1. Chapter 12 Audit of Cash and Other Liquid Assets Copyright © 2010 South-Western/Cengage Learning

2. Audit Opinion Formulation Process

3. LO 1 Overview of Cash Accounts General checking accounts Cash management accounts Imprest Payroll Accounts

4. LO 1 Overview of Cash Accounts (continued) Marketable Security Accounts Marketable securities (held as temporary investments) Short-term cash management securities (Treasury bills, CDs, etc) Other types of financial instruments

5. Assertions Relevant to Cash and Other Liquid Assets Existence - cash balances exist at the balance sheet date Completeness - cash balances include all cash transactions that have taken place during the period Rights and obligations - the organization has title to the cash accounts as of the balance sheet date

6. Assertions Relevant to Cash and Other Liquid Assets (continued) Valuation - recorded balances reflect the true underlying economic value of those assets Presentation and disclosure - cash and other liquid assets are properly classified on the balance sheet and disclosed in the footnotes

7. LO 2 Integrated Audit of Cash Phases I and II of the Audit Opinion Formulation Process –Continually update information on business risk –Analyze potential motivations to misstate cash and other liquid asset accounts –Perform preliminary analytical procedures to determine if unexpected relationships exist –Develop an understanding of the internal controls in cash and other liquid asset accounts that are designed to address the risks identified in the three previous steps

8. Integrated Audit of Cash Phases III and IV of the Audit Opinion Formulation Process –Determine the important controls that need to be tested –Develop a plan for testing internal controls and perform the tests of key controls on cash and other liquid asset accounts –Analyze the results of the tests of controls –Perform planned substantive procedures

9. Consider the Risks Related to Cash 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 –Can be easily manipulated

10. Consider the Risks Related to Cash (continued) 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 Inherent risk for cash and marketable securities is high due to its liquidity and the susceptibility to mishandling

11. Consider the Risks Related to Cash (continued) Some other factors include: Individual transactions vary greatly in size Cash is the most negotiable financial instrument Posted to the wrong customer’s account Not recorded on a timely basis

12. 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

13. Identify Typical Internal Controls over Cash Appropriate internal controls would include: –Adequate separation of incompatible duties –Restrictive endorsements on checks received –Independent reconciliation of cash records including bank statement –Computerized control totals and edit tests –Authorization of transactions

14. Identify Typical Internal Controls over Cash (continued) –Use of prenumbered documents and turnaround documents –Periodic internal audits –Competent, well-trained employees

15. Controls for Cash Management Techniques Lockboxes – Sufficient controls must be established to make sure that all customer remittances received by the bank are posted Electronic Funds Transfers – EFT agreements with vendors, customers, and banks should have adequate controls built into the process

16. Controls for Cash Management Techniques (continued) Cash Management Agreements with Financial Institutions – Auditor is interested in the amount of control given to the financial institution regarding the investment of cash

17. Design and Perform Tests of Control and Analyze of Tests of Control Audit program for testing the controls is divided into parts First part of the program focuses on gaining an understanding of internal controls; remaining part identifies tests of controls

18. Design and Perform Tests of Control and Analyze of Tests of Control (continued) The auditor must analyze the results and document relevant conclusions after control testing is completed Deficiencies identified will dictate the nature and extent of substantive audit procedures

19. 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)

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

21. 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

22. Independent Bank Reconciliation (continued) Adjusted book balance must equal adjusted bank balance

23. Cutoff Bank 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

24. The Standard 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

25. The Standard Bank Confirmation (continued) 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

26. 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:

27. Obtain year-end cutoff information (continued) –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

28. Bank Transfer Schedules 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

29. Bank Transfer Schedules (continued) 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

30. Complexities Related to the Audit of Marketable Securities and Financial Instruments Marketable securities include: commercial paper, marketable equity securities, and marketable debt securities. Audit approach to most investments in marketable securities centers on following:

31. Complexities Related to the Audit of Marketable Securities and Financial Instruments (continued) –Identify the assets and management’s internal controls for safeguarding the investments –Understand the economic purpose of major transactions –Identify the risks associated with the company’s financial assets –Confirm agreements and examine contracts associated with the agreements –Review and test transactions and related accounting and disclosure for their economic substance –Determine the existence of a market for the securities

32. Audits of Commercial Paper Commercial paper refers to notes issued by major corporations, especially finance companies, that generally have good credit ratings Assertions and Audit procedures are shown in the figure below

33. Audits of Investments in Equity and Debt Securities Client prepares schedule of marketable securities activity including –Marketable securities held at year-end –Testing balance sheet and income accounts –Interest and dividend revenue Document shows three items related to the value of the security: –Cost –Year-end market value –Carrying value for debt instruments Disposals and resulting gains/losses are shown for all accounts during the year

34. Auditor verifies cost or sales price by examining broker's advices The schedule is an abbreviated worksheet Current market values are verified by referring to market sources Income is recomputed on a selected basis for interest, dividends, and realized and unrealized gains and losses The schedule is footed to determine mathematical accuracy The audit tests address all of the audit assertions except presentation and disclosure Document the conclusion regarding the fairness of presentation of the account balance as adjusted Audits of Investments in Equity and Debt Securities (continued)

35. Audits of Derivative Instruments Currently 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

36. Audits of Derivative Instruments (continued) –Examples: Call Option Put Option Collateralized Debt Obligation Event-Risk Protected Debt Hedges Floating Rate Note Junk Bond Interest Rate Swaps Securitized Receivables

37. 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