Chapter 16: Auditing the Financing/Investing Process: Cash and Investments

This limited applicability of substantive analytical procedures is normally offset by what?

(1) extensive tests of controls and/or substantive tests of transactions for cash receipts and cash disbursements or (2) extensive tests of the entity's bank reconciliations

Large payments initiated in the purchasing process are for what?

-Acquisitions of inventory and property, plant, and equipment. -Payments on long-term debt and repurchase of stock

On most audits, the auditor obtains a copy of the bank reconciliation prepared by the entity's personnel. The working paper reconciles the balance per the bank with the balance per the books. The major reconciling items are deposits in transit, outstanding checks, bank service charges, and a check returned because the customer did not have sufficient cash (i.e., an NSF check) in its account to cover payment of the check.

True

On most audits, the substantive tests of transactions for cash receipts and cash disbursements are conducted together with the tests of controls for the revenue and purchasing processes, respectively.

True

The auditor must consider a number of important financial statement disclosures when auditing cash. What are the primary source of the information for the financial statement disclosures?

-Auditor's review of the minutes of board of directors' meetings -line-of-credit arrangements -loan agreements -In addition, the auditor typically confirms items such as compensating balances required under a bank line of credit

What are the common controls over petty cash?

-Prenumbered petty cash vouchers for withdrawing cash from the fund -A limit should be placed on the size of reimbursements made from petty cash.

What are the main sources of disbursements from cash?

-Purchasing and human resource management process

What are the main source of cash receipts?

-Revenue process -sale of property, plant, and equipment -the proceeds from issuing long-term debt or capital stock

How does an employee do kiting?

-preparing a check on one account before year-end but not recording it as a cash disbursement in the account until the next period (paper checks are still commonly used, particularly by small businesses). -The check is deposited and recorded as a cash receipt in a second account before year-end. The employee makes this deposit close enough to year-end that the check will not clear the first bank account before the end of the year. -While electronic wire transfers are recorded more rapidly than paper transactions, there is often still a one-day delay, which makes kiting possible even without the use of paper checks.

What are the primary purposes of the proof of cash?

1) to ensure that all cash receipts recorded in the entity's cash receipts journal were deposited in the entity's bank account, (2) to ensure that all cash disbursements recorded in the entity's cash disbursements journal have cleared the entity's bank account, and (3) to ensure that no bank transactions have been omitted from the entity's accounting records.

What are the procedures to test the bank reconciliation?

1. Verify the mathematical accuracy of the bank reconciliation working paper and agree the balance per the books to the general ledger. 2. Agree the bank balance on the bank reconciliation with the balance shown on the standard bank confirmation. 3. Trace the deposits in transit on the bank reconciliation to the cutoff bank statement. Any deposit in transit shown on the bank reconciliation should be listed as a deposit shortly after the end of the period. 4. Compare the outstanding checks on the bank reconciliation working paper with the canceled (or substitute) checks contained in the cutoff bank statement for proper payee, amount, and endorsement. (the auditor should also ensure that no checks dated prior to December 31 are included with the cutoff bank statement that are not included as outstanding checks on the bank reconciliation 5. Agree any charges included on the bank statement to the bank reconciliation. In some cases, these charges may result in an adjustment to the entity's books 6. Agree the adjusted book balance to the cash account lead schedule. The adjusted book balance would be part of the amount included in the financial statements for cash.

Accuracy and Classification- Investments

ASC Topic 320 addresses accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. The standard requires that those investments be classified in three categories and accounted for as follows: -Debt securities that the entity has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. -Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. -Debt or equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale securities and are reported at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income until realized

The difference between the bank reconciliation on the working paper and the balance in cash on the financial statements is represented by what?

Cash equivalents -Treasury bills -commercial paper

Branch Accounts

Companies that operate branches in multiple locations may maintain separate accounts at local banks. This allows each branch to pay local expenses and to maintain a banking relationship in the local community. Branch cash accounts can be operated in a number of ways. In some cases, the branch accounts are nothing more than imprest accounts for branch payments in which a minimum balance is maintained. The branch submits periodic cash reports to headquarters, and the branch account receives a check or transfer from the general cash account. In other cases, the branch account functions as a general cash account by recording both cash receipts and cash disbursements

Imprest Cash Accounts

Contains a stipulated amount of money to be used for a specific purpose.

Occurrence and Authorization- Investments

Controls must ensure that the purchase or sale of any investment is properly initiated by authorized individuals. First, the entity should have adequate documents to verify that a particular purchase or sale of a security was properly initiated and approved. The presence of adequate documentation allows the auditor to determine the validity of the transaction. Second, the commitment of resources to investment activities should be approved by the board of directors or by an executive who has been delegated this authority.

