a u d i t i n g a risk-based approach to conducting a quality audit 9 th edition karla m. johnstone...
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A U D I T I N GA RISK-BASED APPROACH TO
CONDUCTING A QUALITY AUDIT
9th Edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
Copyright © 2014 South-Western/Cengage Learning
Chapter 10Auditing Cash and
Marketable Securities
Copyright © 2014 South-Western/Cengage Learning10-2
Learning Objectives
1. Identify the significant accounts, disclosures, and relevant assertions in auditing cash accounts
2. Identify and assess inherent risks of material misstatement in cash accounts
3. Identify and assess fraud risks of material misstatement in cash accounts
4. Identify and assess control risks of material misstatement in cash accounts
Copyright © 2014 South-Western/Cengage Learning10-3
Learning Objectives
5. Describe how to use preliminary analytical procedures to identify possible material misstatements for cash accounts, disclosures, and assertions
6. Determine appropriate responses to identified risks of material misstatement for cash accounts, disclosures, and assertions
7. Determine appropriate tests of controls and consider the results of tests of controls for cash accounts, disclosures, and assertions
Copyright © 2014 South-Western/Cengage Learning10-4
Learning Objectives
8. Determine and apply sufficient appropriate substantive audit procedures for testing cash accounts, disclosures, and assertions
9. Identify types of marketable securities, articulate the risks and controls typically associated with these accounts, and outline an audit approach for testing these accounts
10. Apply frameworks for professional decision making and ethical decision making to issues involving the audit of cash accounts, disclosures, and assertions
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THE AUDIT OPINION FORMULATION PROCESS
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PROFESSIONAL JUDGMENT IN CONTEXT - Fraudulent Petty Cash Transactions at Koss Corporation
• Former vice president of finance orchestrated a $31 million embezzlement• Remediation actions• Eliminating petty cash fund
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PROFESSIONAL JUDGMENT IN CONTEXT - Fraud at Peregrine Financial
• Embezzlement of over $200 million from Peregrine Financial Group’s (PFG) brokerage clients over a 20-year period• Bankruptcy filed immediately after implementation of
change in online system • Where bank statement information would be sent
electronically directly to National Futures Association
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PROFESSIONAL JUDGMENT IN CONTEXT - Fraud at KOSS Corporation and Peregrine Financial
• Why is cash an inherently risky account? (LO 2, 3)• What controls should be in place to help ensure that
cash accounts are not misappropriated? (LO 4)• What are the audit implications of poor controls over
cash accounts? (LO 6)• What types of audit procedures would auditors
employ when auditing cash? (LO 7, 8)
Identify the significant accounts, disclosures, and relevant assertions in auditing cash
accounts
Learning objective 1
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Major types of cash accounts
• General checking accounts• Cash management accounts• Imprest payroll accounts• Petty cash accounts• Marketable security accounts: A security that is
readily marketable and held by a company as an investment
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Imprest Payroll Accounts
• Imprest bank account• Normally carrying a zero balance• Replenished when checks are to be written against the
account • Provides additional control over cash• Payroll account - The most widely used imprest bank
account • Company makes a deposit equal to amount of payroll
checks issued
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BENEFITS OF Cash Management Techniques
Speed the collection and deposit of cash
Reduce the amount of paperwork
Automate the cash management process
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Cash Management Techniques
LockboxesElectronic
Funds Transfers
Cash Management Agreements
with Financial
Institutions
Compensating Balances
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Lockboxes
• Cash management arrangement with a bank whereby payments are sent directly to a post office box number accessible to client’s bank• Bank opens cash remittances and directly deposits
money in client’s account• Advantages• Company immediately earns interest on deposited funds• Manual processing is shifted to bank• Speeds up receipt of cash and allows organization to use
cash to earn a return
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Relevant Financial Statement Assertions relevant to cash
Existence or occurrence• Cash balances exist at balance sheet date
Completeness• Cash balances include all cash transactions that occurred during
the periodRights and obligations
• Company has title to the cash accounts as of balance sheet date
Valuation or allocation• Recorded balances reflect true underlying economic value of
those assetsPresentation and disclosure
• Cash is properly classified on the balance sheet and disclosed in notes to the financial statements
Identify and assess inherent risks of material misstatement in cash accounts
Learning objective 2
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Performing Risk Assessment Procedures for Cash Accounts
