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CHAPTER 2
2. AUDIT OF CASH AND MARKETABLE SECURITIES

2.1 Definition of Cash

 Cash, the most liquid of assets, is the standard medium of exchange and the basis for
measuring and accounting for all other items.
 Companies generally classify cash as a current asset.
 Cash consists of coin, currency, money orders, certified checks, cashier’s checks, personal
checks, ordinary checks, Selling checks, negotiable checks, bank drafts, checking checks etc.

2.2 Sources and Nature of Cash

Cash normally include general, payroll, petty cash and less frequently saving accounts. General
accounts are checking accounts similar in nature to those maintained by individuals. Cash sales,
collections of receivables, and investment of additional capital typically increase the account;
business expenditure decrease it.
Payroll and petty cash are “imprest” at all levels. When payroll is paid, a check from the general
account is drawn to deposit funds into the payroll account. Petty cash, used for very small
expenditures, replenished as necessary
 Sources of Cash
o Sales of goods and services on cash
o Receipts from investment (e.g. dividend from shares, interest on loans granted to
others)
o Collection from customers on account
o Loans (e.g. sales of bonds)
o Cash from sale of shares (investment of additional capital)
o Collection from sale of non-current assets
 Types of cash accounts
o General accounts o Saving account
o Imprest payroll fund account o Branch account
o Imprest Petty cash account o Cash equivalents
 Nature of cash
 Cash is the only account included in every business transactions and cycles.
 Cash is important because of its susceptibility to theft, and cash can also be
significantly misstated.
 The relationship between cash in the bank and the other transaction cycles serves
a dual function:
1. It shows the importance of audit tests of various transaction cycles on
the audit of cash.
2. It aids in further understanding the integration of the different
transaction cycles.

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2.3 Auditors’ Objectives in the Audit of Cash
The overall objective of the audit of cash is to determine that cash is fairly presented in
conformity with GAAP. The auditors’ objectives in the audit of cash are to:
1. Consider internal control over cash transactions
2. Substantive test of existence of recorded cash
3. Establish completeness of recorded cash
4. Determine the client has right to the recorded cash
5. Establish clerical accuracy of cash schedules
6. Determine presentation and disclosure of cash including restricted funds (such as
compensating balances and bond sinking funds), are appropriate.
Valuation is generally not major concern in the audit of cash because the financial statements are
presented in monetary units; valuation of cash is typically a problem only if conversion to or
from foreign currency is involved.

2.4 Internal Control over Cash

General Principles of Internal Control
Internal control consists of all of the related methods and measures adopted within a business
to:
a. Safeguard assets from employee theft, robbery, and unauthorized use; and
b. Enhance the accuracy and reliability of its accounting records by reducing the risk
of errors (unintentional mistakes) and irregularities (intentional mistakes and
misrepresentations) in the accounting process.
Safeguarding of Assets
To safeguard assets and enhance the accuracy and reliability of its accounting records, a
company follows internal control principles. The following six internal control principles apply
to most companies:

Principle1. Establishment of Responsibility

An essential characteristic of internal control is the assignment of responsibility to specific
individuals.
a. Control is most effective when only one person is responsible for a given task.
b. Establishing responsibility includes the authorization and approval of transactions.

Principle 2: Segregation of Duties

Segregation of duties is indispensable in a system of internal control. The rationale for
segregation of duties is that the work of one employee should, without a duplication of effort,
provide a reliable basis for evaluating the work of another employee. There are two common
applications of this principle:
a. The responsibility for related activities should be assigned to different individuals. When
one individual is responsible for all of the related activities, the potential for errors
and irregularities is increased.

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• Related purchasing activities should be assigned to different individuals. Related

purchasing activities include ordering merchandise, receiving goods, and paying
(or authorizing payment) for merchandise.
• Related sales activities also should be assigned to different individuals. Related
sales activities include making a sale, shipping (or delivering) the goods to the
customer, and billing the customer.
b. The responsibility for record keeping for an asset should be separate from the physical
custody of an asset. The custodian of the asset is not likely to convert the assets to
personal use if one employee maintains the record of the asset that should be on hand and
a different employee has physical custody of the asset.

Principle 3: Documentation Procedures: Documents provide evidence that transactions and

events have occurred.
 Documents should be pre-numbered and all documents should be accounted for. For
instance numbers on checks and invoices (like restaurant receipts).
 Source documents for accounting entries should be promptly forwarded to the accounting
department to help ensure timely recording of the transaction and event.

