10-1 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-1

Chapter 10

Cash and Financial Investments

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-2

Sources and Nature of Cash

Sources General checking account Payroll checking accounts Petty cash Savings accounts

Cash equivalents Money market funds Certificates of deposit Savings certificates


10-3

Objectives for the Audit Cash

1. Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to cash

2. Obtain an understanding of internal control over cash.

3. Assess the risks of material misstatement of cash and design tests of controls and substantive procedures that:

a. Substantiate the existence of recorded cash and occurrence of the related transactions

b. Establish the completeness of recorded cashc. Verify the cutoff and accuracy of cash

transactionsd. Determine that the client has rights to recorded

cashe. Determine that the presentation and

disclosure of cash, including restricted funds, are appropriate


10-4

Audit time for cash

Cash typically has a small account balance, but auditors devote a large proportion of total audit hours because: Liabilities, revenues, expenses and most other

assets flow through cash Most liquid asset so greater temptation for

misappropriation High risk account


10-5

Management Assurance

Finance and accounting department work together to provide assurance that: All cash that should have been received was

in fact received, recorded accurately and deposited promptly

Cash disbursements have been made for authorized purposes only and have been properly recorded

Cash balances are maintained at adequate, but not excessive, levels by forecasting


10-6

Guidelines for Internal Control

(1 of 2)1. Do not permit any one employee to

handle a transaction from beginning to end.

2. Separate cash handling from recordkeeping.

3. Centralize receiving of cash to the extent practical.

4. Record cash receipts on a timely basis.5. Encourage customers to obtain receipts

and observe cash register totals.


10-7

Guidelines for Internal Control (2 of 2)

6. Deposit cash receipts daily.7. Make all disbursements by check or electronic

funds transfer, with the exception of small expenditures from petty cash.

8. Have monthly bank reconciliations prepared by employees not responsible for the issuance of checks or custody of cash. The completed reconciliation should be reviewed promptly by an appropriate official.

9. Monitor cash receipts and disbursements by comparing recorded amounts to forecasted amounts


10-8

Internal Control Over—Cash Receipts

Cash sales Involvement of two or more employees Cash Registers Electronic point of sales systems

Collections of receivables Initial listing of cash receipts Custody and depositing of cash receipts Maintenance of customer account records Reconciliation of customers’ ledgers with control

accounts Mailing monthly statements to customers Collection activity and past-due accounts Direct receipt of funds by financial institution


10-9

Cash Receipts Flowchart Figure 10.1


10-10

Segregation of duties Payment by check or electronic funds transfer Pre-numbered check Match of purchase order and receiving

documents with vendor’s invoice Review of supporting documents by

authorized check signer Cancel of supporting documents Authorized check signer should mail checks Monthly bank reconciliation

Internal Control — Cash Disbursements


10-11Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Flowchart of a Cash Disbursements Cycle Figures 10.2

10-12

Audit of Cash (1 of 3)

A. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to cash.

B. Obtain an understanding of internal control over cash.

C. Assess the risks of material misstatement and design further audit procedures.


10-13


D. Perform further audit procedures—tests of controls.1. Examples of tests of controls:

a. Test the accounting records and reconciliations by re-performance.

b. Compare the details of a sample of cash receipts listings to the cash receipts journal, accounts receivable postings, and authenticated deposit slips.

c. Compare the details of a sample of recorded disbursements in the cash payments journal to account payable postings, purchase orders, receiving reports, invoices, and paid checks.2. If necessary, revise the risk of material misstatement based on the results of tests of controls.


10-14


E. Perform further audit procedures—substantive procedures for cash transactions and balances.1. Obtain analyses of cash balances and reconcile them to the general

ledger.2. Confirm cash balances with financial institutions.3. Obtain or prepare reconciliations of bank (financial institution)

accounts as of the balance sheet date and consider the need to reconcile bank activity for additional months.

4. Obtain a cutoff bank statement containing transactions of at least seven business days subsequent to balance sheet date.

5. Count and list cash on hand.6. Verify the client’s cutoff of cash receipts and cash disbursements.7. Analyze bank transfers for the last week of audit year and the first

week of following year.8. Investigate any checks representing large or unusual payments to

related parties.9. Evaluate proper financial statement presentation and disclosure of

cash.


10-15

Summary of Substantive Tests for Cash Balances Figure 10.3


10-16

Examples of fraud with cash

Do the client’s records reflect all cash transactions that took place during the year?

Were all cash payments properly authorized and for a legitimate business purpose?

Fraud that may be disclosed Interception of cash receipts before any record is made Payment for materials not received Duplicate payments Overpayments to employees or payments to fictitious

employees Payments for personal expenditures of officers or

related partiesCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-17Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Potential Misstatements—Cash Receipts Figure 10.4

10-18

Potential Misstatements—Cash Disbursements

Inaccurate recording of a purchase or disbursement

Duplicate recording and payment of purchases

Unrecorded disbursements


10-19

Standard Confirmation—General Information

Confirmation of amounts on deposit by direct communication with financial institution officials

Standard form agreed to by: AICPA American Bankers Association Bank Administration Institute

Addresses only the client’s deposit and loan balances

The confirmation process may be performed electronically if properly controlled


10-20

Standard Confirmation Form Figure 10.6


10-21

Proof of Cash General Information

Reconciles the account balance and reconciles cash transactions during a specified period.

