CHAPTER TWO

2. AUDIT OF CASH AND MARKETABLE SECURITIES

Chapter Outline

 Internal control over cash transactions, receipts and disbursements

 Audit program for cash
 Internal control over marketable securities
 Audit program for marketable securities

2.1 Introducing the Nature and Types of cash

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

Cash is the only account included in every business transactions and cycles. Cash is
important because of its susceptibility to theft and it can also be significantly misstated. The
relationship between cash in the bank and the other transaction cycles serves a dual
function: (1) it shows the importance of audit tests of various transaction cycles on the
audit of cash and (2) it aids in further understanding of the integration of the different
transaction cycles.

Cash typically has a small account balance, but auditors devote a large proportion of total
audit hours because:
– Liabilities, revenues, expenses and most other assets flow through cash.
– It is the most liquid asset; so greater temptation for misappropriation.
– It is a high risk account.

The overall objective of the audit of cash is to determine that cash is fairly presented in
conformity with GAAP. The auditors’ objectives in the audit of cash are to:

1. Consider internal control over cash transactions

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 2. Substantive test of existence of recorded cash
3. Establish completeness of recorded cash
4. Determine the client has right to the recorded cash
5. Establish clerical accuracy of cash schedules
6. Determine presentation and disclosure of cash including restricted funds (such as
compensating balances and bond sinking funds), are appropriate.

Notice that valuation is generally not major concern in the audit of cash because the
financial statements are presented in monetary units; valuation of cash is typically a
problem only if conversion to or from foreign currency is involved.

The relationships between cash in the bank and transaction cycles have been illustrated in the
following diagram.

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 2.1.1 Types of Cash Accounts

Cash normally includes general, payroll, petty cash and less frequently saving accounts.

• The General cash account: General accounts are checking accounts similar in
nature to those maintained by individuals. The general cash account is the focal
point of cash for most organizations because virtually all cash receipts and
disbursements flow through this account. Cash sales, collections of receivables, and
investment of additional capital typically increase the account; business
expenditures decrease it.

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 • Imprest payroll Accounts: many companies establish a separate imprest payroll
account to improve internal control over payroll disbursements. When payroll is
paid, a check from the general account is drawn to deposit funds into the payroll
account.

• Imprest Petty cash: An imprest petty cash fund is not a bank account, but it is
sufficiently similar to cash in the bank to merit inclusion. A petty cash account is
often something as simple as a preset amount of cash set aside in a cash box for
incidental expenses. It is used for small cash acquisitions that can be paid more
conveniently and quickly by cash than by check, or for the convenience of
employees in cashing personal or payroll check. Petty cash fund is replenished as
necessary.

A fixed balance is maintained in the imprest account, and the authorized personnel
uses these funds for disbursements at their own discretion as long as the payments
are consistent with company policy.

• Branch Bank Account: For a company operating in multiple locations, it is often

desirable to have a separate bank balance at each location. Branch bank accounts are
useful for building banking relations in local communities and permitting the
centralization of operations at the branch level. In some companies, the deposits and
disbursements for each branch are made to a separate bank account, and the excess
cash is periodically transferred electronically to the main office general bank
account.

2.1.2 The Auditors’ Objectives in Audit of Cash

The overall objective of the audit of cash is to determine that cash is fairly presented in
conformity with GAAP. The auditors’ objectives in the audit of cash are to:

1. Use the understanding of the client and its environment to consider inherent risk,
including fraud risks, related to cash.
2. Obtain an understanding ofinternal control over cash transactions.
3. Determine the existence of recorded cash and the client’s ownership (right) of cash.
4. Establish the completeness of recorded cash.

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 5. Establish the clerical accuracy of cash schedules.
6. Determine that the statement presentation and disclosure of cash are appropriate.

2.2 Internal control over Cash transactions, Receipts and Disbursements

Internal control consists of all of the related methods and measures adopted within a
business to:
a. Safeguard assets from employee theft, robbery, and unauthorized use; and
b. Enhance the accuracy and reliability of its accounting records by reducing the risk of
errors (unintentional mistakes) and irregularities (intentional mistakes and
misrepresentations) in the accounting process.

