18 Audit Investments and Cash Balances Ch18fin

CHAPTER 18
AUDIT INVESTMENTS AND CASH BALANCES

Learning Check
18-1. The nature of investments in securities issued by other entities the ownership of certificates
of deposit, preferred and common stocks of other entities, and corporate and government
bonds. The audit area of investments in marketable securities interfaces with two other
cycles. The receipt of interest and dividends from investments relates to the revenue cycle.
The purchase of securities for cash pertains to cash disbursement transactions in the
expenditure cycle.
18-2. The audit objectives for each of the management assertions that pertain to investments in
marketable securities are:
Existence or occurrence
Recorded investment asset and equity balances represent investments that exist at the
balance sheet date.
Investment revenues, realized gains and losses, and unrealized holding gains and losses
included in income resulted from transactions and events that occurred during the period.
Completeness
All investments are included in the balance sheet investment accounts..
The income statement effects of all investment transactions and events during the period
are included in the income statement accounts.
Rights and obligations
All recorded investments are owned by the reporting entity.
Valuation or allocation
Investments are reported on the balance sheet at fair value, cost, amortized cost, or the
amount determined by the equity method, as appropriate for particular investments.
Investment revenues, and realized and unrealized gains, and losses are reported at proper
amounts.
Presentation and disclosure
Investment balances are property identified and classified in the financial statements.
Appropriate disclosures are made concerning (1) related party investments, (2) the bases
for valuing the investments, and (3) the pledging of investments as collateral.
Solutions Manual to Modern Auditing: Copyright
2005, John Wiley and Sons, Inc.
18-1
18-3. a.
Shad is incorrect about the balance sheet inasmuch as marketable securities held as
short-term investments may be material to a company's short-term solvency, and
securities held as long-term investments may be material to total assets. Shad may be
incorrect about the income statement for a company that has trading securities, held
to maturity securities when amortization is significant, or available-for-sale securities
for which unrealized holding gains and losses become realizable due to sale or
reclassification.
b.
Keri is incorrect. The audit strategy decision is generally based on the frequency of
investing transactions. When there are relatively few transactions, the auditor
generally uses a primarily substantive approach. When there are many transactions, it
may be more cost-efficient for the auditor to use a lower assessed level of control
risk approach.
18-4. Typically, the control environment pertaining to investments in marketable securities

enhances internal control. For example, the authority and responsibility for investing
transactions is often assigned to a company officer such as the treasurer. The accounting
system must include provision for capturing and retaining 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. Each of the categories of control activities is applicable. Several common documents
and records are used in investing activities, and internal auditors may be involved in
monitoring investment activities and balances.
18-5. a.
b.
The functions and related controls in the investing cycle consist of the following:
Authorizing investment transactions:
o Purchasing securities.
Receive or deliver securities:
o Receiving/ safeguarding/delivering securities.
o Receiving periodic income.
Recording transactions:
o Recording purchases, sales, and income.
o Recording market adjustments and reclassifications.
Settle transactions:
o Receiving cash.
o Disbursing cash.
o Assessing investment performance and reporting.
The following table summarizes internal controls that might be found in the
investing cycle for each assertion (audit objective).
18-2
Assertion (Audit Objective)

Existence and Occurrence
(Occurrence)
Completeness
(Completeness)
Existence and Occurrence /
Completeness (Cutoff)
Valuation and Allocation

(Accuracy)
Presentation and Disclosure
(Classification)
Rights and Obligations
Control
The computer checks for
authorization to purchase or sell
securities before recording the
transaction.
Test of Controls
Use CAATs to test the control by
submitting data that should be rejected by
the control.
Recorded securities are regularly

compared with brokers statements.
Observe evidence of reconciling recorded

securities with the brokers statements and
reperform control on a test basis.
the control.
The computer prepares an exception

report of authorized investment
transactions that have not been
recorded.
The computer compares the
accounting period in which the
transaction was recorded with the
settlement date on the brokers
advice.
The computer compares recorded
quantities and prices with the
underlying brokers advice.
A disclosure committee reviews
classification of securities as held to
maturity, available for sale, or trading
securities.
A disclosure committee reviews
security transactions to determine if
disclosures are appropriate of
securities are pledged as collateral
for loans or margin trades.

