Auditing Cash and Marketable Securities (Chapter 10)

AUDITING
A RISK-BASED APPROACH
TO CONDUCTING A
QUALITY
AUDIT
9th Edition
Karla M. Johnstone | Audrey A. Gramling | Larry E.
Rittenberg
Chapter 10
Auditing Cash and
Marketable Securities
Copyright 2014 South-Western/Cengage Learning
Learning Objectives
1.
2.
3.
4.
Identify the significant accounts,

disclosures, and relevant assertions in
auditing cash accounts
Identify and assess inherent risks of
material misstatement in cash accounts
Identify and assess fraud risks of material
misstatement in cash accounts
Identify and assess control risks of
material misstatement in cash accounts
10-2
Learning Objectives
5.
6.
7.
Describe how to use preliminary analytical

procedures to identify possible material
misstatements for cash accounts,
disclosures, and assertions
Determine appropriate responses to
identified risks of material misstatement for
cash accounts, disclosures, and assertions
Determine appropriate tests of controls and
consider the results of tests of controls for
cash accounts, disclosures, and assertions
10-3
Learning Objectives
8.
9.
10.
Determine and apply sufficient appropriate

substantive audit procedures for testing cash
accounts, disclosures, and assertions
Identify types of marketable securities,
articulate the risks and controls typically
associated with these accounts, and outline an
audit approach for testing these accounts
Apply frameworks for professional decision
making and ethical decision making to issues
involving the audit of cash accounts,
10-4
THE AUDIT OPINION

FORMULATION PROCESS
10-5
PROFESSIONAL JUDGMENT IN CONTEXT Fraudulent Petty Cash Transactions at Koss

Corporation
Former vice president of finance
orchestrated a $31 million embezzlement
Remediation actions
Eliminating petty cash fund
10-6
PROFESSIONAL JUDGMENT IN CONTEXT Fraud at Peregrine Financial

Embezzlement of over $200 million from
Peregrine Financial Groups (PFG)
brokerage clients over a 20-year period
Bankruptcy filed immediately after
implementation of change in online system
Where bank statement information would be
sent electronically directly to National Futures
Association
10-7
PROFESSIONAL JUDGMENT IN CONTEXT Fraud at KOSS Corporation and Peregrine

Financial
Why is cash an inherently risky account? (LO
2, 3)
What controls should be in place to help
ensure that cash accounts are not
misappropriated? (LO 4)
What are the audit implications of poor
controls over cash accounts? (LO 6)
What types of audit procedures would
auditors employ when auditing cash? (LO 7,
8)
10-8
Learning objective 1
Identify the significant accounts, disclosures,

and relevant assertions in auditing cash
accounts
Major types of cash accounts

General checking accounts
Cash management accounts
Imprest payroll accounts
Petty cash accounts
Marketable security accounts: A
security that is readily marketable and
held by a company as an investment
10-10
Imprest Payroll Accounts

Imprest bank account
Normally carrying a zero balance
Replenished when checks are to be written
against the account
Provides additional control over cash
Payroll account - The most widely used
imprest bank account
Company makes a deposit equal to amount of
payroll checks issued
10-11
BENEFITS OF Cash
Management Techniques
Speed the collection and deposit of
cash
Reduce the amount of paperwork
Automate the cash management

process
10-12
Cash Management Techniques
Lockboxes
Electronic
Funds
Transfers
Cash
Management
Agreements
with
Financial
Institutions
Compensatin
g Balances
10-13
Lockboxes
Cash management arrangement with a bank
whereby payments are sent directly to a post
office box number accessible to clients bank
Bank opens cash remittances and directly deposits
money in clients account
Advantages
Company immediately earns interest on deposited
funds
Manual processing is shifted to bank
Speeds up receipt of cash and allows organization
to use cash to earn a return
10-14
Relevant Financial Statement

Assertions relevant to cash
Existence or occurrence
Cash balances exist at balance sheet date
Completeness
Cash balances include all cash transactions that occurred during
the period
Rights and obligations
Company has title to the cash accounts as of balance sheet date
Valuation or allocation
Recorded balances reflect true underlying economic value of
those assets
Presentation and disclosure
Cash is properly classified on the balance sheet and disclosed in

notes to the financial statements
10-15
Identify and assess inherent risks of material

