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CHAPTER 18 AUDIT INVESTMENTS AND CASH BALANCES

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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.

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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

o Receiving periodic income. The accounting system must include provision for capturing and retaining all the necessary cost. A disclosure committee reviews classification of securities as held to maturity. o Assessing investment performance and reporting. or trading securities. A disclosure committee reviews security transactions to determine if disclosures are appropriate of Rights and Obligations . Use CAATs to test the control by submitting data that should be rejected by the control. both at acquisition and at subsequent reporting dates. fair value. Use CAATs to test the control by submitting data that should be rejected by the control. and income. Each of the categories of control activities is applicable. Use CAATs to test the control by submitting data that should be rejected by the control. • Receive or deliver securities: o Receiving/ safeguarding/delivering securities. • Settle transactions: o Receiving cash. Read the minutes of the disclosure committee and make inquiries about issues discussed by a disclosure committee. Observe evidence of reconciling recorded securities with the broker’s statements and reperform control on a test basis. Review documentation of follow-up on disclosure committee actions. available for sale. Recorded securities are regularly compared with broker’s statements. Test of Controls Use CAATs to test the control by submitting data that should be rejected by the control. The computer compares recorded quantities and prices with the underlying broker’s advice. The functions and related controls in the investing cycle consist of the following: • Authorizing investment transactions: o Purchasing securities. Several common documents and records are used in investing activities. sales. and other data required for each method of accounting for the various categories of investments in equity and debt securities. o Recording market adjustments and reclassifications. • Recording transactions: o Recording purchases. 18-5. and internal auditors may be involved in monitoring investment activities and balances. Assertion (Audit Objective) Existence and Occurrence (Occurrence) Control The computer checks for authorization to purchase or sell securities before recording the transaction. b. The following table summarizes internal controls that might be found in the investing cycle for each assertion (audit objective). The computer compares the accounting period in which the transaction was recorded with the settlement date on the broker’s advice. o Disbursing cash. a.company officer such as the treasurer. 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.

18-12. payment of interest and dividends). The account balance audit objectives for cash are as follows: Specific Audit Objectives Transaction Objectives Occurrence. cash and other negotiable investments should be controlled during the count. This test applies to four assertions: (1) existence or occurrence. cash in bank in general checking and saving accounts. 18-9. name of owner. . the purchase and sale of treasury stock. (b) the possibility of misclassification of investments (presentation and disclosure assertion). and the receipt of interest and dividends). See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. redeeming bonds and retiring stock. a. Cutoff. 18-6. (1) existence or occurrence.securities are pledged as collateral for loans or margin trades. and (3) valuation at historical cost. This date is often at or near the balance sheet date. and imprest accounts such as petty cash and payroll bank account. and (3) all securities. the purchase and sale of securities. (3) rights and obligations. 18-10. number of shares or bonds. Review documentation of follow-up on disclosure committee actions. the acceptable level of detection risk will be low. description of the security. a. b. (2) completeness. Classification. In such cases. under the primarily substantive approach is at the maximum or slightly below the maximum. Accuracy. (3) rights and obligations. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. and name of issuer. (2) a receipt should be obtained from the custodian when the securities are returned to the client. (2) completeness.The precautions are: (1) the custodian should be present during the count. The acceptable level of detection risk is derived from the audit risk model. 18-8. committee. Cash accounts that should not be classified as cash balances on the sheet include certificates of deposit. Completeness. b. 18-7. a. and other accounts that have restrictions on their use. Control risk. certain foreign currency balances. These accounts should be classified as investments. 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. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. Cash accounts that should be included as cash balances on the balance sheet include undeposited receipts on hand. and (c) the complexities pertaining to the valuation methods such as the equity method of accounting (valuation or allocation assertion). See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. This test provides evidence about four assertions. and (4) presentation and disclosure. 18-11. bond sinking fund cash. • Financing (Issuing debt and equity securities. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit objectives related to cash disbursements. Inherent risk for investment balances involves consideration of (a) the vulnerability of the securities to theft and misappropriation (existence or occurrence assertion). The working papers for securities should show the certificate number. 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.