the control.
the control.
Read the minutes of the disclosure
committee and make inquiries about issues
discussed by a disclosure committee.
Review documentation of follow-up on
disclosure committee actions.
Read the minutes of the disclosure
committee and make inquiries about issues
discussed by a disclosure committee.
Review documentation of follow-up on
disclosure committee actions.
18-6. The acceptable level of detection risk is derived from the audit risk model. Inherent risk for
investment balances involves consideration of (a) the vulnerability of the securities to theft
and misappropriation (existence or occurrence assertion), (b) the possibility of
misclassification of investments (presentation and disclosure assertion), and (c) the
complexities pertaining to the valuation methods such as the equity method of accounting
(valuation or allocation assertion). Control risk, under the primarily substantive approach is
at the maximum or slightly below the maximum. In such cases, the acceptable level of
detection risk will be low.
18-7. a.
The precautions are: (1) the custodian should be present during the count, (2) a
receipt should be obtained from the custodian when the securities are returned to the
client, and (3) all securities, cash and other negotiable investments should be
controlled during the count.
b.
This test applies to four assertions: (1) existence or occurrence, (2) completeness, (3)
rights and obligations, and (4) presentation and disclosure.
18-3
18-8. The working papers for securities should show the certificate number, name of owner,
description of the security, number of shares or bonds, and name of issuer.
18-9.
a.
Securities held by others for the client should be positively confirmed with the
custodian as of the date securities held by the client are counted. This date is often at
or near the balance sheet date.
b.
This test provides evidence about four assertions, (1) existence or occurrence, (2)
completeness, (3) rights and obligations, and (3) valuation at historical cost.
18-10. Cash accounts that should be included as cash balances on the balance sheet include
undeposited receipts on hand, cash in bank in general checking and saving accounts, and
imprest accounts such as petty cash and payroll bank account. Cash accounts that should not
be classified as cash balances on the sheet include certificates of deposit, bond sinking fund
cash, certain foreign currency balances, and other accounts that have restrictions on their
use. These accounts should be classified as investments.
18-11. The transaction cycles that affect cash are:
Revenue (cash sales and receivable collections)
Expenditure (cash purchases and payments on account)
Personnel services (payment of employees and taxing authorities)
Investing (The purchase of long-term assets, the purchase and sale of securities, and the
receipt of interest and dividends).
Financing (Issuing debt and equity securities, redeeming bonds and retiring stock, the
purchase and sale of treasury stock, payment of interest and dividends).
18-12. a.
The account balance audit objectives for cash are as follows:

Specific Audit Objectives
Transaction Objectives
Occurrence. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit
objectives related to cash disbursements.
Completeness. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for
audit objectives related to cash disbursements.
Accuracy. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit
Cutoff. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit
Classification. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for
Balance Objectives
Existence. Recorded cash balances exist at the balance sheet date (EO1). Year end transfers of
cash between banks are recorded in the proper period (EO2).
Completeness. Recorded cash balances include the effects of all transactions that have occurred
(C1). Year end transfers of cash between banks are recorded in the proper period (C2).
Rights and Obligations. The entity has legal title to all cash balances shown at the balance sheet
date (RO1).
Valuation and Allocation. Recorded cash balances are realizable at the amounts stated on the
balance sheet and agree with supporting schedules (VA1).
18-4
Disclosure Objectives
Occurrence and Rights and Obligations. Disclosed cash events and transactions have occurred
and pertain to the entity (PD1).
Completeness. All cash disclosures that should have been included in the financial statements
have been included (PD2).
Understandability. All cash disclosures are appropriately presented and information in
disclosures is understandable to users (PD3).
Accuracy and Valuation. Cash information is disclosed accurately and at appropriate amounts
(PD4).
b.
Inherent risk for cash balances is frequently assessed as high for the existence or
occurrence and completeness assertions because of the high volume of cash
transactions and the vulnerability of cash to misappropriation. In contrast, lower
assessments of inherent risk may be made for the other assertions because they do not
involve any contentious accounting issues.
18-13. Although the portion of current or total assets at any point in time represented by cash
balances may be very small; with five of the six transaction cycles affecting cash the amount
of cash flowing through the accounts over a period of time that is susceptible to
misappropriation can be very large. The volume of transactions, and the susceptibility of a
valuable asset to misappropriation are the key reasons that strong internal controls over cash
is important.
18-14. Because of the unique aspects of cash, auditors tend to plan their procedures to detect much
smaller levels of misstatements than for other accounts. Further, management may request that the
auditor plan work in the cash areas with a more extensive scope than would otherwise be required due
to the inherent risks in this area. Hence, the auditor may follow a primarily substantive approach.
When an entity has strong internal controls and many cash accounts the lower assessed level of
control risk approach may be used to limit the number of cash accounts where substantive
tests may be performed.
18-15. a.
Three different tests of details of transactions that can be performed in auditing cash
balances are:
Perform cash cutoff tests for cash receipts and cash disbursements.
Trace bank transfers.
Prepare proof of cash.
b.
A proof of cash need not be prepared when control risk pertaining to cash
transactions and balances is low and the entity's bank accounts have been reconciled.
18-16. a.
Kiting is an irregularity in which a bank transfer is recorded as a deposit in the

