Solutions. I. Auditing Cash and Cash Equivalents. A. Learning Question Answers

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1 Solutions I. Auditing Cash and Cash Equivalents A. Learning Question Answers 1. A is correct. As a result, cash and cash equivalents are typically shown in the same financial statement line item on the balance sheet. B is incorrect. Short-term investments that essentially function like cash should be considered cash equivalents. Each company should disclose its policy regarding determining and presenting cash equivalents. C is incorrect. Short-term investments that mature in nine months are current assets, but are not cash equivalents. 2. A is incorrect. Valuation/allocation and related presentation/disclosure issues tend to center around special use of funds, compensating balance requirements, or other withdrawal restrictions. These issues tend to be verifiable by reading written agreements and/or confirmation with third parties. B is incorrect. Evidence obtained directly from third parties is generally moderately to strongly persuasive, and should be considered when risk and materiality is deemed high for cash. C is correct. Due to the nature of cash, it is susceptible to misappropriation (e.g., theft and stealing). 3. A is incorrect. Cash receipt and disbursement transactions occurring prior to year-end should be reflected in the financial statements. For example, cash disbursements would be an expense or a prepaid, or cash receipts could be revenue or deferred revenue. B is incorrect. Cash receipt and disbursement transactions occurring after year-end should be excluded from the financial statements. Examples include not reflecting a cash disbursement as an accounts payable or establishing a cash receipt as an accounts receivable. C is correct. Rights and obligations relate to whether the entity holds or controls rights to the assets. 4. A is incorrect. If a deposit-in-transit on the bank reconciliation was not truly deposited prior to year-end, but not processed by the bank subsequent to year-end, then the amount would be overstating cash at year-end. B is incorrect. If the balance per the bank on the bank reconciliation is higher than the confirmed balance per the bank, there could be a risk of overstatement of cash. C is correct. This test relates to presentation/disclosure of cash accounts. 5. A is correct. With an imprest account, only the amount of cash to cover the current period s approved payroll is transferred into the account. This discourages someone from creating a ghost employee or paying an unauthorized bonus. B is incorrect. The purpose of an imprest account is to prevent unauthorized access to payroll funds, as only the amount of cash to cover the current period s approved payroll is transferred into the account. C is incorrect. Monitoring is an element of internal control, which focuses on ensuring that controls are operating as intended at an entity-wide level. 1

2 6. A is correct. Positive pay occurs when the bank compares all checks submitted for payment to an electronic file of company-authorized disbursements. Any checks not meeting all of the criteria in the file are flagged for exception. B is incorrect. Positive pay flags checks that meet certain criteria (e.g., exceeding a specified dollar limit or past a certain date) which require specific authorization for further processing. C is incorrect. Kiting is a fraud scheme related to double-counting cash in multiple bank accounts to overstate cash. 7. A is incorrect. Manual check processing creates greater risk of misappropriation by employees, as there is more opportunity to manipulate, alter, or intercept manual vs. electronic checks. B is correct. Non-check disbursements may be more difficult to track and monitor because they may not have controls such as sequential numbering for wire transfers, cash payments, etc. C is incorrect. A high volume of transactions would increase the risk of material misstatement, as misappropriation, fraudulent financial reporting or error may go undetected in a larger population. 8. A is incorrect. Existence would be concerned about cash being overstated, not understated. Cash being misappropriated prior to recording would result in a completeness risk. B is correct. There is an increased risk that cash donations may be misappropriated before they are even entered into the nonprofit s financial records. This would result in understatement of cash. C is incorrect. Classification risk would relate to concerns such as cash equivalents being improperly included in investments. 9. A is correct. External confirmation must be in writing, and the confirmation process must be controlled by the auditor. B is incorrect. Even though this is generally considered to be persuasive evidence, it does not qualify as an external confirmation unless there is a direct written communication between the auditor and an independent, knowledgeable third party. C is incorrect. As the client controlled the receipt of the bank statement, it cannot qualify as an external confirmation. 2

