Chapter 12

Auditing Liquid Assets

List Cash Accounts  General checking accounts  Cash management accounts  Payroll checking accounts Marketable Security Accounts  Marketable securities (held as temporary

investments)  Short-term cash management securities

(Treasury bills, CDs, etc)  Short-term hybrid-type securities

Review Planning for Audits of Cash and Marketable Securities

Materiality and Risk Considerations  Volume of transactions flowing through the

account  Liquidity and easy transferability  Automated systems and increased

computerization of account activity  Importance in meeting debt covenants With smaller clients, auditors usually

concentrate on substantively testing year-end Cash account balances

With large clients, auditors focus on evaluating and testing internal controls

Planning for Audits of Cash and Marketable Securities (Continued)

Inherent risk for cash and marketable securities is high

 Liquidity of assets  Susceptibility of mishandling  Difficulty in understanding financial risks

associated with derivatives  Complexity of some financial instruments Control risk  Analysis of control environment over cash

and marketable securities should occur during planning of the audit

Discuss Cash Management Techniques

 Speed collection and deposit of cash  Minimize possibility of error or fraud  Reduce paperwork  Automate cash management process  Techniques include

 Lockboxes  Electronic funds transfers  Cash management agreements with

financial institutions  Compensating balances

Review Evaluating Control Risk: Cash Accounts

Appropriate internal controls would include:  Adequate separation of incompatible duties  Cash receipts deposited daily and intact  Restrictive endorsements on checks received   Independent reconciliation of cash records including

bank statement  Computerized control totals and edit tests  Authorization of transactions  Use of prenumbered documents and turnaround

documents  Periodic internal audits  Competent, well-trained employees  Access to assets and accounting records restricted

Comment on Understanding and Testing Internal Controls

 Understanding of internal control is obtained through inquiry, observation, and review of client documentation

 Auditors use flowcharts, memos, and questionnaires to document their understanding

  If auditor assesses control risk as low and believes it is cost-effective to rely on the controls, an audit program for testing the controls is developed

 The program is designed around the basic control objectives and is cross-referenced to the audit objectives

 Based on the results of testing, the auditor reassesses control risk and develops procedures to substantively test Cash account balances

Discuss Substantive Testing of Cash Balances

Common types of misstatements regarding cash include:

 Transactions recorded in the wrong period

 Embezzlements covered up by omitting or under-footing outstanding checks on the bank reconciliation

 Manipulating accounts to record the same cash in two accounts at the same time (kiting)

Discuss Substantive Testing of Cash Balances (Continued)

 Independent bank reconciliation

 Bank cutoff statement  Bank confirmation  Obtaining year-end cutoff

information

Explain Independent Bank Reconciliation

Reconciles year-end General Ledger Cash account balance to year-end bank statement balance

Two part bank reconciliation:  Start with year-end bank balance and adjust

for items recorded in the books, but not by the bank

 Start with year-end General Ledger Cash balance and adjust for items recorded by the bank, but not on the books

Adjusted book balance must equal adjusted bank balance

Explain the Use of the Bank Cutoff Statement

Bank cutoff statement:  Normal bank statement for the first few

weeks after year-end  Sent directly to the auditor  Includes canceled deposit slips and

checks  Allows auditor to verify existence and

amount of deposits in transit and outstanding checks on the bank reconciliation

What’s the bank confirmation used for?

Auditor usually sends a confirmation to each bank with which the client transacted business during the year

Confirmation is usually open form:  Respondent (bank) fills in the form  Auditor reconciles provided information with client

records Standard confirmation has two parts:  First part seeks information on client's account

balances  Second part seeks information on any loans or

collateral agreements the client may have with the bank

Bank confirmations are generally considered to be reliable evidence

Why obtain year-end cutoff information?

Management manipulation of cash includes:  Over-recording cash receipts  Under-recording cash disbursements If the auditor assesses the risk of such irregularities as

high, following procedures may be used:  Obtain information on last checks issued during the

audit period  Number of last check issued  Observe that all previous checks had been mailed and

corroborate by timely clearing of the bank per the bank cutoff statement

 Obtain information of last cash receipts  Note last few receipts  Trace receipts to bank reconciliation and bank cutoff

statement

How is a bank transfer schedule used?

Kiting involves transferring funds from one bank account to another just before year-end in order to overstate cash:

 Deposit is recorded into the second account before year-end

 Disbursement is not recorded in the first account until after year-end

Auditor tests for kiting by preparing a bank transfer schedule:

 Schedule lists all transfers between company bank accounts for a few days before, and a few days after year-end

 Schedule lists dates transfers cleared the bank and dates they were recorded in the books

 Auditor checks to see deposit and withdrawal were BOTH recorded in the same accounting period

Discuss Operational Audits of Cash

Internal auditors often use the following procedures to test the effectiveness of internal controls over cash accounts:

  Review procedures for handling cash receipts   Review procedures for identifying and investing excess of

idle funds   Measure and evaluate the effectiveness of cash

management and budgeting   Review arrangements with financial institutions to identify

risks   Determine compliance with company policies   Evaluate effectiveness of controls over electronic transfers   Evaluate effectiveness of controls to minimize loss of

misuse of cash   Determine if payments made timely to take advantage of

cash discounts

Define Marketable Securities and Financial Instruments

Marketable securities are  Debt or equity securities that are

readily marketable  That management intends to hold for a

short time  Includes commercial paper, marketable

equity securities, and marketable debt securities

Review Substantive Audit Procedures: Other Short-Term Securities

 Client prepares schedule of marketable securities activity including  Marketable securities held at year-end  Audit period transactions - purchases and

disposals  Interest and dividend revenue

 The schedule is footed to determine mathematical accuracy

 Auditor verifies cost or sales price by examining broker's advices

 Auditor recalculates gains/losses on disposal of securities

 Existence of securities owned at year-end is verified by physically examining securities held by the client, or confirmation with client's broker for securities held by the broker

 Current market values are verified by referring to market sources

 Auditor recomputes interest and dividend income, and realized and unrealized gains and losses

 Auditor asks management about any changes in the expected holding period, and any restrictions on securities

 Auditor reviews investment or loan agreements that specify the securities as collateral for disclosure issues

Review Substantive Audit Procedures: Other Short-Term Securities (Continued)

Discuss Auditing Other Financial Instruments and Derivatives

During last the 20 years, a number of new financial instruments have been developed:

 Some have been created to take advantage of short-term anomalies

 Others have been developed to remove liabilities from the balance sheet

 Examples:  Event-risk protected debt  Floating rate note  Junk bond  Pay-in-kind (PIK) debenture  Zero-coupon bond  Securities sold with a put option  Collateralized mortgage obligation  Securitized receivables

Comment on Management Control Considerations for Companies that use

Financial Instruments  Identify the risk management objectives  Understand the product  Understand the accounting and tax

ramifications  Develop corporate policies and procedures  Monitor and evaluate results  Understand the credit risk  Control collateral when risk is not acceptable