Completeness. Disclosed cash events and transactions have occurred and pertain to the entity (PD1). b. 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. The entity has legal title to all cash balances shown at the balance sheet date (RO1). The check is included in the December 31 deposit of bank B. an unauthorized check is drawn on bank A to cover a shortage in bank 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. no December book entries are made for the check on Bank A. All cash disclosures that should have been included in the financial statements have been included (PD2). Valuation and Allocation. 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. b. Cash information is disclosed accurately and at appropriate amounts (PD4). Rights and Obligations. Further. • Trace bank transfers. • Prepare proof of cash. 18-17. Accuracy and Valuation. lower assessments of inherent risk may be made for the other assertions because they do not involve any contentious accounting issues. To illustrate. Year end transfers of cash between banks are recorded in the proper period (EO2).Balance Objectives Existence. Recorded cash balances include the effects of all transactions that have occurred (C1). the auditor may follow a primarily substantive approach. In contrast. Recorded cash balances are realizable at the amounts stated on the balance sheet and agree with supporting schedules (VA1). 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. Year end transfers of cash between banks are recorded in the proper period (C2). 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. Hence. Completeness. auditors tend to plan their procedures to detect much smaller levels of misstatements than for other accounts. (2) insist that the custodian of the cash be present throughout the count. the auditor should (1) control all cash and negotiable instruments held by the client until all funds have been counted. 18-13. 18-14. 18-16. a. Recorded cash balances exist at the balance sheet date (EO1). Understandability. Disclosure Objectives Occurrence and Rights and Obligations. Because of the unique aspects of cash. a. To property count cash on hand. b. 18-15. Kiting can be detected by (1) tracing bank transfers and (2) by using a bank cutoff statement. Although the portion of current or total assets at any point in time represented by cash balances may be very small. (3) obtain a signed receipt from the custodian on return of the funds to . The volume of transactions.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. 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. and the susceptibility of a valuable asset to misappropriation are the key reasons that strong internal controls over cash is important. However. All cash disclosures are appropriately presented and information in disclosures is understandable to users (PD3).

b. a. When the acceptable level of detection risk is high. The information requested in confirming bank deposit and loan balances consists of (1) deposit balances. 18-21. After receiving the cutoff bank statement. o Compare Details of Cash Receipts Journal Entries with the Details of Corresponding Daily Deposit Slips. o Make a Surprise Cash Count. 18-19. the auditor should: • Trace all prior-year dated checks to the outstanding checks listed on the bank reconciliation. the auditor may obtain the bank statement directly from the bank for use in preparing the bank reconciliation.the client. 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. 18-22. Conditions conducive to lapping exist when an individual who handles cash receipts also maintains the accounts receivable ledger. and investigating old and unusual items. There are three procedures that should detect lapping: o Confirm Accounts Receivable. In an effort to conceal the shortage. When detection risk is very low. (2) loan balances. the auditor may scan the client prepared bank reconciliation and verify its mathematical accuracy. the auditor may prepare the bank reconciliation using bank data in the client's possession. b. b. 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 customer’s account within three to four days of actual collection so that any discovered discrepancy in the customer’s account can be explained as a delay in receiving the money or posting. 18-18 a. and (4) ascertain that all undeposited checks are owned by the client either directly or through endorsement. A compensating bank balance is the minimum balance the depositor must maintain to have an established line of credit with a bank. the auditor may review the client's reconciliation. and (3) other deposit and loan accounts that may have come to the attention of the authorized bank official. Lapping is usually associated with collections from customers. Tests to detect lapping are only performed when control risk for cash receipts transactions is moderate or high. a.. b. It may involve either a temporary or a permanent abstraction of cash receipts for the personal use of the individual perpetrating the unauthorized act. If detection risk is moderate. This test provides evidence primarily for the existence or occurrence and rights and obligations assertions for cash balances. and the cutoff statement should be obtained by the auditor directly from the bank. 18-20. • 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. The primary assertion related to compensating bank balances is presentation and disclosure. A review includes vouching reconciling items to supporting documentation. 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.Lapping is an form of fraud that results in the deliberate misappropriation of cash receipts. When the acceptable level of detection risk is low. The auditor's primary source of evidence for compensating bank balances is obtained from confirming other arrangements with banks. a. but it may also involve other types of cash receipts.

