1. MODERN AUDITING 7th Edition
William C. Boynton
California Polytechnic State University at San Luis Obispo
Raymond N. Johnson
Portland State University
Walter G. Kell
University of Michigan
Developed by:
Gregory K. Lowry, MBA, CPA
Saint Paul’s College
John Wiley & Sons, Inc.

2. CHAPTER 18 AUDITING INVESTMENTS AND CASH BALANCES
Substantive Tests of Investments
Cash Balances
Substantive Tests of Cash Balances

3. CHAPTER 18 AUDITING INVESTMENTS AND CASH BALANCES
Other Considerations
Value-Added Services Related to Marketable Securities and Cash Balances
Appendix 18A: Preparing a Proof of Cash

4. Investments Overview of Investments
Investing in marketable securities interfaces with 2 other cycles:
1. Dividends and interest received on investments involve cash receipts transactions as part of the revenue cycle.
2. Purchases of securities with cash involves cash disbursements transactions as part of the expenditure cycle.

5. Investments
The following accounts are used in recording short-term and long-term investing transactions and the resulting income statement effects of those investments:

6. Selected Specific Audit Objectives for the Audit of Investments Figure 18-1

7. Investments Materiality
Securities held as short-term investments may be material to an entity’s short-term solvency, but income from such securities is seldom significant to the result of operations of entities outside of the financial services sector. Securities held as long-term investments may be material to both the balance sheet and income statement, depending on the entity.

8. Investments Inherent Risk
Inherent risk for investments is affected by many factors. The volume of investing transactions is generally quite low. However, securities are susceptible to theft, and the accounting for investments can become complex. In addition, inherent risks are more challenging to address with controls, and afford management as opportunity for manipulating the reporting for investments. Specifically, the proper classification of an investment may be contentious, which in turn affects the valuation method, income effects, and disclosure requirements applicable to the investment.

9. Investments Analytical Procedures Risk
Within an industry, the audit of investments will vary significantly from one company to another. Analytical procedures may compare current-year and prior-year balances, or they may compare actual results for the amount of investments and investment income with budgets or other documentation of management’s plans.

10. Investments Control Risk
The understanding of several control environment factors is relevant to the audit of the investing cycle.
The information and communication system must capture and retain all the necessary cost, fair value, and other data required for each method of accounting for the various categories of investments in equity and debt securities, both at acquisition and at subsequent reporting dates. Thus, accounting personnel must be familiar with these requirements and capable of implementing them. Separate subsidiary investment ledgers may be maintained for the various categories of investments.

11. Investments Common Documents and Records
The documents and records applicable to this cycle are:
1. Stock certificate. An engraved form showing the number of shares of stock owned by a shareholder in a corporation. This document provides evidence for the existence or occurrence assertion.
2. Bond certificate. An engraved form showing the number of bonds owned by a bondholder.
3. Bond indenture. A contract stating the terms of bonds issued by a corporation.
4. Broker’s advice. A document issued by a broker specifying the exchange price of investing transactions; it is the primary source document for recording investing transactions. The advice provides evidence for the valuation or allocation assertion.

12. Investments
5. Broker’s statement. A monthly statement issued by a broker specifying securities held in safekeeping by the broker, their cost, and their fair market value at the end of the month. In addition, the monthly statement usually summarizes any transactions that took place during the month.
6. Books of original entry. The general journal is used to record such items as the accrual of bond interest revenue, market adjustments under the fair value method, and income earned under the equity method of accounting. The cash receipts journal is used to record the proceeds from sales transactions and the receipt of interest and dividends. The voucher and check registers are used in purchasing and paying for the cost of securities.

13. Investments
7. Investment subsidiary ledger. Separate subsidiary ledgers may be used for each different class of investments when the company has a portfolio consisting of many different investments.

14. Investments Functions and Related Controls
Activities in the investing cycle include the following investing functions and related controls:
1. Authorize investment transactions:
a. Purchasing securities. Purchases are made in accordance with management’s authorizations.
b. Selling securities. Sales are made in accordance with management’s authorizations.

15. Investments 2. Receive or deliver securities:
a. Receiving/safeguarding/delivering securities. Securities are usually held in safekeeping by a broker, who is responsible for the safekeeping of securities along with the receipt and delivery of securities for the entity. In rare instances, securities are stored in safes or vaults, and access is restricted to authorized personnel; securities are periodically inspected and counted and compared with recorded balances.

16. Investments
b. Receiving periodic income. Dividend and interest checks are promptly deposited intact. When securities are held in safekeeping, dividend and interest income is deposited directly to the entity’s account by the broker.
3. Record transactions:
a. Recording purchases, sales, and income. Transactions are recorded based on appropriate supporting documentation; the duties of recording transactions and maintaining custody of the securities are segregated.

17. Investments
b. Recording market adjustments and reclassifications. Changes in fair values and in circumstances pertaining to the proper classification of investments are periodically analyzed and recorded.
4. Settle transactions:
a. Receiving cash. Control procedures should provide reasonable assurance that documentation establishing accountability is created for cash receipts from the sale of investments and for the transfer of funds from a brokerage account to the primary checking account.

