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CHAPTER 10

Cash andFinancial Investments

Review Questions

10-1 The following circumstances might cause a client to understate assets:

(1) Management of a privately held company may be motivated to understate assets so as tominimize income taes!

(") #an$ accounts may not be recorded so as to ma$e possible unrecorded% illegal payments!(&) Management may wish to 'manage' earnings by deferring income until a subse*uent year!

10-" +or$ on cash is li$ely to be more etensive than one might epect because (only " re*uired):

(1) ,lthough the amount of cash shown on the balance sheet may appear relatively small%

the amounts flowing into and out of the cash account during the year are often greater than forany other account! early all business transactions eventually re*uire a cash settlement!Thus% the year-end cash balance is not the only measure of materiality!

(") .ash is the most li*uid of assets and offers the greatest temptation for theft%embezzlement% and misappropriation!

(&) The eamination of cash transactions assists the auditors in the substantiation of manyother items in the financial statements because these other items either arise from or result incash transactions!

10-& The *uoted statement is not correct! The purpose of an audit is to gather evidence which will enablethe auditors to epress an opinion on the financial statements% and not to pursue an etended

investigation of minor fraud! /f the auditors determine that the fraud could not have a material effectupon the financial statements% they should review the situation with the client before investigatingfurther! This discussion will alert the client to the situation% protect the auditors from charges ofincompetence% and avoid wasting audit time on matters that are not material with respect to thefinancial statements and that may better be pursued by client personnel!

10- The two independent records of the clients cash transactions are: (1) the clients own cash records% and(") the ban$s records of the clients account% as evidenced by the monthly ban$ statements and theyear-end ban$ confirmation available to the auditor!

Solutions Manual, Chapter 10, Page 1 of 24

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10-2 , loc$bo system is one in which a post office bo is controlled by a companys ban$ at which cashremittances from customers are received! The ban$ receives the remittances% immediately credits thecash to the companys ban$ account% and forwards the remittance advices to the company!

10-3 The description of internal control should be prepared first! The areas selected for testing and the sizeof audit samples will be determined according to the relative *uality of internal control over cashreceipts% cash disbursements% and cash forecasting! The purpose of tests of controls is to determine theetent to which controls allegedly in use are actually operating effectively!

10-4 (1) ,ll cash which should have been received was in fact received and recorded promptlyand accurately!

(") .ash disbursements are made only for authorized purposes and are recorded properly!

(&) .ash balances are maintained at ade*uate but not ecessive levels by forecasting epected cashreceipts and payments related to normal operations! The need for obtaining loans or forinvesting ecess cash is thus made $nown on a timely basis!

10-5 (a) ,ccounting department6 (b) ,ccounting department6 (c) 7inance department6 (d) 7inancedepartment6 (e) 7inance department!

10-8 The .hec$ .learing ,ct for the "1st.entury allows financial institutions to destroy physical copies ofchec$s and use an electronic (substitute) copy for chec$ clearing purposes! The audit implications are:1! ,uditors may have to rely on electronic (substitute) copies of chec$s for audit evidence!"! 9iting becomes virtually impossible when the clients financial institutions use electronic

processing% because it ta$es hours (or less) rather than days to clear a chec$!

10-10 The discovery of large chec$s drawn payable to the treasurer and charged to Miscellaneous ;pensesuggests the possibility that the funds went to the treasurer personally and were not epended forbusiness purposes! The auditors should ascertain whether there is ade*uate documentary evidencesupporting the charge to Miscellaneous ;pense% such as purchase orders% invoices% receipts% receivingreports% etc! The auditors should also determine whether the disbursement was specifically approvedby the president or other officer besides the treasurer before issuance of the chec$s! +hen fraud hasbeen detected% the auditor should assure himself

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18>>

,ctually?eceived 7rom

,ctual.ash?eceipts

?ecorded as?eceived 7rom

?eceipts?ecorded and@eposited

?eceipts+ithheld

Auly 1 #a$er

.harles

B &00

1 .harles B 1

B&00

Auly " AonesCmith

&00 2"

#a$erCmith

&00 2"

Auly & Derbertelson

3&0 1

Aoneselson

&00 1

&&0EEEE

B1%50 B1%"10 B3&0

10-1" The old outstanding chec$s should be eliminated as they cause unnecessary clerical wor$ in each ban$reconciliation and also represent a threat to good internal control! , dishonest employee may conceal acash shortage merely by omitting old outstanding chec$s from the ban$ reconciliation! The auditor

should prepare a list of the old chec$s and as$ the client to contact the payees and re*uest them topresent the chec$s for payment! /f this is not feasible% the chec$s should be eliminated by restoring theappropriate amount to the cash balance and setting up a special liability account!

10-1& The Ctandard 7orm to .onfirm ,ccount #alance /nformation with 7inancial /nstitutions re*uests thefinancial institution to confirm amounts on deposit% whether accounts are interest-bearing and

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(d) The purpose of investigating chec$s representing large or unusual payments to related partiesis to determine that the transactions (a) were properly authorized and recorded and (b) areade*uately disclosed in the financial statements!

10-14 To verify the clients cutoff of cash receipts% the auditors may either (1) be on hand to count theundeposited cash receipts on the last business day of the period% or (") eamine the cutoff ban$statement to determine that deposits reported as being in transit at year-end were received by the ban$on the following business day! +hen a client has numerous branches% the auditors usually employ acombination of these procedures in verifying the cutoff at the various locations!

10-15 The term 'window dressing' refers to actions ta$en shortly before the balance sheet date which aredesigned specifically to improve the cash position or in other ways to create an improved financialpicture of the company! Come forms of window dressing are legitimate (such as ma$ing all possibleshipments and billings to customers at year-end)! Hther methods of window dressing (such as holdingthe cash Fournals open) constitute misrepresentation!