2. Recalculate revenue earned Vouch entries in investment accounts to broker’s advice.550. November 30.50.28 $18.25 minutes) a. 4. 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.30 minutes) a. Confirm securities held by others Inspect and count securities on hand Vouch entries in investment accounts to broker’s advice. Comprehensive Questions 18-26. documentary Documentary Mathematical Documentary Documentary (Estimated time .62 $15. $116. (Estimated time .18-24.25 190. 7.513.00 $19.001. Type of Evidence Mathematical Documentary Confirmation Physical. Inspect and count securities on hand Review documentation concerning market values Verify accuracy of balances. Financial Statement Assertion Valuation of allocation All assertions Existence or occurrence.062.25 150. 20XO Cash balance. Substantive Test 1. per books November 30. completeness.50 The cashier removed $719. 18-30. 6.487.901. 20XO Less outstanding checks: 62 182 284 8621 8623 8632 Cash which should be on hand for deposit Cash reported Amount of theft b. 5.00 1.00 253. 8. 20XO Add: Credit by bank Adjusted cash balance (on hand and in bank) Less adjusted bank balance: Bank balance.62 100. schedules and subsidiary ledgers Compare statement presentation with GAAP Compare statement presentation with GAAP b. 9. and (c) a bank overdraft that should be reported as a current liability.80 145.71 $ 4.794. He attempted to conceal his theft by: . 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. (b) disclosure of arrangements with banks.71 206. 3. Patricia Company Computation of Amount Abstracted by Cashier November 30. 10. documentary Documentary Physical.41 $ 719.91 3. 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.29 14.

the clerk may have become careless about promptly depositing the daily receipts. using standard procedures. Underfooting outstanding checks shown on the reconciliation. there is no separation of duties between cash receipts and accounts receivable. . the auditor should make a list of them without the clerk's knowledge. Reason for Other Audit Procedures Since the auditor. Individual items on the deposit slip should be compared to postings to the subsidiary accounts receivable ledger. Once more. If the accounts receivable clerk was careless in performing posting duties. Since there is no separation of duties between cash receipts and accounts receivable. The deposit slip should be totaled and compared to the remittances and the list prepared by the auditor for accuracy. 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. (Estimated time . Prior to the accounts receivable clerk obtaining the cash receipts. or may have been careless in checking the appropriateness of discounts taken. 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. other than from cash receipts journals. entries in the subsidiary accounts receivable ledger should be traced to the cash receipts journal and to the deposit slips. The auditor should ask Gutzler to ask the bank to send the statement containing that deposit directly to the auditor. 18-31. the amount of such discounts and the discount period should be checked.25 minutes) Other Audit Procedures Sources of debit entries in general ledger cash account. Review the subsidiary accounts receivable ledger and confirm accounts that have abnormal transaction activity such as consistently late payments. Subtracting an item from the bank balance that should be added to book balance. taken.o o o c. Not listing all outstanding checks. this procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts. 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. 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 accounts receivable clerk may have appropriated discounts which could have been. should be investigated and supporting documents examined. Also. This procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts. If Gutzier allows customers to take discounts. Since there is no separation of duties between cash receipts and accounts receivable. A surprise examination of cash receipts should be performed. Postings from other deposit slips should be traced to the cash receipts journal and the subsidiary accounts receivable ledger. a surprise examination is the only method of determining if cash receipts are being recorded and deposited properly. Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash. but were not. the accounts receivable clerk may have been careless in performing posting duties.

the auditor should perform that overall check to help substantiate that he or she has investigated all material items during the detail tests.000 200.30 minutes) a. the auditor should perform that review to help substantiate that all material items not covered during other tests have been investigated. Bank Accounts Ck. scan the cash receipts journal and bank statements for unusual items.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. is such exist.000 50. (Estimated time . recorded. Since internal control over cash receipts is weak.000 100.000 125. 125. Since internal control over cash receipts is weak.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. this overall test may highlight points of irregularities. 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. No. 3402. b. 18-32.000 50. . 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. Since internal control over cash receipts is weak. The opening and closing reconciliation of the proof of cash should be compared to the comparable reconciliation prepared by the controller. e. Reason for Other Audit Procedures Since internal control over cash receipts is weak.000 25.000 50. A1245 Deposits in transit: 3402 Check 3402 is indicative of kiting because the check was received. the auditor needs to be satisfied that cash receipts are recorded in the appropriate period. 2476 2890 3140 A1006 A1245 3402 c. but was not recorded as a disbursement until July 1. 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.Other Audit Procedures A proof-of-cash working paper should be prepared which reconciles total cash receipts with credits per bank statements.000 25. For those periods for which the above audit procedures were not performed and for a period after the balance sheet date. and deposited on June 30. 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. A1006.