Auditing Investments and Cash Balances

Auditing the Investments

In the previous chapter has been discussed the auditing of financing cycle. The possible financing scheme are:

– From long term loan (i.e. bank loan)– From the issuance of bond payable (debt

security)– From the issuance of stock (equity security)

The audit objectives are to verify the fairness of the reporting balances related to those financing activities.

Auditing the Investments

• In the financing cycle the bonds and stocks are viewed from the entity issuing the both securities.

• In the investment cycle, the securities (debt and equities securities) are viewed from the investor side.

• The audit objectives are to verify the fairness of management’s assertion associated to the investment activities, either in debt or equity securities.

Investments v.s. FinancingThe Statement of Financial Position

Marketable Securities XXXX(Investment in bondsor stock for short term)

Long Term Investments XXXX(Investment in bondsor stock for long term)

Bonds Payable XXXX

Equity

Preferred Stocks XXXX Common Stocks XXXX Paid in Capital XXXX Allowances XXXX Retained Earning XXXX

Auditing Investment Cycle

Auditing Financing Cycle

Inherent Risk• Possible error in classification of short-term

investment as: available for sale or trading, different classification will be different accounting treatment.

• Possible error in recording the income of investment as well as the valuation of investment.

• Possible error in recording and reporting the investment due to the complexity of transaction.

Common Documents - Investments

• Monthly statements from securities company or broker of securities

• Electronic evidence of investment.• Broker’s advice• Books of original entry• Investment subsidiary ledger

Functions and Related Controls

• Authorize investment transactions: purchasing and selling transactions.

• Recording transactions• Settlement of transactionsNotes:Documents, Functions, and Controls are fully

depend on the characteristics of transaction – normally are electronic transactions.

Possible Substantive Tests

Initial Procedures• Obtain understanding of the entity and its

environment, and determine:– The significance of investment– The policies of investing the cash surplus.– Key economic drivers of investments– The industry standards and the impact

on earning.

Possible Substantive TestsInitial Procedures

• Perform initial procedures, involve:– Obtain client-prepared schedules of

investment.– Trace beginning balance to prior year audit

balance.– Review activities of investment and

investigate entries that appear unusual in amount or source.

Possible Substantive TestsAnalytical Procedures• Calculate ratios, such as:

– Short-term investment to total current assets– Long-term investment to total assets– Rate of return by investment classification

• Analyze ratio results relative to expectations based on prior year ratio, budget, or other data.

Test of Detail of Transactions• On a test basis, vouch entries in investment and

related income and equity accounts.

Possible Substantive TestsTest of Detail of Balances• Confirm securities held by others• Recalculate investment revenue earned• Determine the appropriateness of investment

classification by reference to:– Documentation of management’s stated intent– Written representation from management

confirming the proper classification of securities.

• Obtain evidence corroborating the fair value of investment and evaluate the appropriateness of valuation models

Possible Substantive TestsPresentation and Disclosure

• Compare the presentation with the applicable standard of reporting, involve:– The appropriateness of investment

classification– The sufficiency disclosures.– Evaluate the completeness of

presentation.

Cash BalanceComponents of Cash Balance:•Cash on hand•The balance of petty cash•Cash in bank in general checking accounts

Notes:

Five transaction cycles – revenue, expenditure, financing, investing, and personnel services cycle – relate directly to cash balances.

Audit ObjectivesExistence or occurrence

Recorded cash balances exist at the balance sheet date.

CompletenessRecorded cash balances include the effects of all cash transactions that have occurred.Year-end transfers of cash between banks are recorded in the proper period.

Rights and obligations The entity has legal title to all cash balances shown at the balance sheet date.

Audit ObjectivesValuation or allocation

Recorded cash balances are realizable at the amounts stated on the balance sheet and agree with supporting schedules.

Presentation and disclosureCash balance are properly identified and classified in the balance sheet.Lines of credit, loan guarantees, compensating balance agreements, and other restrictions on cash balances are appropriately disclosed.

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.

• The nature of cash balances makes them susceptible to theft with numerous kinds of fraudulent schemes.