,nother eample of window dressing occurs when a corporate officer who has borrowedmoney from the corporation repays the loan Fust before the balance sheet date and then promptlyobtains a new loan shortly after the balance sheet date!

10-18 ,de*uate internal control over investment processes should include the following features:

(1) Ceparation of custody of securities from record$eeping!

(") @etailed records of securities owned and related revenue from interest and dividends!

(&) ,uthorization of purchases and sales by the investment committee!

() ?egistration of securities in name of company!

(2) Ieriodic inspection of securities by an internal auditor or official not charged with custody ofsecurities or record$eeping!

(3) Ieriodic review of investment activities by the internal auditor or another independent official!

(4) , budget for investment revenue!

10-"0 The monthly report relating to securities transactions should show:

(1) Cecurities owned at the beginning of the month!

(") Iurchases% sales% gains% and losses during the month!

(&) @ividends and interest received!

() Cecurities owned at the end of the month!

10-"1 /nformation to be noted by the auditors during their inspection of securities includes (a) name of issuingcompany% (b) face amount% (c) serial number% (d) maturity date% (e) date and rate of interest ordividends% (f) presence of all future interest coupons% and (g) name in which registered!

10-"" /n accordance with C,C o! 4&% the auditors should consider the professional *ualifications andindependence of the specialistJthe securities appraiser! /n addition% the auditors should assess the


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appropriateness and reasonableness of the valuation model and evaluate the reasonableness of theassumptions used in the model! The auditors should assure that the model considers all aspects of ris$%such as counterparty credit ris$% ris$ of adverse changes in mar$et factors% and ris$ of losses from legalor regulatory action! /n addition% any significant information provided to the specialist by the client tobe used in appraising the options should be tested!

10-"& The audit of financial investments can be very comple and present special ris$s re*uiring specializeds$ill or $nowledge in performing audit tas$s such as:

/dentifying controls at service organizations that provide financial services and are part of the

clients information system!

Hbtaining an understanding of information systems for securities and derivatives that are

highly dependent on computer technology!

,pplying comple accounting principles to various types of financial investments!

Gnderstanding the methods of determining the fair values of financial investments% especially

those that must be valued using comple valuation models!

,ssessing inherent and control ris$ for assertions about derivatives used in hedging activities!

Therefore% the auditors may decide that the assistance of specialists either within or outside the firm is

needed to assist in the audit of comple financial investments!

10-" The auditors can ma$e an independent computation of dividends earned during the year by reference todividend record boo$s published by investment advisory services!

10-"2 /f a security or derivative is not mar$etable (has no active mar$et)% management may obtain anappraisal of fair value from a securities valuation firm! /n such cases% the auditors should refer to SAS73% 'Gsing the +or$ of a Cpecialist%' which re*uires that they consider the professional *ualificationsand independence of the appraiser and obtain an understanding of the methods and assumptions used!+hen a valuation model% such as an option-pricing model% is used% the auditors should assess thereasonableness and appropriateness of the model and evaluate the reasonableness of the underlyingassumptions! The auditors should ma$e sure that the model considers all aspects of ris$% such ascounterparty credit ris$% ris$ of adverse changes in mar$et factors% and ris$ of losses from legal or

regulatory action! /n addition% any significant information provided to the specialist by the client to beused in appraising the derivative or security should be tested!

Questions Requiring Analsis

10-"3 (a) The prelisting of cash receipts strengthens a companys internal control bysafeguarding against unauthorized removals of incoming cash by employees whose dutieswould permit them to conceal the removals! ,n effective system of prelisting cash receiptsnormally provides for an employee with no other cash duties to open the mail and prepare alisting of the individual receipts included! Hne copy of the prelisting must be controlled andlater used by a responsible employee with no related duties to ascertain that all cash received inthe mail has been entered in the cash Fournal and credited by the ban$!

(b) The following duties should be ecluded from the wor$ of all employees who are in a positionto intercept cash receipts from trade customers before they are recorded so that none of thesame employees will have an opportunity also to conceal any unauthorized removals:

(1) Maintaining the cash receipts Fournal!(") Totaling the columns of the cash receipts Fournal!(&) Ireparing any cash receipts records to be used in posting!() Hriginating credit memoranda for customers accounts!


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(2) Maintaining the sales and

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The other element of the *uoted statement relating to the auditors concern over the possibleomission of a deposit in transit is also in error! To omit a deposit in transit would cause anunderstatement of the year-end cash balance!

/f the *uoted statement were revised into acceptable form% it would read along the followinglines: '+hen auditors are verifying a clients ban$ reconciliation% they are particularly concerned withthe possibility that an outstanding chec$ may be omitted or that a non-eistent deposit in transit may beincluded!'

10-&1 (a) The .I,s will use the Auly 10 cutoff ban$ statement in their review of the Aune &0ban$ reconciliation to determine whether:

(1) The beginning balance on the cutoff ban$ statement agrees with the 'balance per ban$'on the Aune &0 reconciliation!

(") The Aune &0 ban$ reconciliation includes those paid chec$s that were returned with thecutoff ban$ statement and are dated or bear ban$ endorsements prior to Auly 1!

(&) @eposits in transit are cleared within a reasonable time!() /nterban$ transfers have been considered properly in determining the Aune &0 adFusted

ban$ balance!(2) Hther reconciling items which had not cleared the ban$ at Aune &0 (such as ban$

errors) clear during the cutoff period!

(b) The .I,s may obtain other information by:

(1) /nvestigating unusual entries on the cutoff ban$ statement!(") ;amining paid chec$s% particularly noting unusual payees or endorsements!(&) ?eviewing other documentation supporting the cutoff ban$ statement!

