Chapter TWO

AUDITING CASH AND

MARKETABLE SECURITIES

 An essential part of the auditor’s responsibility in auditing

cash receipts is to identify deficiencies in internal control that
increase the likelihood of fraud.

Mengistu D. 1
 Jimma UNIVERSITY
COLLEGE OF BUSINESS AND
ECONMICS
DEPARTMENT OF ACCOUNTING AND
FINANCE

AUDITING PRINCIPLES AND PRACTICE-

II(ACFN3162)
Mengistu D. 2
 CHAPTER OVERVIEW AND LEARNING
OBJECTIVES
Upon completion of this chapter you will able to
1. Identify the significant accounts, disclosures, and
relevant assertions in auditing cash accounts.
2. Identify and assess inherent risks of material
misstatement in cash accounts.
3. Identify and assess fraud risks of material
misstatement in cash accounts.
4. Identify and assess control risks of material
misstatement in cash accounts.
Mengistu D. 3
 CHAPTER OVERVIEW AND LEARNING
OBJECTIVES

6. Determine appropriate responses to identified

risks of material misstatement for cash accounts,
disclosures, and assertions.
7. Determine appropriate tests of controls and
consider the results of tests of controls for cash
accounts, disclosures, and assertions.
8. Determine and apply sufficient appropriate
substantive audit procedures for testing cash
accounts, disclosures,Mengistu
and [Link]. 4
 CHAPTER OVERVIEW AND LEARNING
OBJECTIVES

9. Identify types of marketable securities, articulate

the risks and controls typically associated with
these accounts, and outline an audit approach for
testing these accounts.
[Link] the frameworks for professional decision
making and ethical decision making to issues
involving the audit of cash accounts, disclosures,
and assertions.

Mengistu D. 5
 Audit of Cash

A udit of C ash
and B ank
B alances

Im portance Internal Substantive B ank B ank Fraud-R elated

and A ssertions C ontrols P rocedures R econciliation C onfirm ation A udit
P rocedures

Inherent C ash R eceipts P roof of

R isks and C ash
P ayments

Internal T est of Details T est of

C ontrol of C ash K iting
O bje ctives B alances

T est of
Lapping

Mengistu D. 6
Significant Accounts and Relevant
Assertions
An organization may have many different kinds of
cash accounts. Major types of cash accounts
include;
 General checking accounts
 Cash management accounts
 Imprest payroll checking accounts
 Petty cash accounts
In addition to these accounts, many organizations
have marketable security accounts.
Mengistu D. 7
Significant Accounts and Relevant
Assertions

Marketable Security Accounts

 Marketable securities (held as
temporary investments): A security
i.e, readily marketable and held by a
company as an investment
 Short-term cash management
securities includes
Mengistu D. treasury bills,
8
 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

Mengistu D. 9
 Relevant Financial Statement
Assertions
The five management assertions relevant to cash
are as follows:
1. Existence or occurrence: Cash balances exist at
the balance sheet date.
2. Completeness: Cash balances include all cash
transactions that have taken place during the
period.
3. Rights and obligations: The company has title to
the cash accounts as of the balance sheet date.
4. Valuation or allocation: The recorded balances
reflect the true underlying economic value of
those assets.
5. Presentation and disclosure: Cash is properly
classified on the balance sheet
Mengistu D. and disclosed in 10
 OBJECTIVES OF CASH AUDIT

1. Uunderstanding of 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 risks of material
Mengistu D. 11
 Cont.…

4. Substantiate existence of recorded cash

and occurrence of related
transactions
5. Establish completeness of recorded
cash
6. Verify cutoff and accuracy of cash
transactions
7. Determine that client has rights to
recorded cash Mengistu D. 12
 PLANING FOR AUDITS OF CASH AND
MARKETABLE SECURITIES

Cash is an inherently risky asset. Inherent

risk for cash is usually assessed as high
because of the following reasons:
 Volume of transactions flowing through
account
 Liquidity and easy transferability
 Automated systems and increased
computerization of account activity
 Importance in meeting debt covenants
Mengistu D. 13
 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
Mengistu D. 14
 Cont'd
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
Mengistu D. 15
 AUDITING IN PRACTICE-COMMON FRAUD
SCHEMES/STRATEGY/ RELATING TO CASH

Frauds relating to cash receipts

Inventory sold, but employee does not
record sale and steals cash
Employee receives a check and deposits it,
but does not record sale; then employee
writes a check out to himself and does not
record disbursement
Employee collects a customer payment,
Mengistu D. 16
 AUDITING IN PRACTICE-COMMON FRAUD
SCHEMES/STRATEGY/ RELATING TO 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
Mengistu D. 17
 AUDITING IN PRACTICE-COMMON FRAUD
SCHEMES/STRATEGY/ RELATING TO CASH

Frauds relating to cash payments

Selling 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

Mengistu D.
into an account
18
AUDITORS' OBJECTIVES IN EXAMINIATION OF CASH

Auditors have five objectives in audit

of cash:
[Link] internal control over cash
transactions
[Link] existence of recorded cash and

client’s ownership of this asset.

