or a luxury which few can afford. This argument is based on the ever- increasing inflation rate, interest rate hikes, spiraling fuel prices, electricity rate hikes and the weakening exchange rate, the pressure on the financial resources of companies is tremendous, and the questions that most shareholders and directors of companies are asking is where to cut costs, by distinguishing between the necessities and luxuries. For several years now audit firms have heard about complaints regarding the fact that the audit report for a private company is a luxury which only consumes valuable financial resources, and that the benefit derived from these reports does not equal the cost and time spent.

While the reduction of business costs is definitely a worthwhile aim, which should be pursued, it must not be seen as an end in itself. Simply achieving cost reductions would not be a satisfactory outcome if the other consequences for companies included lower standards of financial management, higher rates of insolvency and resulting loss of jobs, and a higher risk of financial crime in the SME sector. It is essential that the merits of any possible changes in the areas of company law, accounting and auditing be assessed not solely from the perspective of how much money abolition would save for the individual company but by reference to the wider context of costs and benefits, both for the company, its stakeholders and the public interest generally.

External audit reinforces sound financial management and corporate governance - which are both essential to a company's health. Many companies will choose to take advantage of audit exemption on the grounds of cost alone, and will not replace the audit with other services from professionally qualified practitioners. They will, therefore, lose the advantages which audit brings, and it is widely accepted that inadequate financial management is a major element in small company failure. The cost of audit is small compared to that of other statutory regulations bearing on small companies. In contrast to external audit, few of these regulatory burdens bring direct or indirect benefits to the companies themselves.

Many small, local practices which have provided the bulk of accountancy services to small businesses may, over time, cease to carry out audit work. This will reduce choice severely for those small entities which retain the audit on a voluntary basis.

It is accepted that the audit imposes some indirect costs in addition to direct costs, such as: the cost of the bank letter and other 'certificates' required by auditor from third parties and the time cost of staff dealing with audit queries and explaining accounting and related systems to audit staff. There is general acceptance of the argument that the credibility of the audit report to non-member readers suffers to some extent because of the long delay between the accounting year-end of a small company and the time of its audit. SMEs may not always have the necessary internal resources or expertise to ensure compliance with the Financial and Reporting Standards or keep up with changes in them.

The benefits of an audit are hard to appreciate while the costs are fairly straightforward according to discussions with many directors of small business. Further, they reveal that auditing principally arose due to owners’ aspiration of an independent review of their firm. In small limited firms, the owner is usually the one who runs the firm. In this case, auditing is mostly useful for stakeholders such as, banks, suppliers, tax authority, despite that the cost of auditing is only on the firm.

Directors of small business disagree with the notion that small limited firms are facilitated in acquiring loans from banks as a result of auditing. This is since they imply that banks can receive the necessary information from other sources.

CONSEQUENCE OF DEREGULATION

After the abolishment the Government will no longer act as the head principal that requires auditing, such that auditing will no longer be law regulated. Instead the role of the principal will shift to other stakeholders, which may require that a firm’s annual reports are audited before developing an exchange relationship with them. Auditing may facilitate granting of loans, longer credit periods and loyalty, a credible image of the firm, as a result of business owners providing trustworthy information to the stakeholders. Furthermore, by taking these benefits into consideration, a firm is able to determine whether the benefit of auditing exceeds the cost.

In some cases, auditing may not be considered necessary to maintain. This could be the case in sme firms for instance, despite the benefits discussed. This is could be such that there may be a lesser need to get access to financial information in order to control the performance of the management. Since sme firms usually comprises of only one owner who also is the manager of the firm, and the only worker, s/he thereby already possesses all information concerning the business. Moreover, if a firm already has an established circle of customers, they will, as long as they are content with the experienced exchange relationship, probably not pay attention to whether the business owner maintains audited reports of his/her business or not. On the other hand, it is beneficial to maintain an audit to gain the trust of new circle of customers. However, it is beneficial for small firms, to maintain an audit of their business. This is because, such firms are large enough to benefit the by products that auditing yields.

One can easily present and demonstrate the advantages respectively the disadvantages of auditing; yet, it is difficult to generalise an individual firms’ need of reviewing their businesses.

Instead, each firm should take into consideration the pros and cons of auditing that are applicable to their business and thereby decide whether to maintain or exclude an audit. However, by realising the importance of auditing, reveals that being a means of revising annual reports, it assures that the firm’s financial information is reliable and trustworthy. Getting an audit of the business enhances a firm’s reputation. A firm gains credibility and assurance of quality through auditing. This is indeed, one of the main grounds for upholding such routine, after the abolishment. Nevertheless, it can be concluded that it is beneficial for small limited firms to maintain an audit of their business, despite the abolishment of statutory audit, to uphold a credible and trustworthy external image of the firm.

CONCLUSION

This is a very difficult issue. South Africa is caught in a position in which there are conflicting

forces. On the one hand, businesses are screaming for relief from the massive regulatory burdens being placed on them. Also, if the South African economy is to grow at a reasonable rate, barriers to small business need to be reduced to a minimum. In addition, South Africa needs to retain its competitiveness in the international arena to attract foreign capital. On the other hand, regulators have difficulty in doing their job without some assurances. Relaxation of audit could also hamper skills development.

Although regulation often corrects market failures or promotes the public interest, it is important to realise that there may be a trade-off between these goals and economic efficiency. Hence, overbearing regulation can diminish competition and hold back entrepreneurship. Therefore, the impact of new and existing regulations on businesses – especially SMEs – needs to be considered thoroughly. In theory, as competition is eased, there are deleterious effects on economic efficiency. Reduced competition is likely to lead to greater price cost margins as incumbent firms have greater market power, reducing allocative efficiency.

It is also likely to lead to a reduction in productive efficiency; firms’ utilisation of inputs is improved by greater competitive pressures impacting on workers and managers. Finally, reduced competitive pressure will have an effect on long-run dynamic efficiency as there will be lower incentives to innovate.

The questions arise – Will the SME industry collapse based on the premise that an audit is an expense that has been perceived to be unaffordable and a regulatory burden? Will company law be brought into the 21st century simply by removing the audit of a SME limited liability company?