,mong the transactions or circumstances that these procedures might disclose are:

(1) /rregular payments or payments related to matters which the .I, should investigate!7or eample% the .I, would want to learn the reason for an unusual legal fee or apayment to a company officer!

(") #orrowings in the new fiscal year or repayment of recorded or unrecorded loansoutstanding at year-end!

(&) C7 chec$s applicable to the year ended Aune &0!() Material ependitures during the cutoff period!

10-&" The outstanding chec$s said by the controller to have been distributed after @ecember &1 should bereversed to the etent that they were actually distributed after that date! The primary purpose of thereversal is to properly cut off the cash and show the proper cash balance! Chowing the correct cashbalance eliminates 'window dressing'6 recorded but undistributed chec$s would distort the current ratioby reducing both cash and accounts payable! #ut% if the chec$s had been mailed prior to year-end% anoverdraft should be revealed and not be eliminated by improper Fournal entries!

10-&& (a) .hec$s outstanding at the end of the test period should be added to the ban$ figure for

chec$s paid (.olumn &) to arrive at the accounting records figure for disbursements! Theoutstanding chec$s should also be deducted from the ovember &0 balance per ban$ (.olumn)!

(b) The deposit in transit at the beginning of the test period should be added to the Hctober &1balance per ban$ (.olumn 1) and deducted from deposits for the period (.olumn ")! Thedeposit in transit is deducted from the ban$s ovember deposits because the cash receipt wasrecorded in the accounting records in Hctober rather than in ovember!


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(c) , chec$ issued and paid during the test period is already included in both the ban$s figure forchec$s paid and disbursements per the accounting records! Therefore% this chec$ does notappear as a reconciling item in the proof of cash! +hile drawing chec$s payable to '.ash' is apoor practice% it does not affect the treatment of the chec$ in a ban$ reconciliation!

(d) The B1%500 in C7 chec$s returned by the ban$ should be deducted from chec$s paid by theban$ (.olumn &)% since these returned items are not considered disbursements in theaccounting records! The B1%20 redeposited in ovember should be deducted from deposits(.olumn ")6 redepositing chec$s does not constitute another receipt of cash in the accountingrecords! The B&20 redeposited in @ecember was cash on hand at ovember &0 and should beadded to the ovember &0 balance per ban$ (.olumn ) to attain the cash balance per theaccounting records!

10-& (a) The maFor elements of ade*uate internal control over derivatives include the following:

7ormal investment policies that limit the nature of derivative transactions to those that are

consistent with the ris$ appetite of management!

,n investment committee of the board of directors that authorizes and reviews financial

investment activities for compliance with investment policies!

Ceparation of duties between the eecutive authorizingpurchases and sales of derivative

instruments% the custodianof the securities% and the person maintaining the recordsofinvestments!

.omplete detailed records of derivative instruments owned and the related provisions and

terms!

@etermination of appropriate accounting for comple financial instruments by competent

personnel!

Ieriodic audits by the internal auditors to determine compliance with investment policies

and evaluate level of ris$ assumed!

(b) The auditors may perform substantive tests such as the following:

Hbtain or prepare an analysis of the investment account and related revenue% gain and loss

accounts and reconcile to the general ledger!

.onfirm with Danovers commodity bro$er that it is holding the instrument!

Kouch transactions (the purchase and any others) during the year relating to such

contracts!

?eview investment committee minutes and reports to determine that the transaction was

properly authorized!

Ma$e independent computations of revenue from the derivative (if any)!

/nspect documentation of managements intent to classify the derivative transaction as a

hedging activity!

;valuate the method of accounting for the futures contract (as per 7,C# o! 1&&)!

Test the valuation of the futures contract (as per 7,C# o! 1&&)! ;valuate financial statement presentation and disclosure of the futures contract!

10-&2 (a) The purpose of a ban$ transfer schedule is to trace ban$ transfers to discloseoverstatement of cash balances resulting from $iting! +hen a chec$ drawn on one ban$ isdeposited in another% several days (called the float period) usually pass before the chec$ clearsthe ban$ on which it is drawn! @uring this period% the amount of the chec$ is included in the


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the chec$s ma$es it more difficult for this sort of fraud in that the perpetrator mustalso establish a safe address for the chec$ to be mailed to! ,nswer (1) is incorrectbecause control is stronger if individuals who are otherwise independent of the cashfunction prepare and review the monthly ban$ reconciliation! ,nswer (") is incorrectbecause% as discussed% the chec$s should not be returned to accounts payable! ,nswer(&) is incorrect because the individual signing the chec$s needs access to thesupporting documents so he or she can determine whether the ependiture is proper!

(d) () The general ledger will not have information on the alan!e per an"!The cutoff ban$ statement% year-end ban$ statement and ban$ confirmation will allinclude information on the balance per ban$!

(e) (&) Gnless all negotiable assets are verified at one time% an opportunityeists for a dishonest officer or employee to conceal a shortage by transferring it fromone asset category to another a step ahead of the auditors! 7or eample% mar$etablesecurities could be pledged as collateral for a loan! The cash thus obtained could beincluded with other cash being counted by the auditors! ,fter the cash count% the cashderived from the securities could be removed and used to redeem the pledged securitieswhich would then be available for counting by the auditors! Hf course% this type ofmanipulation could hardly be carried on unless there were wea$nesses in internal

control!,nswer (1) is incorrect because counting cash in advance of the balance sheet

date does not relate to $iting! ,nswer (") is not persuasive because accounts payablecan not be substituted for cash as can negotiable assets! ,nswer () is not correctbecause there is no particular significance to the amount of cash on hand on the daythe ban$ confirmation letters happen to be returned!

