Chapter 2

Audit of Cash and Other

marketable securities
 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

auditing II CH 2 2
 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
auditing II CH 2 3
 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

auditing II CH 2 4
 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
auditing II CH 2 5
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

auditing II CH 2 6
 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
auditing II CH 2 7
 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)
auditing II CH 2 8
 Substantive Testing of
Cash Balances (continued)
• Independent bank reconciliation
• Bank cutoff statement
• Bank confirmation
• Obtaining year-end cutoff
information

auditing II CH 2 9
 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

auditing II CH 2 10
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
auditing II CH 2 11
 What is 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

auditing II CH 2 12
 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
auditing II CH 2 13
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

auditing II CH 2 14
 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

auditing II CH 2 15
 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

auditing II CH 2 16
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
auditing II CH 2 17
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

auditing II CH 2 18
 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
auditing II CH 2 19
 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

auditing II CH 2 20
• END OF CHAP ER 2

auditing II CH 2 21