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Corporate governance series of guidance on the King Report: draft for comment issued by the South African Institute of Chartered Accountants - Comments from the Association of Chartered Certified Accountants

Introduction

1. The Association of Chartered Certified Accountants (ACCA) is pleased to have this opportunity to comment on the proposed guidance for auditors on reporting on internal control.

General points

2. The stated purpose of the document is to provide guidance to an auditor when directors report on their entity's system of internal control. However, the status of the document and the place of the guidance series in the canon of pronouncements by the South African Institute of Chartered Accountants (SAICA) are not clear. We recommend that the status of the guidance, and, therefore, the implications if it is not followed by auditors, should be stated if this is not already covered elsewhere in SAICA official material.

3. The authority of the guidance is also confused by the terminology. The document uses terms such as "should" and "would require the auditor to …". The word 'should' is reserved for fundamental principles and essential procedures in International Standards on Auditing, and in the equivalent pronouncements issued by the Auditing Practices Board (APB) in the United Kingdom and Republic of Ireland. The authority of APB Auditing Standards is reinforced indirectly by legislation in the UK and Ireland, and failure to comply with an applicable Standard is a disciplinary offence. Similar terminology is used in American Statements on Auditing Standards.

4. The authority of the material is not helped by the structure of the document. Guidance on procedures is relegated to an appendix, but still uses the word "should" and similar expressions. We consider that it would be better to combine the guidance into a single text so that there is no apparent hierarchy. The appendices would then be restricted to supporting material and examples such as the summary chart in appendix I, the criteria chart in paragraph 14 in appendix II, and the audit report examples in appendices III and IV.

5. We consider it regrettable that the Johannesburg Stock Exchange (JSE) Listing Requirements allow the directors' statement on the system of internal control to be included in a separate section of the company's annual report which is not audited. This provision appears to mean that directors can choose whether their internal control report is subject to scrutiny by the auditors or not.

6. The requirements for directors and auditors appear to go further than those in other countries in requiring directors to report publicly on the effectiveness of their company's system of internal control. Our understanding of the proposed guidance for auditors is that the latters' report, although addressed to the directors, is also to be public.

7. We are concerned that such public reporting of what must be very subjective opinions may lead to an expectations gap. If the directors make a statement as to the effectiveness of the company's system of internal financial control and the auditors report that they have audited the system and, in their opinion, it is effective in all material respects, who would be liable if the system were found to be deficient? A major fraud may have occurred but not been detected in the year covered by the report, or the same system which was judged 'effective' may fail to prevent or detect such a fraud in subsequent periods.

8. We doubt that it is possible to 'audit' a system of internal financial control and give a high level of assurance as to its effectiveness in positive terms. The purpose of the paragraphs headed 'Inherent limitation' in the report examples given by SAICA may be to address the problem, but we question whether this section may not undermine the credibility of the report altogether. We consider that it would be better for both the directors' statement and the auditors' report to be made in less ambitious terms. For example, the Turnbull Committee in the UK has proposed that the directors should explain in their statement how their company has maintained a sound system of internal controls, and report that they have reviewed the effectiveness of the system. The auditors' report would be based on the directors' statement.

Detailed comments

9. Paragraph .28 states that evidence obtained from auditors' tests of control could be augmented by reference to existing knowledge of the business and discussions with directors and management. Discussion with internal audit is at least as important as a source, and should be included in this context.

10. Paragraphs .49 in the main text and .11 and .12 in appendix II consider the role of internal auditors. We recommended in paragraph 4 above that the material in the main text and appendix II be combined, but if the texts are to be separate, they should be cross-referenced.

11. Paragraph .02 in appendix II states that "the guidance in this appendix should also be followed where a directors' statement … is included in that part of the annual report that is not covered by the auditor's report …". Given the importance of this requirement, we recommend that it be included in the main text under the heading "Reference to the auditor in the directors' statement" (currently paragraphs .43 to .46).

Drafting points

12. Paragraph .03 refers to the Guidance for Directors: Reporting on Internal Controls issued by SAICA. It would be helpful if this were identified consistently in later references (for example, paragraphs .05, .06 and .08) as, say, 'the Guidance for Directors'. It would then be clear that the text was referring to specific, official material.

13. The connection between the first and second sentences in paragraph .06 is not clear. The two sentences need to be linked with an explanation as to why the auditors consider the system of internal control in the course of their work.

14. Paragraph .11 states that the guide addresses issues arising when directors report on internal financial controls. Care needs to be taken that references throughout the document are consistent in order to avoid confusion. Currently, for example, paragraphs .13, .15 and .21 refer simply to "system of internal control".

15. Paragraph .04 in appendix II states that particular attention needs to be paid to defining the criteria against which the effectiveness of the system of internal financial control is to be assessed. The paragraph could usefully cross-refer this statement to the later paragraph .14.

16. Subject to our reservations about the use of the word in a guidance note (see our paragraph 3 above), we believe that the second sentence in paragraph .12 in appendix II is meant to start with 'should'.

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