• Information useful in assessing risk of material misstatement is obtained• Inherent risks• Financial statement level • Account and assertion level
• Fraud risks• Feedback from audit team brainstorming sessions• Strengths and weaknesses in internal control• Results from preliminary analytical procedures
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Reasons for Identifying cash as having high Inherent Risk
Volume of activity
Liquidity
Automated systems
Importance in meeting debt covenants
Can be easily manipulated
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Inherent Risk Analysis Questionnaire: Cash
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Inherent Risk Analysis Questionnaire: Cash
Identify and assess fraud risks of material misstatement in cash accounts
Learning Objective 3
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Topics to be covered in a brainstorming session
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Auditing in Practice - Common Fraud Schemes Relating to Cash
• Frauds relating to cash receipts• Inventory sold, but employee does not record the sale
and steals the cash• Employee receives a check and deposits it, but does
not record the sale; then the employee writes a check out to himself and does not record the disbursement• Employee collects a customer payment, steals cash,
and writes off accounts receivable as uncollectible
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Auditing in Practice - Common Fraud Schemes Relating to Cash
• Lapping: Employee steals a payment from one customer, and covers it up by using payments from another customer to disguise the theft• Skimming: Type of fraud that occurs when an
employee makes a sale but does not record it, and steals the cash
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Auditing in Practice - Common Fraud Schemes Relating to Cash
• Frauds relating to cash payments• Purchasing merchandise and recording sale at an
unauthorized discounted amount• Selling merchandise to a friend at a discounted price;
friend returning merchandise for a refund at undiscounted price; splitting profits• Employee stealing cash and concealing it by recording
a fictitious discount• Employee writing a check to a fictitious vendor and
depositing the check into an account controlled by the employee
Identify and assess control risks of material misstatement in cash accounts
Learning objective 4
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Common Controls Over Cash
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Common Controls Over Cash
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Auditing in Practice - The Parmalat Fraud and Its Many Victims
• Evolved over a 10-year period• Included invention of over $11 billion in fictitious
cash in offshore front companies to offset liabilities at parent company• In reality, cash was not accounted for and Parmalat
had only about 500 million euros in cash• Involved large number of individuals acting
collusively in various ways
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Implications of Weak Controls Related to Completeness
• Employee required to record a cash receipt • Not performing the task• Not reflecting the cash being received, a sale made, or
reduced accounts receivable
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Auditing in Practice - Skimming and the Completeness Assertion
• When a transaction is not immediately recorded, completeness assertion is violated• Applicable where customers pay cash directly to an
employee
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Controls for Petty Cash
• Limiting access by keeping funds in a locked box • Requiring receipts for petty cash disbursements with:• Date• Amount received• Purpose or use for funds• Name of employee receiving funds
• Reconciling petty cash fund before replenishing it• Keeping customer receipts separate from petty cash
funds
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Controls for Cash Management Techniques
Lockboxes
Electronic funds transfers
Cash management agreements with financial institutions
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Assessing Control Risk for Cash
• Controls minimize potential risks to cash accounts• Requires the auditor to have an understanding of
internal controls for:• Integrated audits • Financial statement only audits• Understood by:• A walkthrough of process• Inquiry• Observation• Review of documentation
Copyright © 2014 South-Western/Cengage Learning10-35
Assessing Control Risk for Cash
• At account and assertion levels, considering:• Entity-wide controls • Transaction controls
• At entity-wide level, considering control environment• Commitment to financial accounting competencies• Independence of the board of directors• Risk assessment• Information and communication• Monitoring controls
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Assessing Control Risk for Cash
• Integrated audit of cash involves evaluating:• Design of internal controls• Operation of internal controls
• Smaller organizations - Testing of operating effectiveness of controls is not a required part of the audit • Larger organizations - Evaluating and testing of
internal controls happen via an integrated audit
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Control Risk Questionnaire - Cash
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Control Risk Questionnaire - Cash
