CHAPTER 18 AUDIT INVESTMENTS AND CASH BALANCES

Learning Check
18-1. The nature of investments in securities issued by other entities the ownership of certificates of deposit, preferred and common stocks of other entities, and corporate and government bonds. The audit area of investments in marketable securities interfaces with two other cycles. The receipt of interest and dividends from investments relates to the revenue cycle. The purchase of securities for cash pertains to cash disbursement transactions in the expenditure cycle. The audit objectives for each of the management assertions that pertain to investments in marketable securities are: Existence or occurrence Recorded investment asset and equity balances represent investments that exist at the balance sheet date. Investment revenues, realized gains and losses, and unrealized holding gains and losses included in income resulted from transactions and events that occurred during the period. Completeness All investments are included in the balance sheet investment accounts.. The income statement effects of all investment transactions and events during the period are included in the income statement accounts. Rights and obligations All recorded investments are owned by the reporting entity. Valuation or allocation Investments are reported on the balance sheet at fair value, cost, amortized cost, or the amount determined by the equity method, as appropriate for particular investments. Investment revenues, and realized and unrealized gains, and losses are reported at proper amounts. Presentation and disclosure Investment balances are property identified and classified in the financial statements. Appropriate disclosures are made concerning (1) related party investments, (2) the bases for valuing the investments, and (3) the pledging of investments as collateral. 18-3. a.Shad is incorrect about the balance sheet inasmuch as marketable securities held as short-term investments may be material to a company's short-term solvency, and securities held as longterm investments may be material to total assets. Shad may be incorrect about the income statement for a company that has trading securities, held to maturity securities when amortization is significant, or available-for-sale securities for which unrealized holding gains and losses become realizable due to sale or reclassification. b. Keri is incorrect. The audit strategy decision is generally based on the frequency of investing transactions. When there are relatively few transactions, the auditor generally uses a primarily substantive approach. When there are many transactions, it may be more cost-efficient for the auditor to use a lower assessed level of control risk approach.

18-2.

18-4.

Typically, the control environment pertaining to investments in marketable securities enhances internal control. For example, the authority and responsibility for investing transactions is often assigned to a

company officer such as the treasurer. The accounting system must include provision for capturing and retaining all the necessary cost, fair value, and other data required for each method of accounting for the various categories of investments in equity and debt securities, both at acquisition and at subsequent reporting dates. Each of the categories of control activities is applicable. Several common documents and records are used in investing activities, and internal auditors may be involved in monitoring investment activities and balances. 18-5. a. The functions and related controls in the investing cycle consist of the following: Authorizing investment transactions: o Purchasing securities. Receive or deliver securities: o Receiving/ safeguarding/delivering securities. o Receiving periodic income. Recording transactions: o Recording purchases, sales, and income. o Recording market adjustments and reclassifications. Settle transactions: o Receiving cash. o Disbursing cash. o Assessing investment performance and reporting. The following table summarizes internal controls that might be found in the investing cycle for each assertion (audit objective).

b.

Assertion (Audit Objective) Existence and Occurrence (Occurrence)

Control The computer checks for authorization to purchase or sell securities before recording the transaction. Recorded securities are regularly compared with brokers statements.

Test of Controls Use CAATs to test the control by submitting data that should be rejected by the control. Observe evidence of reconciling recorded securities with the brokers statements and reperform control on a test basis. Use CAATs to test the control by submitting data that should be rejected by the control. Use CAATs to test the control by submitting data that should be rejected by the control. Use CAATs to test the control by submitting data that should be rejected by the control. Read the minutes of the disclosure committee and make inquiries about issues discussed by a disclosure committee. Review documentation of follow-up on disclosure committee actions. Read the minutes of the disclosure committee and make inquiries about issues discussed by a disclosure

Completeness (Completeness) Existence and Occurrence / Completeness (Cutoff)

Valuation and Allocation (Accuracy) Presentation and Disclosure (Classification)

The computer prepares an exception report of authorized investment transactions that have not been recorded. The computer compares the accounting period in which the transaction was recorded with the settlement date on the brokers advice. The computer compares recorded quantities and prices with the underlying brokers advice. A disclosure committee reviews classification of securities as held to maturity, available for sale, or trading securities. A disclosure committee reviews security transactions to determine if disclosures are appropriate of

Rights and Obligations

securities are pledged as collateral for loans or margin trades.

committee. Review documentation of follow-up on disclosure committee actions.

18-6.

The acceptable level of detection risk is derived from the audit risk model. Inherent risk for investment balances involves consideration of (a) the vulnerability of the securities to theft and misappropriation (existence or occurrence assertion), (b) the possibility of misclassification of investments (presentation and disclosure assertion), and (c) the complexities pertaining to the valuation methods such as the equity method of accounting (valuation or allocation assertion). Control risk, under the primarily substantive approach is at the maximum or slightly below the maximum. In such cases, the acceptable level of detection risk will be low.