(f) (1) The use of cash registers and tapes helps assure that all sales of a retail storeare recorded! ,nswer (") is incorrect because the cash has already been recorded!,nswer (&) is incorrect because the procedure only deals with recorded deposits and%therefore% the completeness assertion is not addressed as directly as in answer (1)!,nswer () is incorrect because one would not epect the cash balance in the generalledger to agree with the ban$ confirmation re*uest due to items in transit and chec$soutstanding!

(g) (1) The individual who reconciles the ban$ account should not be involved in theprocessing of cash receipts or disbursements! Therefore% answer (1) is correct! ,ll ofthe other functions are compatible with reconciliation responsibilities!

(h) (1) =apping will result in a delay in the recording of specific remittance credits inthe financial records% but the chec$s will be deposited in the ban$ as they are received!Therefore% a comparison of the chec$s deposited to the credits to customer accountswill li$ely uncover the scheme!

(i) () Daving the securities held in safe$eeping by a ban$ or stoc$bro$er provides

strong internal control because they are not available to employees responsible formaintaining the accounting records of the securities! Thus the separation of thecustody of securities from the accounting function is complete!

(F) (1) The investment committee of the board of directors is not involved in theroutine of ma$ing buy and sell decisions and can therefore review the transactionsobFectively! Hn the other hand% the chief operating officer% the controller% and the


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treasurer may be closely associated on a daily basis with the financial eecutiveresponsible for the investment decisions!

($) (&) #ecause of the li*uidity of many securities% the auditor should insist that aclient representative be present in order to ac$nowledge the receipt of securitiesreturned! /n the event of subse*uent disappearance of a security the auditor will notbe a suspect!

(l) (") .omparing the recorded amount of dividend revenue with dividend recordboo$s (published by investment advisory services) provides evidence of the amount ofdividend revenue that should have been received during the year! /t is virtuallyimpossible to confirm the receipt of dividends with the company paying thosedividends!

Pro#lems

10-&5 CH=GT/H: ,rt ,ppreciation Cociety (;stimated time: "0 minutes)

+ea$ness ?ecommendation

1!

1! There is no segregation ofthe responsibilities ofcollecting admission feesand authorizing admission!

Hne cler$ (hereafter referred to as the collectioncler$) should collect admission fees and issueprenumbered tic$ets! The other cler$ (hereafterreferred to as the admission cler$) shouldauthorize admission upon receipt of the tic$etor proof of membership!

"!

"! ,n independent count ofpaying patrons is no made!

The admission tic$et stubs should retain aportion of the prenumbered admission tic$ets(admission tic$et stubs)!

&!

&! There is no proof ofaccuracy of amountscollected by the cler$s!

,dmission tic$et stubs should be recorded bythe collection cler$ daily on a permanent recordthat will serve as the first record ofaccountability!

!

.ash receipts records arenot promptly prepared!

The cash collections should be recorded by thecollection cler$ daily on a permanent recordthat will serve as the first record ofaccountability!

2

!

2% .ash receipts are not

promptly deposited! .ashshould not be leftundeposited for a wee$!

;ach days cash receipts should be deposited

intact!


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3!

3! There is no proof ofaccuracy of amountsdeposited!

,uthenticated deposit slips should be comparedwith daily cash collection records!@iscrepancies should be promptly investigatedand resolved! /n addition% the treasurer shouldestablish a policy that includes an analyticalanalysis of cash collections!

4!

4! There is no record ofinternal accountability forcash!

The treasurer should issue a signed receipt forall proceeds received from the collection cler$!These receipts should be maintained and shouldbe periodically chec$ed against cash collectionsand deposit records!

10-&8 CH=GT/H: Mission .orporation (;stimated time: &0 minutes)

The more important deficiencies in internal control and the remedies are:

(1) The ban$ apparently has not been instructed to refuse to accept chec$s payable to the companyfor deposit in the petty cash fund ban$ account! /t should be so instructed% and the account

should be in the name of the company% with the cashier as agent-custodian!

(") The cashier processes the monthly statements to customers! De should not be permitted tohave access to customers statements!

(&) The cashier apparently opens or has access to incoming mail containing customersremittances! The mail should be opened by someone not connected with the cashiers office orthe accounts receivable ledger! The person opening the mail should ma$e a detailed listing intriplicate of all remittances received% one copy going to the accounting cler$ for entry inaccounts receivable% one copy going to the cashier for entry in the cash records% and one copygoing to the controllers office for subse*uent comparison with the duplicate deposit slip!

() The cashier% who has access to cash funds% reconciles the ban$ account! This should be doneby some person not connected with the cashiers office!

(2) The amount of the B200 chec$ may indicate that disbursements from the petty cash fund ban$account have not been limited to relatively small amounts! .onsideration should be given toestablishing a limitation on the size of a chec$ that may be drawn!

10-0 CH=GT/H: Cpartan @rug Ctore% /nc! (;stimated time "0 minutes)

Cpartan @rug Ctore% /nc! Irocessing .ash .ollections /nternal .ontrol Luestionnaire

1! ,re customers who pay be chec$ identified via store /!@! card or other means

"! @oes company policy prohibit accepting chec$s for anything ecept merchandise sales plus anominal cash amount

&! /s a receipt produced by the cash register given to each customer


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! /s the reading of each cash register ta$en periodically by an employee who is independent ofthe handling of cash receipts

2! ,re cash counts made on a surprise basis by an individual who is independent of the handlingof cash receipts

3! /s the reading of each cash register compared regularly to the cash received

4! /s a summary listing of cash register readings prepared by an employee who is independent ofphysically handling cash receipts

5! /s a summary listing of cash register readings prepared by an employee who is independent ofphysically handling cash receipts