3 B. Homework Answers Typical Cash Audit Procedures 1. Using the standard AICPA bank confirmation form, consider requesting confirmation as of the balance sheet date for each bank account. Trace the bank balance on the reconciliation to the bank confirmation received from the bank. This should include confirmation of material savings accounts, certificates of deposit, and compensating balance requirements, restrictions on withdrawal of funds. (Note: Accounts selected for confirmation should be based on professional judgment considering risk and materiality. If the client has only a few accounts, it may make sense to send confirmations for every account. If the client has numerous primary and secondary accounts, perhaps only the primary account(s) are confirmed. In some cases, all bank balances may simply be agreed to the original bank statements or on-line inquiry.) JT 2/5/XY See workpaper A Consider sending standard bank confirmations for accounts closed during the year if there is a risk of fraud or unrecorded debt. JT 2/5/XY No accounts closed during the year. 3. Perform alternate procedures for confirmations not received. An example would include agreeing the balance per bank reconciliation to the client-received bank statement, bank cut-off statement received by the auditors, or other information accessible through on-line inquiry directly with the bank. JT 2/5/XY All accounts confirmed at workpaper A For accounts with a significant volume of transactions, consider requesting a cutoff bank statement for the subsequent period after the balance sheet date to be mailed directly to the auditors. Compare the beginning bank balance on the subsequent bank statement to the bank reconciliation. Investigate any difference. JT 2/5/XY Cutoff statement received to test workpaper A Trace the reconciled book balance to the general ledger trail balance. JT 2/5/XY See workpaper A. 6. Consider testing the clerical accuracy of the reconciliation and detail supporting schedules. JT 2/5/XY See workpapers A-1 & A Obtain the bank reconciliation and review the nature and extent of reconciling items for reasonableness for accounts with significant balances or volume of activity, and determine the necessity and extent of reconciling items testing based on professional judgment. Be alert for unusual reconciling items, even if not quantitatively material. JT 2/5/XY See workpapers A-1 & A Consider tracing material deposits per the bank reconciliation to deposits in the subsequent period s/ cutoff bank statement noting reasonableness of the time period between book and bank recording. JT 2/5/XY See workpaper A-1. 3

4 9. Consider inspecting selected canceled checks returned with the subsequent period s cutoff bank statement. Trace checks dated before the balance-sheet date above a specified scope to the list of outstanding checks. Be alert for large or unusual outstanding checks. Investigate any large or unusual outstanding checks that did not clear with the subsequent period s cutoff bank statement. JT 2/5/XY See workpaper A Inquire whether any checks drawn before year end were released after year end or are being held. Consider classification of any significant held checks to accounts payable. JT 2/5/XY See note (1) at workpaper A Consider reviewing the client s schedule of material interbank transfers for a sufficient period before and after year end to determine that the deposit and disbursement side of each transfer is recorded in the proper period, and that incomplete transfers are properly recorded as reconciling items on the bank reconciliations. (Note: In the past, interbank transfer schedules were traditionally prepared for five days before and after year end to detect kiting. Kiting is where a company shows a deposit-in-transit in one account, but does not show the deduction on the other account. Before the prevalence of electronic banking, it used to take several days for banks to process interbank transfers. So, this fraud scheme was possible. The purpose of the interbank test is to ensure all year-end transfers were recorded in each appropriate account before yearend, and all post year-end transfers were recorded in each appropriate account post year-end. Transfers not clearing the bank in the same accounting period should be shown as reconciling items on the bank reconciliations. Theoretically, interbank transfers should be tested through the bank reconciliation testing and a specific test is not necessary. If a deposit-in-transit is related to an interbank transfer, the auditor would simply ensure that there was an outstanding debit on the other account s bank reconciliation. However, if there are numerous bank accounts with significant activity at year end, then the risk of kiting may substantiate a specific test of this nature. This is particularly true if there is a specific identified risk of fraud with cash. The auditor should challenge the need for this test, as well as the length of time before and after year-end that makes sense based on the bank s typical timeline for processing interbank activity.) JT 2/5/XY Interbank transfer activity is minimal; procedure not deemed necessary. 12. Inquire whether amounts are designated for a special purpose. Cash restricted for special purposes should be segregated from cash available for general operations. If restricted cash offsets current liabilities, then it may be shown as a current asset. Otherwise, the amount is typically shown as a non-current asset. In some cases, restricted cash could have both a current and non-current portion. JT 2/5/XY Noted no amounts designated for special purposes. 13. Inquire about compensating balances (minimum balance requirements of loan agreements or debt service funds established by debt indentures) or other withdrawal restrictions. Compensating balance agreements should be disclosed if the agreement legally restricts the use of funds. JT 2/5/XY Noted no compensating balances or other restrictions on cash. 14. Inquire about related guarantees, endorsements and/or letters of credit, including guarantee arrangements for related parties. JT 2/5/XY Debt is guaranteed by owner and will be disclosed in the footnotes. 4