Principle 4: Physical, Mechanical, and Electronic Controls –

Physical controls relate primarily to the safeguarding of assets. Mechanical and electronic
controls safeguard assets and enhance the accuracy and reliability of the accounting records. Use
of physical, mechanical, and electronic controls is essential. Examples of these controls include:
a. Safes, vaults, and safety deposit boxes for cash and business papers.
b. Locked warehouses and storage cabinets for inventory and records.
c. Computer facilities with pass key access or fingerprint or eyeball scans.
d. Alarms to prevent break-ins.
e. Television monitors and garment sensors to deter theft.
f. Time clocks for recording time worked.

Principle 5: Independent Internal Verification

Independent internal verification involves the review, comparison, and reconciliation of data
prepared by employees.
a. Verification should be made periodically or on a surprise basis.
b. Verification should be done by an employee independent of the personnel responsible
for the information.
c. Discrepancies and exceptions should be reported to a management level that can take
appropriate corrective action.
d. In large companies, independent internal verification is often assigned to internal
auditors.
e. Internal auditors are employees of the company who evaluate on a continuous basis the
effectiveness of the company’s system of internal control.They periodically review the

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activities of departments and individuals to determine whether prescribed internal
controls are being followed.

Principle 6: Other Controls:

a. Bonding of employees who handle cash.
b. Rotating employees' duties and requiring employees to take vacations.

Applications of Internal Control to Cash Receipts

Cash receipts may result from cash sales; collections on account from customers; the receipt of
interest, rents, and dividends; investments by owners; bank loans; and proceeds from the sale of
non-current assets. The following internal control principles explained earlier apply to cash
receipts transactions as shown:
1. Establishment of responsibility - Only designated personnel (cashiers) are authorized to
handle cash receipts.
2. Segregation of duties- Separate cash receipt from recordkeeping. Different individuals
receive cash, record cash receipts, and hold the cash.
3. Documentation procedures - Use remittance advice (mail receipts), cash register tapes,
and deposit slips.
4. Physical, mechanical, and electronic controls - Store cash in safes and bank vaults; limit
access to storage areas; use cash registers.
5. Independent internal verification. Do not permit any one employee to handle a
transaction from beginning to end. For example, supervisors count cash receipts daily;
treasurer compares total receipts to bank deposits daily.
6. Other controls.
 Bond personnel who handle cash;
 require vacations and rotation of employees
 Deposit all cash receipts in bank daily.

2. Methods of Disbursing and/or safeguarding Cash:

a. Electronic Funds Transfer (EFT) System: A new approach developed to transfer
funds among parties without the use of paper (deposit tickets, checks, etc.). The
approach, called electronic funds transfers (EFT), uses wire, telephone, telegraph, or
computer to transfer cash from one location to another.
b. Petty Cash Fund - A cash fund used to pay relatively small amounts. Information on
the operation of a petty cash fund is provided in the Appendix to this chapter.
c. Use of a Bank. First it contributes significantly to good internal control over cash by
creating a separate set of records (bank and books). Second the asset account Cash
maintained by the company is the “flip-side” of the bank’s liability account for that
company. It should be possible to reconcile these accounts—make them agree—at
any time. Each month the company receives a bank statement showing its bank
transactions and balances. For example, some transactions and balances shown
include:

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 Checks paid and other debits that reduce the balance in the
depositor's account.
 Deposits and other credits that increase the balance in the
depositor's account.
 The account balance after each day's transactions.
2.5 Audit Program for Cash
Audit program is a detailed listing of the specific audit procedures to be performed in the course
of audit engagement. The following audit program indicates the general pattern of work
performed by the auditors in the verification of cash (p 394 Wittington).

2.5.1. Consider internal control over cash

Test of controls provide auditors with evidence as to whether prescribed control are in use and
operating effectively. The result of these tests assists the auditor in evaluating the likelihood of
material misstatements having occurred. This implies that the auditor should assure that the
above internal control over cash receipts and cash disbursements are in place.
Some of the specific activities include:
1. Obtain an understanding of internal control over cash
2. Assess control risk and design additional attests of controls for cash
3. Perform additional tests of controls for those controls which the auditors plan to consider
to support their planned assessed level of control risks, such as

2.5.2. Perform Substantive test of cash transactions and balances

Substantive tests are designed to detect material misstatement if they exist in the financial
statements. The amount of substantive testing done by the auditor is greatly influenced by their
assessment of the likelihood that misstatement exists. The auditor undertakes the following
activities in relation to the substantive test of cash transactions and balances.

