AUDIT OF CASH AND

FINANCIAL INSTRUMENTS
CHAPTER 23

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 CHAPTER 23 LEARNING OBJECTIVES
23-1 Identify the major types of cash and financial instruments
accounts maintained by business entities.
23-2 Show the relationship of cash in the bank to the various
transaction cycles.
23-3 Design and perform audit tests of the general cash account.
23-4 Recognize when to extend audit tests of the general cash
account to test further for material fraud.
23-5 Design and perform audit tests of financial instruments
accounts.

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 OBJECTIVE 23-1
Identify the major types of cash and
financial instruments accounts
maintained by business entities.

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 TYPES OF CASH AND FINANCIAL INSTRUMENTS
General Cash Account: For most organizations virtually all cash
receipts and disbursements flow through this account.
The relationship of the general cash account to other cash accounts is
shown in Figure 23-1.
Imprest Accounts: Many companies establish a separate account for
payroll to improve internal control over payroll disbursements.
Branch Bank Accounts: Companies operating in multiple locations
often have separate bank accounts at each location.
Imprest Petty Cash Fund: Not a bank account, but a preset amount of
cash kept on hand for incidental expenses.
Financial Instruments: Investments in marketable securities,
derivative instruments and hedging activities.
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Copyright © 2017 Pearson Education, Ltd. 23-5
 OBJECTIVE 23-2
Show the relationship of cash in the
bank to the various transaction
cycles.

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 CASH IN THE BANK AND TRANSACTION CYCLES

Understanding the relationship between cash in the bank and

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 of the integration of the
different transaction cycles.
The relationships of cash in the bank and transaction cycles are
illustrated in Figure 23-2.

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 CASH IN THE BANK AND TRANSACTION CYCLES (CONT.)
Auditors must distinguish between
• Verifying the client’s reconciliation of the cash balance and
• Verifying whether cash recorded in the general ledger correctly reflects all
cash transactions that occurred.
Test of the bank reconciliation often identify these misstatements:
• Failure to include a check that has not cleared the bank on the outstanding check list,
even though it has been recorded in the cash disbursements
• Cash received by the client subsequent to the balance sheet date but recorded as cash
receipts in the current year
• Deposits recorded as cash receipts near the end of the year, deposited in the bank in
the same month, and included in the bank reconciliation as a deposit in transit
• Payments on notes payable debited directly to the bank balance by the bank but not
entered in the client’s records

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 CASH IN THE BANK AND TRANSACTION CYCLES (CONT.)
Reconciliations of cash most likely will not detect these misstatements:
• Failure to bill a customer
• An embezzlement of cash by intercepting cash receipts from customers before
they are recorded, with the account charged off as a bad debt
• Duplicate payment of a vendor’s invoice
• Improper payments of officers’ personal expenditures
• Payment of raw materials that were not received
• Payment to an employee for more hours than he or she worked
• Payment of interest to a related party for an amount in excess of the going rate

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 OBJECTIVE 23-3
Design and perform audit tests of
the general cash account.

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 AUDIT OF THE GENERAL CASH ACCOUNT
The methodology for auditing year-end cash is essentially the same as
that for all other balance sheet accounts:
• Identify Client Business Risks Affecting Cash (Phase I).
• Set Performance Materiality and Assess Inherent Risk (Phase I).
• Assess Control Risk (Phase I): There are two categories of internal
controls for cash:
1. Controls over the transaction cycles affecting the recording of cash
receipts and disbursements.
2. Independent bank reconciliations—accounting software often
incorporates bank reconciliations. The control is enhanced when a
qualified employee reviews the monthly bank reconciliation soon
after its completion.

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 AUDIT OF THE GENERAL CASH ACCOUNT (CONT.)

The methodology for auditing year-end cash is essentially the same

as that for all other balance sheet accounts (cont):
• Design and Perform Tests of Controls and Substantive Tests of
Transactions (Phase II).
• Design and Perform Substantive Analytical Procedures (Phase
III).
• Design Tests of Details of Cash Balance (Phase III).
An example of an audit schedule for a bank reconciliation is shown
in Figure 23-3 on page 743.
Balance-related audit objectives and tests of details of balances for
general cash in bank are summarized in Table 23-1.

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 AUDIT OF THE GENERAL CASH ACCOUNT (CONT.)

The following three procedures are important to the audit of cash in the
bank:
1. Receipt of a Bank Confirmation:
• Auditing standards do not require bank confirmations, but auditors
usually obtain a direct receipt of a confirmation from every bank or
financial institution with which the client does business.
• A completed “standard form to confirm account balance information
with financial institutions” is shown in Figure 23-4 on page 745
• The confirmation also requests information regarding any loans
not included.

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 AUDIT OF THE GENERAL CASH ACCOUNT (CONT.)