2.2.1 General Principles of Internal Controls over Cash

To safeguard assets and enhance the accuracy and reliability of its accounting records, a
company follows internal control principles. The following six internal control principles
apply to most companies:

Principle1: Establishment of Responsibility

An essential characteristic of internal control is the assignment of responsibility to specific
individuals.
a. Control is most effective when only one person is responsible for a given task.
b. Establishing responsibility includes the authorization and approval of transactions.
Principle 2: Segregation of Duties
Segregation of duties is indispensable in a system of internal control. The rationale for
segregation of duties is that the work of one employee should, without a duplication of
effort, provide a reliable basis for evaluating the work of another employee. There are two
common applications of this principle:

a. The responsibility for related activities should be assigned to different

individuals. When one individual is responsible for all of the related activities, the
potential for errors and irregularities is increased.
• Related purchasing activities should be assigned to different individuals.
Related purchasing activities include ordering merchandise, receiving goods,
and paying (or authorizing payment) for merchandise.

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

Principle 3: Documentation Procedures

Documents provide evidence that transactions and events have occurred.
• Documents should be pre-numbered and all documents should be accounted for.
• Source documents for accounting entries should be promptly forwarded to the
accounting department to help ensure timely recording of the transaction and event.

Principle 4: Physical, Mechanical, and Electronic Controls

Physical controls relate primarily to the safeguarding of assets. Mechanical and electronic
controls safeguard assets and enhance the accuracy and reliability of the accounting records.
Use of physical, mechanical, and electronic controls is essential.

Examples of these controls include:

a. Safes, vaults, and safety deposit boxes for cash and business papers.
b. Locked warehouses and storage cabinets for inventory and records.
c. Computer facilities with pass key access or fingerprint or eyeball scans.
d. Alarms to prevent break-ins.
e. Television monitors and garment sensors to deter theft.
f. Time clocks for recording time worked.

Principle 5: Independent Internal Verification

Independent internal verification involves the review, comparison, and reconciliation of data
prepared by employees.
a. Verification should be made periodically or on a surprise basis.
b. Verification should be done by an employee independent of the personnel
responsible for the information.

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 c. Discrepancies and exceptions should be reported to a management level that can
take appropriate corrective action.
d. In large companies, independent internal verification is often assigned to internal
auditors.

Principle 6: Other Controls

a. Bonding of employees who handle cash.

b. Rotating employees' duties and requiring employees to take vacations.

2.2.2 Applications of Internal Control to Cash Receipts

Cash receipts may result from sales of goods and services on cash; collections from
customers on account; the receipt of interest, rents, and dividends; investments by owners;
bank loans and sale of bonds; and proceeds from the sale of non-current assets.

The following internal control principles explained earlier apply to cash receipts transactions:

1. Establishment of responsibility- Only designated personnel (cashiers) is authorized to

handle cash receipts.
2. Segregation of duties- Separate cash receipt from recordkeeping. Different individuals
receive cash, record cash receipts, and hold the cash.
3. Documentation procedures- Use remittance advice (mail receipts), cash register tapes,
and deposit slips.
4. Physical, mechanical, and electronic controls- Store cash in safes and bank vaults;
limit access to storage areas; and use cash registers.

5. Independent internal verification- Do not permit any one employee to handle a

transaction from beginning to end. For example, supervisors count cash receipts daily;
treasurer compares total receipts to bank deposits daily.
6. Other controls.
• Bond personnel who handle cash.
• Require vacations and rotation of employees.
• Deposit all cash receipts in bank daily.

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 2.2.3 Applications of Internal Control to Cash Disbursements
1. Cash is disbursed to pay expenses and liabilities or to purchase assets.
a. Internal control over cash disbursements is more effective when payments are made by
check, rather than by cash, except for incidental amounts that are paid out of petty
cash.
b. Cash payments are generally made only after specific control procedures have been
followed.
c. The paid check provides proof of payment.
d. The principles of internal control applicable to cash disbursements include:
• Establishment of responsibility - Only designated personnel (treasurer) are
authorized to sign checks. Make all disbursements by check or electronic fund
transfer, with the exception of small expenditures from petty cash.
• Segregation of duties - Different individuals approve and make payments; check
signors do not record disbursements.
• Documentation procedures - Use pre-numbered checks and account for them in
sequence; each check must have approved invoice.
• Physical, mechanical, and electronic controls - Store blank checks in safes with
limited access; print check amounts by machine with indelible (permanent) ink.
• Independent internal verification - Compare checks to invoices; reconcile bank
statement monthly. Have monthly bank reconciliation prepared by employees not
responsible for the issuance of checks or custody of cash. The completed
reconciliation should be reviewed promptly by an appropriate official
• Other controls - Stamp invoices PAID.
2. Methods of disbursing and/or safeguarding Cash:

