Auditing Cash and Marketable Securities Auditing A Risk-Based Approach To Conducting A Quality Audit 10th edition Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg Chapter 10 Auditing Cash and Marketable Securities

Learning Objectives Identify the significant accounts, disclosures, and relevant assertions in auditing cash accounts Identify and assess inherent risks of material misstatement in cash accounts Identify and assess fraud risks of material misstatement in cash accounts Identify and assess control risks of material misstatement in cash accounts Describe how to use planning analytical procedures to identify possible material misstatements for cash accounts, disclosures, and assertions

Learning Objectives Determine appropriate responses to identified risks of material misstatement for cash accounts, disclosures, and assertions Determine appropriate tests of controls and consider the results of tests of controls for cash accounts, disclosures, and assertions Determine and apply sufficient appropriate substantive audit procedures for testing cash accounts, disclosures, and assertions Identify types of marketable securities, articulate the risks and controls typically associated with these accounts, and outline an audit approach for testing these accounts

THE AUDIT OPINION FORMULATION PROCESS

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

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

Cash Management Techniques Lockboxes Electronic Funds Transfers Cash Management Agreements with Financial Institutions Compensating Balances

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 period Rights 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 assets Presentation and disclosure Cash is properly classified on the balance sheet and disclosed in notes to the financial statements

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

Reasons for Identifying cash as having high Inherent Risk Volume of activity Liquidity Automated systems Importance in meeting debt covenants Can be easily manipulated

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

Fraud Topics to be covered in a brainstorming session Incentives Opportunities Rationalization

FOCUS ON FRAUD - Common Fraud Schemes Relating to Cash 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

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

Common Controls Over Cash Segregation of duties Restrictive endorsements of customer checks Independent bank reconciliations by employees who do not handle cash Computerized control totals and edit tests Authorization of transactions Prenumbered cash receipt documents Turnaround documents Periodic internal audits Competent, well-trained employees

Weak Controls Implications for the existence assertion See Focus on Fraud “The Parmalat Fraud and its Many Victims” Implications for the completeness assertion Employee required to record a cash receipt Not performing the task Not reflecting the cash being received, a sale made, or reduced accounts receivable See Focus on Fraud “Skimming and the Completeness Assertion”

Cash Management Techniques Common controls Petty Cash Cash Management Techniques Limiting access with a locked box and restricting employees who have access Requiring receipts for all petty cash disbursements Reconciling the petty cash fund before replenishing it Keeping customer receipts separate from petty cash funds Having internal audit conduct periodic surprise audits of petty cash Lockboxes Electronic Funds Transfers Cash Management Agreements

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

Learning objective 5 Describe how to use planning analytical procedures to identify possible material misstatements for cash accounts, disclosures, and assertions

Performing planning 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 Review Exhibit 10.4 for relevant trend analyses to use

Performing PLANNING 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

Learning objective 6 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

Learning objective 7 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 Tests controls that are important to the auditor’s conclusion about whether the organization’s controls adequately address the risk of material misstatement Typical tests of 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

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

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 Inspecting or reperforming bank reconciliations Obtaining bank confirmations and bank cutoff statements Preparing interbank transfer schedules

EXHIBIT 10.7 - TESTS OF CLIENT’S BANK RECONCILIATION

Bank Confirmation Sent to all banks with which the client had business Provides 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 Interest rates Dates through which interest has been paid Collateral for outstanding loans

Cutoff Bank Statements A statement for a period of time 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 Consider the number of checks returned listed on the cutoff statement

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 Investigating voided checks and other voided transactions

Documentation related to Substantive Procedures for cash accounts Copies of bank reconciliations inspected or reperformed 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

Learning objective 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

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

AUDITOR’S JUDGMENTAL CHALLENGE Corroborating management’s intent in classifying assets Determining fair market value

Relevant Financial Statement Assertions Existence or occurrence Securities exist at balance sheet date Completeness Securities balances include all securities transactions taken place during the period Rights and obligations Company has title to such securities accounts as of balance sheet date Valuation or allocation Recorded balances reflect true underlying economic value and are reported in accordance with the applicable reporting framework Presentation and disclosure Properly classifying the securities on balance sheet and disclosing in notes to financial statements

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 Refer to Exhibit 10.13

Planning Analytical Procedures for Marketable Securities Developing expectations about level of amounts in ending balances--based on purchase or sales activity 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, and reviewing related documentation about its process for Establishing valuation Inquiring about process for reclassifications and reviewing related documentation 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 Determining that unrealized gains and losses are properly accounted for Valuation or allocation Determining management’s intent and whether securities are properly classified Presentation and disclosure

Focus on fraud - Audit Procedures Used to Address Risk Related to Common Fraud Schemes for Investments Employ a specialist to assist in fair value measurements Conduct background checks on and credit ratings of employees who have access to investment accounts, or the authorization to purchase or sell securities Require that the client produce original documentation of securities, not copies or faxes Trace dividend payments, interest payments, and sales of securities to cash deposits recorded on the bank statement Trace purchases of securities to cash disbursements on the bank statement Review any unusual journal entries in investment accounts

Documentation related to substantive procedures for marketable securities Schedule of marketable securities Documentation of any confirmation of securities Documentation of securities transactions scrutinized Memo containing rationalization for management’s judgments Reports of any outside valuation experts Documentation of calculation of potential impairments