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Documenting Controls
• Documenting auditor’s understanding of internal controls for:• Integrated audits • Financial statement only audits
• A questionnaire often used to guide auditors in documenting understanding of internal controls
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EXHIBIT 10.3 - Control Activities Questionnaire: Cash Receipts
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Describe how to use preliminary analytical procedures to identify possible material
misstatements for cash accounts, disclosures, and assertions
Learning objective 5
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Performing Preliminary Analytical Procedures
• Helps identify areas of potential misstatements when planning the audit• Cash is examined in relation to:• Operational data • Budgetary forecasts
• Requires awareness of importance of cash balances to debt covenants
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Performing Preliminary Analytical Procedures
• Relationships indicating heightened risk of fraud in cash:• Consistent profits over several years, but cash flows
are declining• Unexpected reductions in accounts receivable
collections, or timeliness of collections• Unexpected declines in petty cash account
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Using Trend Analysis of Account Balances and Ratios in Preliminary Analytical Procedures for Cash Accounts
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Using Trend Analysis of Account Balances and Ratios in Preliminary Analytical Procedures for Cash Accounts
Determine appropriate responses to identified risks of material misstatement for cash accounts,
disclosures, and assertions
Learning objective 6
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Responding to Identified Risks of Material Misstatement
• Audit procedures are proportional to assessed risks• Areas of higher risk receive more audit attention and
effort• Developing audit approach that contains:• Tests of controls (if applicable)• Substantive procedures, including analytical
procedures• Audit programs are customized based on assessment
of risk of material misstatement
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EXHIBIT 10.5 - Panel A: Sufficiency of Evidence for Existence and Completeness of Cash
Copyright © 2014 South-Western/Cengage Learning10-49
EXHIBIT 10.5 - Panel B: Approaches to Obtaining Audit Evidence for Existence and Completeness of Cash
Determine appropriate tests of controls and consider the results of tests of controls for cash accounts,
disclosures, and assertions
Learning objective 7
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Selecting Controls to Test and Performing Tests of Controls
• Auditors make decisions about:• Which controls to test for formulating an opinion on
entity’s internal controls• Whether the level of control risk warrants reduction of
substantive testing
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Selecting Controls to Test and Performing Tests of Controls
• Tests of transactions controls• Inquiry of personnel performing the control• Observation of control being performed• Inspection of documentation confirming that control
has been performed• Reperformance of control by individual testing the
control
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Considering the Results of Tests of Controls
Control deficiencies identified
Assessing those deficiencies to determine their severity
Modifying preliminary control risk assessment
Documenting implications of control deficiencies
No control deficiencies identified
Determining that preliminary assessment of
control risk as low is appropriate
Determining the extent that controls can provide
evidence on correctness of account balances
Determining planned substantive audit
procedures
Determine and apply sufficient appropriate substantive audit procedures for testing cash
accounts, disclosures, and assertions
Learning objective 8
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Auditing in Practice - Weaknesses in Substantive Procedures Related to Cash
• Auditor needs to consider types of substantive procedures for cash that should be performed• Make sure that engagement team performs those
procedures• PCAOB disciplinary proceedings against two audit
firms provide insight on weaknesses in cash-related audit procedures
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Substantive Analytics for Cash Accounts
• Focusing on substantive tests of details• Minimal substantive analytics to be performed
include identifying significant:• Fluctuations in cash balances• Differences between budgeted and actual levels of
cash
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Substantive Tests of Details for Cash Accounts
Preparing independent bank reconciliations
Obtaining bank confirmations and bank cutoff statements
Preparing bank transfer schedules
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Preparing Independent Bank Reconciliations
• Provides evidence for accuracy of year-end cash balance• Process includes reconciling balance per bank
statements with balance per booksAuditor independently verifies the
following items when testing client’s bank reconciliation
Balance as per bank statement
Deposits in transit
Outstanding checks
Other adjustments
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EXHIBIT 10.7 - TESTS OF CLIENT’S BANK RECONCILIATION