Performing Risk Assessment

Procedures for Cash Accounts
Information useful in assessing risk of
material misstatement is obtained
Inherent risks
Financial statement level
Account and assertion level
Fraud risks
Feedback from audit team brainstorming
sessions
Strengths and weaknesses in internal control
Results from preliminary analytical procedures
10-17
Reasons for Identifying cash as

having high Inherent Risk
Volume of activity
Liquidity
Automated systems
Importance in meeting debt
covenants
Can be easily manipulated
10-18
Inherent Risk Analysis

Questionnaire: Cash
10-19
Inherent Risk Analysis

Questionnaire: Cash
10-20
Learning Objective 3
Identify and assess fraud risks of material

Topics to be covered in a
brainstorming session
10-22
Auditing in Practice - Common

Fraud Schemes Relating to
Cash
Frauds relating to cash receipts
Inventory sold, but employee does not

record the sale and steals the cash
Employee receives a check and deposits it,
but does not record the sale; then the
employee writes a check out to himself and
does not record the disbursement
Employee collects a customer payment,
steals cash, and writes off accounts
receivable as uncollectible
10-23

Cash
Lapping: Employee steals a payment from
one customer, and covers it up by using
payments from another customer to
disguise the theft
Skimming: Type of fraud that occurs when
an employee makes a sale but does not
record it, and steals the cash
10-24

Cash
Frauds relating to cash payments
Purchasing merchandise and recording sale at

an unauthorized discounted amount
Selling merchandise to a friend at a discounted
price; friend returning merchandise for a refund
at undiscounted price; splitting profits
Employee stealing cash and concealing it by
recording a fictitious discount
Employee writing a check to a fictitious vendor
and depositing the check into an account
controlled by the employee
10-25
Identify and assess control risks of material

Common Controls Over Cash
10-27
Common Controls Over Cash
10-28
Auditing in Practice - The Parmalat

Fraud and Its Many Victims
Evolved over a 10-year period
Included invention of over $11 billion in
fictitious cash in offshore front companies
to offset liabilities at parent company
In reality, cash was not accounted for and
Parmalat had only about 500 million euros
in cash
Involved large number of individuals
acting collusively in various ways
10-29
Implications of Weak Controls

Related to Completeness
Employee required to record a cash receipt
Not performing the task
Not reflecting the cash being received, a
sale made, or reduced accounts receivable
10-30
Auditing in Practice - Skimming

and the Completeness
Assertion
When a transaction is not immediately
recorded, completeness assertion is
violated
Applicable where customers pay cash
directly to an employee
10-31
Controls for Petty Cash

Limiting access by keeping funds in a locked box
Requiring receipts for petty cash disbursements
with:
Date
Amount received
Purpose or use for funds
Name of employee receiving funds
Reconciling petty cash fund before replenishing it

Keeping customer receipts separate from petty
cash funds
10-32
Controls for Cash Management

Techniques
Lockboxes
Electronic funds transfers
Cash management agreements

with financial institutions
10-33
Assessing Control Risk for Cash

Controls minimize potential risks to cash
accounts
Requires the auditor to have an understanding
of internal controls for:
Integrated audits
Financial statement only audits
Understood by:
A walkthrough of process
Inquiry
Observation
Review of documentation
10-34

At account and assertion levels, considering:
Entity-wide controls
Transaction controls
At entity-wide level, considering control

environment
Commitment to financial accounting competencies

Independence of the board of directors
Risk assessment
Information and communication
Monitoring controls
10-35

Integrated audit of cash involves evaluating:
Design of internal controls
Operation of internal controls
Smaller organizations - Testing of operating

effectiveness of controls is not a required
part of the audit
Larger organizations - Evaluating and
testing of internal controls happen via an
integrated audit
10-36
Control Risk Questionnaire Cash
10-37
Control Risk Questionnaire Cash
10-38
Documenting Controls
Documenting auditors understanding of
internal controls for:
Integrated audits
Financial statement only audits
A questionnaire often used to guide

auditors in documenting understanding of
internal controls
10-39
EXHIBIT 10.3 - Control Activities

Questionnaire: Cash Receipts
10.3 A.png
10-40
Describe how to use preliminary analytical

procedures to identify possible material
misstatements for cash accounts, disclosures, and
assertions
Performing Preliminary
Analytical Procedures
Helps identify areas of potential
misstatements when planning the audit
Cash is examined in relation to:
Operational data
Budgetary forecasts
Requires awareness of importance of cash

balances to debt covenants
10-42
Performing Preliminary
Analytical Procedures
Relationships indicating heightened risk of
fraud in cash:
Consistent profits over several years, but
cash flows are declining
Unexpected reductions in accounts
receivable collections, or timeliness of
collections
Unexpected declines in petty cash account
10-43
Using Trend Analysis of Account Balances

and Ratios in Preliminary Analytical
10-44
Using Trend Analysis of Account Balances

and Ratios in Preliminary Analytical
10-45
Determine appropriate responses to identified risks

of material misstatement for cash accounts,
Responding to Identified Risks

of Material Misstatement
Audit procedures are proportional to assessed
risks
Areas of higher risk receive more audit
attention and effort
Developing audit approach that contains:

