Chapter 16 – Auditing the Financing/Investing Process: Cash and Investments

Cash and Cash Equivalents

• “Cash” on the F/S includes:

  • Currency & coins on-hand.

  • Demand deposits (checking).

  • Time deposits, savings, certificates of deposit (CDs).

• Cash Equivalents (combined with cash for reporting):

  • Definition: Short-term, highly-liquid investments that are readily convertible to cash AND so near maturity that risk of value change is insignificant.

  • Typical examples: Treasury Bills, Money-Market Funds.

• Recall foundational principle (from earlier chapters): classification hinges on $ext{maturity} \le 3\text{ months}$ at acquisition.

Cash & Major Accounting Processes

• Sources of Cash (inflows):

  • Revenue collection.

  • Sale of PP&E.

  • Issuance of long-term debt or capital stock.

• Disbursements of Cash (outflows):

  • Inventory purchases.

  • PP&E acquisitions.

  • Payroll.

  • Debt service & equity-related payouts.

• Residual nature of cash ⇒ almost every cycle ultimately affects the account.

Types of Bank Accounts

• General Cash Account – primary operating account.

• Imprest Accounts – fixed balance accounts (e.g., payroll, branch).

• Branch Accounts – separate accounts for geographically-dispersed operations.

• Cash-flow optimization objective: accelerate collections / decelerate payments within legal & relational limits.

Control Environment for Cash

• Reliable internal control ⟹ reduced extent of substantive testing.

• Key control categories:

  • Cash Receipts controls (segregated duties, daily deposit, lockbox, etc.).

  • Cash Disbursement controls (prenumbered checks, dual signatures, voucher packets).

  • Mandatory, timely monthly bank reconciliation (independent preparer & reviewer).

• Impact: better controls ↓ sample sizes & may shift toward reliance testing.

Substantive Analytical Procedures—Cash

• Limited usefulness because cash is residual and volatile.

• Typical analytics confined to:

  • Comparison with prior-year ending balances.

  • Comparison with budgeted cash levels.

• Limitation is offset by:

  • Extensive TOCs / substantive tests of transactions.

  • Extensive testing of bank reconciliations.

Substantive Tests of Transactions & Balances (Cash)

Assertions for Classes of Transactions

• Occurrence, Completeness, Authorization, Accuracy, Cutoff, Classification.

Example Dual-Purpose Tests—Cash Receipts

• Vouch entries → remittance advices, deposit slips, bank statement.

• Trace remittance advices → cash-receipts journal & deposit slips.

• Examine deposit-slip signature & check endorsements (auth’n).

• Foot (add) remittance advices & deposit slips; agree to journal & bank.

• Weekly footing of cash-receipts journal; agree to G/L.

• Compare recorded dates vs. bank deposit dates (cutoff).

• Year-end observation of cash on hand; trace to journal & cutoff statement.

• Check proper account classification on sample remittance advices.

Example Dual-Purpose Tests—Cash Disbursements

• Vouch journal entries → cancelled checks, voucher packet, bank stmt.

• Trace cancelled checks → disbursements journal.

• Verify authorized signatures & endorsements.

• Agree PO, receiving report, invoice, cancelled check & journal amounts.

• Weekly footing of disbursements journal; agree to G/L.

• Compare recorded check date vs. bank-clearing date (cutoff).

• Record last check issued on year-end & trace to journal.

• Check classification on sample cancelled checks.

Balance-Related Assertions & Tests

• Existence, Completeness, Valuation & Allocation.

• Typical tests:

  • Bank confirmation for each account.

  • Detailed testing of bank reconciliation: footing, tie-out to G/L, tie-out to confirmation, cutoff statement review.

  • If high CR or fraud risk: extended reconciliation procedures, proof of cash, kiting tests.

Auditing the General Cash Account

• Obtain:

  1. Copy of bank reconciliation (client-prepared, year-end).

  2. Standard bank confirmation (AICPA/ABA form).

  3. Cutoff bank statement – normally covers 7-10 days post-balance-sheet date.

Bank Reconciliation Working Paper

• Auditor re-computes reconciliation; ties:

  • Balance per books ↔ G/L.

  • Balance per bank ↔ confirmation.

  • Deposits in transit ↔ cutoff statement.

  • Outstanding checks ↔ cutoff statement (payee, amount, endorsement).

  • Bank charges, NSF, etc. ↔ reconciliation & books.

  • Final adjusted book balance ↔ cash lead schedule.

Standard Bank Confirmation

• Confirms: demand & time deposits, loan balances, interest rates, collateral, unused lines, compensating balances, etc.

• Sent & returned under auditor control; may reveal unrecorded obligations.

Cutoff Bank Statement

• Ensures reconciling items clear shortly after year-end; unusual lag may signal fictitious items.

