MANAGEMENT AND AUDITOR RESPONSIBILITIES
Introduction Most computer systems currently store the year component of a date in a two digit field. For example, this field will contain the digits 96 to represent a date in the year 1996. This design philosophy means that the date field will cope with all dates up to 31 December 1999. At the beginning of the next century, the date field will start to malfunction as 00 is entered to denote a date in the Year 2000.
General awareness of the Year 2000 issue is growing in South Africa. Examples of how computer systems which currently use two digit fields for storing the date information will malfunction are often cited. The question arises as to how management will deal with the problems which will start arising when the century changes?
Failure to deal with Year 2000 issues timeously could negatively impact on the overall level of internal control within an organisation from 1999 onwards, i.e. when computer systems start malfunctioning as a result of Year 2000 date issues. Directors of companies which subscribe to the King Commission’s Code of Corporate Conduct, are required to sign annual certificates indicating that their companies maintain effective internal control systems. If the company experiences significant Year 2000 problems which impact its overall level of internal control, then directors will find it difficult to sign their internal control certificates. It follows that the directors and management could be held directly responsible for Year 2000 issues on the basis that they know of the impending problem and did not do sufficient to reduce the company’s Year 2000 risks.
This topic is doubly relevant: the information systems complications of the Year 2000 are looming for many organisations, and the findings of the King Commission focus primarily on management’s responsibilities for the maintenance of a proper system of internal control within an organisation. Viewed together, these two developments cannot be ignored.
Both internal and external auditors have roles to play in dealing with Year 2000 issues. Management often make use of internal auditors to review internal control systems and to report on whether these systems are operating correctly. Internal auditors will therefore become involved in Year 2000 issues when internal control systems are impacted.
It is clear that if the financial records of an organisation are adversely impacted by Year 2000 issues, then the matter must be dealt with in the first instance by management. Because external auditors report on the accuracy of the organisation’s financial statement, Year 2000 could become an external audit issue if it is not properly addressed by management.
External audit involvement
It is essential to point out that all legal entities, except for sole proprietors and close corporations, require an annual audit to be performed. It therefore follows that external auditors need to be aware of the Year 2000 issue in dealing with their clients.
Another factor to be considered is the audit profession’s growing fear of litigation. It is not clear to what extent professional indemnity insurance will cover any auditor negligence on a Year 2000 issue. In view of the uncertainty, it is likely that auditors will require an in-depth understanding of the Year 2000 issues as they relate to each of their clients.
Nevertheless, the concept of materiality will guide auditors in the execution of their responsibilities. This means that if auditors do not think the Year 2000 presents significant problems for a particular client, then they will not address it as part of the annual audit of that client.
Auditors using the “old style approach” to conducting audits would be less likely to view the Year 2000 issues as a material problem. This is because the old approach to auditing was primarily focused on substantiating each figure which was included in an organisation’s annual financial statements. However, the “new style approach” to auditing has a completely different focus. It has a cyclical approach and places a considerable amount of audit effort on understanding the business processes of the clients. In line with this last point, a major emphasis is also placed on understanding the information systems which support each of the various business processes.
As a result, clients can expect the use of information systems auditors to assist in the understanding and evaluating of the controls in these systems to increase in future audits. These specialists will start to concentrate on Year 2000 issues as the end of the century approaches.
The going concern issue will continue to be of paramount importance to auditors of all organisations. From an auditor’s perspective, the Year 2000 problem is probably going to be the best test of an organisation’s disaster recovery plan (DRP) and business continuity plan (BCP).
In summary, external auditors will be primarily concerned with the following client issues with regard to the Year 2000:
- The possible loss of the integrity of the organisation’s financial data as a result of the corruption of date-related information which is often used to index financial transactions. This could result in the financial records being inaccurate
- The organisation’s failure to properly recognise and provide for the costs relating to Year 2000, such as :
- The cost of assessing the scope of the Year 2000 problem as a project within the organisation
- The cost of implementing a Year 2000 solution
- The costs of possible business damages to be incurred by the audit client in defending Year 2000 actions against themselves.
