Cash and Financial Investments Chapter 10 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

10-2 Sources and Nature of Cash  Sources General checking account Payroll checking accounts Petty cash Savings accounts  Cash equivalents Money market funds Certificates of deposit Savings certificates

10-3 Objectives for the Audit Cash Objectives for the Audit Cash 1. Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to cash 2. Obtain an understanding of internal control over cash. 3. Assess the risks of material misstatement of cash and design tests of controls and substantive procedures that: a.Substantiate the existence of recorded cash and occurrence of the related transactions b.Establish the completeness of recorded cash c.Verify the cutoff and accuracy of cash transactions d.Determine that the client has rights to recorded cash e.Determine that the presentation and disclosure of cash, including restricted funds, are appropriate

10-4 Audit time for cash  Cash typically has a small account balance, but auditors devote a large proportion of total audit hours because: Liabilities, revenues, expenses and most other assets flow through cash Most liquid asset so greater temptation for misappropriation High risk account

10-5 Management Assurance  Finance and accounting department work together to provide assurance that: All cash that should have been received was in fact received, recorded accurately and deposited promptly Cash disbursements have been made for authorized purposes only and have been properly recorded Cash balances are maintained at adequate, but not excessive, levels by forecasting

10-6 Guidelines for Internal Control (1 of 2) 1. Do not permit any one employee to handle a transaction from beginning to end. 2. Separate cash handling from recordkeeping. 3. Centralize receiving of cash to the extent practical. 4. Record cash receipts on a timely basis. 5. Encourage customers to obtain receipts and observe cash register totals.

10-7 Guidelines for Internal Control (2 of 2) 6. Deposit cash receipts daily. 7. Make all disbursements by check or electronic funds transfer, with the exception of small expenditures from petty cash. 8. Have monthly bank reconciliations prepared by employees not responsible for the issuance of checks or custody of cash. The completed reconciliation should be reviewed promptly by an appropriate official. 9. Monitor cash receipts and disbursements by comparing recorded amounts to forecasted amounts

10-8 Internal Control Over --Cash Receipts Internal Control Over --Cash Receipts  Cash sales  Involvement of two or more employees  Cash Registers  Electronic point of sales systems  Collections of receivables  Initial listing of cash receipts  Custody and depositing of cash receipts  Maintenance of customer account records  Reconciliation of customers’ ledgers with control accounts  Mailing monthly statements to customers  Collection activity and past-due accounts  Direct receipt of funds by financial institution

10-9 Cash Receipts Flowchart

10-10 Internal Control--Cash Disbursements Internal Control--Cash Disbursements  Segregation of duties  Payment by check or electronic funds transfer  Pre-numbered check  Match of purchase order and receiving documents with vendor’s invoice  Review of supporting documents by authorized check signer  Cancel of supporting documents  Authorized check signer should mail checks  Monthly bank reconciliation

10-11

10-12 Audit of Cash (1 of 3) A. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to cash. B. Obtain an understanding of internal control over cash. C. Assess the risks of material misstatement and design further audit procedures.

10-13 Audit of Cash (2 of 3) D. Perform further audit procedures—tests of controls. 1. Examples of tests of controls: a. Test the accounting records and reconciliations by reperformance. b. Compare the details of a sample of cash receipts listings to the cash receipts journal, accounts receivable postings, and authenticated deposit slips. c. Compare the details of a sample of recorded disbursements in the cash payments journal to account payable postings, purchase orders, receiving reports, invoices, and paid checks. 2. If necessary, revise the risk of material misstatement based on the results of tests of controls.

10-14 Audit of Cash (3 of 3) E. Perform further audit procedures—substantive procedures for cash transactions and balances. 1. Obtain analyses of cash balances and reconcile them to the general ledger. 2. Send standard confirmation forms to financial institutions to verify amounts on deposit. 3. Obtain or prepare reconciliations of bank (financial institution) accounts as of the balance sheet date and consider the need to reconcile bank activity for additional months. 4. Obtain a cutoff bank statement containing transactions of at least seven business days subsequent to balance sheet date. 5. Count and list cash on hand. 6. Verify the client’s cutoff of cash receipts and cash disbursements. 7. Analyze bank transfers for the last week of audit year and the first week of following year. 8. Investigate any checks representing large or unusual payments to related parties. 9. Evaluate proper financial statement presentation and disclosure of cash.