18-7. a.The precautions are: (1) the custodian should be present during the count, (2) a receipt should be obtained from the custodian when the securities are returned to the client, and (3) all securities, cash and other negotiable investments should be controlled during the count. b. 18-8. 18-9. This test applies to four assertions: (1) existence or occurrence, (2) completeness, (3) rights and obligations, and (4) presentation and disclosure.

The working papers for securities should show the certificate number, name of owner, description of the security, number of shares or bonds, and name of issuer. a. Securities held by others for the client should be positively confirmed with the custodian as of the date securities held by the client are counted. This date is often at or near the balance sheet date. This test provides evidence about four assertions, (1) existence or occurrence, (2) completeness, (3) rights and obligations, and (3) valuation at historical cost.

b. 18-10.

Cash accounts that should be included as cash balances on the balance sheet include undeposited receipts on hand, cash in bank in general checking and saving accounts, and imprest accounts such as petty cash and payroll bank account. Cash accounts that should not be classified as cash balances on the sheet include certificates of deposit, bond sinking fund cash, certain foreign currency balances, and other accounts that have restrictions on their use. These accounts should be classified as investments. The transaction cycles that affect cash are: Revenue (cash sales and receivable collections) Expenditure (cash purchases and payments on account) Personnel services (payment of employees and taxing authorities) Investing (The purchase of long-term assets, the purchase and sale of securities, and the receipt of interest and dividends). Financing (Issuing debt and equity securities, redeeming bonds and retiring stock, the purchase and sale of treasury stock, payment of interest and dividends). The account balance audit objectives for cash are as follows: Specific Audit Objectives Transaction Objectives Occurrence. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. Completeness. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. Accuracy. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. Cutoff. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. Classification. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements.

18-11.

18-12. a.

Balance Objectives Existence. Recorded cash balances exist at the balance sheet date (EO1). Year end transfers of cash between banks are recorded in the proper period (EO2). Completeness. Recorded cash balances include the effects of all transactions that have occurred (C1). Year end transfers of cash between banks are recorded in the proper period (C2). Rights and Obligations. The entity has legal title to all cash balances shown at the balance sheet date (RO1). Valuation and Allocation. Recorded cash balances are realizable at the amounts stated on the balance sheet and agree with supporting schedules (VA1). Disclosure Objectives Occurrence and Rights and Obligations. Disclosed cash events and transactions have occurred and pertain to the entity (PD1). Completeness. All cash disclosures that should have been included in the financial statements have been included (PD2). Understandability. All cash disclosures are appropriately presented and information in disclosures is understandable to users (PD3). Accuracy and Valuation. Cash information is disclosed accurately and at appropriate amounts (PD4). b. Inherent risk for cash balances is frequently assessed as high for the existence or occurrence and completeness assertions because of the high volume of cash transactions and the vulnerability of cash to misappropriation. In contrast, lower assessments of inherent risk may be made for the other assertions because they do not involve any contentious accounting issues.

18-13.

Although the portion of current or total assets at any point in time represented by cash balances may be very small; with five of the six transaction cycles affecting cash the amount of cash flowing through the accounts over a period of time that is susceptible to misappropriation can be very large. The volume of transactions, and the susceptibility of a valuable asset to misappropriation are the key reasons that strong internal controls over cash is important. Because of the unique aspects of cash, auditors tend to plan their procedures to detect much smaller levels of misstatements than for other accounts. Further, management may request that the auditor plan work in the cash areas with a more extensive scope than would otherwise be required due to the inherent risks in this area. Hence, the auditor may follow a primarily substantive approach. When an entity has strong internal controls and many cash accounts the lower assessed level of control risk approach may be used to limit the number of cash accounts where substantive tests may be performed. Three different tests of details of transactions that can be performed in auditing cash balances are: Perform cash cutoff tests for cash receipts and cash disbursements. Trace bank transfers. Prepare proof of cash. A proof of cash need not be prepared when control risk pertaining to cash transactions and balances is low and the entity's bank accounts have been reconciled.

18-14.

18-15. a.

b.

18-16. a.Kiting is an irregularity in which a bank transfer is recorded as a deposit in the receiving bank and is intentionally not recorded as a deduction from the bank on which it is drawn. To illustrate, an unauthorized check is drawn on bank A to cover a shortage in bank B. The check is included in the December 31 deposit of bank B. However, no December book entries are made for the check on Bank A. b. 18-17. Kiting can be detected by (1) tracing bank transfers and (2) by using a bank cutoff statement.