Tests of controls (if applicable)
Substantive procedures, including analytical
procedures
Audit programs are customized based on

assessment of risk of material misstatement
10-47
EXHIBIT 10.5 - Panel A: Sufficiency of

Evidence for Existence and Completeness
of Cash
10-48
EXHIBIT 10.5 - Panel B: Approaches to

Obtaining Audit Evidence for Existence and
Completeness of Cash
10-49
Determine appropriate tests of controls and consider

the results of tests of controls for cash accounts,
Selecting Controls to Test and

Performing Tests of Controls
Auditors make decisions about:
Which controls to test for formulating an
opinion on entitys internal controls
Whether the level of control risk warrants
reduction of substantive testing
10-51
Selecting Controls to Test and

Performing Tests of Controls
Tests of transactions controls
Inquiry of personnel performing the control
Observation of control being performed
Inspection of documentation confirming that
control has been performed
Reperformance of control by individual
testing the control
10-52
Considering the Results of

Tests of Controls
Control deficiencies
identified
No control deficiencies
identified
Assessing those deficiencies

to determine their severity
Determining that
preliminary assessment of
control risk as low is
appropriate
Modifying preliminary
control risk assessment
Determining the extent that

controls can provide
evidence on correctness of
account balances
Documenting implications of
control deficiencies
Determining planned
substantive audit
procedures
10-53
Determine and apply sufficient appropriate

substantive audit procedures for testing cash
accounts, disclosures, and assertions
Auditing in Practice - Weaknesses in

Substantive Procedures Related to
Cash
Auditor needs to consider types of
substantive procedures for cash that
should be performed
Make sure that engagement team
performs those procedures
PCAOB disciplinary proceedings against
two audit firms provide insight on
weaknesses in cash-related audit
procedures
10-55
Substantive Analytics for Cash

Accounts
Focusing on substantive tests of details
Minimal substantive analytics to be
performed include identifying significant:
Fluctuations in cash balances
Differences between budgeted and actual
levels of cash
10-56
Substantive Tests of Details for

Cash Accounts
Preparing independent bank
reconciliations
Obtaining bank confirmations and

bank cutoff statements
Preparing bank transfer schedules
10-57
Preparing Independent Bank

Reconciliations
Provides evidence for accuracy of year-end
cash balance
Process includes reconciling balance per
bank statements with balance per books
Auditor independently verifies the
following items when testing clients bank
reconciliation
Balance as per bank
statement
Deposits in transit
Outstanding checks
Other adjustments
10-58
EXHIBIT 10.7 - TESTS OF

CLIENTS BANK
RECONCILIATION
10.7.png
10-59
Bank Confirmation
A standard confirmation sent to all banks with
which the client had business during the year
Used to obtain information about year-end
cash balance and additional information
about loans outstanding
Seeks information on:
Clients deposit balances
Existence of loans
Due dates of loans
10-60
Bank Confirmation
Interest rates
Dates through which interest has been paid
Collateral
An asset or a claim on an asset held by a
borrower or an issuer of a debt instrument
To serve as a guarantee for value of a loan or
security
If the borrower fails to pay interest or
principal, collateral is available to lender to
recover principal amount of loan
10-61
EXHIBIT 10.8 - Standard Bank

Confirmation: Account Balances
10.8.png
10-62
Auditing in Practice Confirmations with Financial

Institutions
PCAOB-proposed Auditing Standard would
require auditor to:
Perform confirmation procedures for cash
and other relationships with financial
institutions
10-63
OBTAINING BANK
CONFIRMATIONS LOAN
GUARANTEES
These requirements are referred to as

covenants
A violation of covenants makes loans
immediately due and payable
Considering clients ability to continue to

operate as a going concern
In case of a long-term debt, reclassifying it
as a current liability
10-64
EXHIBIT 10.9 - Standard Bank

