Chapter 10 auditing

common controls over cash

1. Segregation of Duties 2. Restrictive Endorsements of customer checks 3. Independent bank reconciliations by employees who do not handle cash 4. Computerized control totals and edit tests 5. Authorization of transactions 6. Prenumbered cash receipt documents 7. Turnaround documents 8. Periodic internal audits 9. Competent, well-trained employees

cutoff bank statement

A bank statement for a period of time after yearend (usually seven to ten days); sent directly to the auditor, who uses it to verify reconciling items on the client's year-end bank reconciliation.

financial instruments

A broad class of instruments—usually debt securities, but also equity or hedges—that represents financial agreements between a party (usually an issuer) and a counterparty (usually an investor) based on either underlying assets or agreements to incur financial obligations or make payments; instruments range in complexity from a simple bond to complicated agreements containing puts or options.

lockbox

A cash management arrangement with a bank whereby an organization's customers send payments directly to a post office box number accessible to the client's bank; the bank opens the cash remittances and directly deposits the money in the client's account.

turnaround documents

A document sent to the customer to be returned with the customer's remittance; may be machine-readable and may contain information to improve the efficiency of receipt processing.

false

A fake cash problem relates to management's cash valuation assertion.

kiting

A fraudulent cash scheme to overstate cash assets at year end by showing the same cash in two different bank accounts using an interbank transfer.

marketable security

A security that is readily marketable and held by the company as an investment.

bank confirmation

A standard confirmation sent to all banks with which the client had business during the year to obtain information about the year-end cash balance and additional information about loans outstanding. Most relevant to the existence assertion

false

A typical bank statement prepared at an interim agreed-upon date and sent directly to the auditor is a bank transfer statement.

all of the above

Affirmative answers to which of the following questions would lead the auditor to assess fraud risk at a higher level for cash? Is an individual with access to cash or its recording experiencing financial or personal distress? Is an individual with access to cash or its recording being compensated at an amount that he or she might consider low? Is the company in potential violation of its debt covenants? Two of the above (a-c) All of the above (a-c).

collateral

An asset or a claim on an asset usually held by a borrower or an issuer of a debt instrument to serve as a guarantee for the value of a loan or security. If the borrower fails to pay interest or principal, the collateral is available to the lender as a basis to recover the principal amount of the loan or debt instrument.

Approve all new investments prior to reviewing their risks.

An audit client has invested heavily in new equity and debt securities. Which of the following would not constitute an appropriate role for the organization's board of directors or others charged with governance? Receive and review periodic reports by the internal audit function on compliance with the organization's investment policies and procedures. Approve all new investments prior to reviewing their risks. Review and approve written policies and guidelines for investments in marketable securities. Periodically review the risks inherent in the portfolio of marketable securities to determine whether the risk is within parameters deemed acceptable by the board.

interbank transfer schedule

An audit document that lists all transfers between client bank accounts starting a short period before year end and continuing for a short period after year end; its purpose is to assure that cash in transit is not recorded twice.

true

An example of a monitoring control in cash would include a review of cash budgets and a comparison of them with actual cash balances, with appropriate follow-up.

misrepresentation and outright theft

As we learn through discussions of cash-related frauds at Koss Corporation, Peregrine Financial Group, and China Huishan Dairy Holdings, cash can be stolen by an individual with power over the account balances if there exists a lack of oversight.

authorization and authentication tools

Authorization privileges should be assigned to individuals based on unique activities associated with the individual and position. Authorization should follow the principles of need to know and right to know. Authorizations should be reviewed periodically by senior management. Authentication procedures should assure that only authorized personnel execute transactions. The authentication process may be implemented through electronic verification by using elements such as passwords, physical characteristics, cards, encryption, or terminals that are hardwired to the computer. In a manual system, the authorization controls may involve limiting access to the area where checks are signed and to the prenumbered checks. Any changes to existing bank accounts or the opening of a new bank account must be authorized and reviewed by senior management. Monitoring should be established so that a detailed daily review of transactions occurs and is compared with cash budgets, authorization limits by individuals, and riskiness of transactions.

false

Because a primary concern is that cash will be stolen and thus understated, the auditor is not usually concerned about overstatements of cash.

false

Because cash balances are usually relatively low at year-end, auditing standards encourage auditors to send bank confirmations on a sample basis.

