Chapter 12

1. Chapter 12 Auditing Liquid Assets

2. List 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

3. Review 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

4. 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

5. Discuss 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

6. Review 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

7. Comment on 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

8. Discuss 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)

9. Discuss Substantive Testing of Cash Balances (Continued) • Independent bank reconciliation • Bank cutoff statement • Bank confirmation • Obtaining year-end cutoff information

10. Explain 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

11. Explain 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

12. What’s 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

13. 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

14. 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 year-end 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

15. Discuss 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

16. Define 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

17. Review 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

18. Review 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

19. Discuss 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 short-term 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

20. Comment on 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