8! ,re receipts forwarded to an independent employee who ma$es the ban$ deposits

10! ,re each days receipts deposited intact daily

11! /s the summary listing of cash register receipts reconciled to the duplicate deposit slipsauthenticated by the ban$

1"! ,re entries to the cash receipts Fournal prepared from duplicate deposit slips or the summarylisting of cash register readings

1&! ,re the entries to the cash receipts Fournal compared to the deposits per ban$ statement

1! ,re areas involving the physical handling of cash reasonably safeguarded

12! ,re employees who handle receipts bonded

13! ,re charged bac$ items (C7 chec$s% etc!) directed to an employee who does not physicallyhandle receipts or have access to the boo$s

10-1 CH=GT/H: /nternal .ontrol% Cubstantive Testing (;stimated time: "0 minutes)

(a) (1) Cegregation of the custody and record$eeping functions for mar$etable e*uitysecurities is designed to prevent personnel from being in a position to abstract theclients securities and alter the records to conceal the abstraction!

(") ?egistration in the companys name is designed to prevent employees with custody ofsecurities from using them for their own purposes! 7or eample% securities registeredin the name of the custodian easily could be used as collateral for a personal loan tothat custodian!

(&) ,n analysis of the investment committee minutes and reports may disclose unrecorded

purchases and sales of securities or other financial instruments% as well as transactionsthat are not consistent with company policies! This procedure is especially importantif the client engages in derivatives because transactions giving rise to derivatives maynot involve the payment or receipt of cash!

(b) (1) Cegregation of duties is tested by ma$ing in*uiries as to which employeesperformed specific tas$s throughout the year% and observing personnel performing


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those tas$s! The auditors also should ma$e in*uiries as to who performs assignedtas$s under unusual circumstances% such as prolonged illness of an employee!

(") ?egistration of securities in the name of the company could be tested by ma$ingin*uiries regarding the policy and observing securities on hand% preferably on asurprise basis!

(&) /nvestment committee minutes may be obtained from the client!

(c) (1) and (")! #oth of these wea$nesses might be compensated for by performing a surprisecount of mar$etable securities! , comparison could be made of the serial numbers onsecurities on hand with those recorded from previous eaminations! Misuse of the clientssecurities during the year also might be indicated by analytical procedures% such as comparisonof the clients rate of earning on investments to prevailing rates!

(&) This wea$ness is li$ely to be very significant in the sense that unauthorized purchasesand sales of derivative transactions may be involved! The auditors will epand theanalysis of derivative transactions to determine eactly the nature of transactions thathave occurred! @epending upon the nature of these transactions% this may involve ananalysis of all investments and possibly a search of receipts and disbursements

transactions related to such transactions! /n addition% because many such transactionsmay not involve the receipt or payment of cash% it is essential that the auditorsunderstand the natures of the transactions involved!


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10-" CH=GT/H: ?eliable ,uto Iarts% /nc! (;stimated time: &0 minutes)

?;=/,#=; ,GTH I,?TC% /.!.orrected Iroof of .ash for ,pril% "00>

Auly &1% "00>

#alance .hec$s #alance & ""!15 ""!15

,pril% "00> (18!1) 18!1

ote receivable collectedby ban$

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;amine chec$s accompanying the Aanuary "00O cutoff ban$ statement and trace all "00>% or

prior% chec$s to the outstanding chec$ list!

,scertain why chec$ number 5&4 is still outstanding% if possible!

C7 chec$ returned (item d)

7ollow up on the ultimate disposition of the C7 chec$!

;amine all supporting documents!

ote collected (item e)

;amine ban$ credit memo!

#alance per boo$s (item f)

7oot this total and compare this balance with the general ledger balance!

10- CH=GT/H: Cunset #uilding Cupply (;stimated time: "2 minutes)

(a)CGC;T #G/=@/N CGII=O

.omparison of .hec$s and @isbursements@ecember &1% 18--

.hec$s returned or still outstanding:?eturned in cutoff statement B20%0Hutstanding chec$s on 1

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shortage and raise suspicions of employee fraud! The auditors should call the matterto the attention of appropriate client officials and determine whether the client wishesto have the auditors investigate further! The appropriate adFusting entry wouldrecognize a loss and reduce the overstated cash balance!

() The cash disbursements Fournal may be underfooted for the first part of Aanuary! Theauditors should prove the footings and% if an error eists% propose an adFusting entrydebiting the appropriate account and crediting .ash!

(2) The amount of a chec$ may have been raised by the payee! The auditors should callthis alteration to the attention of the client and propose an adFusting entry recognizinga loss and crediting .ash! (The prospects for recovering stolen funds seldom Fustifyrecording a receivable!)

(3) The ban$ may have charged the ban$ account with a chec$ drawn on another account!The auditors should advise the client to notify the ban$ of the error6 no adFusting entryis necessary!

(4) , stop payment order may have been ignored by the ban$! ,gain% this is a ban$ errorand no adFusting entry is necessary!

10-2 CH=GT/H: M=N .ompany (;stimated time: &2 minutes)

(1) ?eview answers to *uestions on confirmation re*uests to determine proper recognition in

accounting records and the necessity for financial statement disclosure!

(") Ma$e in*uiries as to compensating balances and restrictions!

(&) Hbtain copies of the ban$ reconciliations as of the balance sheet date% and:

(a) Trace the adFusted boo$ balances to the general ledger balances!(b) .ompare the ban$ balances to the opening balances on the cutoff ban$ statement!(c) .ompare the ban$ balances to the balances on the confirmations!(d) Trace amounts of deposits in transit to the cutoff ban$ statements and ascertain

whether the time lags are reasonable!(e) Kerify the clerical accuracy of the reconciliations!(f) Hbtain eplanations for unusual reconciling items% including chec$s drawn to 'bearer%'

'cash%' and related parties!(g) Trace chec$s dated prior to the end of the period that were returned with the cut-off

statements to the list of outstanding chec$s!(h) /nvestigate outstanding chec$s that did not clear with the cutoff ban$ statements!(i) ;amine a sample of chec$s for payee% amount% date% authorized signatures% and

endorsements to determine any deviations from company policy!