a. Electronic Funds Transfer (EFT) System: A new approach developed to

transfer funds among parties without the use of paper (deposit tickets, checks,
etc.). The approach, called electronic funds transfers (EFT), uses wire, telephone,
telegraph, or computer to transfer cash from one location to another.
b. Petty Cash Fund - A cash fund used to pay relatively small amounts.
c. Use of a Bank. First it contributes significantly to good internal control over cash
by creating a separate set of records (bank and books). Second the asset account

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 Cash maintained by the company is the “flip-side” of the bank’s liability account
for that company. It should be possible to reconcile these accounts at any time.
Each month the company receives a bank statement showing its bank transactions
and balances. For example, some transactions and balances shown include:
• Checks paid and other debits that reduce the balance in the depositor's
account.
• Deposits and other credits that increase the balance in the depositor's
account.
• The account balance after each day's transactions.
d. Minimize the amount of cash that must be kept on hand

Summary
Important Internal Controls for Cash Disbursements are summarized below:

1. Segregate duties. The foundation of a good internal control system is segregation

of duties. The duties of authorization (signing a check or releasing a wire transfer), custody
(having access to the blank check stock or the ability to establish a wire transfer), and
recordkeeping (ability to record the transaction in the accounting system) should be
separated so that one individual cannot complete a transaction from start to finish. The
concept behind segregation of duties is that in order to misappropriate cash, individuals
would have to collude, rather than one individual acting alone.

For many businesses, proper segregation of duties can be difficult to achieve. In these
instances, company owners may want to consider the bank statements delivered to them
unopened. The owners should then review the bank statements and the check images for
any transactions that appear unusual, and follow up on these transactions to obtain an
understanding of them. This process alone has uncovered many situations.

2. Review authorized signors. Carefully consider who your authorized signors are
(authorization of the transaction). Those individuals should not have access to the blank
check stock (custody of the asset) nor the ability to enter the transaction into the accounting
system (recording of the transaction). The use of a signature stamp, although efficient, may
be problematic in that you must have separate controls to ensure that the stamp is not
readily available for inappropriate use.

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3. Consider requiring dual signatures. Your company may also want to consider the
use of dual signatures. A dual signature policy includes the establishment of a dollar
threshold over which checks require two signatures. The utilization of dual signatures
establishes an element of segregation of duties for disbursements over a specified threshold
in that these disbursements require more than one individual to authorize the transaction.

4. Remember the wire transfers. The use of wire transfers has increased
significantly over the years, and segregation of duties around wire transfers is paramount.
The responsibilities for establishing a wire transfer should be segregated from the
responsibility of releasing the wire transfer. If this segregation is not possible, consideration
should be given to using a callback procedure, in which the financial institution will call a
specified individual when a wire transfer is initiated. Most important, the call back cannot
go to any individual who is able to initiate a wire transfer.

5. Reconcile bank accounts in a timely manner. The bank reconciliation should be

completed in a timely manner by someone who is independent of the cash disbursement
process. The bank reconciliation should also include a review of the bank statement and the
check images that are returned with the bank statement for unusual transactions. Any
unusual items should be investigated and evaluated when necessary.

2.3 Guidelines for Internal Control over Cash

Auditors need to determine whether following general guidelines for internal control over
cash have been followed by the client.

1. Do not permit any one employee to handle a transaction from start to finish.
2. Separate cash handling from recordkeeping.
3. Centralize receiving of cash to the extent practical.
4. Record cash receipts on a timely basis.
5. Encourage customers to obtain receipts and observe cash register totals.
6. Deposit cash receipts daily.
7. Make all disbursements by check or electronic funds transfer (EFT), with the
exception of small expenditures from petty cash.