existence/occurrence; completeness

Because of the high level of inherent risk often associated with cash, the auditor primarily focuses on the ___________________ and ____________ assertions

false

Because of the level of inherent risk associated with cash accounts, auditors are required to test the controls over cash accounts.

existence/occurence

Cash balances exist at the balance sheet date.

completeness

Cash balances include all cash transactions that have taken place during the period.

presentation and disclosure

Cash is properly classified on the balance sheet and disclosed in the notes to the financial statements. For example, restricted cash might need to be reported in the noncurrent asset section of the balance sheet. Further, the auditor will want to determine the accuracy of the classifications on the cash flow statement.

relationships that might suggest a heightened risk of fraud in cash

Consistent profits over several years, but cash inflows are declining Unexpected reductions in accounts receivable collections, or the timeliness of collections Unexpected declines in the petty cash account

control totals to assure the completeness of processing

Control totals should be established and reconciled with the computer-generated totals. A control total would also be established to reconcile the debits to cash and the credits to accounts receivable.

false

Controls for completeness of cash are important because they help to provide reasonable assurance that the cash exists.

completeness

Controls related to ______________ provide reasonable assurance that all valid cash transactions (receipts and disbursements) are recorded; controls might include prenumbered cash receipts documents, as well as competent and well-trained employees

existence assertion

Controls related to the ________________ should provide reasonable assurance that the cash balances included on the financial statements exist; that is, cash is not materially overstated.

planning analytical procedures for marketable securities

Develop expectations about the level of amounts in ending balances of marketable securities accounts based on purchase or sales activity reported by management during the year Develop expectations about the relationship between the balances in marketable securities accounts, the rates anticipated to be earned on those accounts, and any changes therein, and associated interest and dividend revenues Review changes in the balances, risk composition, and classification types of marketable securities in relation to stated investment policies and plans

true

If the auditor observes that the company reports consistent profits over several years while cash inflows are decreasing, the auditor should likely assess a heightened risk of fraud in cash.

true

In assessing fraud risk related to cash, auditors engage in brainstorming to consider incentives, opportunities to commit fraud, and rationalization about risks relating to cash.

periodic reconciliation of the bank accounts

Independent reconciliation of the balance on the bank statement with the balance on the books should identify misstatements and unusual banking activity that may have occurred. From a financial reporting risk perspective, this is the single most important control over the existence of cash.

all of the above

Inherent risk for cash is usually assessed as high for which of the following reasons? The volume of transactions flowing through cash accounts throughout the year makes the account more susceptible to error. The cash account is more susceptible to fraud because cash is liquid and easily transferable. The electronic transfer of cash and the automated controls over cash are such that if errors are built into computer programs, they will be repeated on a large volume of transactions. Cash can be easily manipulated. All of the above.

typical substantive tests of details

Inspecting or reperforming bank reconciliations Obtaining bank confirmations Obtaining bank cutoff statements Preparing interbank transfer schedules

marketable securities

Investments in securities with a maturity date greater than three months at the date of purchase and other securities for which there is more than an insignificant risk of change in value due to interest rate, quoted price, or penalty on withdrawal

reasonable expected relationships for cash accounts

No unusual large cash transactions Operating cash flow consistent with sales and net income Operating cash flow not significantly different from the prior year Investment income consistent with the level of and returns expected from the investments

commercial paper

Notes issued by major corporations, usually for short periods of time and at rates approximating prime lending rates, usually with high credit rating; their quality may change if the financial strength of the issuer declines.

false

Planning analytical procedures for cash balances are highly effective because of the generally stable relationship with past cash levels and the fact that cash is a managed account.

common tests of controls for marketable securities

Review policies for authorization to purchase, sell, and manage marketable securities Inquire of the board of directors about the board's oversight of the marketable securities process and examine related documentation Examine documentation of authorization for selected purchases and sales of marketable securities during the year Review the minutes of the board meetings for reference to investment policies and associated oversight Examine evidence of authorization controls for changes in classification of marketable securities Inquire of management about its process for establishing valuation of marketable securities and review related documentation Inquire of management about their process for reclassifications and review related documentation Examine documentation for selected marketable securities transactions to determine whether segregation of duties is maintained Review reports of internal audit in relation to their activities involving monitoring of marketable securities

inherent and fraud risks related to marketable securities

Risk of sudden market declines, which would adversely affect the valuation of securities Management manipulation of the classification of securities to achieve preferable valuation treatment, that is, market value versus amortized cost Management manipulation of the valuation of fair market value if the securities are thinly traded

control risks related to marketable securities

Risk of theft of securities if they are not physically controlled, or if authorization and monitoring over their purchase or sale is not effective Lack of policies over purchase or sale of securities Lack of monitoring of changes in securities balances Lack of policies over valuation or classification of securities Lack of segregation of duties between individuals responsible for making investment decisions and those responsible for the custody of securities Lack of involvement or oversight by internal audit in relation to securities

false

Short selling enables managers to get away with perpetrating fraud undetected and undeterred.