() Irepare a ban$ transfer schedule from a review of the cash receipts and disbursementsFournals% ban$ statements% and related paid chec$s for the last few days before and the first fewdays after the year-end% and:

(a) ?eview the schedule to determine that the deposit and disbursement of each transfer is

recorded in the proper period!(b) Trace incomplete transfers to the schedule of outstanding chec$s and deposits in

transit!

10-3 CH=GT/H: Daw$ .orporation (;stimated time: &2 minutes)

(a) /nstructions to be given to the assistant regarding the eamination of the securities $ept in thesafe deposit bo include the following:


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(1) , copy of the clients record of the contents of the bo should be obtained and used inconnection with the inspection of the securities! .omparing the contents of the boand the record will provide assurance that all securities listed in the record are onhand! (The validity of the record will be determined by eamination of thetransactions pertaining to investments!) The copy of the record% after being verified%should be added to the auditors wor$ing papers as evidence of wor$ performed!

(") The ban$s record of persons entering the deposit bo should be eamined to determinethat only authorized persons have had access to the bo and that there was no entry tothe bo between @ecember &1 and Aanuary 11! ;ntry to the bo between those datesmay be an indication that a security was returned to safe$eeping after being'borrowed' at year-end! The security may have been 'borrowed' and used ascollateral to obtain cash to cover a shortage at @ecember &1!

(&) The assistant should be instructed to insist that the treasurer be present while thesecurities are being eamined! Most auditors prefer to obtain a signed statement thatall investments inspected were returned at the completion of the inspection made in thepresence of the custodian! /n any event% the wor$ing papers should note the date of theinspection and the name of the witness to the inspection!

(&) The following details of the securities should be eamined:

(a) The name of the registered owner appearing on each security other than bearerbonds should be noted to determine that Daw$ .orporation is a registeredowner and that securities belonging to another owner have not beensubstituted!

(b) The name of the corporation issuing the security and the class of the security(.lass ,% Iar Kalue% 1st Ireferred% etc!) should be noted for assurance that alower priced security (perhaps somewhat similar in corporate name or adifferent security of the issuing corporation) has not been substituted for ahigher priced security!

(c) The face value of bonds and the number of shares represented by each stoc$certificate should be compared with the client record to determine that theentire amount of the corporations holdings of each security is on hand!

(d) The serial numbers of the securities should be compared with those on therecord and% for those securities carried over from the prior year% comparedwith the serial numbers of securities listed in the prior years wor$ing paper! ,change in serial numbers that cannot be properly eplained may be anindication of manipulation of the securities! Kerification of serial numbersalso helps establish the cost of securities sold under either the 7/7H or specificidentification cost method!

(e) The certificates should be read to ascertain the interest rates and paymentdates for bonds and the dividend rates and payment dates% if given% forpreferred stoc$s! This information may be used later in the verification ofinvestment revenue!

(f) #onds should be eamined to determine maturity dates! Maturity dates are

needed for verifying the computation of the amortization of bond premiums ordiscounts! /n addition% the maturity dates will disclose whether any bonds onhand have matured! The presence of matured bonds may be a sign of internalcontrol wea$ness or may indicate that the bonds are in default!

(g) .oupon bonds should be inspected to determine that no past-due interestcoupons are unclipped and all future interest coupons are attached! Thepresence of past-due coupons may be caused by poor internal control and mayindicate an understatement of interest revenue! Hn the other hand% past-due


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coupons may indicate that the interest is in default and that the principal isuncollectible! Missing future interest coupons may be an indication of anirregularity!

(h) The auditors should be alert for any obvious alterations to securities or forgedcertificates! ,lthough auditors usually are not held responsible for thegenuineness of the certificates% any apparent forgeries (or eceptions noted inthe foregoing audit procedures) may point out the need to investigate thevalidity of the certificate!

(b) The treasurers entry into the safe deposit bo on Aanuary has violated the auditors controlover negotiable assets designed to avoid the substitution of a counted asset for an uncountedasset in an attempt to conceal a shortage! The auditors would probably apply the followingadditional procedures:

(1) ?econcile ban$ balances at both year-end and at the date of inspecting securities!(") Hbtain a ban$ confirmation as of the inspection date!(&) ;amine cash Fournals between year-end and the inspection date for any unusual

entries!() ;amine all investment transactions ta$ing place between the balance sheet date and

the inspection date to verify the amount of the investment at the balance sheet date!

(2) /f the client $eeps a large fund of cash on hand% ma$e a surprise count of the cashfund!

(3) ?eview the transactions since year-end relating to any other negotiable assets% such asnotes receivable% to determine if any substitutions have been made!