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 8. Have monthly bank reconciliations prepared by employees not responsible for the
issuance of checks or custody of cash. The completed reconciliation should be
reviewed promptly by an appropriate official.
9. Monitor cash receipts and disbursements by comparing recorded amounts to
forecasted amounts.

2.4 Internal Control Weaknesses

Weak internal control procedures lead to or create opportunity for fraud and/or defalcation.
Thus it is important that the auditor should investigate client's internal control procedures to
see if defalcation techniques are practiced. Some of the defalcation techniques are discussed
as follows.

1. Withholding of Cash Receipts (Skimming): Proceeds from cash sales are

withheld at point of sales recording and receiving of cash. Skimming means to take cash
before recording it. For example, a cash register clerk can fail to register sales, or under-
register amounts, pocketing full or partial amounts, if the customer does not wait for the
receipt and changes or check amounts charged, registered and paid. The clerk could record
an amount less than received or record no sales at all to pocket the amount.

2. Lapping: Cash collected on account from credit customers can be withheld and
entry postponed for the collection of receivables. This is usually practiced as temporary
borrowing, but in the long run may lead to cover up by more elaborate means. Lapping is
basically a way to conceal an unauthorized loan taken from the company. For example, a
clerk takes money paid by Mr. Assefa, which he intends to pay back eventually. The next
day, when Mr. Berhanu's payment arrives, he posts it to Mr. Assefa's account. The next
day, Ms. Konjit's money comes in, and the clerk posts it to Mr. Berhanu's account, and so
on. Sometimes the employee manages to repay the loan, otherwise he may try to write off
the amounts as bad debts.

Of course, this is possible if the cashier-accountant receives cash and keeps accounts
receivables records at the same time.

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Audit procedures to detect Skimming/Lapping
If the cashier is not smart enough to try and cover up skimming, it may be found by a)
counting cash on hand tracing from prelisting cash register tapes /receipt carbon copies
/remittance advices to cash receipts journal, bank records and the A/R master file. If the
control is present, the auditor may compare the records of the cashier to see if they all
match.

The auditor should examine all voided receipts and ensure the numerical continuity of
receipts. This prevents the cashier from stealing money, and later destroying the carbon
copy of the receipt.

The auditor should compare names, dates, and amounts on remittance advices with cash
receipts entries and deposit slip. If the dates, names and amounts in the remittance advice
and cash receipt entries and deposit slips are not the same, this is an indication of lapping.
This procedure is also time - consuming, so it is not done unless lapping is actually
suspected.

If the cash receipt is different from the amount owed, the auditor should investigate this to
determine why it happened. Most customers pay the exact amount that they owe, for each
invoice, so a payment different from the amount owed may mean that the accounting clerk
is dividing receipts to maintain the lapping scheme.

Lapping can be prevented by good control, such as segregating receiving and recording
duties, or by compulsory vacations for the receipts clerk. The clerk cannot continue to
cover his theft if he isn't there, and the new clerk will hopefully post the accounts correctly.

3. Sales Discount: Cash can be abstracted from sales discount not taken by customers.
That is, when customers pay full amount, only amounts net of discount are recorded to
customers and difference pocketed by recording it to discount.

4. Writing-off Bad Debts: Accounts receivable could be written-off as bad debts

when actually customers' remittance is pocketed. This is used to hide cash shortage that
may be apparent by repeated overlapping.

5. Fictitious Accounts Receivable: Goods could be taken for private use or stolen by
charging fictitious customers and writing-off as bad debts later on.

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6. Check Kiting: Assume that an enterprise has two bank accounts say in Bank A and
Bank B. The enterprise writes a check to withdraw an amount from Bank A account
balance and deposit into the account in Bank B. The amount deposited in Bank B is
immediately reflected. But because of lag of time for clearance (float) it is not reflected as
deduction (withdrawal) from Bank A account soon enough. Consequently, the cash position
(current ratio) of the organization is temporarily improved or overstated.

Kiting is practiced to cover up cash shortages, which an auditor might uncover.