5 15. Determine proper classification of cash, cash equivalents, or other short-term investments. Items typically included as cash and cash equivalents include: non-interest-bearing cash on deposit with banks, interest-bearing time deposits, certificates of deposit, money market accounts, shortterm investments with original maturities of three months or less, and repurchase agreements. Related footnote disclosures should be adequate to explain the nature of cash and cash equivalents. JT 2/5/XY Cash appears to be properly classified based on materiality. 16. Count material cash on hand. JT 2/5/XY No material cash on hand noted. 17. Conclude whether procedures performed are adequate to respond to identified fraud risks. JT 2/5/XY See Fraud Memo at GP-10 and workpaper A Consider whether results of procedures indicate significant deficiencies or material weaknesses. JT 2/5/XY See Fraud Memo at GP-10 and workpaper A Conclude whether the results of procedures are sufficient to achieve audit objectives. JT 2/5/XY Cash appears to be fairly stated in all material respects. 5

6 Cash Lead Schedule Carr Parts Company December 31, 20XX Page : 1 Prepared by: Reviewed by: JT 2/5/XY STANDARD LEAD SCHEDULE: A Cash & Cash Equivalents Account Description WP Ref Prior Yr Adjusted 12/31/20XW Dr (Cr) Unadjusted 12/31/20XX Dr (Cr) AJE Ref # Amount Dr (Cr) Adjusted 12/31/20XX Dr (Cr) 100 Petty Cash {b} Operating Cash A-1 36, , , Payroll Cash A Savings {a} 8, , , TOTALS 45, , , {a} Reviewed the December bank statement for this account. Only activity for the month was related to interest earned of $50, which was not properly recorded as of year-end. Therefore, the $10,050 amount confirmed per A-3 is off by the interest earned. Pass adjustment due to immateriality. See management letter comment regarding timely reconciliation of savings account to the general ledger. {b} Petty cash is maintained by the receptionist and should be reimbursed on a monthly basis. Based on discussions with Norma Lee, CFO, petty cash was not reimbursed for December and January. A check for $250 was written in February to replenish the petty cash. See management letter comment regarding reconciling petty cash on a timely basis. Pass further pursuit for adjustment due to immateriality. 6

7 A-1: Operating account bank reconciliation JT 2/5/XY Purpose: A-1 tests the existence and valuation of the operating cash account. Procedure: Obtained and reviewed client reconciliation at year-end. Compared reconciled balance per bank to cash balance per books, noting any variance. Traced unusual or individually significant outstanding checks over scope to clearing on subsequent month s bank statement. Obtained auditorreceived January bank statement to test the existence of deposits in transit and the completeness of the outstanding check list. Traced outstanding checks over scope clearing in the subsequent month s bank statement to proper inclusion/exclusion on the outstanding check list. C - Amount confirmed without exception on A-3. Conclusion: Per tests performed, cash account balance is reasonable and properly valued, and balance exists. (a) (b) (c) Obtained the cut-off bank statement as of 1/15/XY directly from the bank. Agreed beginning balance per bank statement to 12/31 ending balance per bank confirmation w/o exception. Reviewed all unusual checks and checks greater than $5,000 (one-tenth of TM) for propriety. Noted: (i) reasonableness of cancellation date; (ii) proper endorsement; and (iii) proper cut-off treatment as of 12/31/XX, except for the following. 1. Check #6054 written to WM Enterprises appears to be a fraudulent transaction, perpetrated by Willy Makit, accounts payable clerk. See Fraud Memo at GP-10 for discussion and reclassification of expense to Other Expense. 2. Check #5025 appears to be a check held due to a dispute with the vendor. Pass on reclassification of $3,000 balance due to immateriality. There do not appear to be any additional held checks to vendors. See management letter comment regarding proper presentation of held checks. Traced and agreed to cut-off statement, noting that treatment appears proper as of 12/31/XX. See Fraud Memo at GP-10 for a discussion of the fraud perpetrated by Willy Makit, accounts payable clerk, and the reclassification of expense to Other Expense, as amount is not likely to be recovered. 7