Everyone would agree that companies do contribute to people’s prosperity and overall wellbeing. But, too often, companies also cause harm to communities, damage the environment, or violate workers’ rights in the course of doing business. This is because company directors’ desire to operate to high ethical and social standards are often outweighed by their obligations to their shareholders, whose interests take legal precedence over employees, communities and the environment.

Limited liability means that the power of a company's owners is not matched by any responsibility because the law puts them beyond the reach of their fellow citizens. This immunity provides shareholders with the greatest regulatory protection granted to one section of society by the state. Is this fair and equitable and in line with the Constitution of South Africa?

Law and regulation play an important role in promoting ethical behavior. This is particularly so where the legal and regulatory system governs business conduct, as much of that conduct is sufficiently new (relatively speaking) or complex that its propriety cannot be determined by resort to traditional ethical precepts. The importance of law and regulation to business ethics is greater still where the focus is on the conduct of organizations (typically corporations) as opposed to individuals. Consensus does not exist on how conventional notions of actions and intentions – key to ethical theory generally – should be applied to organizations.

The concatenation of these two factors – the need for law and regulation to articulate standards of ethicality in business matters, and the inherent difficulty of determining by what thoughts or deeds a corporation should be judged – places a heightened burden on government to articulate the steps that corporations should take to require proper behavior and corporate social responsibility.

Until a couple of decades or so ago, in order to discharge their accountability, corporate managers were required to produce accountability reports in the form of annual financial statements and to submit these to independent (external) audit. However, since the 1970s, the extent and severity of the impact of unexpected corporate failures, and revelations of instances of misconduct and reckless management by senior company officials, have demonstrated that the twofold approach to securing corporate accountability is inadequate.

Initially, attempts were made to strengthen the external audit function by means of establishing audit committees comprised of non-executive directors. However, unexpected corporate failures and revelations of misconduct by corporate officials continued and, since the early 1990s, it has been recognised that an additional element is needed to secure the accountability of corporate managements – that of responsible corporate governance. This development seems to mark a move to a new stage in the corporate accountability arena, one in which the central role is played by external auditors, internal auditors and the audit committee.

The three forms of assurance (external auditors, internal auditors and the audit committee) cannot as a group apply to SMEs, however the legislature should consider some form of compulsory external assurance for the SME - it is in the public’s best interest.

How the audit abolition fails SA

2010-05-09T23:13:00.001+02:00

THE debate about whether auditing standards should be the same for all companies, large and small, has been running for some time. In this context, the principle of audit exemption has now been accepted by the government.

The Companies Act of 1973 currently imposes a statutory audit requirement for the financial statements of all companies, irrespective of their size, capital structure or business activity. One of the most influential regulatory changes will ensue when the Companies Bill, 61 of 2008, is enacted, allowing for the abolition of the audit requirement for private limited liability companies.

The government’s reason for the removal of the audit requirement for small companies is the elimination of bureaucracy and unnecessary administrative requirements for small companies. It is quite clear that the government views the statutory audit as providing no added value for a private limited liability company and believes the sooner it is abolished, the better. But the public interest is not best served by the abolition.

The shareholders, or members of a limited liability entity, have the privilege of decision making, acting and running operations for which they, in their individual capacity, take only limited responsibility, whether financial or otherwise. For this privilege, the limited liability entity must “pay” by making information available to its stakeholders in a responsible, transparent and unbiased manner.

Gone are the days that a company is accountable only to its shareholders. No company is an island. It is part of a complex infrastructure and as a corporate citizen, is accountable to the community, employees and others. The owners and directors of private limited liability companies must be made accountable in law for their actions. The law should ensure that external stakeholders such as shareholders, minorities, employees, creditors, suppliers, consumers and the general public, are protected.

Questions arise about the rationale for the abolition of the audit for the private limited liability company. The cost burden cannot be the only reason, or is it? One would assume that a regulatory impact assessment would have been conducted in order to provide a detailed appraisal of the potential effects of the new regulation to assess whether the regulation is likely to achieve the desired objectives. This appears not to have been done. It appears that the removal of the statutory audit for private limited liability companies has been developed and implemented with little regard to its effect on the economy. This is the essence of legislative inefficiency.

While auditors carrying out a statutory audit of financial statements are accountable and report to the shareholders of a company only, there may be other stakeholders who believe that an independent audit provides some means of ensuring that the company’s responsibilities to them are being met; in effect that it serves their interests too. Stakeholders such as creditors, lenders, credit agencies, customers and employees may claim an interest in the audit.

Private companies are the forgotten stakeholders in the fair and efficient management of South African corporate governance. The government has assumed that rules, norms and best practice will somehow magically trickle down to private companies.

The bill offers neither resources nor practical guidance on corporate governance. It has deregulated the single aspect of corporate governance that has traditionally served the public interest.

Company-law regulators have sacrificed the promotion of the public interest in favour of economic efficiency when it comes to private companies.

Today's legal structures allow private companies to raise astronomical amounts of finance from the public in the time it takes to bat an eyelid, and to employ these resources as they see fit behind a wall of secrecy and freedom from legal accountability. It is time to end the illusion that an audit has no value.

For a more trustworthy tune, change who pays the fiddler

2010-05-05T16:57:00.003+02:00

FOR decades, the auditing profession has been troubled with high levels of litigation and accusations. The traditional argument is that the criticism of, and litigation against, auditors is due to the failure of auditors to meet society’s expectations.

It is essential to recognise that the legitimacy of the duties and standards adopted by auditors can never be isolated from the expectations of the various interest groups within society, who all rely upon the auditor’s services. This umbilical-cord relationship between the auditing profession and the various interest groups within society forms the basis for the increased scale and frequency of litigation against auditors. Auditors and society have entered into a social contract. It is not written, but is implied. The social contract (or as it is sometimes called, the community licence to operate) incorporates community norms and expectations about how an organisation should conduct its operations (including what information it produces).

A well-functioning economy relies on sound financial statements. Accounting by companies serves not only management but also the wider public interest, including financial stability. Statutory auditors play a pivotal role in this respect, as they are gatekeepers for the benefit of users of such financial statements. The quality of the auditors’ work should allow users to build trust and to decide whether to invest or to divest in companies. If users cannot trust financial statements, companies will no longer have access to the capital they need.