Where does internal audit fit in?
It is likely that management will use internal auditors in investigating and resolving the Year 2000 problem. The involvement of the internal auditors in monitoring the systems development life cycle of the company will be critical in order to ensure that the Year 2000 problems are dealt with in new applications which are being developed. They will also have a major role to play in the testing of changes made to application systems which are being made Year 2000 compliant.
Furthermore, internal auditors will assess other Year 2000-related issues from a value-added perspective. For example, they could be requested to review contracts with outsiders engaged by the company to resolve Year 2000 problems. They could also be requested to review the effectiveness of the project management of a Year 2000 project.
A serious concern is that many organisations have downsized their internal audit departments as a result of cost-cutting or outsourcing initiatives. The question arises as to whether these companies will have the internal audit resources they require.
Assuming that internal audit forms a key component of a company’s internal control mechanism, it must be realised that this downsizing may negatively impact the company’s ability to deal with the Year 2000 problem internally. It also makes management more vulnerable in terms of their responsibility to maintain an adequate level of internal control in the organisation.
Unfortunately, South African business executives do not appear to appreciate the gravity and urgency of the Year 2000 problem. The general attitude is that there is still sufficient time to address it, and that the required resources will be available when they are needed.
The role of audit firms
In view of the heightened awareness, current research shows that audit firms are starting to look at their clients’ systems to ascertain whether they have Year 2000 problems. They are likely to focus strongly on the Year 2000 issues in view of the high probability of being sued for negligence in this area.
In addition, audit firms are starting to develop methodologies and tools to understand and assess the Year 2000 problem.
Specific tools such as data engineering services (DES) are being used to identify these problems. These services enable the auditors to identify date fields in client systems. The auditors are therefore able to begin assessing the extent of the Year 2000 problem for that client.
Service opportunities for audit firms include certifying packaged software for Year 2000 compliance and assisting with the selection of Year 2000 compliant application software packages.
In view of their client responsibilities, auditors will want to see their client’s Year 2000 risk and impact analyses. They will also start doing a Year 2000 information systems risk analysis exercise of their own in order to ascertain whether the client’s one is correct. Initially, the analysis performed by the auditors will probably focus more on the client’s systems rather than on the client’s automated interfaces with other organisations. It must be recognised that clients need to ascertain what their trading partners are doing with regard to Year 2000 as well. Trading relationships may well change where the relationship is highly automated and one party neglects to investigate and resolve its Year 2000 issues.
It is widely agreed that most Year 2000 problems will start in 1999. There is no doubt that failure to adequately provide for the costs relating to Year 2000 problems and rectification thereof could result in audit qualifications during the 1998 year ends of companies. It is important not to underestimate the impact on an organisation when it has a qualified audit report. For example, the implications on the stock exchange and actions taken by other business parties such as banks and creditors.
Companies can also expect a drive on consulting services from audit firms with regard to the Year 2000 issue. Although there may be a shortage of Year 2000 consultants as the date approaches, audit firms are likely to continue to supply advice and direction to their clients on this issue.
SOUTH AFRICA SCORES 5 OUT OF 10
In a scenario where 10 points represent world-class best practice, South Africa scores five out of 10 for the elements of business transformation. For the steps which make up the process of business transformation, South Africa scores four out of 10.
That’s the overall finding of a survey conducted by ourselves and Insight Customer Satisfaction Consultants (Insight), entitled Business Transformation in South Africa.
Local efforts at business transformation were rated on a scorecard which evaluated critical elements as well as the stages of business transformation. These ratings compared South Africa with world-class best practice.
Elements of Business Transformation
The elements of business transformation were defined by the survey as strategy, process, people and organisation, and technology. The average score for these elements was five out of 10.
In terms if strategy, South African companies scored seven out of 10 due to a high degree of world-class best practice analysis. The survey found considerable activity in mergers, unbundling and joint ventures. Organisations have put effort into redefining their strategies, focus, visions and missions.
