A U D I T I N G A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT 9 th Edition Karla M. Johnstone...

A U D I T I N GA RISK-BASED APPROACH TO

CONDUCTING A QUALITY AUDIT

9th Edition

Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

Copyright © 2014 South-Western/Cengage Learning

Chapter 10Auditing Cash and

Marketable Securities

Copyright © 2014 South-Western/Cengage Learning10-2

Learning Objectives

1. Identify the significant accounts, disclosures, and relevant assertions in auditing cash accounts

2. Identify and assess inherent risks of material misstatement in cash accounts

3. Identify and assess fraud risks of material misstatement in cash accounts

4. Identify and assess control risks of material misstatement in cash accounts


Learning Objectives

5. Describe how to use preliminary analytical procedures to identify possible material misstatements for cash accounts, disclosures, and assertions

6. Determine appropriate responses to identified risks of material misstatement for cash accounts, disclosures, and assertions

7. Determine appropriate tests of controls and consider the results of tests of controls for cash accounts, disclosures, and assertions


Learning Objectives

8. Determine and apply sufficient appropriate substantive audit procedures for testing cash accounts, disclosures, and assertions

9. Identify types of marketable securities, articulate the risks and controls typically associated with these accounts, and outline an audit approach for testing these accounts

10. Apply frameworks for professional decision making and ethical decision making to issues involving the audit of cash accounts, disclosures, and assertions


THE AUDIT OPINION FORMULATION PROCESS


PROFESSIONAL JUDGMENT IN CONTEXT - Fraudulent Petty Cash Transactions at Koss Corporation

• Former vice president of finance orchestrated a $31 million embezzlement• Remediation actions• Eliminating petty cash fund


PROFESSIONAL JUDGMENT IN CONTEXT - Fraud at Peregrine Financial

• Embezzlement of over $200 million from Peregrine Financial Group’s (PFG) brokerage clients over a 20-year period• Bankruptcy filed immediately after implementation of

change in online system • Where bank statement information would be sent

electronically directly to National Futures Association


PROFESSIONAL JUDGMENT IN CONTEXT - Fraud at KOSS Corporation and Peregrine Financial

• Why is cash an inherently risky account? (LO 2, 3)• What controls should be in place to help ensure that

cash accounts are not misappropriated? (LO 4)• What are the audit implications of poor controls over

cash accounts? (LO 6)• What types of audit procedures would auditors

employ when auditing cash? (LO 7, 8)

Identify the significant accounts, disclosures, and relevant assertions in auditing cash

accounts

Learning objective 1


Major types of cash accounts

• General checking accounts• Cash management accounts• Imprest payroll accounts• Petty cash accounts• Marketable security accounts: A security that is

readily marketable and held by a company as an investment


Imprest Payroll Accounts

• Imprest bank account• Normally carrying a zero balance• Replenished when checks are to be written against the

account • Provides additional control over cash• Payroll account - The most widely used imprest bank

account • Company makes a deposit equal to amount of payroll

checks issued


BENEFITS OF Cash Management Techniques

Speed the collection and deposit of cash

Reduce the amount of paperwork

Automate the cash management process


Cash Management Techniques

LockboxesElectronic

Funds Transfers

Cash Management Agreements

with Financial

Institutions

Compensating Balances


Lockboxes

• Cash management arrangement with a bank whereby payments are sent directly to a post office box number accessible to client’s bank• Bank opens cash remittances and directly deposits

money in client’s account• Advantages• Company immediately earns interest on deposited funds• Manual processing is shifted to bank• Speeds up receipt of cash and allows organization to use

cash to earn a return


Relevant Financial Statement Assertions relevant to cash

Existence or occurrence• Cash balances exist at balance sheet date

Completeness• Cash balances include all cash transactions that occurred during

the periodRights and obligations

• Company has title to the cash accounts as of balance sheet date

Valuation or allocation• Recorded balances reflect true underlying economic value of

those assetsPresentation and disclosure

• Cash is properly classified on the balance sheet and disclosed in notes to the financial statements

Identify and assess inherent risks of material misstatement in cash accounts



Performing Risk Assessment Procedures for Cash Accounts

• Information useful in assessing risk of material misstatement is obtained• Inherent risks• Financial statement level • Account and assertion level

• Fraud risks• Feedback from audit team brainstorming sessions• Strengths and weaknesses in internal control• Results from preliminary analytical procedures