In some instances, an unscrupulous client might use the year-end bank reconciliation to cover cash defalcations. This is usually accomplished by manipulating the reconciling items in the bank reconciliation.

For example, suppose an entity employee stole $5,000 from the entity. The entity's cash balance at the bank would then be $5,000 less than reported on the entity's books. The employee could hide the $5,000 shortage in the bank reconciliation by including a fictitious deposit in transit. Thus, the typical approach to searching for possible fraud is to extend the bank reconciliation procedures to examine the disposition of the reconciling items included on the prior months' reconciliations and the reconciling items included in the current bank reconciliation.

Existence- Investments

If the entity maintains custody of the securities, the auditor normally examines the securities. During the physical count, the auditor should note the name, class and description, serial number, maturity date, registration in the name of the entity, interest rates or dividend payment dates, and other relevant information about the various securities. The auditor should insist that a representative of the entity be present during the physical inspection of securities in order to acknowledge that all securities inspected are returned.

If the control risk assessment is below the maximum for both cash receipts and disbursements, what does the auditor do?

The auditor can reduce the extent of substantive evidence gathered for the cash balances.

The audit of any imprest cash account such as payroll or a branch account follows the same basic audit steps discussed under the audit or the general cash account

The auditor obtains a bank reconciliation, along with a standard bank confirmation and a cutoff bank statement. However, the audit testing is less extensive for two reasons. First, the imprest balance in the account is generally not material Second, the types of disbursements from the account are homogeneous. The checks are for similar types of transactions and for relatively small amounts. for example, there are often limits on the size of an individual payroll check

What is a major control that directly affects the audit of cash?

The completion of a monthly bank reconciliation by entity personnel who are independent of the handling and recording of cash receipts and cash disbursements. Such bank reconciliations ensure that the entity's books reflect the same balance as the bank's after reconciling items have been considered. Control can be improved further if an independent party such as the internal auditor reviews the bank reconciliation

Safeguarding of assets

The entity should have adequate custodial procedures to safeguard against theft. When securities are held by the entity, they should be stored in a safe or safe-deposit box. Procedures should provide for periodic inspections by an individual independent of both the custodial and accounting responsibilities for securities. If an independent custodian such as a broker maintains securities, the entity needs to establish procedures for authorizing the transfer of securities. For example, one approach would require dual authorization by appropriate management personnel.

Completeness- Investments

The entity should maintain adequate controls to ensure that all securities transactions are recorded, and the auditor should evaluate the design and operating effectiveness of the entity's controls. -One control for handling the detailed securities transactions is maintenance of a securities ledger that records all securities owned by the entity. The entity should reconcile the subsidiary ledger to the general ledger control account regularly. -Personnel responsible for investment activities should periodically review the securities owned to ensure that all dividends and interest have been received and recorded in the entity's records.

General Cash Account

The main cash account for most entities. The major source of cash receipts for this account is the revenue process, and the major sources of cash disbursements are the purchasing and human resource management processes. This cash account may also be used for receipts and disbursements from other bank accounts maintained by the entity. For many small entities, this is the only cash account maintained

What affects the nature and extent of the auditor's tests of details?

The reliability of the entity's controls over cash receipts and cash disbursements

When cash has been stolen by an employee, sometimes the employee will attempt to cover the cash shortage by following a practice known as kiting

This involves an employee covering the cash shortage by transferring money from one bank account to another and recording the transactions improperly on the entity's books

What does the auditor obtain a cutoff bank statement for?

To test the reconciling items included in the bank reconciliation . A cutoff bank statement normally covers the 7 to 10 day period after the date on which the bank account is reconciled. Any reconciling item should have cleared the entity's bank account during the 7 to 10 day period.

A major step in auditing a bank reconciliation is verifying the propriety of the reconciling items such as deposits in transit and outstanding checks

True

A proof of cash will not detect a theft or cash when the cash was stolen before it was recorded in the entity's books.

True

Although the balance in the fund is not material (hence the word "petty"), there is a potential for defalcation because an entity's employee may be able to process numerous fraudulent transactions through the fund over the course of a year. External auditors seldom perform substantive procedures on the petty cash fund, except when fraud is suspected.

True

As a result, this confirmation request cannot be relied upon to identify all information about an entity's bank deposits or loans. If the auditor believes that additional information is needed Page 536 about an entity's arrangements with a financial institution, a separate confirmation letter signed by the entity should be sent to the official at the financial institution responsible for the entity's accounts. Examples are details regarding lines of credit and compensating balances that might be confirmed in this manner.