Example of Kiting
Assume Tirf Trading House has two bank accounts- one in Dashen Bank and another in
Commercial Bank of Ethiopia (CBE). The following scenarios happen in Tirf Trading.

A) Kiting to cover Theft

Account clerk Mr. Atalay "borrows" incoming cash receipt (skimming) of 1,000 Birr.
However, he needs to post amounts to individual customer accounts in the A/R subsidiary
ledger. Otherwise, they will complain and his theft will be discovered. So he makes a
journal entry as follows.

Cash in Bank - Dashen 1,000

Accounts Receivable 1,000

But no deposit was made into the Bank

Then Mr. Atalay realizes that this incorrect entry will be discovered when the bank account
is reconciled. So on the last day of the fiscal year, he writes a check on the CBE account
for 1,000 Birr, and deposits it into Dashen Bank. But no entry will be made to decrease the
account balance in CBE. CBE does not know it as disbursement. The bank reconciliation
will now balance, because CBE will not debit the check until the next fiscal year. Mr.
Atalay assumes that by then he will be able to pay back the "loan".

B) Kiting to Overstate Current Ratio (Management Fraud)

W/ro Akeza is managing director of Tirf Trading. She has applied for a business loan at
Dashen Bank. Tirf Trading is having a difficult year, and needs the money very badly to

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pay suppliers and payroll. She knows well the fundamental principle of banking. So she has
to convince Dashen Bank that Tirf Trading is having a good year. She decides to do this by
overstating the current ratio on the financial statements, because she knows this is a key
area for the loan officer's analysis.

On the last day of the fiscal year, she draws a check for 300,000 Birr from CBE and
deposits it to Dashen Bank. She gives the stamped deposit ticket to the accountant with the
instructions to make this entry on December 31.
Cash in Bank - Dashen Bank 300,000
Miscellaneous Income 300,000
CBE of course, will not process the check until next year, and it will not show up on the
bank reconciliation until January 31. By that time, W/ro Akeza hopes the loan will have
been granted, and a simple correcting journal entry can be made to correct the ledger
balance for Cash in Bank - Dashen.

Audit procedures to detect Kiting

The audit test to discover kiting is to prepare and examine a schedule of interbank transfers.
There are several things that should be audited on the interbank transfer schedule.
1. The accuracy of the information on the interbank transfer schedule should be
verified.
2. The interbank transfer must be recorded in both the receiving and disbursing banks.
If Birr 10,000 is transferred from bank A to B but only disbursement (in A) is
reduced, this is an evidence of an attempt to conceal a cash theft (kiting).
3. The date of recording of the disbursement and receipts for each transfer must be in
the same year. If a cash receipt was recorded in the current fiscal year and
disbursement in the subsequent year, it may be an attempt to cover cash shortage.
4. Disbursements on the interbank transfer schedule should be correctly included in or
excluded from year-end bank reconciliation as outstanding checks. An outstanding
check (CK) for the first bank is an outstanding deposit for the second bank.

Understating outstanding CKs on the bank reconciliation indicates the possibility of

kiting. The dates in disbursement books and dates of disbursement in bank must be
in the same year. If there are CKs recorded in book but not in bank, they must be
included as outstanding CKs in the preparation of bank reconciliation. But if there

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 are checks that are not included as outstanding CKs, this is an indication of
kiting.
5. Receipts on the interbank transfer schedule should be correctly included in or
excluded from year-end bank reconciliations as deposit in transit. Compare receipt
dates as per book and per bank. Any deposit recorded in book but not in bank should
be reflected as outstanding deposit in bank reconciliation. But if there are receipts
recorded as outstanding deposits whose amount is not recorded in cash receipt
journal, it is an indication of kiting.

7. Window-Dressing: Cash shortage or cash position can be improved by holding the

cashbook open beyond closing date to include subsequent receipts. This may be encouraged
by management to improve current period sales.

8. Cash Disbursements: Cash from petty cash could be misused for personal or other
unauthorized expenses by producing false voucher expenses, or voucher charges, or
overstating vouchers submitted for reimbursements or changing dates of previous vouchers.

9. Checks Payable to Self: Checks could be prepared for amounts made payable to
self, forging signatures and destroying returned checks or over footing cash disbursements.