[Link] completeness of recorded cash.

[Link] clerical accuracy

Mengistu D. of cash
19
 Cont'd

[Link] Objectives
Ccentral control objectives are:
 All sums are received and subsequently accounted
for
 No payments are made which should not be made
 All receipts and payments are promptly and
accurately recorded

[Link] Procedures: Appropriate internal

controls would include:
 Adequate separation of incompatible duties
Mengistu D. 20

 Cont'd

 Independent reconciliation of cash records

including bank statement

 Computerized control totals and edit tests

 Authorization of transactions

 Use of pre numbered documents and

turnaround documents
 Periodic internal audits

 Competent, well-trained employees

Mengistu D. 21
 INTERNAL CONTROL OVER CASH
RECEIPTS

Cash receipts resulted from a variety of

activities:
Cash is received from revenue transactions,
short and long term borrowings, issuance of
stock, and sale of marketable securities, long
term investments, and other assets.
Cash receipts from cash sale and collection from
customers on credit sales
Mengistu D. 22
 INTERNAL CONTROL OVER CASH
RECEIPTS

The basic internal controls over cash receipts

include the following:
Authority to collect cash should be clearly defined.

Collections should be recorded when received.

The collector’s cash receipts should be reconciled

to the eventual banking.

Receipts should be banked immediately.

Each day’s receipts should be recorded promptly

in the cashbook. Mengistu D. 23

 Cont'd

Processing of receipts from cash and

credit sales involves the following cash
receipts functions:
 Receiving cash receipts

 Depositing cash in bank

 Recording the receipts

Segregation of duties in performing these

functions is an important internal control
activity. Mengistu D. 24
 INTERNAL CONTROL OVER CASH
DISBURSEMENTS
There are two cash disbursements
functions as follows:
[Link] liability
[Link] cash disbursements.
Basic internal controls over cash disbursements
include:
 Unused checks should be held in a secure place.

person who prepares checks should have no

responsibility over purchase ledger or sales ledger.
Checks should be signed only when evidence of a

properly approved transaction is available.

Mengistu D. 25
 Cont'd

Checks should be evidenced by signing supporting

documents.
Check signatories should be restricted to minimum

practical number.
Two signatories at least should be required except

perhaps for checks of small amounts.

Checks should be crossed before being signed.

Supporting documents should be cancelled as paid

to prevent their use to support further check

payments. Mengistu D. 26
 CONTROL OVER PETTY CASH
Level and location of cash floats should be laid down formally.

Cash should securely hold.

There should be restricted access to floats

All expenditure should require a voucher system signed by a

responsible official, not petty cashier.

Vouchers should be produced before check is signed for

reimbursement.
Maximum amount should be placed on a petty cash payment

to discourage normal purchase procedures being by passed.

Periodically petty cash should be reconciled by an
independent person

Mengistu D. 27
SUMMARY OF SUBSTANTIVE TESTS FOR CASH
BALANCES

Mengistu D. 28
 AUDIT PROGRAM FOR CASH

Audit program indicates general pattern of work

performed by auditors in verification of cash.
[Link] internal control for cash

[Link] an understanding of internal control for

cash.
[Link] control risk and design additional tests of

controls for cash.

[Link] additional tests of control for those

controls, which auditors plan to consider in their

assessment of control risk.
Mengistu D. 29
 Cont'd

[Link] accounting records and reconciliation by re-

performance.
[Link] detail of a sample of recorded
disbursements in cash payments journal to
accounts payable postings, purchase orders,
receiving reports, invoices, and paid checks
[Link] detail of a sample of recorded cash

receipts listings to cash receipts, journal, accounts

receivable postings, and authenticated deposit
slips. Mengistu D. 30
 Cont'd

B. Perform substantive tests of cash transaction and

balances
[Link] analysis of cash balances and reconcile to general

ledger.
[Link] standard confirmation forms to banks to verify amounts

on deposit
[Link] or prepare reconciliation of bank accounts as of

balance sheet date and consider need to reconcile bank

activity for additional months
[Link] a cutoff bank statement containing transactions of at

least seven business days subsequent to balance sheet date

Mengistu D. 31
 Cont'd

[Link] and risk cash on hand.

[Link] client’s cutoff of cash receipts and

disbursements.
[Link] all bank transfers for last week of audit year

and first week of following year

[Link] proper financial statement presentation

and disclosure of cash.

