Chapter 12
Auditing Cash and other
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
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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
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
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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
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
Understanding and Testing Internal
Controls
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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
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)
Substantive Testing of Cash
Balances (Continued)
 Independent
bank reconciliation
 Bank
cutoff statement
 Bank
confirmation
 Obtaining
year-end cutoff
information
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
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
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
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
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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
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Note last few receipts
Trace receipts to bank reconciliation and bank cutoff statement
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
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
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
Substantive Audit Procedures: Other ShortTerm Securities
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Client prepares schedule of marketable
securities activity including
 Marketable securities held
 Audit period transactions -
at year-end
purchases and disposals
 Interest and dividend revenue
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The schedule is footed to determine
mathematical accuracy
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Auditor verifies cost or sales price by examining
broker's advices
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Auditor recalculates gains/losses on disposal of
securities
Substantive Audit Procedures: Other ShortTerm Securities (Continued)
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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
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
Management Control Considerations for
Companies that use Financial Instruments
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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