Auditing Liquid Assets

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
Whats 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