On the issue of process, however, the score was only four out of 10. A low incidence of transformational process re-engineering was attributed to intervention and fragmentation as opposed to adopting an enterprise-wide approach. Both cohesion and the courage to re-engineer appear to be lacking. There was high activity in incremental transactional improvement rather than dramatic, fundamental change.
Although grouped together, people and organisation received vastly differing scores. Organisation, which scored eight out of 10, exhibited extensive reshaping, restructuring, reorganising and downsizing of the fundamental configuration. The primary driver in this area was cost reduction to retain the right to remain on the competitive playing field. In contrast, people scored only three out of 10 due to a low incidence of real leveraging of human contribution accompanied by a minimal investment in training. Training which did take place was predominantly focused on supervisory skills and customer service rather than on managing personal change and diversity. There was a tendency to avoid the more intangible component of human capability and development.
A tendency to use technology with greater frequency scored this category six out of 10. However, the focus is on enabling technologies rather than those which demand the fundamental re-design of the organisation. The survey questions whether these activities are transformation or enhancement.
Stages of Business Transformation
The stages of business transformation were identified as initiation, conceptualisation, ownership, launch, implementation and outcomes, for which the average score was four out of 10.
The relatively high score for initiation (7) indicated good recognition of the drivers for change and the need to respond to those drivers. Transformation is acknowledged as a critical strategic issue in virtually all businesses.
In the area of conceptualisation (5), which relates to the formulation of strategic responses to change drivers, a considerable amount of good work has been done. However, the survey questions whether it is adequately radical to achieve the desired long-term objectives of transformation. Overall, conceptualisation was weak on integration of activities.
The low score for ownership (2) was based on the paltry involvement of all players in the total value chain, including supplies and customers, as well as a tendency to avoid organised labour. Despite the appointment of multi-cultural transformation forums, management continues to retain accountability and budgetary control.
Launch scored four out of 10 because of a tendency to minimise risk by introducing transformation on a low-key, fragmented basis rather than as an organisation-wide directive. Again, the survey questions whether the nature of the launch is adequately radical. Although the need to enter world-class competition is acknowledged, socio-political realities are ignored.
Chief executives are spending a comparatively low percentage of their time on implementation (4), as their top priority is keeping the business together. Implementation therefore tends to be fragmented and low risk.
Although outcomes (5) appear positive in the short term, the score was reduced by competition becoming fiercer in the final stages. This is attributed to the innate inefficiency of South African business.
Business Transformation in South Africa surveyed 375 operating businesses across a variety of industry sectors. Thirty-seven percent of the responding companies employ between 500 and 3000 people, and 45% are listed companies. A total of 72% are South African organisations, with the balance consisting of multinational companies. At presentations held in Cape Town, Durban and Johannesburg, tremendous interest was shown in the results of the study. Interested parties can purchase the detailed report through any of our offices countrywide.
FINANCIAL MAIL / ERNST & YOUNG ANNUAL ACCOUNTS AWARD
The Financial Mail / Ernst & Young Annual Accounts award, has been run since 1964. It is based on an assessment of the annual financial statements and interim reports of all companies listed in the industrial sectors of the Johannesburg Stock Exchange. Accordingly, the award does not cover companies in the mining, metal and minerals and financial sectors of the stock exchange.
The objective is to give due credit to companies that make the effort to apply high standards of reporting to stakeholders – and to expose those that simply disclose the minimum disclosure requirements.
The rules have recently been updated and will be applied for annual reports with 1996 year ends. This is the first time in two years that the rules have been revised and updated. These rules assume that companies comply with the requirements of statements of Generally Accepted Accounting Practice in that compliance with the various statements is not covered by the rules.
The major changes made to the rules and additional disclosure requirements contained in the rules are as follows:
- Further disclosures required on Corporate Governance.
- Disclosure in cash flow statements relating to additions and disposals of fixed assets.
- Current liabilities differentiated between interest bearing and non interest bearing amounts.
- Disclosure of the insured value, replacement value or fair value of assets excluding fixed property.
- Statement of compliance or intention to comply with International Accounting Standards.
- Disclosure of depreciation on intangible assets or reason why no provision is made.
- Providing an analysis of operating income.