8 A-1: Operating account bank reconciliation Carr Parts Company 12/31/20XX Cash Operating PBC JT 2/5/XY Balance per bank statement as of 12/31/20XX 50, Deposits in transit 34, (b) 84, Less outstanding checks: Number Amount , , , (a) , (a) , (a) Total o/s checks: 45, , Less: Bank Charges Bank Error #6020 1, (c) Total Other reconciling: 1, Balance per general ledger 38, A 8

9 A-2: Payroll bank reconciliation Carr Parts Company A-2 12/31/20XX PBC JT Cash Payroll 2/5/XY Balance per bank statement A Deposits in transit: 0.00 Less Outstanding Checks: Number Amount Number Amount {a} 7891 void Total o/s checks Balance per general ledger A 0.00 {a} See Fraud Memo at GP-10 for discussion of the outstanding check. Note: Account is a zero-balance payroll imprest account. Reviewed January bank statement received by the client, noting no unusual or individually significant activity. Balance appears reasonable, as material misstatement deemed unlikely. 9

10 A-3 JT 2/5/XY STANDARD FORM TO CONFIRM ACCOUNT BALANCE INFORMATION WITH FINANCIAL INSTITUTIONS Financial Institution s Name and Address Da Bank P.O. Box Anytown, AS Carr Parts Company CUSTOMER NAME We have provided to our accountants the following information as of the close of business on December 31, 20XX, regarding our deposit and loan balances. Please confirm the accuracy of the information, noting any exceptions to the information provided. If the balances have been left blank, please complete this form by furnishing the balance in the appropriate space below. Although we do not request nor expect you to conduct a comprehensive, detailed search of your records, if, during the process of completing this confirmation, additional information about other deposit and loan accounts we may have with you comes to your attention, please include such information below. Please use the enclosed envelope to return the form directly to our accountants. 1. At the close of business on the date listed above, our records indicated the following deposit balance(s): ACCOUNT NAME ACCOUNT NO. INTEREST RATE BALANCE Operating None A-1 50, Savings % A 10, Payroll None A We were directly liable to the financial institution for loans at the close of business on the date listed above as follows: ACCOUNT NO./ DESCRIPTION INTEREST DATE THROUGH WHICH DESCRIPTION OF BALANCE* DATE DUE RATE INTEREST IS PAID COLLATERAL First Line 500, Demand Prime /15/XX All Assets Personal Guarantee of Iona Carr Norma Lee (Customer s Authorized Signature) See Debt workpapers and footnote disclosure. 12/27/20XX (Date) The information presented above by the customer is in agreement with our records. Although we have not conducted a comprehensive, detailed search of our records, no other deposit or loan accounts have come to our attention except as noted below. Penny Lane (Financial Institution Authorized Signature) Teller (Title) EXCEPTIONS AND/OR COMMENTS Please return this form directly to our accountants: Attn: Smart & Co., LLP Certified Public Accountants & Business Consultants *Ordinarily balances are intentionally left blank if 345 Anywhere Street they are not available at the time the form is prepared. Anytown, AS

11 Open Item List 1. Trace debt per confirmation on A-3 to debt workpapers. 2. Ensure guarantee of debt by Iona Carr is disclosed in the debt footnotes. 3. Trace the $20,000 purchase of the used car per check #6056 on December 28 to the fixed asset additions testing. 4. Write the following management letter comments: Timely reconciliation of savings account to the general ledger Timely reconciliation of petty cash account and reimbursement Proper presentation of held checks Material weakness: Controls over cash and cash disbursements Note: The following information was not retained in the engagement workpaper files, but was retained in a For Your Review file available to reviewers, should they wish to see the detail supporting documentation. Upon report issuance, the For Your Review file would be properly disposed of. All original documents should be returned to the client. All copies of documents should be thrown away. January operating account cut-off bank statement and enclosures Client request for cut-off bank statement January payroll account bank statement December savings account bank statement Based on professional judgment, the auditor may also have eliminated the payroll bank account reconciliation, and documented procedures in a brief memo on the cash lead schedule. The suggested answer key retained the workpaper since it indirectly relates to the identified fraud schemes perpetrated by Willy Makit. 11

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