10. Checks Payable to Others: Checks are prepared in payment of forged

endorsements or fictitious or previously used invoices, or over-invoiced vendors' invoices,
or padding payrolls.

It should be noted that all of the above defalcations are performed only in absence of proper
segregation of duties or when there is collusion among employees.

2.5 Audit Program for Cash

Audit program is a detailed listing of the specific audit procedures to be performed in the
course of audit engagement. The following audit program indicates the general pattern of
work performed by the auditors in the verification of cash.

2.5.1 Consider internal control over cash

Test of controls provide auditors with evidence as to whether prescribed controls are in use
and operating effectively. The result of these tests assists the auditor in evaluating the

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likelihood of material misstatements having occurred. This implies that the auditor should
assure that the above internal control over cash receipts and cash disbursements are in
place. This can be achieved by preparing an internal control questionnaire for cash receipts
and cash disbursement. Some of the specific activities include:

1. Obtain an understanding of internal control over cash

2. Assess control risk and design additional tests of controls for cash
3. Perform additional tests of controls for those controls which the auditors plan to
consider to support their planned assessed level of control risks, such as
a. Test the account records and reconciliations made by re-performance.
b. Compare the details of a sample of cash receipts listing to the cash receipts
journal, A/R posting, and authenticated deposit slips.
c. Compare the details of a sample of recorded disbursements in the cash
payment journals to A/P postings, and purchase orders, receiving reports,
invoices, and paid checks.
4. Reassess control risk and modify substantive tests for cash.

2.5.2 Perform Substantive test of cash transactions and balances

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

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

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

3. Obtain or prepare reconciliation of bank accounts as of the balance sheet date and
consider need to reconcile bank activity for additional month.
4. Obtain a cut-off bank statement containing transactions of at least seven business days
subsequent to balance sheet date.
5. Count cash list on hand.
6. Verify the client’s cutoff of cash receipts and cash disbursements.

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 7. Analyze bank transfers for the last week of audit year and first week of following year
to disclose kitting.
8. Investigate any checks representing large or unusual payments to related parties.
9. Evaluate proper balance sheet presentation and disclosure of cash.

Brief discussion on some of the substantive audit procedures is presented below.

1. Obtain analysis of cash balances and reconcile to the general ledger
The auditor will prepare or obtain a schedule that lists the entire client’s cash account. For
example for cash in bank account, this schedule will typically list the bank, the bank
account number, account type (checking a/c or saving a/c), and the year-end balance per
book. The auditors will trace and reconcile all accounts to the general ledger as necessary.
2. Send standard confirmation forms to financial institutions to verify amounts on
deposit
Auditors usually obtain a direct receipt of a confirmation from every bank or other financial
institution with which the client does business. The main objective of this confirmation
letter is to corroborate (confirm) the existence of the amounts of cash recorded on the
balance sheet of the client. Ask banks if the amount of cash indicated in balance sheet as
‘cash in bank’ really exists in the bank account.

After auditors receive the completed bank confirmation, the balance in the bank account
confirmed by the bank should be traced to the amount stated on the bank reconciliation.
Similarly, all other information on the reconciliation should be traced to the relevant audit
schedules. If the bank confirmation does not agree with the audit schedules, auditors must
investigate the difference.

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

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

A monthly bank reconciliation of the general bank account on a timely basis by someone
independent of the handling or recording of cash receipts and disbursements is an essential
control over the ending cash balance. Companies with significant cash balances and large
volumes of cash transactions may reconcile cash on a daily basis to online banking records.
The reconciliation ensures that the accounting records reflect the same cash balance as the

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actual amount of cash in the bank after considering reconciling items. More important, the
independent reconciliation provides an opportunity for an internal verification of cash
receipts and disbursements transactions.

If the client has already prepared bank reconciliation, there is no need for duplicating the
work. However, the auditors should examine/inspect the reconciliation in detail to satisfy
themselves that it has been properly prepared. Auditors test the bank reconciliation to
determine whether client personnel have carefully prepared the bank reconciliation and to
verify whether the client’s recorded bank balance is the same amount as the actual cash in
the bank except for deposits in transit, outstanding checks, and other reconciling items. In
verifying the reconciliation, the auditor uses information in the cutoff bank statement to
verify the appropriateness of reconciling items.