receiving bank and is intentionally not recorded as a deduction from the bank on
which it is drawn. To illustrate, an unauthorized check is drawn on bank A to cover a
shortage in bank B. The check is included in the December 31 deposit of bank B.
However, no December book entries are made for the check on Bank A.
18-5
b.
Kiting can be detected by (1) tracing bank transfers and (2) by using a bank cutoff
statement.
18-17. To property count cash on hand, the auditor should (1) control all cash and negotiable
instruments held by the client until all funds have been counted, (2) insist that the custodian
of the cash be present throughout the count, (3) obtain a signed receipt from the custodian on
return of the funds to the client, and (4) ascertain that all undeposited checks are owned by
the client either directly or through endorsement.
18-18 a.
Lapping is an form of fraud 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.
b.
Lapping is usually associated with collections from customers, but it may also
involve other types of cash receipts. Conditions conducive to lapping exist when an
individual who handles cash receipts also maintains the accounts receivable ledger.
18-19. a.
The information requested in confirming bank deposit and loan balances consists of
(1) deposit balances, (2) loan balances, and (3) other deposit and loan accounts that
may have come to the attention of the authorized bank official.
b.
18-20. a.
b.
18-21. a.
Tests to detect lapping are only performed when control risk for cash receipts
transactions is moderate or high. There are three procedures that should detect
lapping:
o Confirm Accounts Receivable.
o Make a Surprise Cash Count.
o Compare Details of Cash Receipts Journal Entries with the Details of
Corresponding Daily Deposit Slips.
In an effort to conceal the shortage, the embezzler usually attempts to (1) keep bank
and book amounts in daily agreement so that a bank reconciliation will not detect the
irregularity and (2) correct the customers account within three to four days of actual
collection so that any discovered discrepancy in the customers account can be
explained as a delay in receiving the money or posting.
This test provides evidence primarily for the existence or occurrence and rights and
obligations assertions for cash balances. It contributes to the completeness assertion
but it cannot be relied upon entirely because the respondent is not required to search
bank records for deposit and loan balances other than the ones listed on the request.
A compensating bank balance is the minimum balance the depositor must maintain
to have an established line of credit with a bank.
18-6
b.
The auditor's primary source of evidence for compensating bank balances is obtained
from confirming other arrangements with banks. The primary assertion related to
compensating bank balances is presentation and disclosure.
18-22. When the acceptable level of detection risk is high, the auditor may scan the client prepared
bank reconciliation and verify its mathematical accuracy. If detection risk is moderate, the
auditor may review the client's reconciliation. A review includes vouching reconciling items
to supporting documentation, and investigating old and unusual items. When the acceptable
level of detection risk is low, the auditor may prepare the bank reconciliation using bank
data in the client's possession. When detection risk is very low, the auditor may obtain the
bank statement directly from the bank for use in preparing the bank reconciliation.
18-23. a.
b.
The bank cutoff statement should be obtained at a point in time that will permit the
outstanding checks to clear the bank, and the cutoff statement should be obtained by
the auditor directly from the bank..
After receiving the cutoff bank statement, the auditor should:
Trace all prior-year dated checks to the outstanding checks listed on the bank
reconciliation.
Trace deposits in transit on the bank reconciliation to deposits on the cutoff
statement
Scan the cutoff statement and enclosed data for unusual items.
18-24. Examples of circumstances that affect the presentation and disclosure assertion for cash
include the existence of (a) a bond sinking fund that should be classified as a noncurrent
asset, (b) disclosure of arrangements with banks, and (c) a bank overdraft that should be
reported as a current liability. The auditor should review the minutes of board of directors
meetings as well as make inquiry of management as to restrictions on the use of cash
balances.
Comprehensive Questions
18-25. (Estimated time - 25 minutes)
a.
Several of the categories of internal control activities have been violated.

Segregation of duties. The treasurer executes transactions, records the
transactions, and has custody of the resulting assets. It is proper for the treasurer
to execute the securities transactions. However, accounting personnel should
record the transactions, and another officer or an outside independent agent
should be the custodian.
Proper authorization. For proper control, the board of directors (or a finance
committee of the board) should authorize each purchase and sale of securities.
Documents and records. The securities are apparently registered in the name of
the treasurer. They should be registered in the name of the company.
18-7
b.
Access controls. No mention is made of storing the CDs in a vault or safety

deposit box. Such controls should be used and access should be limited to
authorized personnel.
Independent checks. No comparison is made of recorded accountability with
existing assets. This should be done independently at reasonable intervals and
investigation should be made of any difference.
The substantive tests that would detect the irregularity are (1) inspect and count
securities on hand, (2) vouch entries in investment accounts, and (3) recalculate
revenue earned.