Summary of Reconciliation Testing Steps

1. Mathematical accuracy & book balance → G/L.

2. Bank balance → confirmation.

3. Deposits in transit → cutoff stmt.

4. Outstanding checks → cutoff stmt.

5. Bank charges & credits → books.

6. Adjusted book balance → lead schedule.

Fraud-Related Audit Procedures

Extended Reconciliation Procedures

• Look for manipulation of reconciling items (e.g., fictitious $5{,}000$ deposit-in-transit to mask theft).

Proof of Cash

• 4-column reconciliation covering beginning balance, receipts, disbursements, ending balance for the entire period.

• Reconciles both bank and book activity; exposes postings made to one side only.

Kiting Tests

• Prepare inter-bank transfer schedule around year-end.

• Objective: detect recording of the same cash in two accounts simultaneously (overstatement).

• Red flags: receipt recorded in period 1 while corresponding disbursement recorded in period 2.

• Example: $10{,}000$ transfer recorded as deposit 12/31 but disbursement dated 1/2 ⇒ cash overstated.

Auditing Imprest Accounts

Payroll / Branch Imprest

• Same audit steps as general account: reconcile, confirm, examine supporting docs.

Petty Cash

• Usually immaterial ↔ seldom substantive tests.

• High theft potential ⇒ document controls, surprise counts.

Cash-Related Disclosure Issues

• Policies for defining cash & equivalents.

• Restrictions: sinking funds, board-designated, foreign exchange controls.

• Contractual compensating balance requirements.

• Letters of Credit, escrowed amounts.

• Confirmation letter example (Calabro Wireless) spells out % requirements:

  • Maintain compensating balance $=15\%$ of outstanding loans $+10\%$ of unused LOC.

• Sample note disclosure: 5% compensating balance on borrowings > $500{,}000$; satisfied by normal operating cash.

Auditing Investments

• Typical instruments: common stock, preferred stock, debt securities, hybrids.

• Focus on financing/investing process as distinct from operations.

Control Risk Assessment – Key Assertions

• Occurrence & Authorization: board minutes, documented approvals.

• Completeness: reconciliation of broker advices, subsidiary ledgers.

• Accuracy & Classification: GAAP measurement (HTM, Trading, AFS).

Segregation of Duties (Table 16-4)

• Initiation ≠ final approval (prevents fictitious trades).

• Valuation-monitoring ≠ acquisition (prevents manipulated pricing).

• Securities ledger ≠ G/L posting (prevents concealment of theft).

• Custody ≠ recordkeeping (prevents physical theft).

Substantive Procedures (Table 16-5)

Assertions – Account Balances:

• Existence / Rights & Obligations:

  • Inspect securities or confirm with custodian, issuer, counterparty.

  • Examine brokers’ advices for purchases near year-end.

• Completeness: search for unrecorded purchases/sales just after year-end.

• Valuation & Allocation:

  • Recompute interest/dividends; verify market prices (Level 1 quotes).

  • Determine “other-than-temporary impairment” (OTTI).

  • Test realized gain/loss recognition.

• Disclosures: ensure ASC 320 requirements met; verify pledged securities, fair-value hierarchy levels, current vs. non-current classification.

Tests of Details—Existence

• Perform at least ONE: physical inspection, issuer confirmation, custodian confirmation, broker-dealer confirmation of unsettled trades, counterparty confirmation, read partnership agreements.

Tests of Details—Valuation & Allocation

• Evaluate potential non-temporary impairment indicators:

  • $ext{Fair Value} \ll ext{Cost}$ for extended period.

  • Issuer’s deteriorating financial condition / rating downgrade.

  • Industry or geographic adverse factors.

  • Reduced/eliminated dividends; missed interest.

  • Management lacks intent/ability to hold to recovery.

• If permanent impairment ⇒ write-down to new carrying amount & recognize loss.

Classification & Disclosure Assertions

• Marketable securities must be properly labeled:

  • Held-to-Maturity (HTM) – amortized cost; current/non-current based on maturity \le / > 12\text{ months}.

  • Trading – FV-NI; always current.

  • Available-for-Sale (AFS) – FV-OCI; current/non-current per mgmt’s intent.

Advanced Module: Auditing Fair Value Measurements

• ASC Topic 820 Fair-Value Hierarchy:

  1. Level 1 – quoted prices in active markets, “mark-to-market.”

  2. Level 2 – observable inputs for similar assets, “mark-to-matrix.”

  3. Level 3 – unobservable inputs, management assumptions, “mark-to-model.”

• Auditor responsibilities:

  1. Understand mgmt’s process & assumptions.

  2. Decide if specialist skills are needed (valuation experts).

  3. Test the measurements: recalc models, corroborate inputs, inspect market data.

  4. Evaluate reasonableness & disclosure adequacy (sensitivity analysis, hierarchy level, valuation technique).

These notes consolidate all substantive, control, fraud, and disclosure guidance for Chapter 16—providing a stand-alone study resource bridging earlier control principles and real-world cash/investment audit issues.