True

Bank confirmations provide third-party written evidence on bank account balances and other relevant information such as loans, lines of credit, security arrangements (e.g., account restrictions or guarantees), or complex relationships (e.g., derivative or commodity transactions).

True

Because cash and investments are so liquid, they normally represent critical audit areas.

True

Because of its residual nature, cash does not have a predictable relationship with other financial statement accounts.

True

Because virtually all accounting transactions pass through the cash account as part of their "cradle-to-grave" cycle, cash is affected in one way or another by all of the entity's business processes.

True

Even when a substantive strategy is followed, the auditor must reasonably understand control over investments in order to anticipate the types of misstatements that may occur and plan the substantive Page 544procedures. The main assertions that concern the auditor are occurrence, authorization, completeness, accuracy, and classification.

True

For an entity that has a large investment portfolio, the auditor is likely to follow a reliance strategy in which internal control is formally evaluated and tests of controls are performed in order to set control risk below the maximum. However, for the vast majority of entities that do not require an audit of internal control over financial reporting, it is more efficient for the auditor to follow a substantive strategy and perform a detailed audit of the investment securities at year-end

True

For investments, it is more efficient to follow a substantive strategy.

True

For smaller entities without an internal audit function, the external auditors may also perform limited testing of controls over petty cash

True

If the auditor suspects that cash was stolen without being recorded in the entity's books, the audit procedures discussed under the completeness assertion for cash receipt transactions should be performed

True

If the entity does not have adequate controls over cash or the auditor suspects that some type of fraud or defalcation involving cash has occurred, it may be necessary to extend the normal cash audit procedures. Although many types of fraud, such as forgery or collusion, are difficult to detect, auditing standards indicate that the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.

True

If the entity has good bank reconciliation procedures that are promptly performed, the auditor may choose to test the entity's reconciliation procedures as part of testing controls and thereby reduce the audit work on the ending cash balance

True

If the investment value is determined to be other than temporarily impaired, the security should be written down and a new carrying amount established. Last, the auditor should examine the sale of any security to ensure that proper values were used to record the sale and any realized gain or loss.

True

In some instances an interbank transfer schedule is used even though control activities are adequate and no fraud is suspected. When an entity maintains many cash accounts, cash transfers may be inadvertently mishandled. The use of an interbank transfer schedule provides the auditor with evidence on the proper cutoff for cash transactions.

True

On a general level, the auditor's consideration of investments is no different than for any other financial statement account. That is, the auditor must be assured that the amounts shown on the balance sheet for the various types of investments are not materially misstated. This includes the proper recognition of interest income, dividends, and changes in value that must be included in the financial statements.

True

Periodically, the petty cash fund is reimbursed from the general cash account. Accounts payable clerks should review the vouchers for propriety before replenishing the petty cash fund. Finally, someone independent of the cash function should conduct surprise counts of the petty cash fund.

True

Rather than mailing standard bank confirmations, when auditing larger entities auditors often work with a third-party provider of electronic confirmation services. These providers have direct and secure relationships with the banks and for a fee auditors are able to obtain the bank confirmation information they need. These confirmation services address many of the problems with paper-based bank confirmations, which include inefficiency in preparing, mailing, and remailing the request and more importantly the risk of fraud

True

The approach to auditing a bank reconciliation is basically the same regardless of the type of bank account being examined. However, the type and extent of the audit work are more detailed for the general cash account because it normally represents a material amount and because of the large amount of activity in the account.

True

The auditor generally confirms account balance information with every bank or financial institution that maintains an account for the entity.

True

The auditor obtains a bank reconciliation, along with a standard bank confirmation and a cutoff bank statement.

True

The inherent risks associated with investments vary with the amount of activity, the complexity, and valuation considerations. For example, an investment in stock of a publicly traded company is relatively easy to account for and audit. However, more complex financial instruments, such as derivatives and asset-backed securities, have become increasingly common holdings in investment portfolios. These complex financial instruments require substantial subjective judgments by management in the value of inputs used to determine fair values as of the reporting dates. It is not uncommon for the reasonable range of estimation uncertainty to be very large.1 Due to the judgment and complexity associated with these types of financial instruments, the auditor is likely to assess the inherent risk as high.

True

The major audit procedures for each cash account involve tests of the bank reconciliation

True

The payroll account serves as a clearing account for payroll payments and facilitates the disbursement of cash while also helping to maintain adequate control over cash

True

The rights and obligations assertion is not included in assertions because it is seldom important to the audit of the cash balance

True

The use of imprest accounts also minimizes the time required to reconcile the general cash account

True

When the control risk is set at the maximum, the auditor conducts extensive substantive procedures to reach the planned level of detection risk. Additionally, because of the nature of the audit work due to relatively few transactions and/or the availability of third party investment records, tests of details of transactions are seldom used as a source of evidence.