Check Kiting and Lapping

• Investigate the possible fraud of kiting by performing the analysis of bank transfer.– Kiting is a fraud in form of intentionally recording

a bank transfer as a deposit in the receiving bank while failing to show a deduction in the bank account from which the transfer was drawn.

• Investigate the possible fraud of lapping. Lapping is a fraud by deliberate misappropriate cash receipts for personal benefit and cover the fraud by the next receipts.

Check Kiting and Lapping

The Procedures to Detect Lapping:•Confirm accounts receivable.•Make a surprise cash count•Compare details of cash receipts journal entries with the detail of corresponding daily deposit slips.

Analytical Procedures• Cash balances are significantly affected by

management’s operating, investing, and financing decisions and strategies.

• Well-managed companies regularly develop cash budgets, projecting: cash receipts based on anticipated collection of receivables, cash disbursements for operating needs, and investing and financing activities.

• Analytical procedures involve comparing cash balances with forecasts or budgets, or with company policies regarding minimum cash balances and the investment of cash surplus

Substantive Tests of Cash Balance

Initial Procedures• Obtain and understanding of the

business and industry and determine:– The significance of cash balances

and transactions to the entity.– The entity’s policies for forecasting

cash balances and investing surplus of cash balances.

Substantive Tests of Cash BalanceInitial Procedures• Review records that will be subjected to

further testing.– Trace beginning balances for cash on hand and

in bank to prior year’s working papers.– Review activity in general ledger accounts for

cash and investigate entries that appear unusual in amount or source.

– Obtain client prepared summaries of cash on hand and in bank, verify mathematical accuracy, and determine agreement with general ledger.

Substantive Tests of Cash Balance

Analytical Procedures• Perform analytical procedures.

– Compare cash balances with budgeted amounts, prior year balances, or other expected amounts.

– Calculate cash as percent or current assets and compare to expectations.

Substantive Tests of Cash Balance

Tests of Details of Transactions

• Perform cash cutoff (these tests may have been performed as part of the audit programs for accounts receivable and accounts payable).– Observe that all cash received through

the close of business on the last day of the fiscal year is included in cash on hand or deposits in transit and that no receipts of the subsequent period are included, or

Substantive Tests of Cash Balance

Tests of Details of Transactions– Review documentation such as daily cash

summaries, duplicate deposit slips, and bank statements covering several days before and after the year-end date to determine proper cutoff.

– Observe the last check issued and mailed on the last business day of the fiscal year and trace to the accounting records to determine the accuracy of the cash disbursements cutoff, or

Substantive Tests of Cash Balance

Tests of Details of Transactions– Compare dates on checks issued for several

days before and after the year-end date to the dates the checks were recorded to determine proper cutoff.

• Trace bank transfers for several days before and after the year-end date to determine that each transfer is properly recorded as a disbursement and a receipt in the same accounting period and is properly reflected in bank reconciliations when applicable.

Substantive Tests of Cash Balance• Prepare proof of cash for any bank accounts the

entity has been unable to reconcile or for which there is a high risk that fraudulent transactions have occurred.

Tests of Details of Balances• Count undeposited cash on hand and determine that

such amounts are included in cash balances. • Confirm bank deposit and loan balances with banks.• Confirm other arrangements with bank such as lines

of credit, compensating balance agreements, and loan guarantees or other parties.

Substantive Tests of Cash Balance• Scan, review, or prepare bank reconciliations as

appropriate.• Obtain and use bank cutoff statements to verify bank

reconciliation items, detect any unrecorded checks that have cleared the bank, and look for evidence of window dressing.

Substantive Tests of Cash BalancePresentations and Disclosures• Compare statement presentation with GAAP:

– Determine that cash balances are properly identified and classified.

– Determine that bank overdrafts are reclassified as current liabilities.

– Make inquiries of management, review correspondence with banks, review minutes of board or directors meetings to determine matters requiring disclosure such as lines of credit, loan guarantees, compensating balance agreements, or other restrictions on cash balances.

Thank You