1. Auditing Cash and other Liquid Assets
Chapter 12
Auditing Cash and other Liquid Assets

2. 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

3. 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 with minimal year-end testing

4. 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

5. Cash Management Techniques
Have been develop to:
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

6. 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

7. 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

8. 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)

9. Substantive Testing of Cash Balances (Continued)
Independent bank reconciliation
Bank cutoff statement
Bank confirmation
Obtaining year-end cutoff information

10. 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

11. Use of the 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

12. The bank confirmation
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

13. 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

14. A bank transfer schedule
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

15. 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

16. 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

17. 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

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

19. 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

20. 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