Reasons for Identifying cash as having high Inherent Risk

Volume of activity

Liquidity

Automated systems

Importance in meeting debt covenants

Can be easily manipulated


Inherent Risk Analysis Questionnaire: Cash

Identify and assess fraud risks of material misstatement in cash accounts

Learning Objective 3


Topics to be covered in a brainstorming session


Auditing in Practice - Common Fraud Schemes Relating to Cash

• Frauds relating to cash receipts• Inventory sold, but employee does not record the sale

and steals the cash• Employee receives a check and deposits it, but does

not record the sale; then the employee writes a check out to himself and does not record the disbursement• Employee collects a customer payment, steals cash,

and writes off accounts receivable as uncollectible



• Lapping: Employee steals a payment from one customer, and covers it up by using payments from another customer to disguise the theft• Skimming: Type of fraud that occurs when an

employee makes a sale but does not record it, and steals the cash



• Frauds relating to cash payments• Purchasing merchandise and recording sale at an

unauthorized discounted amount• Selling merchandise to a friend at a discounted price;

friend returning merchandise for a refund at undiscounted price; splitting profits• Employee stealing cash and concealing it by recording

a fictitious discount• Employee writing a check to a fictitious vendor and

depositing the check into an account controlled by the employee

Identify and assess control risks of material misstatement in cash accounts



Common Controls Over Cash


Auditing in Practice - The Parmalat Fraud and Its Many Victims

• Evolved over a 10-year period• Included invention of over $11 billion in fictitious

cash in offshore front companies to offset liabilities at parent company• In reality, cash was not accounted for and Parmalat

had only about 500 million euros in cash• Involved large number of individuals acting

collusively in various ways


Implications of Weak Controls Related to Completeness

• Employee required to record a cash receipt • Not performing the task• Not reflecting the cash being received, a sale made, or

reduced accounts receivable


Auditing in Practice - Skimming and the Completeness Assertion

• When a transaction is not immediately recorded, completeness assertion is violated• Applicable where customers pay cash directly to an

employee


Controls for Petty Cash

• Limiting access by keeping funds in a locked box • Requiring receipts for petty cash disbursements with:• Date• Amount received• Purpose or use for funds• Name of employee receiving funds

• Reconciling petty cash fund before replenishing it• Keeping customer receipts separate from petty cash

funds


Controls for Cash Management Techniques

Lockboxes

Electronic funds transfers

Cash management agreements with financial institutions


Assessing Control Risk for Cash

• Controls minimize potential risks to cash accounts• Requires the auditor to have an understanding of

internal controls for:• Integrated audits • Financial statement only audits• Understood by:• A walkthrough of process• Inquiry• Observation• Review of documentation



• At account and assertion levels, considering:• Entity-wide controls • Transaction controls

• At entity-wide level, considering control environment• Commitment to financial accounting competencies• Independence of the board of directors• Risk assessment• Information and communication• Monitoring controls



• Integrated audit of cash involves evaluating:• Design of internal controls• Operation of internal controls

• Smaller organizations - Testing of operating effectiveness of controls is not a required part of the audit • Larger organizations - Evaluating and testing of

internal controls happen via an integrated audit


Control Risk Questionnaire - Cash


Documenting Controls

• Documenting auditor’s understanding of internal controls for:• Integrated audits • Financial statement only audits

• A questionnaire often used to guide auditors in documenting understanding of internal controls


EXHIBIT 10.3 - Control Activities Questionnaire: Cash Receipts

10.3 A.png

Describe how to use preliminary analytical procedures to identify possible material

misstatements for cash accounts, disclosures, and assertions



Performing Preliminary Analytical Procedures

• Helps identify areas of potential misstatements when planning the audit• Cash is examined in relation to:• Operational data • Budgetary forecasts

• Requires awareness of importance of cash balances to debt covenants


Performing Preliminary Analytical Procedures

• Relationships indicating heightened risk of fraud in cash:• Consistent profits over several years, but cash flows

are declining• Unexpected reductions in accounts receivable

collections, or timeliness of collections• Unexpected declines in petty cash account


Using Trend Analysis of Account Balances and Ratios in Preliminary Analytical Procedures for Cash Accounts

Determine appropriate responses to identified risks of material misstatement for cash accounts,

disclosures, and assertions



Responding to Identified Risks of Material Misstatement

• Audit procedures are proportional to assessed risks• Areas of higher risk receive more audit attention and

effort• Developing audit approach that contains:• Tests of controls (if applicable)• Substantive procedures, including analytical

procedures• Audit programs are customized based on assessment

of risk of material misstatement


EXHIBIT 10.5 - Panel A: Sufficiency of Evidence for Existence and Completeness of Cash


EXHIBIT 10.5 - Panel B: Approaches to Obtaining Audit Evidence for Existence and Completeness of Cash