a. Substantive Test
1.
2.
Recalculate revenue earned

Vouch entries in investment
accounts to brokers advice.
3.
Confirm securities held by

others
4.
Inspect and count securities

on hand
Vouch entries in investment
accounts to brokers advice.
Inspect and count securities
on hand
Review documentation
concerning market values
Verify accuracy of balances,
schedules and subsidiary
ledgers
Compare statement
presentation with GAAP
Compare statement
presentation with GAAP
5.
6.
7.
8.
9.
10.
b. Financial Statement
Assertion
Valuation of allocation
All assertions
c. Type of
Evidence
Mathematical
Documentary
Existence or occurrence,
completeness, rights and
obligations
All except rights and
obligations
All assertions
Confirmation
All except rights and

obligations
Physical, documentary
Mathematical
Documentary
Documentary
Physical, documentary
Documentary
Documentary
18-8

a.
The objectives of the CPA's examination of the investment account can be

summarized as follows.
Specific Audit Objectives
Transaction Objectives
Occurrence. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit
Completeness. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for
Accuracy. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit
Cutoff. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for audit
Classification. See Chapter 14 for audit objectives related to cash receipts and Chapter 15 for
Balance Objectives
Existence. Recorded cash balances exist at the balance sheet date (EO1). Year end transfers of
cash between banks are recorded in the proper period (EO2).
Completeness. Recorded cash balances include the effects of all transactions that have occurred
(C1). Year end transfers of cash between banks are recorded in the proper period (C2).
Rights and Obligations. The entity has legal title to all cash balances shown at the balance sheet
date (RO1).
Valuation and Allocation. Recorded cash balances are realizable at the amounts stated on the
balance sheet and agree with supporting schedules (VA1).
Disclosure Objectives
Occurrence and Rights and Obligations. Disclosed cash events and transactions have occurred
and pertain to the entity (PD1).
Completeness. All cash disclosures that should have been included in the financial statements
have been included (PD2).
Understandability. All cash disclosures are appropriately presented and information in
disclosures is understandable to users (PD3).
Accuracy and Valuation. Cash information is disclosed accurately and at appropriate amounts
(PD4).
b.
The CPA would accept a confirmation of the securities on hand from the custodian in
lieu of personally inspecting and counting the securities after investigating and
satisfying him or herself as to the standing of the custodian. The CPA would
probably be satisfied upon finding the custodian to be a well-known, reliable
financial institution, completely independent of the client and with resources
substantially larger in amount than the securities of the CPA's client that are on
deposit. Furthermore, to be acceptable as accounting evidence, the confirmation
should be delivered directly to the CPA by the custodian without passing through the
client's hands. The confirmation should contain a statement to the effect that
securities were the property of the depositor on a specified date. In examining the
investment account and the custodian's detailed statements, the CPA would expect to
find few, if any, errors made by the custodian; the discovery of errors on the part of
the custodian would cast serious doubt on the reliability of the confirmation.
18-9
c.
The CPA would recommend that full disclosures be made in a footnote of the sale
and repurchase of the securities so that readers of the financial statements will have
adequate information to compare the current report with reports for prior years. The
gain on the securities transactions would be reported in the income statement on a
separate line after the results of operations for the year. The loss on operations for the
year must be clearly set forth in the income statement so that readers can make
meaningful comparisons with prior years. The securities should be reported in the
balance sheet at their new cost or repurchase price. The sale of the securities resulted
in cash that could have been used to purchase other securities or in other ways. That
management had planned to repurchase the same securities does not alter the fact
that alternative uses for the cash existed. If the cash had been used to buy other
securities, these new securities would have been recorded at their cost--the cash
expended to acquire them. The same treatment should be accorded to the actual
transactions.

a.
The following information is missing:
The date of purchase of S security
The date of purchase and sale of R security
Data concerning the accrual and/or receipt of interest due on R to date of sale
Data concerning the accrual and/or payment of interest due on S to the date of
purchase.
Justification for accrual of dividends
Accounting treatment of bond discount
Data concerning the December 31, 19X1, revenue accruals
Data required to evaluate the classification of securities
b.
Substantive tests noted as having been performed are:

The initial procedure of tracing beginning balances to prior year's working
papers.
The initial procedure of obtaining a client-prepared schedule of investments and
footing and crossfooting the schedule and reconciling selected totals with
corresponding general ledger balances.
Limited vouching of transactions to supporting documentation.
The following substantive tests were not noted as having been performed (this was
not a stated requirement of the question):
The securities were not physically inspected or confirmed.
The broker's advice (or other independent corroborating evidence) verifying the
sale of R was not examined.
Dividend rates were not verified by reference to public records (Standard &
Poor's) of dividend declarations.
The stated interest rates, maturity dates, and market values were not verified.
Computations of year-end accruals were not made.
18-10
Not all amounts (for example, loss on sale of R) were traced to the general
ledger.