1. Obtain analysis of cash balances and reconcile to the general ledger

2. Send standard confirmation forms to financial institutions to verify amounts on deposit
3. Obtain or prepare reconciliation of bank accounts as of the balance sheet date and
consider need to reconcile bank activity for additional month
4. Obtain a cut-off bank statement containing transactions of at least seven business days
subsequent to balance sheet date
5. Count cash list on hand
6. Verify the client’s cutoff of cash receipts and cash disbursements
7. Analyze bank transfers for the last week of audit year and first week of following year
to disclose kitting

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Brief discussion of the above audit programs/procedures presented below.
1. Obtain analysis of cash balances and reconcile to the general ledger
The auditor will prepare or obtain a schedule that lists the entire client’s cash account. For
example for cash in bank account, this schedule will typically list the bank, the bank account
number, account type (checking a/c or saving a/c), and the year-end balance per book. The
auditors will trace and reconcile all a/c to the general ledger as necessary.

2. Send standard confirmation forms to financial institutions to verify amounts on deposit

Auditors usually obtain a direct receipt of a confirmation from every bank or other financial
institution with which the client does business. The main objective of this confirmation letter is
to corroborate (confirm) the existence of the amounts of cash recorded on the balance sheet of
the client. Ask banks if the amount of cash indicated in balance sheet as ‘cash in bank’ really
exist in the bank account.
After auditors receive the completed bank confirmation, the balance in the bank account
confirmed by the bank should be traced to the amount stated on the bank reconciliation.
Similarly, all other information on the reconciliation should be traced to the relevant audit
schedules. If the bank confirmation does not agree with the audit schedules, auditors must
investigate the difference

3. Obtain or prepare reconciliation of bank accounts as of the balance sheet date

In order to ascertain the appropriateness a company’s cash position at the close of the period, the
auditor should reconcile the balance per bank statement at that date with the balance per
company’s accounting records.

A monthly bank reconciliation of the general bank account on a timely basis by someone
independent of the handling or recording of cash receipts and disbursements is an essential
control over the ending cash balance. Companies with significant cash balances and large
volumes of cash transactions may reconcile cash on a daily basis to online banking records. The
reconciliation ensures that the accounting records reflect the same cash balance as the actual
amount of cash in the bank after considering reconciling items. More important, the independent
reconciliation provides an opportunity for an internal verification of cash receipts and
disbursements transactions.
Careful bank reconciliation includes the following actions:
• Compare cancelled checks or electronic bank records of payment with the cash
disbursements records for date, payee and amount
 Examine cancelled checks or electronic bank records of payment for signature,
endorsement, and cancellation
 Compare deposits in the bank with recorded cash receipts for date, customer, and amount
 Account for the numerical sequence of checks, and investigate missing ones
 Reconcile all items causing a difference between the book and bank balance and verify
their appropriateness for the client’s business

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 Reconcile total debits on the bank statement with the totals in the cash disbursements
records
 Reconcile total credits on the bank statement with the totals in the cash receipts records
 Review month-end interbank transfers for appropriateness and proper recording
 Follow up on outstanding checks and stop-payment notices.
If the client has already prepared bank reconciliation, there is no need for duplicating the work.
However, the auditors should examine/inspect the reconciliation in detain to satisfy themselves
that it has been properly prepared. Auditors test the bank reconciliation to determine whether
client personnel have carefully prepared the bank reconciliation and to verify whether the client’s
recorded bank balance is the same amount as the actual cash in the bank except for deposits in
transit, outstanding checks, and other reconciling items.