Shareholders and society have limited access to information about the operations of a company and may believe, therefore, that they are not getting the right information they need to make informed decisions, or that the information being provided by way of the financial statements is biased. As such, shareholders and society may lack trust in the directors and, in such a situation, the benefits of an audit in maintaining confidence and reinforcing trust are likely to be perceived as outweighing the costs.

Shareholders (society) do not have the expertise and skills to check whether agents (management) have met their responsibilities. Faced with such problems, they turn to expert auditors. Auditors are engaged as protector s of society and are expected to be independent of the directors who manage the operations of the business. Yet it is the directors who are allowed in terms of law to hire and remunerate the protectors . Auditors are not paid by those they are supposed to represent. The auditor is dependent on the directors to pay the audit fee.

By not being paid by the stakeholders they represent, legitimate questions arise about whether the auditors’ and stakeholders’ interests are aligned. The problem with this arrangement is when auditors refer to the company, which is controlled by the directors on a day-to-day basis, as the client. But if the system is to serve a modern economy, auditing must serve the investing public and treat it as the client. In simple terms, management uses shareholders’ (society) money to hire auditors to provide a stamp of approval on management’s reports on its own performance to society. Auditors are in an awkward position. They make their living pleasing management but their societal justification requires serving the public.

Auditors are human beings, and make mistakes . The audit process is grounded in the judgment of fallible human beings, who are subject to errors and mistakes. At its core, auditing is a process of making professional judgments. This structural problem, a misalignment of incentives, is ignored by regulators, who impose rules and regulations as a safeguard against audit failure. Attention has been not been focused on the flaws in modern auditing. Regulation alone will not regain public trust and repair the perceived breach of the auditor’s social contract with society. Regulation can never improve the judgment of fallible human beings. Everyone has assumed that the professionalism of individual auditors would enable them to manage the inevitable pressures that arise as they work to provide top-grade service to their clients within the spirit of the standards of their firm and the profession.

The events of the past several years suggest that, for some auditors, those pressures have grown past the tipping point. Some audit partners have done their job and stood tough in the face of client pressures. Many have correctly understood the requirements of the profession and their firms, but some audit partners have lacked the fortitude to stand up to their clients, and some have misunderstood their client management role. What the failures of those individual audit partners have cost their firms, the profession, and the financial community is staggering.

The occasional scandal might be excused as an exception to the norm, but these past few years have seen a series of disasters. It is a different world, in which the pressures being brought to bear on the practice of auditing preclude the continued reliance solely on the professionalism of individual auditors, or on a new set of independence rules. The cost to the profession and to the financial markets is too great to justify reliance on a historical model that may be out of date.

An enduring and well-known payment principle was established in the 17th century: “Who pays the fiddler, calls the tune.” Investor confidence in a company’s reported financial results could be greatly enhanced by changing who calls the tune, and to do that, who pays the fiddler must change as well.

The Companies Act and the JSE have sought to change the relationship between the auditor and client by giving the audit committee of a company’s board of directors a more central role and relationship with the external auditors. This is a nai ve hope and will result in more dashed expectations. With all the talk of having the audit committee “hire” the auditor, no one has talked about how fee disputes will be settled, how scope questions will be answered, or how reporting and disclosure debates will be resolved.

Corporate audit committees will turn to management for help in resolving such critical questions. The audit committee is a company-centric body that must work closely with company management. More responsibility on the audit committee might result in a few more company hands on the fiddle, but the tune will substantively remain the same.

This needs to change. Shareholders and society need to call the tune because the audit is conducted for their benefit. Because shareholder interests coalesce in the stock exchanges, the exchanges themselves should hire and compensate the auditors who audit the listees’ financial statements. Such an arrangement would better align the interests of shareholders and auditors, enhance corporate governance, and bolster the confidence of the financial community.

Given the trauma our financial markets have suffered because of a variety of accounting scandals and audit failures, and given the ever-increasing complaints about how corporations are governed, it is imperative for the stock exchanges to adopt a more proactive role on behalf of investors who purchase the shares of companies they list and not just the role the JSE plays currently: a reactive role with a big stick attached.

Only by changing who pays the fiddler can a different tune be called, one that has the best chance of providing a strong foundation for the rejuvenation of trust in the financial statements and corporate governance of the companies in which most South Africans have a financial stake.

The Law of Accounting Standards and Financial Statements: A Critical Perspective

2010-05-05T16:41:00.004+02:00

This purpose of this study is to explore and give orderly formulation to the more prominent features of the law of accounting standards and financial statements. This critical perspective of the law of accounting standards and financial statements considers the legal concepts which have been derived from judicial decisions , legal opinions , statutory enactments and accounting standards. The interrelationship between law and accounting is intricate and confusing. It is not adequate to suggest that accountants must turn to lawyers for answers to legal questions and lawyers to accountants for answers to accounting questions, for the problem often is whether and to what extent a question is one of law or accounting or a mixture of both.

The accountant has been thrust into the role of judge. He/She must delineate the rights of the various stakeholders in affected by the company. Under Company Law legislation the accountant is in effect obligated to protect these stakeholders. These burdens stem from the fact that the application of the legal rules governing the interrelationship between these stakeholders largely depends on the classification of business facts in terms of accounting concepts.

Many such legal rules are found in Company Law legislation in respect of distributions to security holders and loans to company management. The Companies Act 71 of 2008 requires the company to comply with solvency and liquidity tests before any of these payments can be made. a company satisfies the solvency and liquidity test if : the assets of the company as fairly valued equal or exceed the liabilities of the company; appears that the company will be able to pay its debts as they become due. The company must consider the following when conducting the tests: the accounting records and financial statements. All these tests depend on legal or strategic considerations which arise out of accounting concepts. The question of value, solvency, and the use of financial statements is dependent on the accountant’s understanding and interpretation of rights and obligations of the transacting parties and accounting standards.

The main thrust of this research paper is to explore the issues basic to the future co-operation of the legal fraternity and accountants in company law. The first issue is whether accounting standards which are used to interpret business facts have independent validity in themselves or are merely conventional techniques which should be adapted to the disclosure of legally operative facts. The second issue is whether financial statements assuming disclose legally significant facts with respect to a company, the company and the contracting party with whom the company deals are bound by the facts as disclosed or can the company contend that the facts as disclosed in the financial statements differ materially from the intentions of the contracting parties and cannot be held liable for any misleading disclosures n the financial statements therefore the financial statements are misleading and are not a fair presentation of the rights and obligations of the business facts.