Category
Initial
Procedures
Substantive Test
1) Obtain an understanding of the business and industry and determine:
a) The significance of cash balances and transactions on the entity.
b) The entitys policies for forecasting cash balances and investing surplus cash balances.
2) Perform initial procedures on cash balances and records that will be subjected to further testing.
a) Trace beginning balance for cash on hand and in bank to prior years working papers.
b) Review activity in general ledger accounts for cash and investigate entries that appear unusual in
amount or source.
c) Obtain client-prepared schedules of cash on hand and in bank, verify mathematical accuracy and
determine agreement with general ledger.
Analytical
Procedures
3) Perform analytical procedures:

a) Compare cash balances with budgeted amounts, prior year balances, or other expected amounts.
b) Calculate cash as a percent of current assets and compare with expectations.
4) Perform cash cutoff tests (note these test may have been performed as part of the audit programs for
accounts receivable and accounts payable):
a) 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
b) Review documentation such as daily cash summaries, duplicate deposit slips, and bank statements
covering several days before and after year-end date to determine proper cutoff.
c) Observe the last check issued and mailed on the last business day of the fiscal year and trace to
accounting records to determine the accuracy of the cash disbursements cutoff, or
d) 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.
5) 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.
6) Prepare proof of cash for any bank accounts that the entity has been unable to reconcile or for which
there is a high risk that fraudulent transactions have occurred.
7) Count undeposited cash on hand and determine that such amounts are included in cash balances.
8) Confirm bank deposit and loan balances with banks.
9) Confirm other arrangements with banks such as lines of credit, compensating balance agreements, and
loan guarantees or other parties.
10) Obtain scan, review, and prepare bank reconciliations as appropriate.
11) 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.
12) Compare statement presentation with GAAP.
a) Determine that cash balances are properly identified and classified in the financial statements.
b) Determine that bank overdrafts are reclassified as current liabilities.
c) Make inquires of management, review correspondence with banks, and review minutes of board of
directors meetings to determine matters requiring disclosure such as lines of credit, loan guarantees,
compensating balance agreements, or other restrictions on cash balances.
a) Evaluate the completeness of presentation and disclosures for receivables in drafts of financial
statements to determine conformity to GAAP by reference to disclosure checklist.
d) Read disclosures and independently evaluate their understandability.
Tests of
Details of
Transactions
Tests of
Details of
Balances
Presentation
and
Disclosure
18-11

a.
Patricia Company
Computation of Amount Abstracted by Cashier
November 30, 20XO
Cash balance, per books November 30, 20XO
Add: Credit by bank
Adjusted cash balance (on hand and in bank)
Less adjusted bank balance:
Bank balance, November 30, 20XO
Less outstanding checks:
62
182
284
8621
8623
8632
Cash which should be on hand for deposit
Cash reported
Amount of theft
$18,901.62
100.00
$19,001.62
$15,550.00
$116.25
150.00
253.25
190.71
206.80
145.28
1,062.29
14,487.71
$ 4,513.91
3,794.41
$ 719.50
b.
The cashier removed $719.50. He attempted to conceal his theft by:

o Not listing all outstanding checks.
o Underfooting outstanding checks shown on the reconciliation.
o Subtracting an item from the bank balance that should be added to book balance.
c.
Two controls that were lacking are:

o Someone other than the cashier should trace cash receipts to the deposits in the
bank
o Someone other than the cashier should be responsible for preparing bank
reconciliation.

Other Audit Procedures
Sources of debit entries in general ledger cash
account, other than from cash receipts journals,
should be investigated and supporting
documents examined.
Reason for Other Audit Procedures

Since the auditor, using standard
procedures, only examines the cash receipts
journal, he or she must investigate the
validity of all other sources of cash receipts
which are not recorded in these journals.
18-12

A surprise examination of cash receipts should
be performed. Prior to the accounts receivable
clerk obtaining the cash receipts, the auditor
should make a list of them without the clerk's
knowledge. The undeposited mail receipts
should then be controlled after completion of
their preparation for deposit and after postings
have been made to the subsidiary accounts
receivable ledger. The deposit slip should be
totaled and compared to the remittances and
the list prepared by the auditor for accuracy.
Individual items on the deposit slip should be
compared to postings to the subsidiary
accounts receivable ledger. The auditor should
ask Gutzler to ask the bank to send the
statement containing that deposit directly to
the auditor.

Since there are no initial controls over cash
receipts established prior to the time the
accounts receivable clerk obtains the cash, a
surprise examination is the only method of
determining if cash receipts are being
recorded and deposited properly.
Postings from other deposit slips should be

traced to the cash receipts journal and the
subsidiary accounts receivable ledger. Also,
entries in the subsidiary accounts receivable
ledger should be traced to the cash receipts
journal and to the deposit slips.
Since there is no separation of duties

between cash receipts and accounts
receivable, the accounts receivable clerk
may have been careless in performing
posting duties. This procedure may also
disclose whether the accounts receivable
clerk may have been lapping the accounts.
Review the subsidiary accounts receivable

ledger and confirm accounts that have
abnormal transaction activity such as
consistently late payments.
Once more, there is no separation of duties

receivable. If the accounts receivable clerk
was careless in performing posting duties,
this procedure may also disclose whether
the accounts receivable clerk may have been
lapping the accounts.
If Gutzier allows customers to take discounts,

the amount of such discounts and the discount
period should be checked.
Since there is no separation of duties

receivable, the accounts receivable clerk
may have appropriated discounts which
could have been, but were not, taken, or
may have been careless in checking the
appropriateness of discounts taken.
Dates and amounts of daily deposits per bank
Since there are no initial controls over cash
18-13

statements should be compared with entries in
the cash receipts journal
A proof-of-cash working paper should be
prepared which reconciles total cash receipts
with credits per bank statements. The opening
and closing reconciliation of the proof of cash
should be compared to the comparable
reconciliation prepared by the controller.