4. Obtain a cut-off bank statement

A cut-off bank statement is a partial-period bank statement and the related copies of
cancelled checks, duplicate deposit slips, and other documents included in bank statements,
mailed by the bank directly to the auditor’s (CPA firm’s) office. The purpose of the cut-off
bank statement is to verify the accuracy of reconciling items on the client’s year-end bank
reconciliation with evidence that is not accessible to the client. To fulfil this purpose, the
auditor requests the client to have the bank send the statement for 7 to 10 days subsequent
to the balance sheet date directly to the auditor. It allows the auditors to examine the checks
listed as outstanding and the details of deposits in transit on the company’s reconciliation.

With respect to checks that were shown as outstanding at the year-end, the auditors should
determine the dates on which the bank paid these checks. By noting the dates of payment of
these checks, the auditors can determine whether the time intervals between the dates of the
check and the time of payment by bank were unreasonably long. Unreasonable delay in the
presentation of these checks for payment constitutes a strong implication that the checks
were not mailed by the client until sometime after the close of the year.

In examining the cut-off bank statement, the auditors will also watch for any paid checks
issued on or before the balance sheet date but not listed as outstanding on the client’s
yearend bank reconciliation. Thus, the cut-off bank statement provides assurance that the

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amount of cash shown on the balance sheet was not overstated by omission of one or more
checks from listing of checks outstanding.

5. Count cash list on hand

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

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

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

Example of Inter-bank Transfer Schedule

Date of Date of
Bank Account Disbursement Receipt
Check No. From To Amount Books Bank Books Bank
12 12 12
5897 General Payroll $30,620 1/
/28 3 /28 /28
12 12
6006 General Branch 4 24,018 ½ ¼
/30 /30

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 1 12
6029 Branch 2 General 10,000 1/ 1/
/3 5 3 /31
Disclosure of Kiting: By comparing the dates on the schedule of bank transfers, auditors
can determine whether any manipulation of the cash balance has taken place. The increase
in one bank account and decrease in the other bank account should be recorded in the cash
journals in the same accounting period. Notice that Check No. 6006 in the transfer schedule
was recorded in the cash journals as a receipt on December 30 and a disbursement on
January 2. As a result of recording the debit and credit parts of the transaction in different
accounting periods, cash is overstated on December 31. For the cash receipts journal to
remain in balance, some accounts must have been credited on December 30 to offset the
debit to Cash. If a revenue account was credited, the results of operations were overstated
along with cash.

A bank transfer schedule should disclose this type of kiting because the transfer deposit
appears on the general account bank statement in December, while the transaction was not
recorded in the cash journals until January. Check No. 6029 in the transfers schedule
illustrates this discrepancy.

These illustrations suggest the following rules for determining when it is likely that a cash
transfer has misstated the cash balance:

1. The dates of recording the transfer per the books (from the cash disbursements and
cash receipts journals, respectively) are from different statement period, or
2. The date the check was recorded by the bank (either the disbursement or the receipt,
but not both) is from the financial statement period prior to when it is recorded on the books.

7. Evaluate proper balance sheet presentation and disclosure of cash

Cash must be properly classified, described and disclosures need to be appropriate. Take the
following in to consideration:
1. Inquire of management. See management representation letter.
2. Evaluate restrictions on cash.
3. Assess cash flow statement.
a. evaluate presentation (direct or indirect method).
b. reconcile information with income statement and balance sheet.
4. Read financial statement notes.

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2.6 Audit of Marketable securities

2.6.1 Definition of marketable Securities

Companies often invest excess cash accumulated during certain parts of the operating cycle
that will be needed in the reasonably near future in short-term, highly liquid cash
equivalents. These may include time deposits, certificates of deposit, and money market
funds.

Marketable securities (Short-term investments) are financial investments which are

convertible into cash within one year or one operating cycle. They are listed at their current
market value. Marketable securities are shown on the balance sheet as “Short-term
Investments”.
E.g. Commercial paper, marketable equity securities, and marketable debt securities

Cash equivalents, which can be highly material, are included in the financial statements as a
part of the cash account only if they are short-term investments that are readily convertible
to known amounts of cash, and there is insignificant risk of a change of value from interest
rate changes.