completeness

Skimming most likely results in a violation of which of the following management assertions? Existence Completeness Rights and obligations Valuation All of the above

false

Skimming occurs when an employee purchases merchandise and records the sale at an unauthorized discounted price.

edit tests to identify unusual or incorrect items

Standard edit tests such as reasonableness tests, field checks, self-checking digits on account numbers, and alphanumeric tests should be implemented as deemed practical for the particular application.

liquidity

The cash account is susceptible to theft because cash is liquid and easily transferable.

electronic funds transfer

The client should have EFT agreements with suppliers, customers, and banks that have adequate controls built into the process. For example, the client should be notified of any receipts from customers or disbursements to suppliers. There should exist automated or manual reconciliation procedures between the client and the bank, and the client should maintain an audit trail to enable subsequent oversight regarding any assertions with respect to cash transactions, e.g., existence and completeness.

rights and obligations

The company has title to the cash accounts as of the balance sheet date. For example, cash might be pledged as collateral; if this is the case, the company must disclose relevant information about the collateral arrangement. In most cases, risk related to ownership of cash is low.

automated systems

The electronic transfer of cash and the automated controls over cash are such that if errors are built into computer programs, they will be repeated on a large volume of transactions.

common schemes relating to cash payments

The employee purchases merchandise and records the sale at an unauthorized discounted amount. The employee steals cash and conceals it by recording a fictitious discount. The employee writes a check to a fictitious vendor and deposits the check into an account that he or she controls that has been set up in the name of the fictitious vendor.

The company reports consistent profits over several years, but operating cash flows are declining.

The first step in performing planning analytical procedures is to develop an expectation of the account balance. Which of the following does not typically represent a likely expected relationship for cash accounts? The company reports consistent profits over several years, but operating cash flows are declining. No unusual large cash or other liquid asset transactions are found. Operating cash flow is not significantly different from that of the prior year. Investment income is consistent with the level of and returns expected from the investments. All of the above represent likely expected relationships.

true

The following is a reasonable test of control over marketable securities: Inquire of management about its process for establishing valuation of marketable securities and review related documentation.

Segregation of duties

The general concept of _____________ does not change as processing systems become more automated and integrated. Automation can enhance control, yet there is still a risk of errors or fraud occurring on a larger scale. An assigned employee should be responsible for recording customer cash and check receipts, while other individuals should be responsible for the subsequent processing of these receipts. Postings to accounts receivable should be reconciled to the postings to cash and checks received. Finally, the individuals who reconcile the bank accounts should not handle cash or record cash transactions.

prime lending rates

The interest rate that commercial banks charge their most credit-worthy customers.

cash

The majority of asset misappropriation schemes involve

valuation or allocation

The recorded balances reflect the true underlying economic value of those assets. This assertion usually has a low level of inherent risk, unless the client has cash holdings in foreign currency in a country experiencing political instability.

true

The relative percentage of substantive analytics that an auditor will use as evidence in the audit of cash will be somewhat limited regardless of the riskiness of the client.

a unique identifier assigned to each item

The unique identifier establishes the integrity of the total population and provides a basis for assuring that no items are added to or dropped from the population.

false

The volume of activity in cash accounts makes cash accounts less susceptible to error than most other accounts.

volume of activity

The volume of transactions flowing through the account during the year makes the account susceptible to error.

skimming

This type of fraud occurs when an employee makes a sale but does not record it, and steals the cash.

transaction controls

Typical tests of _________________ include inquiry of personnel performing the control, observation of the control being performed, inspection of documentation confirming that the control has been performed, and reperformance of the control by the individual testing the control.

true

When auditing cash, the auditor will perform a relatively larger percentage of tests of details for a high-risk client compared to a low-risk client.

true

When there is a ready market for financial instruments, the audit procedures related to valuation and disclosures are more straightforward than when the instrument is not readily marketable.