Mengistu D. 32
 UNDERSTANDING AND TESTING INTERNAL
CONTROL FOR CASH

1. Obtain an understanding of internal

control
Understanding internal control over cash receipts
and disbursements helps auditors to observe
whether there is appropriate segregation of duties
and to enquire who performed various functions
throughout the year.
2. Assess control risk and design additional
tests of control
Mengistu D. 33
After obtaining an understanding of client’s internal
 Cont'd

3. Perform additional tests of control

Tests directed toward the effectiveness of control
help to evaluate client’s internal control and
determine extent to which auditors are justified in
reducing assessed levels of control risk for
assertions about cash account.
4. Reassess control risk and design
substantive tests.
When auditors have completed procedures
Mengistu D. 34
described above, they should reassess control risk
 UNDERSTANDING AND TESTING
SUBSTANTIVE TESTS OF CASH

Obtain analyses of cash balances and reconcile to

general ledger.
Send standard confirmation forms to banks to

verify amounts on deposit.

Obtain or prepare reconciliation’s of bank
accounts as of balance sheet date and consider
need to reconcile bank activity for additional
months.
Obtain a cutoff bank statement.
Mengistu D. 35
 Cont.….

Trace all bank transfers for last week of

audit year and first week of following year.

Investigate any cheques representing large

or unusual payments to related parties.

Determine proper financial statement
presentation and disclosure of cash.

Mengistu D. 36
 Common types of misstatements
regarding cash include:

 Transactions recorded in the wrong period

 Embezzlements covered up by omitting or under-
footing outstanding checks on bank reconciliation
 Manipulating accounts to record the same cash in
two accounts at the same time (kiting)

Mengistu D. 37
 AUDITING MARKETABLE SECURITIES

 Held as temporary investments

 Short-term cash management securities
 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(debt and equity
Mengistu D. 38
 Classification of investments in
Marketable Securities

 Held-to-maturity securities: Valued at

amortized cost, subject to an impairment test
 Trading securities: Carried at fair market value
 Available-for-sale securities: Carried at fair
market value

Mengistu D. 39
 AUDITOR’S JUDGMENTAL
CHALLENGE

Confirm management's intent in classifying assets:

 Gathering information about management's trades
in investments
 Importance of market value to management
compensation
Determining fair market value:
 Easily determinable for regularly traded securities
 Financial institutions reluctant to market fair
values for thinly traded securities
Mengistu D. 40
 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
Mengistu D. 41
 Relevant Financial Statement
Assertions
 Presentation and disclosure: Properly classifying
the securities on balance sheet and disclosing in
notes to financial statements

Mengistu D. 42
Inherent and Fraud Risks in Marketable
Securties

Risk of sudden market declines

Manipulation of classification of
securities

Manipulation of valuation of fair

market value

Mengistu D. 43
 Control Risks in Marketable Securites

 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
Mengistu D. 44
 Cont'd

 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

Mengistu D. 45
INHERENT RISK ANALYSIS QUESTIONNAIRE -
MARKETABLE SECURITIES

Is there a regular investment in marketable

securities?

Is there a change in classification of securities?

If yes, what is the reason for the change?

Is there a ready market for the securities?

Mengistu D. 46
 Cont'd

Are the written policies and guidelines

approved by the board?

Is there a clear policy for classification of

marketable securities?

If classification has changed, are the amounts

significant and reviewed by audit committee?

Mengistu D. 47
 Cont'd

How is value of marketable securities

estimated if a liquid market does not exist?

Is there an effective segregation of duties?

Is there a regular audit of the controls and

review of recent reports?

Mengistu D. 48
 Auditing in Practice - Common Fraud Strategy Relating
to Investments of Marketable Security

 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

Mengistu D. 49
 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
Mengistu D. 50
 Tests of Controls for Marketable Security

 Reviewing policies for authorization

 To purchase, sell, and manage of Marketable
securities
 Inquiring of board of directors about board's
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
Mengistu D. 51
 Cont'd
 Examining evidence of authorization controls
 For changes in classification of marketable
securities
 Inquiring of management about its process for
 Establishing valuation
 Reviewing related documentation
 Inquiring about process for reclassifications and
review related documentation
 Examining documentation for selected
marketable securities transactions
Mengistu D. 52
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

Mengistu D. 53
EXHIBIT: audit workpaper for testing marketable
equity securities

[Link]

Mengistu D. 54
 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
Mengistu D. 55
 Cont'd

 Tracing purchases of securities to cash

disbursements on the bank statement
 Reviewing any unusual journal entries in
investment accounts

Mengistu D. 56
 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 management’s:
 Classification of securities
 Valuation of securities Mengistu D. 57
 Cont'd

 Reports of any outside valuation experts

 Documentation of calculation of potential
impairments

Mengistu D. 58
END OF CHAPTER TWO

Mengistu D. 59