To property count cash on hand, the auditor should (1) control all cash and negotiable instruments held by the client until all funds have been counted, (2) insist that the custodian of the cash be present throughout the count, (3) obtain a signed receipt from the custodian on return of the funds to

the client, and (4) ascertain that all undeposited checks are owned by the client either directly or through endorsement. 18-18 a.Lapping is an form of fraud that results in the deliberate misappropriation of cash receipts. It may involve either a temporary or a permanent abstraction of cash receipts for the personal use of the individual perpetrating the unauthorized act. b. Lapping is usually associated with collections from customers, but it may also involve other types of cash receipts. Conditions conducive to lapping exist when an individual who handles cash receipts also maintains the accounts receivable ledger. The information requested in confirming bank deposit and loan balances consists of (1) deposit balances, (2) loan balances, and (3) other deposit and loan accounts that may have come to the attention of the authorized bank official. Tests to detect lapping are only performed when control risk for cash receipts transactions is moderate or high. There are three procedures that should detect lapping: o Confirm Accounts Receivable. o Make a Surprise Cash Count. o Compare Details of Cash Receipts Journal Entries with the Details of Corresponding Daily Deposit Slips. In an effort to conceal the shortage, the embezzler usually attempts to (1) keep bank and book amounts in daily agreement so that a bank reconciliation will not detect the irregularity and (2) correct the customers account within three to four days of actual collection so that any discovered discrepancy in the customers account can be explained as a delay in receiving the money or posting. This test provides evidence primarily for the existence or occurrence and rights and obligations assertions for cash balances. It contributes to the completeness assertion but it cannot be relied upon entirely because the respondent is not required to search bank records for deposit and loan balances other than the ones listed on the request. A compensating bank balance is the minimum balance the depositor must maintain to have an established line of credit with a bank. The auditor's primary source of evidence for compensating bank balances is obtained from confirming other arrangements with banks. The primary assertion related to compensating bank balances is presentation and disclosure.

18-19. a.

b.

18-20. a.

b.

18-21. a. b.

18-22. When the acceptable level of detection risk is high, the auditor may scan the client prepared bank reconciliation and verify its mathematical accuracy. If detection risk is moderate, the auditor may review the client's reconciliation. A review includes vouching reconciling items to supporting documentation, and investigating old and unusual items. When the acceptable level of detection risk is low, the auditor may prepare the bank reconciliation using bank data in the client's possession. When detection risk is very low, the auditor may obtain the bank statement directly from the bank for use in preparing the bank reconciliation. 18-23. a. The bank cutoff statement should be obtained at a point in time that will permit the outstanding checks to clear the bank, and the cutoff statement should be obtained by the auditor directly from the bank.. After receiving the cutoff bank statement, the auditor should: Trace all prior-year dated checks to the outstanding checks listed on the bank reconciliation. Trace deposits in transit on the bank reconciliation to deposits on the cutoff statement Scan the cutoff statement and enclosed data for unusual items.

b.

18-24.

Examples of circumstances that affect the presentation and disclosure assertion for cash include the existence of (a) a bond sinking fund that should be classified as a noncurrent asset, (b) disclosure of arrangements with banks, and (c) a bank overdraft that should be reported as a current liability. The auditor should review the minutes of board of directors meetings as well as make inquiry of management as to restrictions on the use of cash balances.

Comprehensive Questions
18-26. (Estimated time - 25 minutes) a. Substantive Test 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 18-30. Recalculate revenue earned Vouch entries in investment accounts to brokers advice. Confirm securities held by others Inspect and count securities on hand Vouch entries in investment accounts to brokers advice. Inspect and count securities on hand Review documentation concerning market values Verify accuracy of balances, schedules and subsidiary ledgers Compare statement presentation with GAAP Compare statement presentation with GAAP b. Financial Statement Assertion Valuation of allocation All assertions Existence or occurrence, completeness, rights and obligations All except rights and obligations All assertions All except rights and obligations Valuation or allocation Valuation or allocation Presentation and disclosure Presentation and disclosure c. Type of Evidence Mathematical Documentary Confirmation Physical, documentary Documentary Physical, documentary Documentary Mathematical Documentary Documentary

(Estimated time - 30 minutes) a. Patricia Company Computation of Amount Abstracted by Cashier November 30, 20XO Cash balance, per books November 30, 20XO Add: Credit by bank Adjusted cash balance (on hand and in bank) Less adjusted bank balance: Bank balance, November 30, 20XO Less outstanding checks: 62 182 284 8621 8623 8632 Cash which should be on hand for deposit Cash reported Amount of theft b. $116.25 150.00 253.25 190.71 206.80 145.28 $18,901.62 100.00 $19,001.62 $15,550.00

1,062.29

14,487.71 $ 4,513.91 3,794.41 $ 719.50

The cashier removed $719.50. He attempted to conceal his theft by:

o o o c.

