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Ch12

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  • 1. Chapter 12 Auditing Liquid Assets
  • 2. List Cash Accounts <ul><li>General checking accounts </li></ul><ul><li>Cash management accounts </li></ul><ul><li>Payroll checking accounts </li></ul><ul><li>Marketable Security Accounts </li></ul><ul><li>Marketable securities (held as temporary investments) </li></ul><ul><li>Short-term cash management securities (Treasury bills, CDs, etc) </li></ul><ul><li>Short-term hybrid-type securities </li></ul>
  • 3. Review Planning for Audits of Cash and Marketable Securities <ul><li>Materiality and Risk Considerations </li></ul><ul><li>Volume of transactions flowing through the account </li></ul><ul><li>Liquidity and easy transferability </li></ul><ul><li>Automated systems and increased computerization of account activity </li></ul><ul><li>Importance in meeting debt covenants </li></ul><ul><li>With smaller clients, auditors usually concentrate on substantively testing year-end Cash account balances </li></ul><ul><li>With large clients, auditors focus on evaluating and testing internal controls </li></ul>
  • 4. Planning for Audits of Cash and Marketable Securities (Continued) <ul><li>Inherent risk for cash and marketable securities is high </li></ul><ul><li>Liquidity of assets </li></ul><ul><li>Susceptibility of mishandling </li></ul><ul><li>Difficulty in understanding financial risks associated with derivatives </li></ul><ul><li>Complexity of some financial instruments </li></ul><ul><li>Control risk </li></ul><ul><li>Analysis of control environment over cash and marketable securities should occur during planning of the audit </li></ul>
  • 5. Discuss Cash Management Techniques <ul><li>Speed collection and deposit of cash </li></ul><ul><li>Minimize possibility of error or fraud </li></ul><ul><li>Reduce paperwork </li></ul><ul><li>Automate cash management process </li></ul><ul><li>Techniques include </li></ul><ul><ul><li>Lockboxes </li></ul></ul><ul><ul><li>Electronic funds transfers </li></ul></ul><ul><ul><li>Cash management agreements with financial institutions </li></ul></ul><ul><ul><li>Compensating balances </li></ul></ul>
  • 6. Review Evaluating Control Risk: Cash Accounts <ul><li>Appropriate internal controls would include: </li></ul><ul><li>Adequate separation of incompatible duties </li></ul><ul><li>Cash receipts deposited daily and intact </li></ul><ul><li>Restrictive endorsements on checks received </li></ul><ul><li>Independent reconciliation of cash records including bank statement </li></ul><ul><li>Computerized control totals and edit tests </li></ul><ul><li>Authorization of transactions </li></ul><ul><li>Use of prenumbered documents and turnaround documents </li></ul><ul><li>Periodic internal audits </li></ul><ul><li>Competent, well-trained employees </li></ul><ul><li>Access to assets and accounting records restricted </li></ul>
  • 7. Comment on Understanding and Testing Internal Controls <ul><li>Understanding of internal control is obtained through inquiry, observation, and review of client documentation </li></ul><ul><li>Auditors use flowcharts, memos, and questionnaires to document their understanding </li></ul><ul><li>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 </li></ul><ul><li>The program is designed around the basic control objectives and is cross-referenced to the audit objectives </li></ul><ul><li>Based on the results of testing, the auditor reassesses control risk and develops procedures to substantively test Cash account balances </li></ul>
  • 8. Discuss Substantive Testing of Cash Balances <ul><li>Common types of misstatements regarding cash include: </li></ul><ul><li>Transactions recorded in the wrong period </li></ul><ul><li>Embezzlements covered up by omitting or under-footing outstanding checks on the bank reconciliation </li></ul><ul><li>Manipulating accounts to record the same cash in two accounts at the same time (kiting) </li></ul>
  • 9. Discuss Substantive Testing of Cash Balances (Continued) <ul><li>Independent bank reconciliation </li></ul><ul><li>Bank cutoff statement </li></ul><ul><li>Bank confirmation </li></ul><ul><li>Obtaining year-end cutoff information </li></ul>
  • 10. Explain Independent Bank Reconciliation <ul><li>Reconciles year-end General Ledger Cash account balance to year-end bank statement balance </li></ul><ul><li>Two part bank reconciliation: </li></ul><ul><li>Start with year-end bank balance and adjust for items recorded in the books, but not by the bank </li></ul><ul><li>Start with year-end General Ledger Cash balance and adjust for items recorded by the bank, but not on the books </li></ul><ul><li>Adjusted book balance must equal adjusted bank balance </li></ul>
  • 11. Explain the Use of the Bank Cutoff Statement <ul><li>Bank cutoff statement: </li></ul><ul><li>Normal bank statement for the first few weeks after year-end </li></ul><ul><li>Sent directly to the auditor </li></ul><ul><li>Includes canceled deposit slips and checks </li></ul><ul><li>Allows auditor to verify existence and amount of deposits in transit and outstanding checks on the bank reconciliation </li></ul>
  • 12. What’s the bank confirmation used for? <ul><li>Auditor usually sends a confirmation to each bank with which the client transacted business during the year </li></ul><ul><li>Confirmation is usually open form: </li></ul><ul><li>Respondent (bank) fills in the form </li></ul><ul><li>Auditor reconciles provided information with client records </li></ul><ul><li>Standard confirmation has two parts: </li></ul><ul><li>First part seeks information on client's account balances </li></ul><ul><li>Second part seeks information on any loans or collateral agreements the client may have with the bank </li></ul><ul><li>Bank confirmations are generally considered to be reliable evidence </li></ul>