As a result of these changes, the maximum possible marks that can be awarded has been increased from 160 to 190. The additional disclosures are noted with an asterisk on the mark plan, which is available on request. The mark plan also notes areas where the number of marks that could be awarded has been altered.
Whilst we do not jointly agree on the rules with the Financial Mail, we provided input which led to some of the above changes. We are not involved in the judging which is carried out by the Bureau of Financial Analysis at the University of Pretoria.
A BENCHMARKING PROJECT
Since 1992, South Africa companies have been facing accelerating changes on a social, political and business level. Changes in the business environment relate particularly to rising employee expectations and the impact of community issues on business, competition and market changes. The new Labour Relations Act will speed up the pace and intensity of change.
It is widely accepted today that employee involvement (the greater say of employees in organisational decisions and affairs) is a prerequisite for global competitiveness. A recent report on world competitiveness ranks South Africa 42nd in human resources terms, which seems to indicate that companies in this country are clinging to their old autocratic style of management and that workplace democratisation is slow.
How far have we travelled and how much longer is the road?
We have recently concluded a benchmarking study which compares the current position of South African companies against a similar study conducted during 1992 when the democratisation process was initiated and assesses involvement efforts to date by South African companies against the backdrop of the overall democratisation process in the country.
A fairly representative sample of 33 organisations across all the major economic sectors responded to a questionnaire which was designed to elicit information on the nature, design and extent of their employee involvement efforts. In most cases, the questionnaire was completed by senior managers, whose responses may be seen as the most optimistic view of involvement in South African companies.
Structure oriented programmes examined include parallel programmes such as quality circles, employee participation groups and corporate social responsibility, while intrinsic programmes are defined as job enrichment, mini-enterprise units, self-managing work teams and reward oriented programmes such as employee stock ownership plans, profit sharing and flexible, cafeteria style benefits, amongst others.
While there has been an increase in reward oriented programmes, these are only involving employees on the fringes, rather that the core of organisations. The study highlights the fact that employees are not involved, in a significant fashion, in the day to day functioning of organisations; that employee involvement has lost momentum since 1992 and that organisations are steering away from programmes demanding any significant devolution of power. In other words, the changes occurring at macro-societal level in South Africa are not reflected in organisations.
The new Labour Relations Act imposes worker participation in company policy and decisionmaking through information disclosure and workplace forums. This requires all organisations to begin transforming core organisational processes in a real sense if they are genuinely committed to workplace democratisation. The study reveals that the fringe changes that have been initiated are not sufficient in the context of global competitiveness. It suggests that management can respond to the Act by complying with the letter of the law, but it would be far more beneficial to respond to the spirit of the law and involve all stakeholders in taking responsibility for the success of their organisations. The study , which is available at a cost of R1500, gives organisations the chance to benchmark themselves against the findings of the study; and establish how their employee involvement efforts position them in terms of global competitiveness and in relation to the new Labour Relations Act.
Entertainment Expenditure – Employees Away Overnight
Most readers will recall that an amendment was introduced into the VAT Act in 1992, restricting the input credit allowed for subsistence expenditure where an employee (or partner) of a business is away from home on business overnight. This amendment required that the employee should also be away from his “working place”.
The change was introduced primarily in order to catch housing and food costs of so-called migrant workers on mine properties who are away from their “usual place of residence” in the rural areas. It also potentially affects commercial travellers and other employees and executives who regularly work away from their main base and it is this aspect that we deal with here.
In recent discussions with the Commissioner’s office, we have established their view that even substantial periods of time away from an employee’s normal place of work on location at, for example, a country branch or site office, will not disqualify the employer from claiming input credit. To elaborate – there was a concern that where a commercial traveller, executive or construction engineer had effectively two or more offices in different centres which he visited regularly, his presence in those centres did not take him away from his “working place” as each one constitutes a working place of its own. We now understand that Revenue accepts that the phrase “working place” must be read as “usual working place” so that provided an employee has a clearly identifiable principal place of work, absences from there will qualify for input credit in the appropriate circumstances.