receipts established prior to the time the
accounts receivable clerk obtains the cash,
the clerk may have become careless about
promptly depositing the daily receipts.
Since internal control over cash receipts is
weak, the auditor should perform that
overall check to help substantiate that he or
she has investigated all material items
during the detail tests.
Prepare a ratio analysis of monthly collections

to total sales of the preceding month or
monthly collections to total accounts
receivable at the beginning of the month and
compare this analysis with a similar analysis
for the preceding year.

weak, this overall test may highlight points
of irregularities, is such exist.
Visit the client on the balance sheet date or the

next business day to determine that an
appropriate cutoff of cash receipts has been
made.

weak, the auditor needs to be satisfied that
cash receipts are recorded in the appropriate
period.
For those periods for which the above audit

procedures were not performed and for a
period after the balance sheet date, scan the
cash receipts journal and bank statements for
unusual items.

weak, the auditor should perform that
review to help substantiate that all material
items not covered during other tests have
been investigated.

a.
The purposes of auditing bank transfers are to (1) determine that bank balances are
correctly stated at the balance sheet date and (2) to detect kiting.
b.
Bank Accounts
Ck. No.
2476
2890
3140
A1006
A1245
3402
From
C--Reg
C--Reg
C--Reg
M--Spec
M--Spec
C--Reg
To
C--Pay
C--Pay
M--Spec
C--pay
C--Reg
M--Spec
Amount
of
Check
$100,000
200,000
100,000
50,000
25,000
125,000
Disbursement
Date
Books
6/23
6/25
6/28
6/29
6/30
7/1
Bank
6/30
7/2
7/5
7/6
7/7
7/5
Receipt
Date
Books
6/25
6/27
6/30
7/1
7/2
6/30
Bank
6/25
6/27
6/30
7/1
7/2
6/30
18-14
c.
City Bank--Payroll
Bank Clearing (Due to Metro Bank--Special)
50,000
City Bank--Regular
Bank Clearing (Due to Metro Bank--Special)
25,000
Bank Clearing (Due from Metro Bank--Special)

City Bank--Regular
50,000
25,000
125,000
125,000
d.
Outstanding checks: 2890, 3140, 3402, A1006, A1245

Deposits in transit: 3402
e.
Check 3402 is indicative of kiting because the check was received, recorded, and
deposited on June 30, but was not recorded as a disbursement until July 1.

In order to determine whether lapping exists, Stanley would test the aging of accounts
receivable and then o Mail positive accounts receivable confirmation requests directly to all customers with
old balances.
o Investigate all exceptions noted on confirmations.
o Obtain authenticated deposit slips directly from the bank.
o Compare individual customers' names, dates, and amounts shown on the customer's
remittance advices with the names, dates, and amounts recorded in the cash receipts
journal, individual customer ledger accounts, and deposit slips (if practicable).
o Verify the propriety of noncash credits to accounts receivable (for example, sales
discounts, sales returns, bad debt write-offs).
o Perform a surprise inspection of deposits.
o Foot the cash receipts journal, the customers' ledger accounts, and the accounts
receivable control account.
o Reconcile the total of the individual customers' accounts with the accounts receivable
control account.
o Compare information in copies of monthly customers' statements with information in
customers' ledger accounts.
Cases
a. and b.
18-15
This case study contains information for a discussion of audit procedures for investment
securities and related income in a situation involving strong internal controls. Thus,
recognition of the effect of such controls on the nature, timing, and extent of resulting
substantive tests is essential. The solution provides for an evaluation of the appropriateness
of each procedure in the order in which they are presented in the audit program.
U.S. Government securities
o Prepare schedule of securities. Inappropriate. The schedule should be prepared by the
client. the auditor should only verify the accuracy of the schedule and compare it with
the ledger balance. This audit test relates to the valuation or allocation objective.
o Obtain direct confirmation from Utah Banking. Appropriate. The assertions are existence
or occurrence, completeness, and rights and obligations.
o Trace confirmations to schedules. Appropriate. Assertions are the same as (2).
o Verify interest earned and accrued. Appropriate. However, test only needs to be done on
a limited basis because of internal control. Assertions are existence or occurrence,
completeness, rights and obligations, and valuation or allocation.
o Trace appropriate totals to general ledger. Appropriate. Assertion is valuation or
allocation.
Available-for-sale securities
o Prepare analysis, including market values. Inappropriate. This information should be
provided by the client. The auditor should verify accuracy of schedule and some market
values. Assertion is valuation or allocation.
o Count securities at December 31. Appropriate. In principal, the count is necessary to meet
the existence or occurrence, completeness, and rights and obligations assertions. However,
the count may be made at any time close to December 31. The program fails to specify
that the auditor should determine whether or not the securities have been endorsed to
other parties.
o Vouch purchases and sales. Appropriate. However, this only needs to be done on a select
basis. Assertions are existence or occurrence, rights and obligations, and valuation or
allocation.
o Compare dividends received with published dividend record. Appropriate, if done on a
test basis. Assertions are existence or occurrence, completeness, rights and obligations,
and valuation or allocation.
o Verify recorded gain on sale. Appropriate. This ordinarily is done as part of vouching
purchases and sales. Because of strong internal control, only material gains or losses
need to be verified. Assertions are the same as for vouching purchases and sales.
Investment in 60% owned subsidiary
o Request confirmation. Appropriate. This is necessary to meet the existence or
occurrence, completeness, and rights and obligations assertions.
o Review monthly statements, etc. Inappropriate. The subsidiary investment is carried at cost.
The main concern here is to determine whether management can justify using this
method, since it is contrary to the presumption stated in APB No. 18. If no justification,
the client should change method or auditor should qualify the audit report.
18-16
o Discuss December 31 statements with management. Inappropriate. Discussion should be

