Rittenberg/Schwieger/Johnstone
Auditing: A Business Risk Approach
Sixth Edition
Chapter 13
Audit of Cash and Other
Liquid Assets
Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo,
and South-Western are trademarks used herein under license.
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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
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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
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
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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
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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
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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)
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Substantive Testing of
Cash Balances (continued)
Independent bank reconciliation
Bank cutoff statement
Bank confirmation
Obtaining year-end cutoff
information
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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
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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
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What is 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
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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
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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 year-end
 Disbursement is not recorded in the first account until after yearend
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
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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
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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
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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
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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
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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
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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
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