In verifying the reconciliation, the auditor uses information in the cutoff bank statement to verify
the appropriateness of reconciling items. The auditor’s verification of the reconciliation involves
several procedures:
• Verify that the client’s bank reconciliation is mathematically accurate.
• Trace the balance on the bank confirmation and/or the beginning balance on the cutoff
statement to the balance per bank on the bank reconciliation to ensure they are the same.
• Trace checks written and recorded before year-end and included with the cutoff bank
statement to the list of outstanding checks on the bank reconciliation and to the cash
disbursements journal in the period or periods prior to the balance sheet date. All checks
that cleared the bank after the balance sheet date and were included in the cash
disbursements journal should also be included on the outstanding check list. If a check
was included in the cash disbursements journal, it should be included as an outstanding
check if it did not clear before the balance sheet date. Similarly, if a check cleared the
bank before the balance sheet date, it should not be on the bank reconciliation.
• Investigate all significant checks included on the outstanding check list that have not
cleared the bank on the cutoff statement. The first step in the investigation should be to
trace the amount of any items not clearing to the cash disbursements journal. The reason
for the check not being cashed should be discussed with the client, and if the auditor is
concerned about the possibility of fraud, the vendor’s accounts payable balance should be
confirmed to determine whether the vendor has recognized the receipt of the cash in its
records. In addition, a copy of the cancelled check should be examined before the last day
of the audit if it becomes available.
• Trace deposits in transit to the cutoff bank statement. All cash receipts not deposited in the
bank at the end of the year should be traced to the cutoff bank statement to make sure that
they were deposited shortly after the beginning of the new year.
• Account for other reconciling items on the bank statement and bank reconciliation. These
include such items as bank service charges, bank errors and corrections, and unrecorded
transactions debited or credited directly to the bank account by the bank. These

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reconciling items should be investigated to be sure that they have been treated properly by
the client.

4. Obtain a cut-off bank statement

A cut-off bank statement is a partial-period bank statement and the related copies of cancelled
checks, duplicate deposit slips, and other documents included in bank statements, mailed by the
bank directly to the auditor’s (CPA firm’s) office. The purpose of the cut-off bank statement is to
verify the accuracy of reconciling items on the client’s year-end bank reconciliation with
evidence that is not accessible to the client. To fulfil this purpose, the auditor requests the client
to have the bank send the statement for 7 to 14 days subsequent to the balance sheet date directly
to the auditor. It allows the auditors to examine the checks listed as outstanding and the details of
deposits in transit on the company’s reconciliation.

With respect to checks that were shown as outstanding at the year-end, the auditors should
determine the dates on which the bank paid these checks. By noting the dates of payment of
these checks, the auditors can determine whether the time intervals between the dates of the
check and the time of payment by bank were unreasonably long. Unreasonable delay in the
presentation of these checks for payment constitutes a strong implication that the checks were
not mailed by the client until sometime after the close of the year.
In examining the cut-off bank statement, the auditors will also watch for any paid checks issued
on or before the balance sheet date but not listed as outstanding on the client’s year-end bank
reconciliation. Thus, the cut-off bank statement provides assurance that the amount of cash
shown on the balance sheet was not overstated by omission of one or more checks from listing of
checks outstanding.

5. Count cash list on hand

The auditors should physically count the cash on hand, which may include cash receipts, change
funds and petty cash, to verify its existence. This is normally done at the close of business on the
last day of the fiscal period under audit. The auditor should take at least two precautions in
performing the count of cash.

 The cash count should be made simultaneously with the inspection of investments and
negotiable instrument. This requirement prevents the auditor from double counting these
assets. Furthermore, all cash should be controlled throughout the time of the cash count to
avoid the possibility of the auditor again being misled into counting a specified amount of
cash more than once. A common way of achieving this control is to seal each container of
cash immediately after it has been counted. After the count of all each has been completed,
the auditor should retrace the counting cycle to certify that the individual seals were not
broken after the cash in them was counted.
 The count should always be made in the presence of the custodian of each of the funds, and
he or she should be asked to sign a receipt for the return of cash after the count has been
completed.

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7. Analyze bank transfers for the last week of audit year and first week of following year
Embezzlers occasionally cover a theft of cash by a practice known as kiting: transferring money
from one bank to another and incorrectly recording the transaction. The purpose of analyzing
bank transfer is to disclose overstatement of cash balances resulting from kiting. Kiting is a
fraudulent scheme that seeks to take advantage of "float".
Float: Is in the banking system. It refers to the timing difference between the day a check is
credited to an account in one bank, and the debited to an account in another bank.

Kiting is transferring money from one bank to another and improperly recording the transaction.
Near the balance sheet date, a check is drawn on one bank account and immediately deposited in
a second bank account for credit before the end of the accounting period. In making this transfer
the embezzler is careful to make sure that the check is deposited at a late enough date so that it
does not clear the first bank until after the balance sheet date, the amount of the transfer is
recorded as an asset in both bank account.

Both theft and management fraud may be carried out with kiting. Note that kiting is possible
only in the case of weak internal control. For example, lack of proper segregation of duties,
collusion, or management override.

Audit procedure to detect Kitting

The audit test to discover kiting is to prepare and examine a schedule of interbank there are
several things that should be audited on the interbank transfer schedule.