South African company law makes provision that the financial statements of companies must comply with financial reporting standards, and fairly present its financial position and the results of its operations. Financial Reporting Standards in terms of IAS 1 P15 states likewise that financial statements should present fairly the financial position, financial performance and cash flows of an entity. This raises the question as to why company law legislation requires separate compliance with financial reporting standards and fair presentation, as by complying with financial reporting standards alone would probably ensure fair presentation and probable compliance with company law legislation.

This research paper posits the view that the courts must not gratuitously write into a commercial contract generally accepted principles of accounting. Accounting standards do not take priority over company law legislation. For example - if the source be the law of estates, the courts must apply estate accounting precedents regardless of their non-conformity to financial reporting standards. If the question relates to the payment of dividends, the court must interpret the applicable statute to determine whether its minimum requirements have been met. And if the source be statutory regulation, the court must disregard accounting principles which do not conform to regulatory prescription.

This research paper seeks to resolve the following research questions regarding the legal principles in respect of the preparation of financial statements:

When company law legislation requires the preparation of financial statements and requires that financial statements of companies fairly present its financial position and the results of its operations, prohibits untrue and misleading statements the question arises as to what extent will accounting standards or company law legislation determine whether the financial statements are legally compliant?
When company law legislation speaks in terms of fair presentation, financial reporting standards, capital, and profits - to what extent will accounting standards control the legal question?
When such terms are defined by statute or judicial decision, to what extent must the legal definitions be reflected in the financial statements prepared by accountants?
When company law legislation requires the dissemination of financial information - to what extent will accounting standards or company law legislation determine the question of full and adequate disclosure?

The accounting view is that accounting standards take priority over company law legislation and that companies must comply with accounting standards . In terms of Section 301 of the Companies Act, 1973 the auditor is required to report on whether or not the financial statements fairly present the financial position and results of operations in the manner required by the Act. SAICA (1998) interpret this to mean: “Therefore the auditor will have to satisfy himself that the financial statements have been prepared in full compliance with Statements of GAAP”.

It is submitted that this view reflects the requirement that financial statements fairly present is not a priority in the preparation of financial statements as required by Company Law legislation. This opinion by SAICA (1998) suggests that by applying full Statements of GAAP fair presentation is automatically achieved. This research paper vigorously disputes this.

From a legal perspective the primary function of accounting is to display the facts as they exist in a particular situation and for a particular purpose. While interpretation of the facts is also within the domain of the accountant: for example the expression of an audit opinion; acceptance of his/her interpretation and opinion can rest only on its reasonableness in the light of the facts. In the case: Group of Institutional Investors v. Chicago, M., St. P. & P.R.R., 318 U.S. 523, 5 “An accounting statement need not have mathematical certainty nor the pretenses of exactitude, but in the absence of evidence tending to prove that it correctly reflects the effect of reported transactions it is merely a piece of paper”.

This research paper makes a valuable contribution to the compilation and critical discussion of the regulatory developments in respect of corporate law reform currently taking place South Africa and internationally. It is useful and beneficial for all legal practitioners, auditors and accountants as it brings together the various components of disclosure and corporate reporting within company law. In addition this paper will help financial reporting regulators and policy makers to adopt appropriate strategies for improving financial reporting quality. The South African experience may serve to encourage other developed and developing countries to adopt effective policies for financial reporting practices.

The central aim of this method is to construct legal theory, rather than theory testing, by grounding the theory in a rigorous critical analysis of the phenomenon. This kind of research, in general, does not seek to test a prior hypothesis, rather, it seeks to theorise through the data in an inductive manner.
A critical synthesis of the legal and accounting literature will be conducted to provide an objective discourse on what constitutes the Law of Accounting Standards and Financial Statements.

The central ingredient of this study is the analysis and examination of the legal principles and accounting standards for preparing financial statements. A road map is constructed by drawing together material from a range of disciplinary perspectives from company law and the accounting sciences to create the law of accounting standards and financial statements that will help legal practitioners, regulators, and accounting practitioners familiarize themselves with the legal principles and issues surrounding this new aspect and facet of company law legislation.

The remainder of the paper is organized in accordance with the structure of the road map. The road map structured around three core facets of the Law of Accounting Standards and Financial Statements: The introduction is followed by a discussion of the legal structure, form and content of financial statements, followed by an examination of the interaction of accounting standards and the law, which is followed by a critical analysis of the legal application of financial reporting standards in South Africa. Finally, implications and conclusions are presented.

Every company is obliged to keep accounting records . A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. In accounting, it is recognized by an entry in the accounting records. Financial statements are prepared from a summary of the accounting records. It can be determined from Section 284 (3) of the Companies Act, 1973 that financial statements form part of the accounting records of the company and the accounting records must enable annual financial statements to be prepared in accordance with the legal requirements for the preparation of annual financial statements. Novick v Comair Holdings Limited 1979 (2) SA 116 (W): Colman J “Accounting is a system of recording transactions and of presenting financial statements relating to those transactions”.

In terms of Section 286(3) “the annual financial statements of a company shall, in conformity with generally accepted accounting practice, fairly present the state of affairs of the company and its business as at the end of the financial year concerned and the profit or loss of the company for that financial year”.
In 1977 and again in 1987 the Accounting Practices Board (APB) took senior counsel’s opinion on the meaning of “generally accepted accounting practice” (gaap) as referred to in S286 (3) (SAICA, 1998). The opinion of senior counsel was that while compliance with a Statement of Generally Accepted Accounting Practice (GAAP) issued by the Accounting Practices Board (APB) meets the requirements of the Companies Act to conform with generally accepted accounting practice, noncompliance may constitute a contravention of the Act, but would not necessarily do so.

SAICA (1998) posited the view that in South Africa, there were two financial reporting frameworks, the one based on generally accepted accounting practice (gaap) and the other based on Statements of Generally Accepted Accounting Practice (GAAP). This situation arose because of the wording of S286 (3) of the Companies Act as explained above. The essential differences between these two bases of accounting are: Statements of GAAP are those accounting standards and practices which have been codified by the responsible standard setting body in South Africa, namely the Accounting Practices Board.