Confirmation: Loan Guarantees
10.9.png
10-65
Obtaining Year-End Cutoff

Information as Part of Bank
Confirmation Process
Obtaining information on last checks
issued in fiscal year
Last check number
Observing that all previous checks had

been mailed
Obtaining information on last cash receipts
10-66
Cutoff Bank Statements

A statement for a period of time
determined by client and auditor
Shorter than that of regular month-end
statements
Sent directly to auditor, who uses it to
verify reconciling items on clients yearend bank reconciliation
10-67
Preparing Bank Transfer

Schedules
Kiting: Fraudulent cash scheme to overstate
cash assets at year end by showing the
same cash in two different bank accounts
Bank transfer schedule: Audit document
listing all transfers between client bank
accounts
Starts shortly before year end and continues
for a short period after year end
Purpose - Assures that cash in transit is not
recorded twice
10-68
Fraud-Related Substantive
Confirming with financial institutions about
individuals authorized to access cash accounts
Scrutinizing checks that are payable to cash
Scrutinizing checks with unusual vendor
names
Scrutinizing checks made out to employees
outside of normal payroll processing system
Comparing timing of deposits into bank
accounts with timing of cash receipts
Noting any unusual time lags
10-69
Fraud-Related Substantive
Comparing time lags between:
The date a check was issued for payment
The date that it clears the bank
Investigating voided checks and analyzing

voided transactions
10-70
Documentation related to
Substantive Procedures for cash
accounts
Copies of independent bank reconciliations
Copies of bank confirmations
Documentation of oral confirmations
Copies of bank cutoff statements
Copies of bank transfer schedules
Evidence of any restrictions on use of cash
balances or bank compensating balances
10-71
Identify types of marketable securities, articulate the risks
and controls typically associated with these accounts, and
outline an audit approach for testing these accounts
Marketable securities
Held as temporary investments
Short-term cash management securities
U.S. Treasury bills
Certificates of deposit (CDs)
Commercial paper
Notes issued by major corporations at rates
approximating prime lending rates with high
credit rating
Short-term hybrid-type securities

Improve return on temporary investments
10-73
Classification of investments in
securities
Held-to-maturity
securities
Valued at amortized cost,

subject to an impairment
test
Trading
securities
Carried at fair market value
Available-forsale securities
Carried at fair market value
10-74
AUDITORS JUDGMENTAL
CHALLENGE
Corroborating managements intent in
classifying assets
Gathering information about managements
trades in investments
Importance of market value to management
compensation
Determining fair market value

Easily determinable for regularly traded
securities
Financial institutions reluctant to mark fair
values for thinly traded securities
10-75
Relevant Financial Statement

Assertions
Existence or
occurrence
Securities exist at balance sheet date
Completeness
Securities balances include all

securities transactions taken place
during the period
Rights and
obligations
Company has title to such securities

accounts as of balance sheet date
Valuation or
allocation
Recorded balances reflect true

underlying economic value of those
assets
Presentation
and disclosure
Properly classifying the securities on

balance sheet and disclosing in notes
to financial statements
10-76
Inherent and Fraud Risks

Risk of sudden market declines
Manipulation of classification of
securities
Manipulation of valuation of fair

market value
10-77
Control Risks
Risk of theft of securities if:
They are not physically controlled
Authorization and monitoring over their trade is
not effective
Lack of policies over purchase or sale of

securities
Lack of monitoring of changes in securities
balances
Lack of policies over valuation or classification
of securities
10-78
Control Risks
Lack of segregation of duties between
those responsible for:
Making investment decisions
Custody of securities
Lack of involvement or oversight by

internal audit in relation to securities
10-79
INHERENT RISK ANALYSIS

QUESTIONNAIRE - MARKETABLE
SECURITIES
10-80
Control Risk Analysis

Questionnaire - Marketable
Securities
10-81
Control Risk Analysis

Questionnaire - Marketable
Securities
10-82

Investments
Securities purchased, not authorized
Securities purchased, not recorded as purchased
Securities recorded as purchased, not purchased
Securities sold, not recorded as sold
Securities recorded as sold, not sold
Investment income is stolen
Investments are purposely valued inaccurately
Investment classifications are purposely
inaccurate
10-83
Analytical Procedures for

Marketable Securities
Developing expectations about level of
amounts in ending balances
Based on purchase or sales activity reported
Developing expectations about relationship

between balances in marketable securities
accounts
Reviewing changes in:
Balances
Risk composition
Classification types of marketable securities
10-84
Tests of Controls
Reviewing policies for authorization
To purchase, sell, and manage such securities
Inquiring of board of directors about boards

oversight of process and examining related
documentation
Examining documentation of authorization
For selected purchases and sales
Reviewing minutes of board meetings