  • 13. Why obtain year-end cutoff information? <ul><li>Management manipulation of cash includes: </li></ul><ul><li>Over-recording cash receipts </li></ul><ul><li>Under-recording cash disbursements </li></ul><ul><li>If the auditor assesses the risk of such irregularities as high, following procedures may be used: </li></ul><ul><li>Obtain information on last checks issued during the audit period </li></ul><ul><ul><li>Number of last check issued </li></ul></ul><ul><ul><li>Observe that all previous checks had been mailed and corroborate by timely clearing of the bank per the bank cutoff statement </li></ul></ul><ul><li>Obtain information of last cash receipts </li></ul><ul><ul><li>Note last few receipts </li></ul></ul><ul><ul><li>Trace receipts to bank reconciliation and bank cutoff statement </li></ul></ul>
  • 14. How is a bank transfer schedule used? <ul><li>Kiting involves transferring funds from one bank account to another just before year-end in order to overstate cash: </li></ul><ul><li>Deposit is recorded into the second account before year-end </li></ul><ul><li>Disbursement is not recorded in the first account until after year-end </li></ul><ul><li>Auditor tests for kiting by preparing a bank transfer schedule: </li></ul><ul><li>Schedule lists all transfers between company bank accounts for a few days before, and a few days after year-end </li></ul><ul><li>Schedule lists dates transfers cleared the bank and dates they were recorded in the books </li></ul><ul><li>Auditor checks to see deposit and withdrawal were BOTH recorded in the same accounting period </li></ul>
  • 15. Discuss Operational Audits of Cash <ul><li>Internal auditors often use the following procedures to test the effectiveness of internal controls over cash accounts: </li></ul><ul><li>Review procedures for handling cash receipts </li></ul><ul><li>Review procedures for identifying and investing excess of idle funds </li></ul><ul><li>Measure and evaluate the effectiveness of cash management and budgeting </li></ul><ul><li>Review arrangements with financial institutions to identify risks </li></ul><ul><li>Determine compliance with company policies </li></ul><ul><li>Evaluate effectiveness of controls over electronic transfers </li></ul><ul><li>Evaluate effectiveness of controls to minimize loss of misuse of cash </li></ul><ul><li>Determine if payments made timely to take advantage of cash discounts </li></ul>
  • 16. Define Marketable Securities and Financial Instruments <ul><li>Marketable securities are </li></ul><ul><li>Debt or equity securities that are readily marketable </li></ul><ul><li>That management intends to hold for a short time </li></ul><ul><li>Includes commercial paper, marketable equity securities, and marketable debt securities </li></ul>
  • 17. Review Substantive Audit Procedures: Other Short-Term Securities <ul><li>Client prepares schedule of marketable securities activity including </li></ul><ul><ul><li>Marketable securities held at year-end </li></ul></ul><ul><ul><li>Audit period transactions - purchases and disposals </li></ul></ul><ul><ul><li>Interest and dividend revenue </li></ul></ul><ul><li>The schedule is footed to determine mathematical accuracy </li></ul><ul><li>Auditor verifies cost or sales price by examining broker's advices </li></ul><ul><li>Auditor recalculates gains/losses on disposal of securities </li></ul>
  • 18. <ul><li>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 </li></ul><ul><li>Current market values are verified by referring to market sources </li></ul><ul><li>Auditor recomputes interest and dividend income, and realized and unrealized gains and losses </li></ul><ul><li>Auditor asks management about any changes in the expected holding period, and any restrictions on securities </li></ul><ul><li>Auditor reviews investment or loan agreements that specify the securities as collateral for disclosure issues </li></ul>Review Substantive Audit Procedures: Other Short-Term Securities (Continued)
  • 19. Discuss Auditing Other Financial Instruments and Derivatives <ul><li>During last the 20 years, a number of new financial instruments have been developed: </li></ul><ul><li>Some have been created to take advantage of short-term anomalies </li></ul><ul><li>Others have been developed to remove liabilities from the balance sheet </li></ul><ul><li>Examples: </li></ul><ul><ul><li>Event-risk protected debt </li></ul></ul><ul><ul><li>Floating rate note </li></ul></ul><ul><ul><li>Junk bond </li></ul></ul><ul><ul><li>Pay-in-kind (PIK) debenture </li></ul></ul><ul><ul><li>Zero-coupon bond </li></ul></ul><ul><ul><li>Securities sold with a put option </li></ul></ul><ul><ul><li>Collateralized mortgage obligation </li></ul></ul><ul><ul><li>Securitized receivables </li></ul></ul>
  • 20. Comment on Management Control Considerations for Companies that use Financial Instruments <ul><li>Identify the risk management objectives </li></ul><ul><li>Understand the product </li></ul><ul><li>Understand the accounting and tax ramifications </li></ul><ul><li>Develop corporate policies and procedures </li></ul><ul><li>Monitor and evaluate results </li></ul><ul><li>Understand the credit risk </li></ul><ul><li>Control collateral when risk is not acceptable </li></ul>

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