Chapter 16 Notes

Cutoff Bank Statement

A cutoff bank statement normally covers the 7- to 10-day period after the date on which the bank account is reconciled. • Date of Last Bank Reconciliation -----> 7 to 10 Days Later Any item on the client's bank reconciliation should have cleared the entity's bank account during the 7- to 10-day subsequent period.

Uses & Limitations of Bank Reconciliation

All audits of cash begin by the auditor verifying the client's reconciliation of the balance in the bank account to the general ledger. Misstatements which may not be discovered as a part of the audit of the bank reconciliation: • Failure to bill a customer • Improper payment of personal expenditures • Embezzlement of cash receipts from customers • Payment to an employee for more hours than were worked

Tests of Details - Investments ---- Existence

Auditing Standards state that the auditor should perform one of the following procedures when gathering evidence for existence: • Physical examination • Confirmation with the issuer • Confirmation with the custodian • Confirmation of unsettled transactions with the broker-dealer • Confirmation with the counterparty • Reading executed partnership or similar agreements

Fraud-Related Audit Procedures

Bank Transfer Schedule • To test for kiting, auditors can list all interbank transfers made a few days before and a few days after the balance sheet date and trace each transfer to the accounting records for proper recording. • The interbank transfers must be recorded by the client in both the receiving and disbursing bank's records in the same fiscal year

Fraud-Related Audit Procedures

Extended Bank Reconciliation Procedures • When the auditor believes that the year-end bank reconciliation may be intentionally misstated, it is appropriate to perform extended tests of the year-end bank reconciliation. o Trace all deposits-in-transit on the December bank reconciliation to the December cash receipts journal. o Trace entries in the December cash receipts journal to the December bank statement to verify actually deposited in bank. o Trace outstanding checks on the December bank reconciliation to the December cash disbursements journal. o Match cancelled checks in the December bank statement with entries in the December cash disbursements journal

Uses & Limitations of Bank Reconciliation

Misstatements which are normally discovered as a part of the tests of a bank reconciliation: • Failure to include a check on the outstanding check list • Cash received by the client recorded in the wrong period • Deposits recorded near year end, deposited in the bank in the same month, and included in the bank reconciliation as a deposit in transit (ie: double-counting the deposit) • Receipt of customer payment directly into client's bank account but not entered in the clients' records

Fraud-Related Audit Procedures

Proof of Cash • When internal control over cash receipts/disbursements is weak, additional reconciliation procedures are commonly used. • Whereas a bank reconciliation explains the differences between "balance per bank" and "balance per books" (focus is on account balances), a proof of cash focuses on *cash transactions* & is useful for verifying that: o All cash receipts in the accounting records were deposited in a company bank account. o All deposits in the company bank account(s) were recorded in the accounting records. o All cash disbursements were paid out of a company bank account. o All payments that were made from company bank account(s) were recorded in the accounting records.

Fraud-Related Audit Procedures

Tests for Kiting • Embezzlers sometimes use a practice known as kiting to cover a theft of cash • Kiting is a form of fraud that overstates cash by causing it to be simultaneously included in two or more bank accounts • Kiting may be detected by preparing a bank transfer schedule

Auditing a Payroll or Branch Imprest Account

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

Tests of the Bank Reconciliation

The auditor typically uses the following audit procedures to test the bank reconciliation: 1) Verify the mathematical accuracy and agree the balance per the books to the general ledger. 2) Agree the bank balance on the 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. 4) Compare the outstanding checks on the bank reconciliation with the canceled checks contained in the cutoff bank statement for proper payee, amount, and endorsement. 5) Agree any charges included on the bank statement to the bank reconciliation. 6) Agree the adjusted book balance to the cash account lead schedule.

Summary of Audit Procedures

Typical substantive audit procedures for CASH include: • Existence & Occurrence o 1. Send confirmation letters to financial institutions. o 2. Count cash on hand at year end. o 3. Prepare bank transfer schedule (see slide #18 below). • Accuracy o 4. Foot summary schedules & agree totals to F/Stmts. o 5. Reconcile summary schedules to the G/L. • Completeness & Cutoff o 6. Analytical procedures to test reasonableness of cash balances. o 7. Test client's bank reconciliation. o 8. Obtain bank cutoff statement to verify reconciling items. o 9. Review cash receipts/disbursements around year-end. • Authorization o 10. Examine signatures on deposit slips and cancelled checks. • Presentation & Disclosure o 11. Review disclosures for compliance with GAAP. o 12.Inquire of management about compensating balances and restrictions on cash. • Valuation o 13. Test translation of any foreign currencies

Bank Reconciliation, Bank Confirmation, and Cutoff Bank Statement

What are the three common procedures for auditing cash?

Cash and Cash Equivalents

• "Cash" reported in the financial statements represents currency on hand and cash on deposit in bank accounts, including certificates of deposit, time deposits, and savings accounts. • "Cash equivalents" are frequently combines with cash for presentation in the financial statements. o Definition: Short-term, highly liquid investments that are readily convertible to cash or so near their maturity that there is little risk of change in their value. o Examples: Treasury bills and money market funds.