50% tests of details, 10% analytics, 40% tests of controls.

Which mix of evidence would be most appropriate for the following scenario? This is a client where the auditor has assessed the risk of material misstatement related to the existence and completeness of cash as low, and believes that the client has implemented effective controls in this area. 100% tests of details. 70% tests of details, 10% analytics, 20% tests of controls. 50% tests of details, 10% analytics, 40% tests of controls. 20% tests of details, 40% analytics, 40% tests of controls.

70% tests of details, 10% analytics, 20% tests of controls.

Which mix of evidence would be most appropriate for the following scenario? This is a client where the auditor has assessed the risk of material misstatement related to the existence and completeness of cash at high. This client has incentives to overstate cash in order to meet debt covenants. Further, the client has relatively weak controls to prevent theft of cash. 100% tests of details. 70% tests of details, 10% analytics, 20% tests of controls. 50% tests of details, 10% analytics, 40% tests of controls. 20% tests of details, 40% analytics, 40% tests of controls.

valuation or allocation

Which of the following assertions is relevant to whether the cash balances reflect the true underlying economic value of those assets? Existence/occurrence. Completeness. Rights and obligations. Valuation or allocation. All of the above.

rights and obligations

Which of the following assertions is relevant to whether the company owns the cash accounts as of the balance sheet date? Existence/occurrence. Completeness. Rights and obligations. Valuation or allocation. All of the above.

all of the above

Which of the following is a common example of trend analysis of accounts and ratios that the auditor might consider for cash accounts? Compare monthly cash balances with past years and budgets. Identify unexpected spikes or lows in cash during the year. Compute trends in interest returns on investments. Two of the above (a-c). All of the above (a-c).

Management's objective for entering into such transactions may relate to misstating the financial statements.

Which of the following is a risk associated with complex financial instruments? Management's objective for entering into such transactions may relate to misstating the financial statements. Most of these financial instruments have a high volume of activity and relate to deep capital markets. Most management teams today have the necessary sophistication to invest in complex financial instruments with relatively little downside risk. All of the above are risks.

Bank reconciliations by employees who handle cash

Which of the following is not a type of common control over cash? Segregation of duties Restrictive endorsements of customer checks Prenumbered cash receipt documents and turnaround documents Two of the above (a-d)

Does the company have significant cash flow problems in meeting its current obligations on a timely basis?

Which of the following questions would be relevant for an inherent risk analysis related to cash? Does the company have significant cash flow problems in meeting its current obligations on a timely basis? Are cash transactions properly authorized? Are bank reconciliations performed on a timely basis by personnel independent of processing? Does the internal audit department conduct timely reviews of the cash management and cash-handling process? All of the above.

lapping

Which of the following terms best defines this scenario? The employee steals a payment from Customer X. To cover the theft, the employee applies a payment from Customer Y to Customer X's account. Before Customer Y has time to notice that its account has not been appropriately credited, the employee applies a payment from Customer Z to Customer Y's account. Skimming. Kiting. Collateralizing. Lapping.

substantive analytics

_________________ for cash accounts are typically not very effective. Rather, the auditor tends to focus on substantive tests of details. The minimal __________________ that an auditor might perform include identifying significant differences between management's cash budget, which is prepared at the beginning of the year and the recorded year-end balance.

analytical procedures

__________________ for cash balances are not very effective because of the absence of a stable relationship with past cash levels and the fact that cash is a managed account. However, auditors may use management's budgeted cash balance as an expectation, and can compare that expectation to the balance that the client has recorded at year-end. Examples are trend analysis and ratios

cash and cash equivalents

are highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of change in value due to interest rate, quoted price, or penalty on withdrawal.

debt covenants

are often tied to cash balances or to maintaining minimum levels of working capital. Debt covenants specify restrictions on the organization to protect the lender. Typical covenants restrict cash balances, specify the maintenance of minimum working capital, and may restrict the company's ability to pay dividends.

Held-to-maturity securities

are valued at amortized cost, subject to an impairment test.

major types of cash accounts

checking accounts, cash management accounts, and petty cash.

controls for petty cash

limiting access to petty cash, requiring receipts for petty cash disbursements, reconciling the fund before replenishing it, and having internal audit conduct periodic surprise audits of petty cash funds.

valuation

the ______________ assertion is usually the most relevant for auditing marketable securities because of the difficulties sometimes experienced when securities are thinly traded and management reluctance in writing down the value of securities.