Auditing the Financing/Investing Process: Cash and Investments Chapter 16 Auditing the Financing/Investing Process: Cash and Investments Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Cash and Cash Equivalents LO# 1 Cash and Cash Equivalents “Cash” reported in the financial statements represents currency on hand and cash on deposit in bank accounts, including certificates of deposit, time deposits, and savings accounts. “Cash equivalents” are frequently combined with cash for presentation in the financial statements. Definition: Short-term, highly liquid investments that are readily convertible to cash or so near their maturity that there is little risk of change in their value. Examples: Treasury bills and money market funds. 16-2 2

LO# 1 Cash and the Effect of Major Accounting Transactions/Business Processes 16-3

Types of Bank Accounts Types of Bank Accounts LO# 2 Types of Bank Accounts General Cash Account Imprest Cash Accounts Branch Accounts Types of Bank Accounts In order to optimize its cash flow, an entity implements procedures for accelerating the collection of cash receipts and delaying the payment of cash disbursements, to the extent delay is appropriate. 16-4 4

The Effects of Controls LO# 2 The Effects of Controls Controls for Cash Receipts Controls for Cash Disbursements The reliability of the entity’s controls over cash affects the nature and extent of the auditor’s tests of details. Completion of Monthly Bank Reconciliation 16-5

Substantive Analytical Procedures—Cash LO# 3&4 Because of the residual nature of the cash account, the auditor’s use of substantive analytical procedures for auditing cash is limited to . . . comparisons with prior years’ cash balances. comparisons with budgeted amounts. This limited applicability of substantive analytical procedures is normally offset by (1) extensive tests of controls and/or substantive tests of transactions for cash receipts and disbursements or (2) extensive tests of the entity’s bank reconciliations. 16-6 6

Substantive Tests of Details of Transactions and Balances LO# 3&4 Substantive Tests of Details of Transactions and Balances 16-7 7

Balance-Related Assertions LO# 3&4 Balance-Related Assertions 16-8

Auditing the General Cash Account LO# 5 Auditing the General Cash Account Copy of Bank Reconciliation To audit a cash account, the auditor should obtain these items. Standard Bank Confirmation Cutoff Bank Statement 16-9

Bank Reconciliation Working Paper LO# 5 16-10 10

Standard Bank Confirmation Form LO# 5 Standard Bank Confirmation Form 16-11 11

Date of Last Bank Reconciliation LO# 5 Cutoff Bank Statement Date of Last Bank Reconciliation 7 to 10 Days A cutoff bank statement normally covers the 7- to 10-day period after the date on which the bank account is reconciled. For reconciliation purposes, any item should have cleared the entity’s bank account during the 7- to 10-day period. 16-12

Tests of the Bank Reconciliation LO# 5 The auditor typically uses the following audit procedures to test the bank reconciliation: Verify the mathematical accuracy and agree the balance per the books to the general ledger. Agree the bank balance on the reconciliation with the balance shown on the standard bank confirmation. Trace the deposits in transit on the bank reconciliation to the cutoff bank statement. Compare the outstanding checks on the bank reconciliation with the canceled checks contained in the cutoff bank statement for proper payee, amount, and endorsement. Agree any charges included on the bank statement to the bank reconciliation. Agree the adjusted book balance to the cash account lead schedule. 16-13

Fraud-Related Audit Procedures LO# 6 Fraud-Related Audit Procedures Extended Bank Reconciliation Procedures Proof of Cash Tests for Kiting 16-14

Extended Bank Reconciliation Procedures LO# 6 Extended Bank Reconciliation Procedures In some instances, the year-end bank reconciliation can be used to cover cash defalcations. This is usually accomplished by manipulating the reconciling items in the bank reconciliation. For example, suppose an employee was able to steal $5,000 from the entity. The entity’s cash balance at the bank would then be $5,000 less than reported on the entity’s books. The employee could “hide” the $5,000 shortage in the bank reconciliation by including a fictitious deposit in transit. 16-15 15

Proof of Cash LO# 6 16-16 16

LO# 6 Tests for Kiting 16-17 17

Auditing a Payroll or Branch Imprest Account The audit of any imprest cash account such as payroll or a branch account follows the same basic audit steps discussed under the audit of the general cash account. 16-18

Potential for defalcation. Seldom perform substantive tests. LO# 6 Auditing Petty Cash Usually not material. Potential for defalcation. Seldom perform substantive tests. Document controls. 16-19

Disclosure Issues for Cash 16-20

Disclosure Issues for Cash 16-21 21

Disclosure Issues for Cash 16-22 22

Auditing Investments Common Stock Preferred Stock Debt Securities LO# 7 Auditing Investments Common Stock Preferred Stock Debt Securities Hybrid Securities 16-23

Control Risk Assessment—Investments LO# 8 Control Risk Assessment—Investments Here are some of the more important assertions for investments. Occurrence and Authorization Completeness Accuracy and Classification 16-24

LO# 9 Segregation of Duties 16-25

Substantive Procedures for Testing Investments LO# 10 Substantive Procedures for Testing Investments 16-26

Tests of Details—Investments LO# 10 Tests of Details—Investments Existence Auditing Standards state that the auditor should perform one of the following procedures when gathering evidence for existence: Physical examination Confirmation with the issuer Confirmation with the custodian Confirmation of unsettled transactions with the broker-dealer Confirmation with the counterparty Reading executed partnership or similar agreements 16-27

Tests of Details—Investments LO# 10 Tests of Details—Investments Valuation and Allocation The auditor must also determine if there has been any “other than temporary” or permanent decline in the value of an investment security. Auditing and accounting standards provide guidance for determining whether a decline in value below amortized cost is other than temporary. 16-28

Tests of Details—Investments LO# 10 Tests of Details—Investments Valuation and Allocation Here are some factors that may indicate a non-temporary impairment of investment value: Fair value is significantly below cost Decline in fair value is attributable to specific adverse conditions affecting a particular investment Decline in fair value is attributable to specific conditions, such as conditions in an industry or in a geographic area Management does not possess both the intent and ability to hold the investment long enough to allow for any anticipated recovery in fair value The decline in fair value has existed for an extended period A debt security has been downgraded by a rating agency The financial condition of the issuer has deteriorated Dividends have been reduced or eliminated, or scheduled interest payments on debt securities have not been made Permanently Impaired = Write down to new carrying amount 16-29

Tests of Details—Investments LO# 10 Tests of Details—Investments Disclosure Assertions Marketable securities need to be properly classified as held-to-maturity, trading, and available-for-sale. Held-to-maturity securities and individual available-for-sale securities should be classified as current or non- current assets based on whether management expects to convert them to cash within 12 months. All trading securities should be classified as current assets. 16-30

Advanced Module: Auditing Fair Value Measurements LO# 11 Advanced Module: Auditing Fair Value Measurements ASC Topic 820 Levels Level 1: Valuations based on quoted prices in active markets for identical assets. Also known as “marking to market.” Level 2: Valuations based on directly or indirectly observable market data for similar assets. Also known as “marking to matrix.” Level 3: Valuations based on management’s best judgment and involve management’s assumptions. Also known as “marking to model.” 16-31

Advanced Module: Auditing Fair Value Measurements LO# 11 Advanced Module: Auditing Fair Value Measurements Obtain an understanding of how management makes the fair value measurements. Consider whether specialized skills or knowledge are required. Test the entity’s fair value measurements. Evaluate the reasonableness of the fair value measurements. 16-32

End of Chapter 16 16-33 33