True

While alternative sources could be used to verify bank balances (e.g., bank statement or bank website), such procedures would not be effective at identifying the "other information."

True

he main source of evidence for the existence, completeness, and valuation assertions is the audit work completed on the bank reconciliation

True

Disclosure assertions- Investments

Two issues are important when the auditor examines the proper classification of investments. -First, marketable securities need to be properly classified as held-to-maturity, trading, or available-for-sale because both the balance sheet and income statement are affected by misclassification. -Second, the financial statement classification requires that all trading securities be reported as current assets. Held-to-maturity securities and individual available-for-sale securities should be classified as current or noncurrent assets based on whether management expects to convert them to cash within the next 12 months. If the security is expected to be converted to cash within 12 months, it should be classified as a current asset. The auditor should ask management about its plans to sell securities.

Valuation and Allocation- Investments

When securities are initially purchased, they are recorded at their acquisition cost. The auditor can verify the purchase price of a security by examining a broker's invoice or similar document. Debt securities that are to be held to maturity should be valued at their amortized cost. The auditor should have verified the purchase price of the debt at the time of purchase, and the effective interest rate should be used to recognize the interest income, which the auditor can recompute. The fair value of most equity securities is available from securities exchanges registered with the Securities and Exchange Commission or on the over-the-counter market. The auditor can verify these values by tracing them to sources such as brokers, The Wall Street Journal, or other reliable financial publications.

How does the auditor obtain the cutoff bank statement?

by having the entity request that the bank send the statement, including canceled or electronic check images, directly to the auditor

What does cash reported on the financial statements represent?

currency on hand and cash on deposit in bank accounts, including certificates of deposit, time deposits, and savings accounts. Frequently, certain "cash equivalents" are combined with cash for presentation in the financial statements

Because the proof contains four columns, a proof of cash is commonly referred to as a four-column proof of cash. The four columns include

-A bank reconciliation for the beginning of the period -A reconciliation of the cash deposited in the bank with the cash receipts recorded in the cash receipts journal -A reconciliation of the cash disbursed through the bank account with the cash disbursements recorded in the cash disbursements journal -A bank reconciliation for the end of the period

To audit a cash account, the auditor should obtain the following documents:

-A copy of the bank reconciliation -A standard form to confirm account balance information with financial statements (standard bank confirmation) -A cutoff bank statement

Substantive analytical procedures such as the following can be used to evaluate the overall reasonableness of investments and related income statement accounts:

-Comparison of the balances in the current year's investment accounts with prior years' balances after consideration of the effects of current-year operating and financing activities on cash and investments. -Comparison of current-year interest and dividend income with the reported income for prior years and with the expected return on investments -Recompute current-year interest income using the face amount of securities held, interest rate, and time period held

The auditor's use of substantive analytical procedures for auditing cash is typically limited to what?

-Comparisons with prior years' cash balances and to budgeted amounts

Management must be concerned with the control and safekeeping of cash. The use of different types of banks accounts aids in controlling the entity's cash. What are the following types of bank accounts used?

-General cash account -imprest cash accounts -branch accounts

By testing both cash receipts and disbursements, the auditor contains important evidence about what?

-The relevant assertions for the cash account

Three audit procedures that auditors typically use to detect fraudulent activities in the cash accounts are what?

1. Extended bank reconciliation procedures 2. Proof of cash 3. Tests for kiting

What is an approach auditors commonly use to test for kiting?

The preparation of an interbank transfer schedule. (on exhibit 16-6)

What is a proof of cash used for?

To reconcile the cash receipts and disbursements recorded on the entity's books with the cash deposited into and disbursed form the entity's bank account for a specific time period.

Bank confirmation requests should be sent and received under the auditor's control

True

In order to optimize its cash flow, an entity implements procedures for accelerating the collection of cash receipts and delaying the payment of cash disbursements, to the extent delay is appropriate.

True

Look at exhibit 16-1

True

Look at exhibit 16-2. Copy of confirmation form. Form is also used to obtain information about any loans the entity may have with the bank

True

What is an example of imprest cash accounts?

separate imprest accounts are frequently used for disbursing payroll and dividend checks. In the case of payroll, a separate bank account is established for disbursing payroll. Prior to the disbursement of payroll to employees through check or direct deposit, funds sufficient to cover payroll are transferred from the general cash account to the payroll imprest account.

cash equivalents

short-term, highly liquid investments that are readily convertible to cash and so near their maturity that there is little risk of change in their value. Examples of such financial instruments include Treasury bills and money market funds.