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 yearend 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 yearend
 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 yearend
 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
Review 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
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 shortterm 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