Not listing all outstanding checks. Underfooting outstanding checks shown on the reconciliation. Subtracting an item from the bank balance that should be added to book balance.

Two controls that were lacking are: o Someone other than the cashier should trace cash receipts to the deposits in the bank o Someone other than the cashier should be responsible for preparing bank reconciliation.

18-31.

(Estimated time - 25 minutes) Other Audit Procedures Sources of debit entries in general ledger cash account, other than from cash receipts journals, should be investigated and supporting documents examined. Reason for Other Audit Procedures Since the auditor, using standard procedures, only examines the cash receipts journal, he or she must investigate the validity of all other sources of cash receipts which are not recorded in these journals.

A surprise examination of cash receipts should be performed. Prior to the accounts receivable clerk obtaining the cash receipts, the auditor should make a list of them without the clerk's knowledge. The undeposited mail receipts should then be controlled after completion of their preparation for deposit and after postings have been made to the subsidiary accounts receivable ledger. The deposit slip should be totaled and compared to the remittances and the list prepared by the auditor for accuracy. Individual items on the deposit slip should be compared to postings to the subsidiary accounts receivable ledger. The auditor should ask Gutzler to ask the bank to send the statement containing that deposit directly to the auditor. Postings from other deposit slips should be traced to the cash receipts journal and the subsidiary accounts receivable ledger. Also, entries in the subsidiary accounts receivable ledger should be traced to the cash receipts journal and to the deposit slips. Review the subsidiary accounts receivable ledger and confirm accounts that have abnormal transaction activity such as consistently late payments.

Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, a surprise examination is the only method of determining if cash receipts are being recorded and deposited properly.

Since there is no separation of duties between cash receipts and accounts receivable, the accounts receivable clerk may have been careless in performing posting duties. This procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts. Once more, there is no separation of duties between cash receipts and accounts receivable. If the accounts receivable clerk was careless in performing posting duties, this procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts. Since there is no separation of duties between cash receipts and accounts receivable, the accounts receivable clerk may have appropriated discounts which could have been, but were not, taken, or may have been careless in checking the appropriateness of discounts taken.

If Gutzier allows customers to take discounts, the amount of such discounts and the discount period should be checked.

Dates and amounts of daily deposits per bank statements should be compared with entries in the cash receipts journal

Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, the clerk may have become careless about promptly depositing the daily receipts.

Other Audit Procedures A proof-of-cash working paper should be prepared which reconciles total cash receipts with credits per bank statements. The opening and closing reconciliation of the proof of cash should be compared to the comparable reconciliation prepared by the controller. Prepare a ratio analysis of monthly collections to total sales of the preceding month or monthly collections to total accounts receivable at the beginning of the month and compare this analysis with a similar analysis for the preceding year. Visit the client on the balance sheet date or the next business day to determine that an appropriate cutoff of cash receipts has been made. For those periods for which the above audit procedures were not performed and for a period after the balance sheet date, scan the cash receipts journal and bank statements for unusual items. 18-32.

Reason for Other Audit Procedures Since internal control over cash receipts is weak, the auditor should perform that overall check to help substantiate that he or she has investigated all material items during the detail tests. Since internal control over cash receipts is weak, this overall test may highlight points of irregularities, is such exist.

Since internal control over cash receipts is weak, the auditor needs to be satisfied that cash receipts are recorded in the appropriate period. Since internal control over cash receipts is weak, the auditor should perform that review to help substantiate that all material items not covered during other tests have been investigated.

(Estimated time - 30 minutes) a. The purposes of auditing bank transfers are to (1) determine that bank balances are correctly stated at the balance sheet date and (2) to detect kiting. b. Bank Accounts Ck. No. 2476 2890 3140 A1006 A1245 3402 c. City Bank--Payroll Bank Clearing (Due to Metro Bank--Special) City Bank--Regular Bank Clearing (Due to Metro Bank--Special) Bank Clearing (Due from Metro Bank--Special) City Bank--Regular d. e. 125,000 125,000 50,000 50,000 25,000 25,000 From C--Reg C--Reg C--Reg M--Spec M--Spec C--Reg To C--Pay C--Pay M--Spec C--pay C--Reg M--Spec $100,000 200,000 100,000 50,000 25,000 125,000 Books 6/23 6/25 6/28 6/29 6/30 7/1 Bank 6/30 7/2 7/5 7/6 7/7 7/5 Books 6/25 6/27 6/30 7/1 7/2 6/30 Bank 6/25 6/27 6/30 7/1 7/2 6/30 Amount of Check Disbursement Date Receipt Date

Outstanding checks: 2890, 3140, 3402, A1006, A1245 Deposits in transit: 3402 Check 3402 is indicative of kiting because the check was received, recorded, and deposited on June 30, but was not recorded as a disbursement until July 1.