directed at propriety of method used, not unrecorded amounts, since internal control is
strong.
o Establish that intercompany accounts are in agreement. Appropriate. This procedure is
needed to meet the valuation or allocation assertion.
o Record equity in net assets. Inappropriate. The company is using the cost method. Also
inappropriate in that auditor would be making the entry. If client agrees to adopt equity
method, an adjustment should be proposed by the auditor to meet the valuation or
allocation assertion. The program also fails to require the auditor to determine whether
the investment should be written down at December 31.
c.
Other points
o The program does not require the auditor to apply analytical procedures on the
investment accounts. This substantive test is important in meeting the existence or
occurrence, completeness, valuation or allocation, and presentation and disclosure
assertions.
o The program does not require the auditor to determine the propriety of the statement
presentation and disclosure, including the proper classification of the investment
securities as trading, available-for-sale, held-to-maturity, or equity method investments.
This should be done by making appropriate inquiries of management to learn
management's intent regarding holding periods, assessing its abilities regarding holding
periods, and comparing the financial statement presentation to GAAP, including the
treatment of any realized and unrealized gains and losses due to changes in market value.
The auditor may learn of the existence of any liens from an inspection of the minutes
book and by inquiry of management.
Professional Simulations
Research
Situation
Audit
Planning
Audit
Procedures
AU 332,57 and .58 addresses how the auditor should obtain to evaluate assertions about securities
based on managements intent and ability. These paragraphs are presented below.
56
Generally accepted accounting principles require that managements intent and ability be
considered in valuing certain securities; for example, whether
Debt securities are classified as held-to-maturity and reported at their cost depends
on managements intent and ability to hold them to their maturity.
Equity securities are reported using the equity method depends on managements
ability to significantly influence the investee.
Equity securities are classified as trading or available-for-sale depends on

managements intent and objectives in investing in the securities.
18-17
.57
In evaluating managements intent and ability, the auditor should

a.
Obtain an understanding of the process used by management to classify securities as
trading, available-for-sale, or held-to-maturity.
b.
For an investment accounted for using the equity method, inquire of management as
to whether the entity has the ability to exercise significant influence over the
operating and financial policies of the investee and evaluate the attendant
circumstances that serve as a basis for managements conclusions.
c.
If the entity accounts for the investment contrary to the presumption established by
generally accepted accounting principles for use of the equity method, obtain
sufficient competent evidential matter about whether that presumption has been
overcome and whether appropriate disclosure is made regarding the reasons for not
accounting for the investment in keeping with that presumption.
d.
Consider whether managements activities corroborate or conflict with its stated
intent. For example, the auditor should evaluate an assertion that management
intends to hold debt securities to their maturity by examining evidence such as
documentation of managements strategies and sales and other historical activities
with respect to those securities and similar securities.
e.
Determine whether generally accepted accounting principles require management to
document its intentions and specify the content and timeliness of that documentation.
fn 19 The auditor should inspect the documentation and obtain evidential matter
about its timeliness. Unlike the formal documentation required for hedging activities,
evidential matter supporting the classification of debt and equity securities may be
more informal.
f.
Determine whether managements activities, contractual agreements, or the entitys
financial condition provide evidence of its ability. Examples follow:
(1)
The entitys financial position, working capital needs, operating results, debt
agreements, guarantees, alternate sources of liquidity, and other relevant
contractual obligations, as well as laws and regulations, may provide
evidence about an entitys ability to hold debt securities to their maturity.
(2)
Managements cash flow projections may suggest that it does not have the
ability to hold debt securities to their maturity.
(3)
Managements inability to obtain information from an investee may suggest
that it does not have the ability to significantly influence the investee.
(4)
If the entity asserts that it maintains effective control over securities
transferred under a repurchase agreement, the contractual agreement may be
such that the entity actually surrendered control over the securities and
therefore should account for the transfer as a sale instead of a secured
borrowing.
18-18
Audit
Planning
Research
Situation
Audit
Procedures
To:
Audit File
Re:
Staff Training for Audit of Cash Balances
From: CPA Candidate
The following table contrasts the audit of cash balances when the client has good controls over cash
balances vs. having poor controls over cash balances.
Good Internal Controls over
Cash Transactions and Cash Balances
When control risk is low (and detection risk is high), the
auditor may scan the client-prepared bank reconciliation
and verify the mathematical accuracy of the reconciliation.
If detection risk is moderate, the auditor may review the
clients bank reconciliation more carefully. The review
will normally include
Comparing the ending bank balance with the balance
confirmed on the bank confirmation form
Verifying the validity of deposits in transit and
outstanding checks
Establishing the mathematical accuracy of the
reconciliation
Vouching reconciling items such as bank charges and
credits and errors to supporting documentation
Investigating old items such as checks outstanding for
a long period of time and unusual items
Weak Internal Controls over