For reference to investment policies and
associated oversight
10-85
Tests of Controls
Examining evidence of authorization controls
For changes in classification of such securities
Inquiring of management about its process for

Establishing valuation
Reviewing related documentation
Inquiring about process for reclassifications

and review related documentation
10-86
Tests of Controls
Examining documentation for selected
marketable securities transactions
Reviewing reports of internal audit
10-87
Assertions and Related Substantive

Tests of Details - Marketable Securities
Existence or occurrence
Requesting for a schedule of securities and verifying their
existence
Completeness
Footing schedule of marketable securities and examining them
Rights and obligations

Examining selected documents to determine any restrictions
Valuation or allocation
Determining current market value
Re-computing interest and proper recording of accrued
interest
Presentation and disclosure

Determining whether securities are properly classified
10-88
EXHIBIT 10.15 - audit workpaper

for testing marketable equity
securities
10.15.png
10-89
Auditing in Practice - Audit Procedures Used to

Address Risk Related to Common Fraud Schemes for
Investments
Employing specialist to assist in fair value

measurements
Conducting background checks of
employees having access to investment
accounts
Requiring original documents of securities
Tracing:
Dividend payments
Interest payments
Sales of securities
10-90
Auditing in Practice - Audit Procedures Used to

Address Risk Related to Common Fraud Schemes for
Investments
Tracing purchases of securities to cash

disbursements on the bank statement
Reviewing any unusual journal entries in
investment accounts
10-91
Documentation related to substantive

procedures for marketable securities
Schedule of marketable securities as:
Prepared by client
Reviewed by auditor
Documentation of any confirmation of securities

Documentation of securities transactions
scrutinized
Memo containing rationalization for judgments
about managements:
Classification of securities
Valuation of securities
10-92
Documentation related to substantive

procedures for marketable securities
Reports of any outside valuation experts
Documentation of calculation of potential
impairments
10-93

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AUDITING

Copyright 2014 South-Western/Cengage Learning

Identify the significant accounts,

Describe how to use preliminary analytical

Determine and apply sufficient appropriate

THE AUDIT OPINION

PROFESSIONAL JUDGMENT IN CONTEXT Fraudulent Petty Cash Transactions at Koss

PROFESSIONAL JUDGMENT IN CONTEXT Fraud at Peregrine Financial

PROFESSIONAL JUDGMENT IN CONTEXT Fraud at KOSS Corporation and Peregrine

Identify the significant accounts, disclosures,

Major types of cash accounts

Imprest Payroll Accounts

Reduce the amount of paperwork

Automate the cash management

Cash Management Techniques

Relevant Financial Statement

Rights and obligations

Company has title to the cash accounts as of balance sheet date

Presentation and disclosure

Cash is properly classified on the balance sheet and disclosed in

Identify and assess inherent risks of material

Performing Risk Assessment

Reasons for Identifying cash as

Inherent Risk Analysis

Inherent Risk Analysis

Identify and assess fraud risks of material

Auditing in Practice - Common

Frauds relating to cash receipts

Inventory sold, but employee does not

Auditing in Practice - Common

Auditing in Practice - Common

Frauds relating to cash payments

Purchasing merchandise and recording sale at

Identify and assess control risks of material

Common Controls Over Cash

Common Controls Over Cash

Auditing in Practice - The Parmalat

Implications of Weak Controls

Auditing in Practice - Skimming

Controls for Petty Cash

Reconciling petty cash fund before replenishing it

Controls for Cash Management

Electronic funds transfers

Cash management agreements

Assessing Control Risk for Cash

Assessing Control Risk for Cash

At entity-wide level, considering control

Commitment to financial accounting competencies

Assessing Control Risk for Cash

Smaller organizations - Testing of operating

Control Risk Questionnaire Cash

Control Risk Questionnaire Cash

A questionnaire often used to guide

EXHIBIT 10.3 - Control Activities

Describe how to use preliminary analytical

Requires awareness of importance of cash

Using Trend Analysis of Account Balances

Using Trend Analysis of Account Balances

Determine appropriate responses to identified risks

Responding to Identified Risks

Developing audit approach that contains:

Audit programs are customized based on

EXHIBIT 10.5 - Panel A: Sufficiency of

EXHIBIT 10.5 - Panel B: Approaches to