Used to identify: Cash receipts and disbursements recorded in

the accounting records, but not on the bank statement.

Cash deposits and disbursements recorded on the bank statement, but not on the accounting records.

Cash receipts and disbursements recorded at different amounts by the bank than in the accounting records.Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-22

Proof of Cash Figure 10.7


10-23

Check 21 Act

Checks may be processed electronically Electronic processing creates a substitute

check – an electronic image of check Legal equivalent of original check for all

purposes Audit implications

Need to rely on substitute check for evidence of check

Impossible for clients to kite checks (manipulate bank balances to conceal cash shortage)


10-24

Kiting

Manipulations that utilize temporarily overstated bank balances to conceal cash shortage or meet short-term cash needs

Kiting schemes rely upon the existence of a “float period” in which transactions are not processed in real time; increased electronic processing has made kiting more difficult through reducing (or eliminating the float period).

Auditors can detect kiting by preparing a schedule of bank transfers for a few days before and after balance sheet date

Misstatements Date of recording per transfer per the books are from

different financial statement periods Date the check was recorded by the bank is from

financial statement period prior to booksCopyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-25

Bank Transfer Schedule


10-26

Specialized Knowledge to Audit Financial Investments

Identifying controls at service organizations that provide financial services and are part of the client’s information system.

Obtaining an understanding of information systems for securities and derivatives that are highly dependent on computer technology.

Applying complex accounting principles to various types of financial investments.

Understanding the methods used to determine the fair values of financial investments, especially those that must be valued using complex valuation models.

Assessing inherent and control risk for assertions about derivatives used in hedging activities.


10-27

Objectives for the Audit of Financial Investments

1. Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to financial instruments

2. Obtain an understanding of internal control over financial instruments.

3. Assess the risks of material misstatement of financial instruments and design tests of controls and substantive procedures that:

a. Substantiate the existence of recorded financial investments and the occurrence of investment transactions.

b. Establish the completeness of financial investments and investment transactions.

c. Verify the cutoff of investment transactions.d. Determine that the client has rights to recorded

investments.


10-28

Controls Over Financial Investments

Establishment of formal investment policies Review and approval of investment activities by

the investment committee of the board of directors

Separation of duties among employees1. Authorizing purchases and sales2. Having custody of the securities3. Maintaining records

Detailed records of all securities owned and the related revenue from interest and dividends

Registration in the name of the company Periodic physical inspection of securities Determination of accounting for complex

instruments by competent personnel


10-29

Audit of Financial Investments

(1 of 4)A. Use the understanding of the client and its

environment to consider inherent risks, including fraud risks related to financial investments.

B. Obtain an understanding of internal control over financial investments

C. Assess the risks of material misstatement and design further audit procedures.


10-30

Audit of Financial Investments (2 of 4)

D. Perform further audit procedures—tests of controls.

1. Examples of tests of controls:a. Trace several transactions for purchases and sales of

investments through the accounting system.b. Review and test reports of investment activity prepared for

the investment committee.c. Inspect reports by internal auditors regarding their periodic

inspection and review of securities and derivative instruments.

d. Inspect monthly reports on securities owned, purchased, and sold and amounts of revenue earned and budgeted.

2. If necessary, revise the risk of material misstatement based on the results of tests of controls.


10-31

Audit of Financial Investments (3 of 4)

E. Perform further audit procedures—substantive procedures for investment transactions and year-end balances.1. Obtain or prepare analyses of the investment accounts and

related revenue, gain, and loss accounts and reconcile them to the general ledger.

2. Inspect securities on hand and review agreements underlying derivatives.

3. Confirm securities and derivative instruments with holders and counterparties.

4. Vouch selected purchases and sales of financial investments during the year and verify the client’s cutoff of investment transactions.

5. Review investment committee minutes and reports.


10-32

Audit of Financial Statements (4 of 4)

E. further audit procedures cont.6. Perform analytical procedures.7. Make independent computations of revenue

from securities.8. Inspect documentation of management’s

intent to classify derivative transactions as hedging activities.

9. Evaluate the method of accounting for investments.

10. Test the valuation of financial investments.11. Evaluate financial statement presentation

and disclosure of financial investments.Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10-33

Test Valuation

FASB requirements for derivative instruments and hedging activities: All derivative instruments valued at fair values Unrealized gains or losses depend on

classification as hedges FASB requirements allow companies to

choose to use fair value accounting in this area.


10-34

Potential Misstatements—Financial Investments

Misstatement of recorded value of investments

Unauthorized investment transactions Incomplete recording of investments Inadequate disclosure of the nature of

investment activities


10-35

Summary of Substantive Procedures for Financial Investments Figure 10.9


10-1 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Documents

cash disbursements

disclosure of cash

custody of cash

existence of recorded

completeness of recorded

recorded cash balances

deposit cash receipts

record cash receipts