It must be stressed, of course, that the credit is still restricted by the requirement that it relates to subsistence expenses and not to “entertainment” in the broad sense.
Pool Motor Vehicle – VAT on Fringe Benefits
An unusual quirk in the VAT Act is that VAT may be charged on the private use of a so-called “pool car” even though that use is not itself subject to income tax under the fringe benefit rules.
So, for example, if an individual makes regular use of a vehicle for private purposes but that vehicle nonetheless qualifies as a pool car, a VAT charge must be raised on a deemed supply valued at 0,3% of the “determined value” of the vehicle per month (pro rated for the actual days of private use).
This anomaly is quite bizarre and seems to be totally at odds with the overall intention of the legislature in providing for the levy of VAT on fringe benefits. The wording of the Act, however, is completely clear and we understand that Revenue applies the rule strictly.
It should be a relatively uncommon situation for a vehicle which is genuinely exempt from income fringe benefit charges still to be used privately and in so doing generate a VAT charge, but we are aware of at least one instance in which this has occurred and clients should be on the lookout for such situations.
For the record, a pool car which is not subject to fringe benefit income taxation is one which:
- is available to and in fact used by employees in general; and
- is used by an employee for private purposes infrequently or incidentally to business use; and
- is not normally kept at or near the employee’s residence when not in use outside business hours.
Recent Tax Cases
Expenditure to Reduce Future Expenses
In the second case in recent times to deal with this topic, the Income Tax Special Court has again affirmed in ITC 1600 that expenditure which does not directly go to produce “income” but rather goes to reduce expenditure, may nonetheless be tax deductible.
The facts were that an organisation paid up the leasing and suspensive sale finance on certain mainframe computer equipment so as to cut off future finance and manpower expenditure and to replace the mainframe with a more cost effective PC network. Revenue claimed that the expenditure incurred in terminating the agreements was not incurred in the production of “income” but was to reduce expenses and was accordingly not deductible. The Court, on the other hand, accepted that the expenditure was incurred for the better operation of the business and was accordingly incurred in the production of income in an indirect sense. Important in this decision was the fact that there was no penalty cost incurred in terms of the agreement – but in the light of the principles which were used to grant the deduction, it seems to us that the aspect of penalty or damages for breach should also not be a bar to deduction in the circumstances.
Subject to certain exceptions, the Secondary Tax on Companies (STC) provisions treat as a dividend any loan made to a shareholder if, at the time of that loan, the company has profits which are “available for distribution”.
A very similar phrase, “amount ..which could properly ..have been ..distributed” appeared in Section 8B of the Act (an ancestor, so to speak, of Section 64C) and its meaning has recently been considered in CIR v Dirmeik.
The company concerned had realised capital profits on the disposal of certain fixed assets and loaned them to its shareholder.
It argued that because its Memorandum and Articles required it to treat surpluses on realisation of capital assets as part of its investment capital and because it was an investment holding company whose purpose was to hold its assets in the long term, the proceeds were not available for distribution as a dividend. However, because the articles did not actually prohibit a distribution the Court found (correctly in our view) that there was no reason why capital profits should not have been distributed as an actual dividend and that the profits were accordingly “available”. The loan was therefore a deemed dividend subject to tax. The same reasoning will undoubtedly apply in the equivalent situation in STC.
The SA Revenue Service (SARS) recently issued a replacement brochure on the taxation of fringe benefits and allowances, replacing its earlier release in 1991. There are few changes in Revenue’s interpretation of the law but the brochure emphasises two points in particular which we have continually stressed in advising clients on remuneration packaging but which taxpayers generally seem reluctant to believe.
The brochure emphasises that “the provision of security in the form of fences, burglar bars, alarm systems or the provision of armed response at the home of an employee is a taxable benefit”.
Although in the very early days of Seventh Schedule interpretation a ruling was given by Revenue that this did not constitute a benefit, there was no support for such a ruling in law. The fact remains that the employee and his family make private use of the alarm system irrespective that it may be the employee’s frequent absence from home on business which leads to the installation in the first place.