Determine appropriate tests of controls and consider the results of tests of controls for cash accounts,

disclosures, and assertions



Selecting Controls to Test and Performing Tests of Controls

• Auditors make decisions about:• Which controls to test for formulating an opinion on

entity’s internal controls• Whether the level of control risk warrants reduction of

substantive testing


Selecting Controls to Test and Performing Tests of Controls

• Tests of transactions controls• Inquiry of personnel performing the control• Observation of control being performed• Inspection of documentation confirming that control

has been performed• Reperformance of control by individual testing the

control


Considering the Results of Tests of Controls

Control deficiencies identified

Assessing those deficiencies to determine their severity

Modifying preliminary control risk assessment

Documenting implications of control deficiencies

No control deficiencies identified

Determining that preliminary assessment of

control risk as low is appropriate

Determining the extent that controls can provide

evidence on correctness of account balances

Determining planned substantive audit

procedures

Determine and apply sufficient appropriate substantive audit procedures for testing cash

accounts, disclosures, and assertions



Auditing in Practice - Weaknesses in Substantive Procedures Related to Cash

• Auditor needs to consider types of substantive procedures for cash that should be performed• Make sure that engagement team performs those

procedures• PCAOB disciplinary proceedings against two audit

firms provide insight on weaknesses in cash-related audit procedures


Substantive Analytics for Cash Accounts

• Focusing on substantive tests of details• Minimal substantive analytics to be performed

include identifying significant:• Fluctuations in cash balances• Differences between budgeted and actual levels of

cash


Substantive Tests of Details for Cash Accounts

Preparing independent bank reconciliations

Obtaining bank confirmations and bank cutoff statements

Preparing bank transfer schedules


Preparing Independent Bank Reconciliations

• Provides evidence for accuracy of year-end cash balance• Process includes reconciling balance per bank

statements with balance per booksAuditor independently verifies the

following items when testing client’s bank reconciliation

Balance as per bank statement

Deposits in transit

Outstanding checks

Other adjustments


EXHIBIT 10.7 - TESTS OF CLIENT’S BANK RECONCILIATION

10.7.png


Bank Confirmation

• A standard confirmation sent to all banks with which the client had business during the year • Used to obtain information about year-end cash

balance and additional information about loans outstanding• Seeks information on:• Client’s deposit balances• Existence of loans • Due dates of loans


Bank Confirmation

• Interest rates• Dates through which interest has been paid• Collateral• An asset or a claim on an asset held by a borrower or an

issuer of a debt instrument • To serve as a guarantee for value of a loan or security• If the borrower fails to pay interest or principal, collateral

is available to lender to recover principal amount of loan


EXHIBIT 10.8 - Standard Bank Confirmation: Account Balances

10.8.png


Auditing in Practice - Confirmations with Financial Institutions

• PCAOB-proposed Auditing Standard would require auditor to:• Perform confirmation procedures for cash and other

relationships with financial institutions


OBTAINING BANK CONFIRMATIONS – LOAN GUARANTEES

• These requirements are referred to as covenants • A violation of covenants makes loans immediately

due and payable • Considering client‘s ability to continue to operate as a

going concern • In case of a long-term debt, reclassifying it as a current

liability


EXHIBIT 10.9 - Standard Bank Confirmation: Loan Guarantees

10.9.png


Obtaining Year-End Cutoff Information as Part of Bank Confirmation Process

• Obtaining information on last checks issued in fiscal year• Last check number

• Observing that all previous checks had been mailed• Obtaining information on last cash receipts


Cutoff Bank Statements

• A statement for a period of time determined by client and auditor • Shorter than that of regular month-end statements • Sent directly to auditor, who uses it to verify

reconciling items on client’s year-end bank reconciliation


Preparing Bank Transfer Schedules

• Kiting: Fraudulent cash scheme to overstate cash assets at year end by showing the same cash in two different bank accounts • Bank transfer schedule: Audit document listing all

transfers between client bank accounts• Starts shortly before year end and continues for a

short period after year end• Purpose - Assures that cash in transit is not recorded

twice


Fraud-Related Substantive Procedures for Cash Accounts

• Confirming with financial institutions about individuals authorized to access cash accounts• Scrutinizing checks that are payable to cash• Scrutinizing checks with unusual vendor names• Scrutinizing checks made out to employees outside

of normal payroll processing system• Comparing timing of deposits into bank accounts

with timing of cash receipts• Noting any unusual time lags


Fraud-Related Substantive Procedures for Cash Accounts

• Comparing time lags between:• The date a check was issued for payment • The date that it clears the bank

