Chapter 12
Audit of Cash
and Other Liquid
Assets
Copyright © 2010 South-Western/Cengage Learning
Audit Opinion Formulation Process
LO 1 Overview of Cash Accounts
• General checking accounts
• Cash management accounts
• Imprest Payroll Accounts
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
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
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
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
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
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
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
Consider the Risks Related to Cash
(continued)
Some other factors include:
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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
Cash Management Techniques
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Speed collection and deposit of cash
Minimize possibility of error or fraud
Reduce paperwork
Automate cash management process
Techniques include
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Lockboxes
Electronic funds transfers
Cash management agreements with financial institutions
Compensating balances
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
Identify Typical Internal Controls over
Cash (continued)
– Use of prenumbered documents and turnaround
documents
– Periodic internal audits
– Competent, well-trained employees
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
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
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
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
Substantive Testing of
Cash Balances
• Common types of misstatements regarding
cash include:
– Transactions recorded in the wrong period
– Embezzlements covered up by omitting or underfooting 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)
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Independent bank reconciliation
Bank cutoff statement
Standard 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
Independent Bank Reconciliation
(continued)
• Adjusted book balance must equal adjusted
bank balance
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
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
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
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 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
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
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
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:
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
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
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
Audits of Investments in Equity and Debt
Securities (continued)
• 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 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
Audits of Derivative Instruments (continued)
– Examples:
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Call Option
Put Option
Collateralized Debt Obligation
Event-Risk Protected Debt
Hedges
Floating Rate Note
Junk Bond
Interest Rate Swaps
Securitized Receivables
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