1. The accuracy of the information on the interbank transfer schedule should be verified.
2. The interbank transfer must be recorded in both the receiving and disbursing banks. If
10,000 is transferred from bank A to B but only disbursement (in A) is reduced, this is an
evidence of an attempt to conceal a cash theft (kitting)
3. The date of recording of the disbursement and receipts for each transfer must be in the
same year. If a cash receipt was recorded in the current fiscal year and disbursement in
the subsequent FY, it may be an attempt to cover cash shortage.
4. Disbursements on the interbank transfer schedule should be correctly included in or
excluded from year - end bank reconciliation as outstanding checks. An outstanding
check (CK) for the first bank is an outstanding deposit for the second bank. But if there
are some CKs that are not included as outstanding CKs, this is an indication of kiting.
5. Receipts on the interbank transfer schedule should be correctly included or excluded from
year - end bank reconciliations as deposit in transit. Compare receipt dates as per book
and per bank. Any deposit recorded in book but not in bank should be reflected as
outstanding deposit in bank reconciliation. But if there are receipts recorded as
outstanding deposits whose amount is not recorded in cash receipt journal, it is an
indication of kiting.

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Proof of cash
Another substantive test auditors perform is preparing a proof of cash to verify completeness of
cash balance.
When auditors decide that the risk associated with a client’s control procedures related to
recoding cash receipts and disbursements is high, they frequently prepare a proof of cash, also
known as a four – column bank reconciliation. A proof of cash reconciles the following:
 Beginning and ending cash balances per the bank statement with cash balances per the
general ledger.
 Cash receipts as recorded by the bank with cash receipts recorded in the cash receipts
journal.
 Cash disbursements as recorded by the bank with cash disbursements recorded in the
cash disbursements journal.
A proof of cash can be performed for one month, several months, or an entire year. The
advantage of a proof of cash over standard bank reconciliation is that a proof of cash provides
evidence that the cash receipts and disbursements that the bank has recorded are recorded on the
client’s books. It does not provide any other evidence about cash receipts or disbursements, such
as that all cash received was deposited or that checks were written only for approved purposes.
Proof of cash receipts is not useful for detection the theft of cash receipt or the recording and
deposit of an improper amount of cash.
2.6 Audit of Marketable securities
2.6.1 Definition of marketable Securities
Marketable securities (Short-term investments) are financial investments which are convertible
into cash within one year or one operating cycle. They are listed at their current market value.
Marketable Securities are shown on the balance sheet as “Short-term Investments”.
E.g. Commercial paper, marketable equity securities, and marketable debt securities

2.6.2 Nature of marketable Securities

Short-term liquid securities are classified differently when it comes to their accounting, based on
the purpose for which they are bought.

There are three different classifications of marketable securities:

1. Available for sale

2. Held for trading
3. Held to maturity

2.6.3 Potential Misstatements of Marketable securities

o Misstatement of recorded value of Securities
o Unauthorized Security transactions
o Incomplete recording of Securities

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o Inadequate disclosure of the nature of Security activities

2.6.4 Controls over Marketable Securities

 Establishment of formal security policies
 Review and approval of security activities by the security committee of the board of
directors
 Separation of duties among employees
- Authorizing purchases and sales
- Having custody of the securities
- Maintaining records
 Detailed records of all securities owned
 Registration in the name of the company
 Periodic physical inspection of securities
 Determination of accounting for complex securities by competent personnel

2.6.4 Objectives for the Audit of Marketable Securities

 To consider the inherent risks, including fraud risks
 To consider internal control over Marketable securities
 To determine the existence of recorded Marketable securities and that the client has
rights to the securities
 To establish the completeness of recorded Marketable securities
 To determine that the valuation of Marketable securities is in accordance with GAAP
 To establish the clerical accuracy of schedules of securities
 To determine that the presentation and disclosure of Marketable securities are
appropriate

2.6.5 Substantive Audit Procedures: Marketable Securities

• Client prepares schedule of marketable securities activity including
– Marketable securities held at year-end
– Audit period transactions - purchases and disposals
• The schedule is footed to determine mathematical accuracy
• Auditor verifies cost or sales price by examining broker's advices
• Auditor recalculates gains/losses on disposal of securities
• Existence of securities owned at year-end is verified by physically examining securities
held by the client, or confirmation with client's broker for securities held by the broker
• Current market values are verified by referring to market sources
• Auditor asks management about any changes in the expected holding period, and any
restrictions on securities

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