Bank Reconciliation

• A timely and accurate bank reconciliation is an essential internal control over cash • Auditor must perform substantive tests of the client's bank reconciliation • Focus of auditor's tests is beginning/ending balances and reconciling items

Disclosure Items for Cash

• Accounting policy for defining cash and cash equivalents • Any restrictions on cash such as a sinking fund requirement for funds allocated by the entity's board of directors for special purposes • Contractual obligations to maintain compensating balances • Cash balances restricted by foreign exchange controls • Letters of Credit

Fraud-Related Audit Procedures

• Cash is the most liquid of assets and offers the greatest temptation for theft, embezzlement and misappropriation. • The auditor must extend the procedures in the audit of year-end cash to determine the possibility of a material fraud when the client has inadequate internal controls over cash. o Custody of Cash is not separated from recordkeeping o Bank reconciliations are not prepared monthly by an employee who is independent of the cash receipts and disbursements functions.

Auditing Investments

• Common Stock • Preferred Stock • Debt Securities • Hybrid Securities

The Effects of Controls

• Controls for Cash Receipts and Controls for Cash Disbursements o The reliability of the entity's controls over cash affects the nature and extent of the auditor's tests of details Completion of Monthly Bank Reconciliation

Typical substantive audit procedures for Investments include:

• Existence & Occurrence o 1. Confirm securities & derivatives with holders & counterparties. o 2. Inspect and count securities on hand. o 3. Vouch selected purchases/sales of F.I.'s during the year. • Accuracy o 4. Foot summary schedules & agree totals to F/Stmts o 5. Reconcile summary schedules to the G/L • Completeness & Cutoff o 6. Analytical procedures to test reasonableness of F.I. balances o 7. Review investment committee minutes and reports. o 8. Examine investment transactions near year-end. o 9. Reconcile dividends received to published records for dividends. • Rights & Obligations o 10. Review agreements underlying securities and derivatives • Presentation & Disclosure o 11. Inspect documentation of management's intent to hold securities o 12. Evaluate the method of accounting for investments • Valuation o 13. Determine the market value for Trading and AFS securities

Types of Cash Accounts

• General cash account - "operating account" • Imprest accounts - payroll is the most common • Branch bank account - used when business has many locations • Petty cash fund - used for small expenditures • Cash equivalents - original maturities < 90 days • Financial Investments - stocks, bonds, derivatives, and hedges

Tests of Details - Investments ---- Disclosure Assertions

• Marketable securities need to be properly classified as held-to-maturity, trading, and available-for-sale. • Held-to-maturity securities and individual available-for-sale securities should be classified as current or non-current assets based on whether management expects to convert them to cash within 12 months. • All trading securities should be classified as current assets.

Cutoff Bank Statement

• Partial-period bank statement (with cancelled checks and deposit slips) sent directly to CPA • Can also be accomplished by client giving CPA access to client's online bank account information • Purpose is to verify the reconciling items on the client's bank reconciliation

Bank Confirmation

• Standard Form approved by AICPA • Often completed in electronic format only • Contains information about cash balances AND outstanding loan balances. • NOT required by o AICPA standards o ISA standards

Tests of Details - Investments ---- Valuation and Allocation

• The auditor must also determine if there has been any "other than temporary" or permanent decline in the value of an investment security. • Auditing and accounting standards provide guidance for determining whether a decline in value below amortized cost is other than temporary. • If Permanently Impaired = Write down to new carrying amount

Cash in the Bank

• The general cash account ("Cash in Bank") is considered significant in almost all audits, even when the ending balance is immaterial. • Why? o High number of transactions affecting cash. o Susceptibility of cash to embezzlement. o Balance per books -vs- Balance per bank.

Auditing Investments

• The liquid nature of financial investments that are marketable makes the potential for fraud high. • Auditors should coordinate their audit procedures for Cash and Financial Investments to detect any possible fraud involving unauthorized substitution (ie: the sale of securities to hide a cash shortage between these accounts.)

Auditing Investments

• The most important group of financial investments, from the viewpoint of the auditors, consist of marketable stocks and bonds because they are found frequently and usually are of greater dollar value than other kinds of financial instruments. • Other types of financial investments that auditors often encounter include: commercial paper, cash surrender value of keyman life insurance policies, and derivatives that are used for speculation, or to hedge various financial and operational risks

Auditor's Objectives in Auditing Investments

• Use the understanding of the client and its environment to consider inherent risks (including fraud risks) relating to Investments • Obtain an understanding of internal controls over Investments. • Assess the risks of material misstatement of Investments and design tests of controls (if applicable) and substantive tests of details that: o Support the *existence* of F.I.'s & the *occurrence* of Investment transactions. o Determine the *accuracy* of recorded Investment transactions. o Establish the *completeness* of the recorded Investment transactions. o Verify the *cutoff* of Investment transactions ("proper amt in proper period"). o Determine that the client has *rights* to the recorded Investments. o Evaluate the *presentation and disclosure* of Investments, including management's classification (Trading, AFS, HTM), and any unrealized holding G/L's. o Verify the *valuation* of Investments is appropriate and in accordance with the cost method, equity method, consolidation method, or fair value method.

Auditor's Objectives in the Audit of Cash

• Use the understanding of the client and its environment to consider inherent risks (including fraud risks) relating to cash. • Obtain an understanding of internal controls over cash. • Assess the risks of material misstatement of cash and design tests of controls (if applicable) and substantive tests that: o Support the *existence* of cash & the *occurrence* of cash transactions. o Determine the *accuracy* of recorded cash transactions. o Establish the *completeness* of the recorded cash balance. o Verify the *cutoff* of cash transactions ("proper amt in proper period") o Determine that the client has *rights* to the recorded cash. o Evaluate the *presentation and disclosure* of cash, including any restricted funds (such as compensating balances & bond sinking funds) o Verify the *valuation* of foreign currency translated to U.S. Dollars

Auditing Petty Cash

• Usually not material • Potential for defalcation • Seldom perform substantive tests • Document controls