Cash Transactions and Cash Balances
When control risk is high or maximum (and detection risk
is low), the auditor may prepare the bank reconciliation
using bank data in the clients possession. When detection
risk is very low or the auditor suspects possible material
misstatements, the auditor may obtain the year-end bank
statement directly from the bank and prepare the bank
reconciliation. To do so, the auditor must request the client
to instruct the bank to send the bank statement and
accompanying data (paid checks, debit memos, etc.)
directly to the auditor. This procedure will prevent the
client from making alterations of the data to cover any
misstatements.
The evidence provided by a bank reconciliation alone is
generally not considered sufficient to verify the balance of
cash in bank because of uncertainties concerning the
following two most important reconciling items: (1)
deposits in transit and (2) outstanding checks. Such
evidence is obtainable only by tracing these items to the
bank statement in the next accounting period. The
procedure of obtaining a bank cutoff statement is
designed, in part, for this purpose. When the cutoff
statement validates these and other reconciling items, the
reliance that an auditor can place on a bank reconciliation
is significantly enhanced.
18-19
Audit
Procedures
Research
Situation
Audit
Planning
The following table explains the auditing procedures that should be performed associated with the
legend identified as a) through i).
Legend
a)
b)
c)
d)
e)
f)
g)
h)
i)
Audit Procedure
Agreed bank cutoff statement received directly from the bank.
Vouched to bank cutoff statement. Cash receipts journal show deposit in December of
20X3 and bank cutoff statements shows deposit per bank in January 20X4.
Vouched to bank cutoff statement. The check was dated prior to December 31, 20X3
and it check cleared the bank in January 20X4.
NSF check vouched to bank documentation accompanying the return of the customers
check.
Bank charges vouched to bank statement received in January 20x4.
Check number was recorded in error. Vouched to actual check that cleared the bank,
bank statement, and cash disbursements journal.
Vouched to remittance advice received from the bank with notification of collection of
note from customer.
Traced to general ledger at December 31, 20x4.
foot
18-20

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18 Audit Investments and Cash Balances Ch18fin

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CHAPTER 18

AUDIT INVESTMENTS AND CASH BALANCES

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

18-4. Typically, the control environment pertaining to investments in marketable securities

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Assertion (Audit Objective)

Valuation and Allocation

Rights and Obligations

Recorded securities are regularly

Observe evidence of reconciling recorded

The computer prepares an exception

Use CAATs to test the control by

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

The account balance audit objectives for cash are as follows:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Kiting is an irregularity in which a bank transfer is recorded as a deposit in the

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Lapping is an form of fraud that results in the deliberate misappropriation of cash

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Several of the categories of internal control activities have been violated.

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Access controls. No mention is made of storing the CDs in a vault or safety

18-26. (Estimated time - 25 minutes)

Recalculate revenue earned

Confirm securities held by

Inspect and count securities

All except rights and

Presentation and disclosure

Presentation and disclosure

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

18-27. (Estimated time - 30 minutes)

The objectives of the CPA's examination of the investment account can be

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

18-28. (Estimated time - 25 minutes)

Substantive tests noted as having been performed are:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

18-29. (Estimated time - 20 minutes)

3) Perform analytical procedures:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

18-30. (Estimated time - 30 minutes)

The cashier removed $719.50. He attempted to conceal his theft by:

Two controls that were lacking are:

18-31. (Estimated time - 25 minutes)

Solutions Manual to Modern Auditing: Copyright

Reason for Other Audit Procedures

2005, John Wiley and Sons, Inc.

Other Audit Procedures

Reason for Other Audit Procedures

Postings from other deposit slips should be

Since there is no separation of duties

Review the subsidiary accounts receivable

Once more, there is no separation of duties

If Gutzier allows customers to take discounts,