In remarking on the exclusion from income of amounts reimbursed by an employer to an employee for entertainment expenses incurred, the brochure remarks that
“it is important to note that this exclusion is not applicable in cases where the employer has paid the amount of any club subscription on behalf of an employee or has reimbursed him in respect of the payment of such subscription. In cases of this nature, the employee is considered to be in receipt of a taxable benefit under the provisions of the Seventh Schedule to the Act”.
Technically, we believe that taxation of this payment takes place under the ordinary definition of gross income and the Seventh Schedule merely emphasises that point. But be that as it may, it is clear that where membership of a club is personal (i.e. not a true company membership) the only way an employee/executive can escape tax on the payment is by claiming a deduction for entertainment expenditure incurred. That deduction must always be limited by Section 11(u) of the Act to a maximum of R2 500 per annum. Indeed, Section 11(u) expressly records that the amount is intended to cover “club subscriptions” and it is clear that any amount in excess of this limit is simply not deductible by the employee.
It is frequently argued that if the employer makes it a condition that the employee shall become a member of a particular club, then that somehow changes the status of the payment. With respect, there is no foundation for any such argument and much as we dislike having to advise clients that tax free payment of club subscriptions (whether social, sporting and so on) is impossible, that is the simple fact (with one exception mentioned below). We happen to believe it is high time that the figure of R2 500, which came into the legislation in 1986, is long overdue for an increase but in the light of the Commissioner’s view on fringe benefits which we refer to later, it seems unlikely that there is much hope of this happening.
The exclusion which we refer to above is contained in paragraph 10(2)(c) of the Seventh Schedule and applies to:
“services rendered by an employer to his employee É for recreational purposes at É a place of recreation provided by the employer for the use of his employees in general”.
The difficulty posed by this exclusion is the availability to employees “in general”. Clearly, “in general” means just that – it is not sufficient if, say, the use of a gym is available only to executives of a particular level. Other sections of the legislation, for example paragraph (c)(ii)(bb) of the definition of pension fund, make reference to all employees of a particular class but that is not the case in 10(2)(c) of the Schedule. Where membership is provided on a cost of employment/sacrifice basis, availability to all employees in an organisation is simply not realistic but there is a further problem – that is, it is extremely uncommon for any club to grant a true company membership. Generally, a corporate discount is applied to individual membership. It is therefore impractical to provide what might be termed a “floating membership card” to satisfy the requirement that the club concerned is available to employees in general through the circulation of that card amongst all employees.
Future of Fringe Benefit Taxation
The Commissioner for Inland Revenue was recently quoted in the press as remarking that he intended to tax fringe benefits more heavily. This lead to some panic reaction that a penal tax on non-cash benefits was to be levied but we understand that the Commissioner was mis-reported. His intention was to re-emphasise the commitment that government made some years ago to tax benefits in kind no differently to benefits in cash, so that there would ultimately be no difference and elaborate fringe benefit packaging would become a thing of the past. Government’s ability to give effect to this aim is, of course, limited by the practical reality that it is not a straightforward task to assign a cash equivalent value to all benefits. So it is unlikely that the aim will ever be perfectly achieved. On the other hand, the past several years has seen an increasing erosion (through inflation) of a number of previously tempting differentials between cost of employment and taxable benefit, including: the R20 000 threshold for housing benefits; the R2 500 cap on entertainment allowances; and the R500 “free service” allowance; and the R2 000 long service award.
It is unquestionably true that fringe benefit packaging produces less and less for more and more effort as the years go on. On the other hand, there are still real benefits to be had if the exercise is performed properly and within the law. Far greater benefits of course are available by simply ignoring the rules or failing to ask whether any rules exist in the first place – an attitude which appears to be regrettably widespread although not, we hope, amongst our own clients.
Our tax professionals – specialising in flexible remuneration packaging are available to advise and steer clients through a fringe benefit review and structuring process.
For those who wish to read more about the rules, practical issues and opportunities, Ernst & Young’s Practical Guide to Fringe Benefits, published by Butterworths, recently went into its second print-run for 1996 and is still available from the publisher [telephone Durban (031) 268-3111] for R45,60 including handling and VAT.