In October 1992, Schedule 4 of the Companies Act was amended. Amongst other changes, Paragraph 5 was introduced into Schedule 4. This paragraph reads as follows: “If it appears to the directors of a company that there are reasons for departing from any of the accounting concepts stated in Statements of Generally Accepted Accounting Practice approved by the Accounting Practices Board, where such appropriate Statements exist, in preparing the company’s financial statements in respect of any accounting period they may do so, but particulars of the departure, the effects and the reasons for it shall be given”.

In September 1999 a further legal opinion was obtained by the South African Institute of Chartered Accountants (SAICA) from WH Trengove SC and T Plewman on the interpretation of Paragraph 5 of Schedule 4. Their conclusion was as follows: “On the evidence available to us, paragraph 5 of Schedule 4 requires disclosure whenever the financial statements of a company depart from any of the Accounting Practices Board (APB) Statements”.

According to the opinion, in order for directors to meet the requirements of the Companies Act the financial statements should be prepared and presented in accordance with gaap. However, if they materially depart from Statements of GAAP, the financial statements should provide disclosure of the departure, the particulars thereof, the reasons therefore and the effect of such departure on the financial statements. It is submitted that Section 286(3) of the Companies Act did not require companies to comply with South African Statements of GAAP, rather Section 286(3) provided for a fair presentation override.

If a company’s financial statements asserted to be prepared in accordance with Statements of GAAP, it was a requirement that they should comply in all material respects with all Statements of GAAP. In this respect AC101 was particularly pertinent and read as follows:

Paragraph .12 of AC101 states: “An enterprise whose financial statements comply with Statements of Generally Accepted Accounting Practice should disclose that fact. Financial statements should not be described as complying with Statements of Generally Accepted Accounting Practice unless they comply with all the requirements of each applicable Statement and each applicable approved interpretation”.
AC 101 acknowledged in paragraph 14 that in extremely rare circumstances management may conclude that compliance with a requirement in a Statement of GAAP would be misleading, and therefore that departure from that requirement is necessary to achieve fair presentation. It should be noted that this ‘fair presentation’ override can only be applied in extremely rare circumstances where compliance with a Statement of GAAP would be misleading, resulting in fair presentation not being achieved in the financial statements.

It is therefore expected that this override will rarely, if ever, be applied in practice (SAICA, 1988). However the principle of a fair presentation override existed in accounting standards even though it might only have been applied in rare circumstances.

It is submitted that the principle of a fair presentation override existed not only in the accounting standards but was mandatory in terms of Section 286(3) of the Companies Act. This meant that the statement made by SAICA (1998)” It is therefore expected that this override will rarely, if ever, be applied in practice” was not in compliance with the requirements of the Companies Act, 1973.

In this context: Continental Vending [U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969)]
Continental Vending [U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969)] was one of the first major criminal cases successfully brought against auditors. Charges against the auditors involved in the case included the violation of U.S. securities laws by certifying a document the auditors knew to be false. The auditors were engaged to audit Continental Vending Machine Corporation. A Continental affiliate, Valley Commercial Corporation, borrowed a large sum of money from Continental. Valley then loaned the funds to a dominant officer and significant shareholder of both Valley and Continental.

The auditors learned that the dominant officer would not be able to repay Valley, and the auditors knew that as a consequence Valley would be unable to repay Continental. Nevertheless, the Continental financial statements showed the receivable from Valley as an asset, with only a relatively obscure footnote explaining the circumstances surrounding the receivable.

Continental never did collect payments from Valley on the receivable in question; in fact, Continental went bankrupt shortly after the financial statements were issued. When the U.S. government brought criminal charges against the auditors, the auditors maintained that they properly followed generally accepted auditing standards (GAAS) during the audit and that the footnote also complied with applicable standards. Moreover, several experts testified that the footnote disclosure explaining the receivable from Valley complied with generally accepted accounting principles (GAAP) and that the auditors had followed GAAS.

Near the end of the trial, the district court judge instructed the jury that mere compliance with professional accounting standards was not a complete defense. Rather, the critical test was whether the financial statements fairly represented Continental’s financial status.

The jury found the defendants guilty. On appeal, the appellate court held that the district court judge did not err in his instructions to the jury. As Professor Robert R. Sterling stated in a January 1973 Journal of Accountancy article: “[T] he courts are telling us that we can no longer defend ourselves on the basis of accepted accounting theory and practice. Instead, we must assure ourselves that the statements are true, correct and understandable to non-accountants.”

The appellate court judge in Continental Vending, in refusing to find error in the district court’s jury instructions, clearly told the accounting profession that “fairly presented … in accordance with generally accepted accounting principles” is two statements rather than one. Furthermore, the clear message was that if one is to prevail over the other, it must be “fairly presented.” “Fairly presented” is principles-based accounting, and “in accordance with GAAP” is rules-based accounting.

A central issue in Continental Vending was whether the auditors could defend themselves by demonstrating compliance with GAAS and demonstrating that the financial statements were in accordance with GAAP. The court held that even if the auditors could prove that they had complied with GAAS and that the financial statements were prepared in accordance with GAAP, this would not be a complete defense to the criminal charge of willfully and knowingly making a false statement. The decision clearly illustrates that the auditor must make sure that the financial statements adequately disclose known material facts.

It was with the advent of the Corporate Laws Amendment Act No 24 of 2006 that Company Law legislation in South Africa legislation finally provided statutory recognition of the existence and role of accounting standards. Section 285A introduced legal backing for the compulsory use of financial reporting standards.

Section 285A reads as follows: A widely held company: (a) must comply with financial reporting standards; (b) must comply with the provisions of this Act and Schedule 4 that are applicable to public interest companies; (c) must prepare financial statements that fairly present the financial position and the results of the operations of the company (and its subsidiaries, if applicable) in accordance with paragraph (a). (2) A limited interest company (a) must comply with the accounting standards developed for limited interest companies under section 440S (1) (b); (b) must comply with the provisions of this Act and Schedule 4 that are applicable to limited interest companies; (c) must prepare financial statements that fairly present the financial position and the results of operations of the company (and its subsidiaries, if applicable) in accordance with paragraphs (a) and (b).