18. Investments
b. Disbursing cash. Cash disbursements to settle purchases of investments should include comparisons of disbursements with underlying brokerage advices and controls over the transfer of funds to a brokerage account from the primary checking account.
5. Assess investment performance and reporting. Performance reviews are made by management to detect poor investment performance and/or erroneous reporting, including comparisons of investment balances and rates of return for various classes of investments with budgeted amounts, and reviews of the propriety of the classification of individual investments.

19. Substantive Tests of Investments
Determining Detection Risk
In applying the audit risk model to determine detection risk for investing cycle assertions, it may be necessary for the auditor to combine his or her inherent and control risk assessments for cash receipts and cash disbursements transactions with the additional considerations unique to investing transactions.

20. Substantive Tests of Investments
Difficulties in designing controls to adequately address risks associated with:
1. the use of fair values, when required, and
2. the proper classification of investments often means that low acceptable levels of detection risk for tests of details are usually specified for the valuation or allocation and presentation and disclosure assertions.

21. Substantive Tests of Investments
Initial Procedures
The series of procedures in this category as shown in Figure 18-2 follows the pattern established for major accounts in the other cycle chapters. That is, first, the auditor obtains an understanding of the entity’s business and industry. It is important for the auditor to understand the economic drivers that allow an entity to engage in investing activities, such as an entity’s policy for investing excess cash, its financing activities, and its ability to generate free cash flow. Second, agreement of the beginning investment balances with audited amounts in the prior year’s working papers is verified.

22. Substantive Tests of Investments
Next, the activity in investment-related accounts is reviewed to determine the presence of any entries that are unusual in nature or amount that should be investigated. Then, client-prepared schedules of all investments, or additions and disposals in the current period, are checked for mathematical accuracy and agreement with the underlying accounting records. The latter procedure includes determining that schedules and subsidiary investment ledgers agree with related general ledger control account balances. The schedules can then serve as the basis for additional substantive tests.

23. Substantive Tests of Investments
Analytical Procedures
An important part of the investing cycle is determining that the financial information subjected to audit is consistent with the auditor’s expectations. When performing analytical procedures, the auditor should maintain an appropriate level of professional skepticism and investigate abnormal results. If the results of analytical procedures are consistent with the auditor’s expectations, audit strategy might be modified to reduce the extent of details tests of transactions and balances.

24. Substantive Tests of Investments
Test of Details of Transactions
Tests of details of transactions may be particularly effective as an audit approach when the entity has a low volume of transactions. These substantive tests consist of vouching the individual debits and credits in the various investment accounts.
For investments accounted for by the equity method, post-acquisition debits can be vouched to documentation showing the investor’s share of the investee’s earnings. Credits can be vouched to documentation of dividends received from investees or to worksheets showing the calculation of the periodic amortization of the excess of cost over underlying book value.

25. Substantive Tests of Investments
Knowledge of the proper accounting for investing activities affecting other investment balances will inform the auditor as to the sources to which the debits and credits can be vouched. Depending on the particular debits or credits being vouched, careful examination of the supporting documentation can provide evidence bearing on any of the 5 categories of assertions.

26. Substantive Tests of Investments
Test of Details of Balances
3 substantive tests in this category are:
1. inspect and count securities on hand,
2. confirm securities held by others, and
3. recalculate investment revenue earned.

27. Substantive Tests of Plant Asset Balances
Test of Details of Balances: Accounting Estimates
When auditing investments, the auditor must apply significant audit judgment with respect to evaluating:
1. the proper classification of investments and
2. the fair value of investments.

28. Cash Balances Relationship of Cash Balances to Transaction Cycles
5 transaction cycles relate directly to general cash balances, as shown in Figure The cycles are revenue, expenditure, financing, investing, and personnel services. The production cycle does not have transactions that relate directly to cash, while the investing and financing cycles both increase and decrease cash. The revenue cycle increases, and the expenditure and personnel services cycles, decrease cash.

29. Selected Specific Audit Objectives for Cash Balances Figure 18-5

30. Cash Balances Materiality
For many entities, the portion of current or total assets at any point in time represented by cash balances is a very small, and often immaterial. However, with transactions in 5 of the 6 transaction cycles affecting cash, the amount of cash flowing through the accounts over a period of time can be quite material. In fact, the volume of transactions that affects cash is usually greater than for any other account in the financial statements.

31. Cash Balances Inherent Risk
The high volume of transactions alone contributes to a significant level of inherent risk for certain cash balance assertions, particularly existence or occurrence and completeness. In addition, the nature of cash balances makes them susceptible to theft as numerous kinds of fraudulent schemes involving cash have borne out. In contrast to receivables or inventories, however, the risks pertaining to the rights and obligations, valuation or allocation, and presentation and disclosure assertions for cash are minimal due to the absence of complexities involving rights, accounting measurements, estimates, and disclosures.