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Bank Confirmation
• A standard confirmation sent to all banks with which the client had business during the year • Used to obtain information about year-end cash
balance and additional information about loans outstanding• Seeks information on:• Client’s deposit balances• Existence of loans • Due dates of loans
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Bank Confirmation
• Interest rates• Dates through which interest has been paid• Collateral• An asset or a claim on an asset held by a borrower or an
issuer of a debt instrument • To serve as a guarantee for value of a loan or security• If the borrower fails to pay interest or principal, collateral
is available to lender to recover principal amount of loan
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EXHIBIT 10.8 - Standard Bank Confirmation: Account Balances
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Auditing in Practice - Confirmations with Financial Institutions
• PCAOB-proposed Auditing Standard would require auditor to:• Perform confirmation procedures for cash and other
relationships with financial institutions
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OBTAINING BANK CONFIRMATIONS – LOAN GUARANTEES
• These requirements are referred to as covenants • A violation of covenants makes loans immediately
due and payable • Considering client‘s ability to continue to operate as a
going concern • In case of a long-term debt, reclassifying it as a current
liability
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EXHIBIT 10.9 - Standard Bank Confirmation: Loan Guarantees
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Obtaining Year-End Cutoff Information as Part of Bank Confirmation Process
• Obtaining information on last checks issued in fiscal year• Last check number
• Observing that all previous checks had been mailed• Obtaining information on last cash receipts
Copyright © 2014 South-Western/Cengage Learning10-67
Cutoff Bank Statements
• A statement for a period of time determined by client and auditor • Shorter than that of regular month-end statements • Sent directly to auditor, who uses it to verify
reconciling items on client’s year-end bank reconciliation
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Preparing Bank Transfer Schedules
• Kiting: Fraudulent cash scheme to overstate cash assets at year end by showing the same cash in two different bank accounts • Bank transfer schedule: Audit document listing all
transfers between client bank accounts• Starts shortly before year end and continues for a
short period after year end• Purpose - Assures that cash in transit is not recorded
twice
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Fraud-Related Substantive Procedures for Cash Accounts
• Confirming with financial institutions about individuals authorized to access cash accounts• Scrutinizing checks that are payable to cash• Scrutinizing checks with unusual vendor names• Scrutinizing checks made out to employees outside
of normal payroll processing system• Comparing timing of deposits into bank accounts
with timing of cash receipts• Noting any unusual time lags
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Fraud-Related Substantive Procedures for Cash Accounts
• Comparing time lags between:• The date a check was issued for payment • The date that it clears the bank
• Investigating voided checks and analyzing voided transactions
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Documentation related to Substantive Procedures for cash accounts
• Copies of independent bank reconciliations• Copies of bank confirmations• Documentation of oral confirmations• Copies of bank cutoff statements• Copies of bank transfer schedules• Evidence of any restrictions on use of cash balances
or bank compensating balances
Identify types of marketable securities, articulate the risks and controls typically associated with these accounts, and
outline an audit approach for testing these accounts
Learning objective 9
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Marketable securities
• Held as temporary investments• Short-term cash management securities • U.S. Treasury bills• Certificates of deposit (CDs)• Commercial paper• Notes issued by major corporations at rates
approximating prime lending rates with high credit rating
• Short-term hybrid-type securities • Improve return on temporary investments
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Classification of investments in securities
• Valued at amortized cost, subject to an impairment test
Held-to-maturity securities
• Carried at fair market valueTrading securities
• Carried at fair market valueAvailable-for-sale securities
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AUDITOR’S JUDGMENTAL CHALLENGE
• Corroborating management’s intent in classifying assets• Gathering information about management’s trades in
investments • Importance of market value to management
compensation• Determining fair market value• Easily determinable for regularly traded securities• Financial institutions reluctant to mark fair values for
thinly traded securities
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Relevant Financial Statement Assertions
Securities exist at balance sheet dateExistence or occurrence
Securities balances include all securities transactions taken place during the period
Completeness