Whether a company is widely held or limited interest must prepare financial statements that fairly present the financial position and the results of operations of the company and must comply with financial reporting standards. Here there is no doubt as to whether “fairly presented … in accordance with financial reporting standards” is two statements rather than one. It is submitted that the principle of a fair presentation override exists in terms of Section 285A of the Companies Act. Therefore the legal principles in Continental Vending [U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969)] apply to Corporate Laws Amendment Act No 24 of 2006.

At a date still to be decided the Companies Act, No. 71 of 2008 will replace both the Companies Act of 1973 and Corporate Laws Amendment Act No 24 of 2006. Section 30(1) states the following: “Each year, a company must prepare annual financial statements ...” Section 29 of the same Act sets out six requirements for these annual financial statements. In fact these requirements apply to any financial statements given to any person for any reason, and not only annual financial statements, they must comply with six requirements.

The first two are pertinent: 1.They must “satisfy the financial reporting standards as to form and content”. 2. They must “present fairly the state of affairs and business of the company and explain the transactions and financial position of the business of the company”.

Again there is no doubt as to whether “fairly presented … in accordance with financial reporting standards” is two statements rather than one. It is submitted that the principle of a fair presentation override exists in terms of Section 29 of the Companies Act No. 71 of 2008. Therefore the legal principles in Continental Vending [U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969)] apply to Corporate Laws Amendment Act No 24 of 2006.

Most accountants acknowledge that accounting involves such substantial elements of judgment that two equally reputable and competent accountants may widely disagree as to the proper income statements and balance sheets of the same enterprise. Such matters of choice and discretion as the allocation of expenditures to capital account or to expense, the amortization or the writing off of debt discount and expense and the selection of depreciation formulae, allow much latitude to corporate managements and their accountants in shaping financial statements.

Nonetheless, many accountants argue that this selective process need not be influenced by applicable legal considerations. Lawyers and Regulators, conversely, are quite convinced that accountants must heed legal rules. This conflict can best be illustrated in terms of the example: IAS 16 states that after acquisition, an entity may choose to measure property, plant and equipment either at cost less accumulated depreciation, or at fair value (ie revaluation). The revaluation model may, however, only be chosen for subsequent measurement of an item of property, plant and equipment if the fair value of the asset can be measured reliably.

The reason the revaluation model was allowed as there was extensive controversy surrounding the contention that accountants are not revealing legally significant facts because they persist in adhering to their convention of carrying fixed assets on the balance sheet at cost (Kripke, 1941). Because the balance sheet based on the cost convention does not in fact show value, its advocates have been perennially criticized (Kripke, 1941). 85. Norfolk & W. Ry. v. United States, 52 F. (2d) 967 (W. D. Va. 1931) ; Chesapeake & Ohio Ry. v. United States, 5 F. Supp. 7 (E. D. Va. 1933): “the most unfortunate feature of regulation in this country is that the book values of operating companies are totally unrelated to the legal values under which these companies operate, sell their electricity, and do their business. In other words, you have got a value on your books that has nothing to do with the income you can earn”.

It is clear that PPE, especially those items with a very long useful life, will be significantly undervalued if only the cost model is used (Koornhof, 2009). If, for example, an asset’s price increases by 15% per annum, the price will double in five years. Using the cost model will result in the original cost price being depreciated. It is therefore recommended that entities with such assets should revalue their assets periodically in order to: ensure that the equity in the statement of financial position is not understated (limiting their ability to obtain loans); align the amount of depreciation written-off on the asset to a greater extent with the real loss in value during a particular financial period and in doing so, facilitate the replacement of the asset without further debt, and prevent the take-over of the entity. For instance, if the shareholders are not aware of the real value of the assets in an entity, they may more readily agree to the take-over of the entity at a lower price than if they had information on the real value of the assets and therefore, of the real value of their shares at the time of the offer (Koornhof, 2009).

Supporters of the fair value model believe that fair values give users of financial statements more useful information than other measures, such as depreciated cost. In their view, rental income and changes in fair value are inextricably linked as integral components of the financial performance of an investment property and measurement at fair value is necessary if that financial performance is to be reported in a meaningful way (IAS 40 B 44).

It is submitted that as Financial Reporting Standards creates an environment for asset revaluations to occur asset revaluations reflect management's attempt to comply with the requirement of company law that financial statements “fairly present” and comply with financial reporting standards.

The concept of fair presentation is not new to accounting literature, yet it is one that is, by its very nature, one of the most difficult to apply. IAS 1 (AC 101).15 states that financial statements should present fairly the financial position (referring to the statement of financial position), financial performance (referring to the statement of comprehensive income) and cash flows (referring to the statement of cash flows) of an entity. IAS 1 (AC 101) states that fair presentation is achieved by faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework.

Representational faithfulness refers to that characteristic of financial reports that will reassure users of such reports that they can rely on the information contained therein to faithfully represent the economic circumstances and events that it purports to represent or would reasonably be expected to represent. Users of financial statements are assured that all items that impact on the financial position, financial results and cash flow of an entity are represented appropriately.

At a practical level, this means that, for instance, the item ”inventories” in the statement of financial position indeed represents those units and only those units that qualify for inclusion as inventory (and would therefore meet the definition of assets), appropriately recognised and measured in accordance with the relevant standards.

Company law in South Africa clearly views the presumption that the application of IFRSs, with additional disclosure when necessary, results in financial statements that achieve a fair presentation is a rebuttable one, although the standard makes clear that in virtually all situations a fair presentation is achieved through compliance. When assessing whether complying with a specific requirement in a standard or an interpretation would be so misleading that it would conflict with the objective of financial statements, IAS 1 (2009) requires consideration of exactly the same issues AC 101 (October 1998) when a departure from accounting standards are considered necessary.

The concept of “fair presentation refers to accounting practices that are regarded as permissible by the accounting profession and regulators internationally — which means a broad consensus between users, preparers, auditors, regulators and the markets, across rather than within national boundaries.