• Investigating voided checks and analyzing voided transactions


Documentation related to Substantive Procedures for cash accounts

• Copies of independent bank reconciliations• Copies of bank confirmations• Documentation of oral confirmations• Copies of bank cutoff statements• Copies of bank transfer schedules• Evidence of any restrictions on use of cash balances

or bank compensating balances

Identify types of marketable securities, articulate the risks and controls typically associated with these accounts, and

outline an audit approach for testing these accounts



Marketable securities

• Held as temporary investments• Short-term cash management securities • U.S. Treasury bills• Certificates of deposit (CDs)• Commercial paper• Notes issued by major corporations at rates

approximating prime lending rates with high credit rating

• Short-term hybrid-type securities • Improve return on temporary investments


Classification of investments in securities

• Valued at amortized cost, subject to an impairment test

Held-to-maturity securities

• Carried at fair market valueTrading securities

• Carried at fair market valueAvailable-for-sale securities


AUDITOR’S JUDGMENTAL CHALLENGE

• Corroborating management’s intent in classifying assets• Gathering information about management’s trades in

investments • Importance of market value to management

compensation• Determining fair market value• Easily determinable for regularly traded securities• Financial institutions reluctant to mark fair values for

thinly traded securities


Relevant Financial Statement Assertions

Securities exist at balance sheet dateExistence or occurrence

Securities balances include all securities transactions taken place during the period

Completeness

Company has title to such securities accounts as of balance sheet date

Rights and obligations

Recorded balances reflect true underlying economic value of those assets

Valuation or allocation

Properly classifying the securities on balance sheet and disclosing in notes to financial statements

Presentation and disclosure


Inherent and Fraud Risks

Risk of sudden market declines

Manipulation of classification of securities

Manipulation of valuation of fair market value


Control Risks

• Risk of theft of securities if:• They are not physically controlled• Authorization and monitoring over their trade is not

effective• Lack of policies over purchase or sale of securities• Lack of monitoring of changes in securities balances• Lack of policies over valuation or classification of

securities


Control Risks

• Lack of segregation of duties between those responsible for:• Making investment decisions • Custody of securities

• Lack of involvement or oversight by internal audit in relation to securities


INHERENT RISK ANALYSIS QUESTIONNAIRE - MARKETABLE SECURITIES


Control Risk Analysis Questionnaire - Marketable Securities


Auditing in Practice - Common Fraud Schemes Relating to Investments

• Securities purchased, not authorized• Securities purchased, not recorded as purchased• Securities recorded as purchased, not purchased• Securities sold, not recorded as sold• Securities recorded as sold, not sold• Investment income is stolen• Investments are purposely valued inaccurately• Investment classifications are purposely inaccurate


Analytical Procedures for Marketable Securities

• Developing expectations about level of amounts in ending balances• Based on purchase or sales activity reported

• Developing expectations about relationship between balances in marketable securities accounts• Reviewing changes in:• Balances• Risk composition• Classification types of marketable securities


Tests of Controls

• Reviewing policies for authorization• To purchase, sell, and manage such securities

• Inquiring of board of directors about board’s oversight of process and examining related documentation• Examining documentation of authorization • For selected purchases and sales

• Reviewing minutes of board meetings • For reference to investment policies and associated

oversight


Tests of Controls

• Examining evidence of authorization controls • For changes in classification of such securities

• Inquiring of management about its process for • Establishing valuation • Reviewing related documentation

• Inquiring about process for reclassifications and review related documentation


Tests of Controls

• Examining documentation for selected marketable securities transactions • Reviewing reports of internal audit


Assertions and Related Substantive Tests of Details - Marketable Securities

• Requesting for a schedule of securities and verifying their existence

Existence or occurrence

• Footing schedule of marketable securities and examining them

Completeness

• Examining selected documents to determine any restrictions

Rights and obligations

• Determining current market value• Re-computing interest and proper recording of accrued

interest

Valuation or allocation

• Determining whether securities are properly classified

Presentation and disclosure


EXHIBIT 10.15 - audit workpaper for testing marketable equity securities

10.15.png


Auditing in Practice - Audit Procedures Used to Address Risk Related to Common Fraud Schemes for Investments

• Employing specialist to assist in fair value measurements• Conducting background checks of employees having

access to investment accounts• Requiring original documents of securities• Tracing: • Dividend payments• Interest payments• Sales of securities


Auditing in Practice - Audit Procedures Used to Address Risk Related to Common Fraud Schemes for Investments

• Tracing purchases of securities to cash disbursements on the bank statement• Reviewing any unusual journal entries in investment

accounts


Documentation related to substantive procedures for marketable securities

• Schedule of marketable securities as:• Prepared by client• Reviewed by auditor

• Documentation of any confirmation of securities• Documentation of securities transactions scrutinized• Memo containing rationalization for judgments about

management’s: • Classification of securities• Valuation of securities


Documentation related to substantive procedures for marketable securities

• Reports of any outside valuation experts• Documentation of calculation of potential

impairments

A U D I T I N G A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT 9 th Edition Karla M. Johnstone...

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