Company has title to such securities accounts as of balance sheet date
Rights and obligations
Recorded balances reflect true underlying economic value of those assets
Valuation or allocation
Properly classifying the securities on balance sheet and disclosing in notes to financial statements
Presentation and disclosure
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Inherent and Fraud Risks
Risk of sudden market declines
Manipulation of classification of securities
Manipulation of valuation of fair market value
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Control Risks
• Risk of theft of securities if:• They are not physically controlled• Authorization and monitoring over their trade is not
effective• Lack of policies over purchase or sale of securities• Lack of monitoring of changes in securities balances• Lack of policies over valuation or classification of
securities
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Control Risks
• Lack of segregation of duties between those responsible for:• Making investment decisions • Custody of securities
• Lack of involvement or oversight by internal audit in relation to securities
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INHERENT RISK ANALYSIS QUESTIONNAIRE - MARKETABLE SECURITIES
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Control Risk Analysis Questionnaire - Marketable Securities
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Control Risk Analysis Questionnaire - Marketable Securities
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Auditing in Practice - Common Fraud Schemes Relating to Investments
• Securities purchased, not authorized• Securities purchased, not recorded as purchased• Securities recorded as purchased, not purchased• Securities sold, not recorded as sold• Securities recorded as sold, not sold• Investment income is stolen• Investments are purposely valued inaccurately• Investment classifications are purposely inaccurate
Copyright © 2014 South-Western/Cengage Learning10-84
Analytical Procedures for Marketable Securities
• Developing expectations about level of amounts in ending balances• Based on purchase or sales activity reported
• Developing expectations about relationship between balances in marketable securities accounts• Reviewing changes in:• Balances• Risk composition• Classification types of marketable securities
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Tests of Controls
• Reviewing policies for authorization• To purchase, sell, and manage such securities
• Inquiring of board of directors about board’s oversight of process and examining related documentation• Examining documentation of authorization • For selected purchases and sales
• Reviewing minutes of board meetings • For reference to investment policies and associated
oversight
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Tests of Controls
• Examining evidence of authorization controls • For changes in classification of such securities
• Inquiring of management about its process for • Establishing valuation • Reviewing related documentation
• Inquiring about process for reclassifications and review related documentation
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Tests of Controls
• Examining documentation for selected marketable securities transactions • Reviewing reports of internal audit
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Assertions and Related Substantive Tests of Details - Marketable Securities
• Requesting for a schedule of securities and verifying their existence
Existence or occurrence
• Footing schedule of marketable securities and examining them
Completeness
• Examining selected documents to determine any restrictions
Rights and obligations
• Determining current market value• Re-computing interest and proper recording of accrued
interest
Valuation or allocation
• Determining whether securities are properly classified
Presentation and disclosure
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EXHIBIT 10.15 - audit workpaper for testing marketable equity securities
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Auditing in Practice - Audit Procedures Used to Address Risk Related to Common Fraud Schemes for Investments
• Employing specialist to assist in fair value measurements• Conducting background checks of employees having
access to investment accounts• Requiring original documents of securities• Tracing: • Dividend payments• Interest payments• Sales of securities
Copyright © 2014 South-Western/Cengage Learning10-91
Auditing in Practice - Audit Procedures Used to Address Risk Related to Common Fraud Schemes for Investments
• Tracing purchases of securities to cash disbursements on the bank statement• Reviewing any unusual journal entries in investment
accounts
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Documentation related to substantive procedures for marketable securities
• Schedule of marketable securities as:• Prepared by client• Reviewed by auditor
• Documentation of any confirmation of securities• Documentation of securities transactions scrutinized• Memo containing rationalization for judgments about
management’s: • Classification of securities• Valuation of securities
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Documentation related to substantive procedures for marketable securities
• Reports of any outside valuation experts• Documentation of calculation of potential
impairments