In general, accounting practice that is legitimate under South African company law must be determined by reference to one or more of the following factors: Is the practice addressed in accounting standards or other official pronouncements? Is the practice addressed in accounting standards that deal with similar and related issues? If the practice is not addressed in accounting standards, is it dealt with in the standards of another country that could reasonably be considered to offer authoritative guidance? Is the practice consistent with the needs of users and the objectives of financial reporting? Does the practice have authoritative support in the accounting literature? Is the practice consistent with the underlying conceptual framework document? Does the practice meet basic criteria as to the quality of information required for financial statements to be useful to users?

Does the practice fairly reflect the economic substance of the transaction involved? Is the practice consistent with the fundamental concept of 'fair presentation'? Are other companies in similar situations generally applying the practice?

In an IFRS context, these factors build on the requirements set out in paragraphs 10 to 12 of IAS 8, which state that, in the absence of a Standard or an Interpretation that specifically applies to a transaction, other event or condition, management is required to use its judgment in developing and applying an accounting policy that results in information that is: (a) relevant to the economic decision-making needs of users; and (b) reliable, in that the financial statements: (i) represent faithfully the financial position, financial performance and cash flows of the entity; (ii) reflect the economic substance of transactions, other events and conditions, and not merely the legal form; (iii) are neutral, i.e. free from bias; (iv) are prudent; and (v) are complete in all material respects.

In support of this primary requirement, the standard gives guidance on how management should apply this judgment. This guidance comes in two 'strengths' —certain things which management 'shall' refer to and consider, and others which it may also' consider, as follows: In making this judgment, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in standards and interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework; and in making this judgment, management may also consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in (a) and (b) above.

When the relevant regulatory framework does not allow a departure from IFRS, IAS 1 accepts that, notwithstanding the failure to achieve fair presentation, that it should not be made. Although intended to occur only in extremely rare circumstances, this is a very important provision of the standard as it allows a 'relevant regulatory framework' to override a requirement of IFRS which is specifically necessary to achieve a fair presentation. In that light, it is perhaps surprising that there is no definition or discussion in the standard of just what a relevant regulatory framework may be.

There can be no reasonable basis that financial statements must be prepared only in terms of International Financial Reporting Standards as IAS 1 clearly indicates it allows a 'relevant regulatory framework' to override a requirement of IFRS which is specifically necessary to achieve a fair presentation. The intended application of the Law of Accounting and Financial Statements in South Africa is to ensure fair presentation above all else and to ensure that financial statements will give a faithful representation of the events it purports to represent.

By complying with standards and interpretations of the IASB, and fairly presenting the effects of transactions and other events in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework, fair presentation in the financial statements is usually accomplished.

Trade-offs between relevance and reliability are often called for. In paragraph 32 of the Framework it is stated that “(I) information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading.

For example, if the validity and amount of a claim for damages under a legal action are disputed, it may be inappropriate for the entity to recognize the full amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim.” There are many who question this trade-off, particularly in respect of financial statement measures that reflect fair values rather than historical costs. It is presumed that historical costs are not as relevant as fair values, but they are more reliable. In such cases, it is often argued that the trade-off between relevance and reliability should favour historical costs rather than fair values, i.e. that reliability should override relevance. From their respective positions, preparers of financial statements are invariably in favour of reliability as the dominating characteristic, while investors, on the other hand, often favour relevance. A balance should be found between relevance and reliability in order to increase the usefulness of financial information. For example, information that cannot be supplied timeously may be more reliable, but will probably be less relevant.

Conversely, it is sometimes necessary to report on information before all aspects of a transaction are known, in order to supply the information timeously. With such disclosure, the reliability of information may well be endangered. Achieving fair presentation may, as a result, often require a balancing act between several conflicting characteristics.

A pervasive constraint on the presentation of financial information is the cost involved in supplying the information. Where the costs of preparing the information exceed the benefits to be derived from the supply of the information, the information will not be reported, even though it may meet all the qualitative characteristics of useful information.

The application of accounting standards in the preparation of financial statements must yield to legislative enactment and administrative prescription. Thus the application and interpretation of accounting standards in the compilation of financial statements must give way to corporate law legislation. However in the absence of evidence to support a departure from accounting standards financial reporting standards must be applied. This application must be tempered with a consideration of all the facts surrounding the transaction. Most important of all the rights and obligations of the transacting parties must be fairly presented. These rights and obligations cannot be altered in the financial statements in the name of accounting standards. There can be no doubt that the intention of the contracting parties is paramount in deciding the accounting treatment of a transaction as these intentions are written into the contract. The financial statements would be misleading and not legally compliant to suggest a different set of intentions to that of the contracting parties just because the accounting standards stated otherwise. This is the very reason why South African Corporate Law legislation allows for a fair presentation override, which allows for the correct application of the intention of the contracting parties.

In this context the accounting framework cannot be ignored in the preparation of financial statements. A framework serves as a general frame of reference for a specific area of enquiry. It should provide a theoretical background against which practical problems can be tested. In accounting terms, a framework is a set of theoretical principles which serve as the basis for developing new reporting practices and evaluating current practices. A framework provides guidance to preparers of financial reports about which business, economic and other events should be accounted for and how these events should be measured and communicated to users.

It is necessary in appraising the position of accounting in jurisprudence to accept the fact that courts function to adjudicate disputes not to vindicate the application of the accounting standards.

As a result in some circumstances accounting standards will have no higher standing before the courts than principals or practices not so accepted by the accounting profession. Law and accounting must function co-operatively. Problems will arise from the legal concept that questions of accounting are only questions of fact and from the difference between facts as found by the courts and the conventional treatment of fact as employed by the accounting standards. These problems are compounded from the contention of accountants that the courts should extend judicial recognition to accounting standards because they have been prepared and accepted by accountants.

The courts will envisage accounting as a discipline worthy of recognition where properly and adequately employed reliably present facts having significant financial significance. However where accounting fails to fairly present and faithfully represent the facts the courts will cast aside the accounting standards and ensure the rights and obligations of the contracting parties have been adequately accounted for and fully disclosed.

AUDITOR ROTATION FOR SMEs - A REVOLUTIONERY IDEA

2010-05-05T16:25:00.007+02:00

The quality of auditor judgment may be influenced by who hires, fires, and compensates the auditor. Management often has a great deal of influence over hiring the auditor. Management may use its contracting power to try to influence the conduct and outcome of an audit, undermining the objectivity and judgment of the auditors, as their personal self-interest may be served by keeping management happy. Recent audit scandals have focused public attention on the relationship between management and the auditor.