The following three procedures are important to the audit of cash

in the bank (cont.):
2. Accessing Cutoff Bank Activity after Year-End:
• A cutoff bank statement is a partial-period (usually 7–10 days)
bank statement, along with related documents, provided by the
bank directly to the CPA firm’s office.
• This allows the auditor to verify reconciling items on the bank
reconciliation in a timely manner.
• Because the cutoff statement is received directly from the bank,
the information is highly reliable.

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 AUDIT OF THE GENERAL CASH ACCOUNT (CONT.)
The following three procedures are important to the audit of cash in the
bank (cont.):
3. Tests of the Bank Reconciliation:
• Verify that the client’s bank reconciliation is mathematically accurate.
• Trace the balance on the bank confirmation to the balance per bank.
• Trace checks written and recorded before year-end included with the bank
cutoff statement to the list of outstanding checks.
• Investigate all significant checks included on the outstanding list that did not
clear with the cutoff statement.
• Trace deposits in transit to the cutoff statement.
• Account for other reconciling item on the bank reconciliation.
The types of audit tests used for general cash are illustrated in Figure 23-5.

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 OBJECTIVE 23-4
Recognize when to extend audit tests
of the general cash account to test
further for material fraud.

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 FRAUD-ORIENTED PROCEDURES
A major consideration in the audit of general cash is the possibility of
fraud:
• If internal controls are inadequate, the auditor must extend the audit of cash to
determine the possibility of material fraud.
Extended Tests of the Bank Reconciliation: For a December 31st year-end:
1. Start with the bank reconciliation for November and compare all reconciling items
with the cancelled checks and other documents in the December bank statement.
2. Compare all remaining cancelled checks and deposit slips in the December bank
statement with the December cash disbursements and receipts journals.
3. Trace all uncleared items in the November bank reconciliation and the December cash
disbursements and receipts journals to the client’s December bank reconciliation.
4. Verify that all reconciling items in the December bank reconciliation represent items
from the November bank reconciliation and December’s journals that have not yet
cleared the bank.

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 FRAUD-ORIENTED PROCEDURES (CONT.)
A major consideration in the audit of general cash is the
possibility of fraud (cont):
Proof of Cash: If the client has a material internal control weakness,
the auditor may prepare a proof of cash to determine the following:
• All recorded cash receipts were deposited.
• All deposits in the bank were recorded in the accounting records.
• All recorded cash disbursements were paid by the bank.
• All amounts that were paid by the bank were recorded.
An example of a proof of cash is shown in Figure 23-6.

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Copyright © 2017 Pearson Education, Ltd. 23-22
 FRAUD-ORIENTED PROCEDURES (CONT.)
A major consideration in the audit of general cash is the possibility of
fraud (cont):
Tests of Interbank Transfers: Embezzlers occasionally cover a theft of
cash by a practice known as kiting.
• This involves transferring money from one bank to another and
incorrectly recording the transaction.
To test for kiting as well as unintentional errors in recording interbank
transfers, auditors list all interbank transfers near the balance sheet
date and trace to the accounting records for proper recording.
A typical interbank transfer schedule is shown in Figure 23-7.

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 OBJECTIVE 23-5
Design and perform audit tests of
financial instruments accounts.

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 AUDIT OF FINANCIAL INSTRUMENTS ACCOUNTS
Identify Client Business Risks Affecting Financial Instruments (Phase I): Risks
vary depending on the significance and the aggressiveness of a company’s
investing activity.
Set Performance Materiality and Assess Inherent Risk (Phase I): Factors that
impact inherent risk include
• Management’s objectives related to investment activity,
• The complexity of the securities or derivatives,
• The company’s prior experience with investments, and
• Whether external factors such as credit risk impact the relevant assertions.
An additional factor is that the majority of financial instruments are valued at
fair value estimates.

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 AUDIT OF FINANCIAL INSTRUMENTS
ACCOUNTS (CONT.)
Assess Control Risk (Phase I): Auditors assess internal controls
surrounding the
• initiation, authorization, processing, fair value measurement, and
disclosure of investment activities.
Management needs to have:
1. An investment strategy and awareness of the level of exposure to
various risks
2. Procedures in place to properly classify financial instruments as
trading, available-for-sale, or held-to-maturity based on intent
3. Procedures in place to initiate and record transactions
4. Strong internal controls over determining fair value estimates

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 AUDIT OF FINANCIAL INSTRUMENTS
ACCOUNTS (CONT.)
Design and Perform Tests of Controls and Substantive Tests of Transactions
(Phase II): The auditor usually relies on statements and brokers’ advices to test
purchases and sales of investments.
Design and Perform Substantive Analytical Procedures (Phase II): Analytical
procedures are not as important for financial instruments because they are likely
to fluctuate from year to year.
Design Tests of Details of Financial Instruments Balances (Phase III): The
auditor starts with a schedule of investment activity for the year. Confirmation
requests are sent to broker-dealers to confirm year-end balances as well as
transactions during the year.
The balance-related audit objectives for financial instruments accounts are
summarized in Table 23-2 on page 755.

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