In$Class Team Case

10-4 CH=GT/H: Cteven Cmith .o! (;stimated time: "0 minutes)

Trans%er &nderstated'(verstatedor Correct

E)am"le *man others are "ossi#le+

a! .orrect #oo" entries: The transfer was recorded in the accounting records as achec$ written on the disbursing ban$ on @ecember "8 and acorresponding cash receipt recorded to receiving ban$ on that date!#an" entries: The chec$ was ta$en to the receiving ban$ on @ecember"8 and deposited! The accounts are both in the same ban$% andaccordingly the transaction was recorded in both accounts as of that date!

b! .orrect #oo" entries$ Hn @ecember &0 a chec$ was written on the disbursingban$% recorded as a cash disbursement in the cash disbursements recordsand recorded as a receipt in the cash receipts records!#an" entries The chec$ was deposited in the receiving ban$ the netday% @ecember &1! Hn Aanuary "% the chec$ was received by thedisbursing ban$!

c! Gnderstated #oo" entries$ Hn @ecember &1 a chec$ was written on the disbursing

ban$ to transfer cash to the receiving ban$! The Fournal entry made%however% was to credit cash and debit an epense account (tofraudulently decrease "00> profits--perhaps to decrease taes) ratherthan to debit cash in the receiving ban$! Hn Aanuary "% an entry wasmade to debit cash for the transfer and to credit a revenue account tocorrect the "000> misstatement% and to overstate the "00O profits!#an" entries$ The chec$ was deposited in the receiving ban$ on Aanuary"! Hn Aanuary % the chec$ was received by the disbursing ban$!


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d! .orrect #oo" entries$ Hn @ecember &1 a chec$ was written on the disbursingban$% recorded as a cash disbursement in the cash disbursements recordsand recorded as a receipt in the cash receipts records! The chec$ wasmailed to the receiving ban$!#an" entries$ The chec$ was received by the receiving ban$ on Aanuary"! Hn Aanuary % the chec$ was received by the disbursing ban$

e! .orrect #oo" entries$Hn Aanuary 1 a chec$ was written on the disbursing ban$%recorded as a cash disbursement in the cash disbursements records andrecorded as a receipt in the cash receipts records! The chec$ was mailedto the receiving ban$!#an" entries$The chec$ was received by the receiving ban$ on Aanuary&! Hn Aanuary % the chec$ was received by the disbursing ban$!

f! Hverstated A!!ounting entries$ Hn @ecember &1 a chec$ was written on thedisbursing ban$ to transfer cash to the receiving ban$! The improperFournal entry made% however% was to debit cash (in the receiving ban$saccount) and credit a revenue account (to fraudulently increase profits)!Hn Aanuary 1% an entry was made to credit cash for the transfer and todebit an epense account to correct the "000> misstatement% and tounderstate the "00O profits!

#an" entries$ The chec$ was deposited in the receiving ban$ on@ecember &0! Hn Aanuary " the chec$ was received by the disbursingban$!

g! Hverstated #oo" entries$ ;arlier during the month that amount of cash (B"%000)had been stolen from the receiving ban$! To conceal the shortage on@ecember &1% the embezzler wrote a chec$ transferring B"%000 from thedisbursing ban$ to the receiving ban$! The transfer was not recorded onthe boo$s until Aanuary " of "00O#an" entries$ The chec$ was deposited in the receiving ban$ on@ecember &1! Hn Aanuary " the chec$ was received by the disbursingban$!

h! .orrect (The total cash is correct here% but recorded in the wrong accounts as of

year end!)#oo" entries: ,lthough a chec$ is written on the disbursing ban$ on@ecember &0% no entry was made on the boo$s until Aanuary! 7oreample% assume that a high level employee had a blan$ chec$% wasauthorized to sign it% and did to transfer the funds at year end! Che forgotto record it in the boo$s until Aanuary & when she properly recorded thetransfer!#an" entries$The chec$ was deposited in the receiving ban$ on@ecember &0! #an$ ,ccount Hne recorded the disbursement on@ecember &1% the day it was received!

Research and ,iscussion Case

10-5 CH=GT/H: Cuncraft ,ppliance .orporation (;stimated time: 2 minutes)

The essence of this case is that certain forms of 'window dressing' are permissible and are% in fact%underta$en by most audit clients! Hther forms% however% are not acceptable6 in fact% they might beinterpreted by the courts as acts of fraud!


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(a) (1) Tal$ing customers into placing orders early:This is an acceptable and commonplace form of 'window dressing!' /n fact% many

companies offer discounts in order to entice customers to place orders prior to year-end! ,s long as the transaction actually occurs within the current year% the auditorsare hardly in a position to 'reassign' it to a future period!

(") Chipping all orders received through @ecember &1:/f this is 'window dressing%' it is virtually impossible to distinguish it from

efficient operations! ,gain% as long as the transaction is eecuted within the currentyear% it is properly recorded within the current year!

(&) Hvershipping orders% assuming that returns will not occur until Aanuary:,n overshipment is not a sale! Noods must be ordered by the customer% not

merely shipped by the vendor% for a legitimate sale to have occurred! This is not anacceptable form of 'window dressing!' Daving heard this suggestion% the auditorsshould compare a sample of year-end shipments to the customers purchase orders andalso monitor sales returns in Aanuary to determine whether the client is engaging in thisunacceptable practice!

() =abel orders unshipped as of @ecember &1 as sold and record the sale:This is another unacceptable form of 'window dressing!' , sale occurs when the

title to the merchandise transfers from the seller to the buyer! ormally% this is f!o!b!destination% or f!o!b! shipping point! /n either case% the merchandise must actually

have been shipped by the seller! This proposal by the controller amounts to a cutofferror!

(2) ?ecord chec$s dated @ecember &1 as cash receipts of that date:This proposal is another cutoff error! The date to be used in recording a cash

receipt is the date that the chec$ is received% not the date that it was written! Theauditors should trace the @ecember &1 deposit in transit to the deposit shown on thenet ban$ing day in the cutoff ban$ statement!

(3) Hfficer to repay loan from company% then renew loan:This is a related party transaction% which would have to be fully disclosed in the

companys financial statements! +hile the treasurers repayment and renewal of theloan would be recorded in the companys accounts on the dates that the transactionsoccurred% it is probable that the adverse publicity generated by complete disclosure ofthis transaction would more than offset the beneficial change in the companys year-end cash position!