10-15 Summary of Substantive Tests for Cash Balances

10-16 Examples of fraud with cash  Do the client’s records reflect all cash transactions that took place during the year?  Were all cash payments properly authorized and for a legitimate business purpose?  Fraud that may be disclosed Interception of cash receipts before any record is made Payment for materials not received Duplicate payments Overpayments to employees or payments to fictitious employees Payments for personal expenditures of officers or related parties

10-17

10-18 Potential Misstatements--Cash Disbursements  Inaccurate recording of a purchase or disbursement  Duplicate recording and payment of purchases  Unrecorded disbursements

10-19 Standard Confirmation--General Information  Confirmation of amounts on deposit by direct communication with financial institution officials  Standard form agreed to by: AICPA American Bankers Association Bank Administration Institute  Addresses only the client’s deposit and loan balances

10-20 Standard Confirmation

10-21 Proof of Cash General Information  Reconciles the account balance and reconciles cash transactions during a specified period.  Used to identify: Cash receipts and disbursements recorded in the accounting records, but not on the bank statement. Cash deposits and disbursements recorded on the bank statement, but not on the accounting records. Cash receipts and disbursements recorded at different amounts by the bank than in the accounting records.

10-22 Proof of Cash

10-23 Check 21 Act  Checks may be processed electronically  Electronic processing creates a substitute check – an electronic image of check  Legal equivalent of original check for all purposes  Audit implications Need to rely on substitute check for evidence of check Impossible for clients to kite checks (manipulate bank balances to conceal cash shortage)

10-24 Kiting  Manipulations that utilize temporarily overstated bank balances to conceal cash shortage or meet short-term cash needs  Auditors can detect kiting by preparing a schedule of bank transfers for a few days before and after balance sheet date  Misstatements Date of recording per transfer per the books are from different financial statement periods Date the check was recorded by the bank is from financial statement period prior to books

10-25 Bank Transfer Schedule

10-26 Specialized knowledge to audit financial investments  Identifying controls at service organizations that provide financial services and are part of the client’s information system.  Obtaining an understanding of information systems for securities and derivatives that are highly dependent on computer technology.  Applying complex accounting principles to various types of financial investments.  Understanding the methods used to determine the fair values of financial investments, especially those that must be valued using complex valuation models.  Assessing inherent and control risk for assertions about derivatives used in hedging activities.

10-27 Objectives for the Audit of Financial Investments 1. Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to financial instruments 2. Obtain an understanding of internal control over financial instruments. 3. Assess the risks of material misstatement of financial instruments and design tests of controls and substantive procedures that: a.Substantiate the existence of recorded financial investments and the occurrence of investment transactions. b.Establish the completeness of financial investments and investment transactions. c.Verify the cutoff of investment transactions. d.Determine that the client has rights to recorded investments.

10-28 Controls Over Financial Investments  Establishment of formal investment policies  Review and approval of investment activities by the investment committee of the board of directors  Separation of duties among employees 1. Authorizing purchases and sales 2. Having custody of the securities 3. Maintaining records  Detailed records of all securities owned and the related revenue from interest and dividends  Registration in the name of the company  Periodic physical inspection of securities  Determination of accounting for complex instruments by competent personnel

10-29 Audit of Financial Investments (1 of 4) A. Use the understanding of the client and its environment to consider inherent risks, including fraud risks related to financial investments. B. Obtain an understanding of internal control over financial investments C. Assess the risks of material misstatement and design further audit procedures.

10-30 Audit of Financial Investments (2 of 4) D. Perform further audit procedures—tests of controls. 1. Examples of tests of controls: a. Trace several transactions for purchases and sales of investments through the accounting system. b. Review and test reports of investment activity prepared for the investment committee. c. Inspect reports by internal auditors regarding their periodic inspection and review of securities and derivative instruments. d. Inspect monthly reports on securities owned, purchased, and sold and amounts of revenue earned and budgeted. 2. If necessary, revise the risk of material misstatement based on the results of tests of controls.

10-31 Audit of Financial Investments (3 of 4) E. Perform further audit procedures—substantive procedures for investment transactions and year-end balances. 1. Obtain or prepare analyses of the investment accounts and related revenue, gain, and loss accounts and reconcile them to the general ledger. 2. Inspect securities on hand and review agreements underlying derivatives. 3. Confirm securities and derivative instruments with holders and counterparties. 4. Vouch selected purchases and sales of financial investments during the year and verify the client’s cutoff of investment transactions. 5. Review investment committee minutes and reports.

10-32 Audit of Financial Statements (4 of 4) E. further audit procedures cont. 6. Perform analytical procedures. 7. Make independent computations of revenue from securities. 8. Inspect documentation of management’s intent to classify derivative transactions as hedging activities. 9. Evaluate the method of accounting for investments. 10. Test the valuation of financial investments. 11. Evaluate financial statement presentation and disclosure of financial investments.

10-33 Test Valuation  FASB No. 133 “Accounting for Derivative Instruments and Hedging Activities” All derivative instruments valued at fair values Unrealized gains or losses depend on classification as hedges  FASB No. 159 Allows companies to choose to use fair value accounting rather than approach in FASB No. 133

10-34 Potential Misstatements--Financial Investments  Misstatement of recorded value of investments  Unauthorized investment transactions  Incomplete recording of investments  Inadequate disclosure of the nature of investment activities

10-35 Summary of Substantive Procedures for Financial Investments