Beyond the audit firm, there are a number of professional, regulatory, and other institutional forces that provide guidance on acceptable auditor judgment and conduct, and reinforce society's desire for ethical auditor judgment. Specifically, ethical conduct by an auditor is supported through a code of conduct, rules regarding auditor independence, auditing standards, quality control standards, and external inspection of audit engagements.

Auditors throughout the world must follow a code of conduct that defines unacceptable ethical behavior. The International Federation of Accountants (IFAC) requires that all member bodies adopt, except where prohibited by local law, the in¬tent of the provisions of its "Code of Ethics for Professional Accountants."

In terms of this "Code of Ethics for Professional Accountants" auditors are expected to maintain independence from their clients. An auditor must be concerned with both independence in fact and independence in appearance. Independence in appearance means that an auditor should do nothing that creates a perception that he or she has a vested interest in the outcome of an audit.

The perception that an auditor is not independent, or has a potential conflict of in¬terest in providing audit services of the highest quality, undermines the value of those services even if the auditor is completely unbiased and objective. An auditor who does not possess independence in fact may be tempted to bias the execution of the audit, which could manifest itself in poor decisions related to the gathering and evaluation of evidence or the nature and extent of disclosures in the financial statements.

The "Code of Ethics for Professional Accountants" sets out the types of threats to independence. One of these threats is the “Familiarity Threat” which arises when an auditor becomes too close to a client. It is this ever present “Familiarity Threat” that is at the root of the problem of independence. How is one able to be absolutely certain that an auditor is acting independently? How can the public between the time of the commencement of the audit and the receipt of the audited annual financial statements be aware of the differences of opinion and the nuances of interpretation that might have existed between the auditor and his/her client and what compromises were made? Does one, can one know whether the auditor’s independence has been dented and bruised somewhere along the line?

So perhaps there is something fundamentally wrong with a system which keeps stressing the need for independence but which does not provide a framework within which independence can be seen to be operating. The law, the rules the accounting practices which comprise the system fail possibly because the human element is to a large extent neglected.

And here one comes to the crux of the matter, the auditor client relationship. In most instances small audit clients have remained with the same firm of auditors for many years. Auditors, friendly souls that they are, often fraternise socially with the directors and the senior personnel of a company. The lower echelons of audit trainees likewise fraternise with the office administrative staff.

These indefinite and long standing appointments as auditors, these intimate almost incestuous relationships between personnel of auditing firms and the clients are barriers to complete freedom of action and to absolute independence.

So then one can ask, what is the remedy? How does one tackle a human relationship problem in the arid field of auditing? A suggested remedy is simple, but revolutionary, rotation of auditors for small audit clients. This concept seems to be well worth considering in striving for a client auditor relationship through which the independence of an auditor is not only possible but and this is most important, is seen to be possible. The suggestion is that audit engagement practitioners rotate between clients on five to seven year cycle, thus overcoming the entrenchment and continuity aspects of the present system. National governments would do well to consider this pioneering rotation concept as a long terms objective.

Rotation, say the critics is not practical when it applies to one man and too small to medium size companies. The close relationship which exists between this type of client and the auditor, who not only audits the books and prepares the final accounts but who also acts as a confidante in a wide field is of a valuable nature, it is claimed.

There is merit in this argument but it is precisely this warm relationship in the professional field that can lend itself to abuse. In any event the notion of rotation does not preclude anyone from continuing to seek advice of a favourite or long standing consultant.

Tied up with this aspect is the whole question of mandatory audits for small audit clients. It is necessary, to ask once again, is it necessary to audit the financial statements of a small audit client?

These small, closely-held companies enjoy the privilege of trading with limited liability in accordance with the provisions of Corporations Law. This means that if the company fails or causes damage, the shareholders only lose the sum of money they invested. The property rights of those damaged by companies have been removed to the benefit of a select group of property owners.

For the privilege of limited liability small, closely-held companies must ‘pay’ by making information available to its stakeholders in a responsible, transparent and unbiased manner. Gone are the days that a company is only accountable to its shareholders. No company is an island. It is part of a complex infrastructure and as a corporate citizen, is accountable to the community, employees and others.
The owners and directors of small, closely-held company’s limited liability companies must be made accountable in law for their actions. The law should ensure that external stakeholders, such as shareholders, minorities, employees, creditors, suppliers, consumers and the general public, are protected.

Whilst auditors carrying out a statutory audit of financial statements are accountable and report to the shareholders of a company only, there may be other stakeholders who believe that an independent audit provides some means of ensuring that the company’s responsibilities to them are being met; in effect that it serves their interests too. Stakeholders such as creditors, lenders, credit agencies, customers, and employees may claim an interest in the audit.

Today's legal structures allow small, closely-held companies to raise astronomical amounts of finance from the public in the time it takes to bat an eyelid and to employ these resources as they see fit behind a wall of secrecy and freedom from legal accountability. It is time to end the illusion that an audit has no value.

This revolutionary concept of audit practitioner rotation for small companies, in combination with the external inspection of audit engagements by National governments will change the small audit client practitioner from a benign fraternising and lax practitioner into a delving, hard-nosed and ruthless inquisitor. This is what the public want. This is the kind of protection the banks and other creditors are searching for in these hard times.

The audit of a small, closely-held company is nothing more than a necessary evil is a fallacy. In these hard times many causes of business failure, such as inadequate cash flow management or weaknesses in controls, may be identified and reported earlier as a result of the audit. Auditors are required to have a sound knowledge of the audited company and the business environment in which it operates. They can, therefore, offer advice on a range of issues including the potential for savings or additional profit. Auditors are required to consider the way the directors control their business. Poor or unreliable controls can reduce business efficiency and allow errors and fraud to go undetected.

An independent audit is therefore crucial, it gives credibility to the financial statements in a way that cannot be achieved by any other means and has a clear economic value for the small company. However, an audit of a small, closely-held company needs a major revolutionary change in manner in which the auditors of small, closely-held companies are appointed to establish wherein an auditor of a small, closely-held company can act entirely independent and can be seen to act. Otherwise the illusion will become a reality that an audit of a small, closely-held company has no value.