(4) @ate cash disbursements for current liabilities as of @ecember &1% but do not mail thechec$s:

This is another unacceptable form of 'window dressing!' ,s the client has notactually released the chec$s% neither the balance of the .ash account nor of ,ccountsIayable should be reduced! To detect this improper scheme to increase the companyscurrent ratio% auditors review the cutoff ban$ statement to determine that chec$ssupposedly issued at year-end are clearing on a timely basis!

(5) @efer the write-down of obsolete inventory until net year:Niven that the inventory is obsolete% this is an unacceptable suggestion! , loss

should be recognized as soon as there is obFective evidence that a loss has occurred!To defer the write-down to a future time period would distort the income of both time

periods!(8) @elay purchase of machinery previously ordered for @ecember:

Title to merchandise changes from the seller to the buyer at a specified date%usually the date of shipment or of delivery! /f the transaction is delayed% the companymay legitimately delay the recording of the purchase and the related liability until thetransaction actually occurs! Thus% delaying a purchase is an acceptable form of'window dressing!'


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(b) o! ,uditors can never assure a client of an un*ualified opinion until they have completedtheir eamination! There are many situations beyond those discussed at the meeting that maynecessitate the auditors issuing something other than an un*ualified report!

(c) +hether the discussion held by the client would cause the auditors to withdraw from theengagement is% of course% a personal decision! Hn the one hand% audit ris$ is increased becausethe client is in financial difficulty and has indicated a certain desperation to portray financialhealth in its financial statements! Hn the other hand% the client has been most straightforwardin discussing these proposals in advance with its auditors! /t has candidly sought the auditorsadvice as to whether or not the proposed actions were legitimate! Hur personal decision wouldnot be to withdraw% but we would increase our cutoff procedures and other testing of year-endtransactions! +e also would devise audit procedures to test for every type of transaction thatwe recommend against at the meeting!

Ethics Case

10!8 CH=GT/H: Qaird R ,ssociates (;stimate time: "0 minutes)

(a) The problem here is that you continue to have a difficult time meeting budget and

Carah has at least implicitly suggested that you begin to sign off audit steps withouthaving performed them!

(b) Iossible courses of action include:

(1) %ollo& Sarah's approa!h( 7ollowing Carahs approach is li$ely to be effectivein helping the accountant to meet the time budget! , difficulty is that it mightbe considered fraudulent% and at a minimum is dishonest! ,ttempt to getstudents involved in the issue of signing off unimportant versus importantaudit procedures! Ctudents might argue that if this is only done for proceduresthat seem unnecessary the effect will be minimal! Oet a difficulty here is that

the accountant may be wrong in assessing the importance of particular steps!,lso% what *uite possibly is an unrealistic budget probably remains for netyears audit! /f a particular audit step appears unnecessary% the accountantmight discuss the situation with the in-charge senior who might choose toeliminate the step!

(") )o not follo& Sarah's approa!h( This approach allows the accountant tomaintain honesty and wor$ performance! #ut the problem of not being able toget wor$ done in the budgeted time remains!

(c) +e strongly recommend notfollowing Carahs approach! This leads to dishonesty%unreasonable budgets for subse*uent years% and perhaps misstatements that are notidentified!

(ther (#servations

Oou might wish to etend the discussion at this point and as$ whether students believethat the individual should tell someone in the .I, firm about Carahs approach! Thishas a tendency to lead to a discussion of whether it is appropriate to disclose to others


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information provided to you in confidence versus your responsibility to the firm!

/n many accounting firms% standard auditing programs are ready for use! Cincebusiness processes vary from firm to firm% auditing programs need to be customizedaccordingly! +henever accountants encounter a situation where standard programdoes not apply% discussions with audit team management are strongly encouraged!

CPA -imulation

10-20 CH=GT/H: ,udit Cimulation--.ash (;stimated time: &0 minutes)

(a) (") ,nswer (") is correct because use of a loc$ bo system decreases the ris$ of assetmisappropriation by having customer payments deposited directly into the ban$!

(b) () ,nswer () is correct because reliance upon +ingo .orporation represents a ris$ since+ingo may find either a substitute product to replace CC.s LCand product ordevelop its own such product!

(c) () ,nswer () is correct because the statement of cash flows ma$es clear that the cashflows from operations are negativeJover B1%000%000 negative! ,ccordingly% withoutthe new debt% cash would not have shown an increase!

(d) (&) ,nswer (&) is correct because the increase in accounts receivable is the single largestfactor leading to the negative cash provided by operations!

(e) (1) ,nswer (1) is correct because a ban$ transfer schedule% which is appropriately usedwhen a client has two or more ban$ accounts% is prepared to detect $iting%manipulations that cause cash to be included simultaneously in the balance of two oremore ban$ accounts!

(f) (2) ,nswer (2) is correct because the middle two columns of a four column proof of cashis used to reconcile cash receipt and disbursement totals between company records andban$ records!

(g) (4) ,nswer (4) is correct because the standard ban$ confirmation includes *uestions thathelp the auditor to verify both year-end cash and liability balance information!

(h) (3) ,nswer (3) is correct because a ban$ cutoff statement includes information on ban$transactions for the first 4-10 days after year-end% and accordingly is used to verifyreconciling items on the year-end ban$ reconciliation!

(i) +e will not provide a detailed memo here! Oour memo should be well written% and wellorganized! ,lthough you should notprovide a list such as we have provided below% your memo

should have included points such as the following: The companys board of directors is composed of Nary Cherwood% his wife Madonna

Cherwood% Aane Qhan% and the companys two other shareholdersJ.indy Ctone and9elly Diggins!

Nary Cherwood is the chair of the board!

+ith Nary as chair% the independence of the board is very much at *uestion since he

holds the positions of chief eecutive officer and chair of the board!


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