32. Cash Balances Analytical Procedures Risk
Cash balances are significantly affected by management’s operating, investing, and financing decisions and strategies. Consequently, in some audits these balances may not be expected to show a stable or predictable relationship with other current or historical financial or operating data.

33. Cash Balances
Well-managed companies regularly develop cash budgets, projecting:
1. cash receipts based on anticipated collection of receivables,
2. cash disbursements for operating needs, and
3. investing and financing activities.

34. Cash Balances Control Risk
Cash receipts and disbursements often represent routine transactions that can be controlled by a sound system of internal controls, which may allow the auditor to assess control risk at a low level. Because of the susceptibility of cash balances to theft, many auditors carefully evaluate internal controls over cash, and ensure that any reportable conditions (Chapter 19) are clearly communicated to management.

35. Substantive Tests of Cash Balances
Determining Detection Risk
Some small business owners want the auditor to carefully audit cash to provide them assurance about the validity of cash balances. As a result, the auditor will follow a primarily substantive approach emphasizing tests of details even when the audit risk model might say that such an approach is not necessary because of the effectiveness of analytical procedures or internal controls.
Inherent risk is normally high due to the susceptibility of cash to misappropriation.

36. Substantive Tests of Cash Balances
Designing Substantive Tests
A listing of possible substantive tests to achieve the specific audit objectives for cash balances is presented in Figure The listing is organized following the general framework for developing audit programs for substantive tests.

37. Substantive Tests of Cash Balances
Initial Procedures
Before proceeding with details tests of cash balances, the auditor should ensure that he or she has obtained an understanding of the entity’s business and the importance of cash balances to the entity.
The starting point for verifying cash balances is tracing the current period’s beginning balances to the ending audited balances in the prior year’s working papers (when applicable). Next, the current period’s activity in the general ledger cash accounts should be reviewed for any significant entries that are unusual in nature or amount that require special investigation.

38. Substantive Tests of Cash Balances
Analytical Procedures
The effectiveness of analytical procedures varies significantly from client to client. The effectiveness of analytical procedures may reduce the amount of evidence needed from other substantive tests relative to that required when the data do not conform to reasonable expectations developed from cash budgets or forecasts, or company policies regarding the investment of surplus cash.

39. Substantive Tests of Cash Balances
Test of Details of Transactions
There are 2 important concurrent tests in this category:
1. performing cash cutoff tests and
2. tracing bank transfers.

40. Substantive Tests of Cash Balances
Test of Details of Balances
There are 5 commonly used substantive tests of cash balances in this category:
1. counting cash on hand,
2. confirming bank deposit and loan balances,
3. confirming other arrangements with banks,
4. scanning, reviewing, or preparing bank reconciliations, and
5. obtaining and using bank cutoff statements.

41. Other Considerations Tests to Detect Lapping
Lapping is an irregularity that results in the deliberate misappropriation of cash receipts. It may involve either a temporary or a permanent abstraction of cash receipts for the personal use of the individual perpetrating the unauthorized act. Lapping is usually associated with collections from customers, but it may also involve other types of cash receipts.

42. Other Considerations Auditing Procedures
Tests to detect lapping are only performed when control risk for cash receipts transactions is moderate or high. There are 3 procedures that should detect lapping:
1. confirm accounts receivable,
2. make a surprise cash count, and
3. compare details of cash receipts journal entries with the details of corresponding daily deposit slips.

43. Value-Added Services Related to Marketable Securities and Cash Balances
Following are some important value-added opportunities that CPAs may provide using the knowledge obtained during the audit of marketable securities and cash balances:
1. Determine key assumptions regarding cash collections and the payment of operating expenses that influence the forecasting of cash balances.
2. Assist management in the development of models to forecast cash balances, needed borrowing, or potential surplus cash balances available for investment.

44. Value-Added Services Related to Marketable Securities and Cash Balances
3. Identify opportunities for changes in business practices, such as changes in credit policy or changes in inventory management, which will improve cash flow.
4. Assist management in developing policies for the short-term investment of excess cash.
5. Identify opportunities for improving the rate of return on short-term investments of excess cash.

45. Preparing a Proof of Cash Appendix 18A
A proof of cash is a simultaneous reconciliation of bank transactions and balances with corresponding data per books for a specified period of time. The time period may be for one or more interim months or for the last month of the fiscal year. This test is normally made only when the auditor has concluded that a low level of detection risk for bank balances must be achieved.

46. Preparing a Proof of Cash Appendix 18A
The following steps are helpful in preparing a proof of cash:
1. Obtain the bank and book totals from the bank statement and cash in bank account, respectively.
2. Obtain the beginning and ending balance reconciling items from the bank reconciliations at the designated dates.
3. Determine the reconciling items for the 2 middle columns by analysis.

47. CHAPTER 18 AUDITING INVESTMENTS AND CASH BALANCES

48. Copyright
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