2.6.2 Nature of marketable Securities

Companies group investments in debt and equity securities into three separate portfolios for
valuation and reporting purposes as:
• Held-to-maturity,
• Trading, and
• Available-for-sale securities.

2.6.3 Potential Misstatements of Marketable

securities o Misstatement of recorded value of Securities
o Unauthorized Security transactions o Incomplete
recording of Securities
o Inadequate disclosure of the nature of Security activities

2.6.4 Controls over Marketable Securities

 Establishment of formal security policies

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

2.6.5 Objectives for the Audit of Marketable Securities

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

2.6.6 Substantive Audit Procedures: Marketable Securities

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

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End of Chapter Notes!
CHAPTER 3 3. AUDIT OF RECEIVABLES AND SALES

Chapter Outline

 Meaning, Sources and Nature of Receivables

 Internal Control over Receivables/Sales

 Objectives for the Audit of Receivables and Revenue

 Audit Program for Receivable/Sales (Receivables Audit Steps)

Introduction
The overall objective of the audit of accounts receivable and sales is to determine if they are
fairly presented in the context of the financial statements as a whole. The sales account is
closely tied to accounts receivable; therefore, evidence supporting accounts receivable
tends to support sales. For example, having determined that an account receivable is valid,
the auditor has thereby supported the validity of the sale. Analytical procedures can often
be used to test the sales account. An unusual relationship detected in the audit of
receivables and inventory may reflect a problem for the reported sales figure as well.

3.1 Meaning, Sources and Nature of Receivables

 Receivables are all money claims against individuals, organizations or other debtors.
 They are acquired by business enterprises in various types of transactions, common being
the sale of goods (merchandise) or services on a credit basis.
 Receivables that are based on oral agreements are known as open accounts (Accounts
receivables). Receivables that are based on formal (written) instruments are called
promissory notes (Notes receivables).
 Accounts and Notes receivables originating from sales transactions are called Trade
Receivables.
 Receivables are shown on the balance sheet at their net realizable value (I.e. A/R balance
less Allowance for uncollectible accounts).

Sources of Receivables: Accounts receivable/Notes receivable include the business

organization’s:

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  Claims against customers from sale of goods and services
 Loans given to officers or employees
 Loans given to subsidiaries
 Claims for tax refunds
 Claims against various other refunds Advances to suppliers

Sources of Notes Receivable

Written promises to pay certain amounts at future dates
Notes for substantial amounts
– Sale of industrial machinery, farm equipment
– Issuance of capital stock
– Loans to officers, employees

Audit Risk: Audit risk is significant in A/R, N/R or Sales accounts because:
– Many incidences of fraud have involved overstatement of receivables and revenue.
– Revenue recognition may be based on complex accounting rules.
– Receivables and revenues are usually subject to valuation using significant
accounting estimates.

3.2 Internal Control over Receivables/Sales

The auditor, in evaluating the internal control system, is concerned to determine the extent
to which the common characteristics of control are present within the system. Because the
specific placement of responsibility, compliance and qualified personnel characteristics all
apply in the same way to all subsystems, we shall concentrate our attention on the others as
they relate specifically to the revenue system.
The internal controls with regard to accounts receivable include the following:

a) Appropriate segregation of responsibilities

1. Persons handling cash receipts do not have access to the accounts receivable records.
2. The billing function should be separated from the handling of cash receipts.
3. Any special discount concessions to customers should be approved by a responsible
supervisor.

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 4. The credit function should be separated from the handling of cash receipts and the
record keeping function.

5. The A/R ledger clerk recording sales and cash collections should be someone other
than the general bookkeeper.
6. Persons having the authority to originate non-cash credits to receivables should not
have access to cash.

b. Documentation approvals and records

1. Sales invoices should be sequentially numbered and procedures should be established

to account for the use of the invoice forms.
2. Credit memos should also be sequentially numbered and controlled in the same
manner as are sales invoices.
3. Sequentially numbered remittance advice forms should be prepared when cash is
received by the company.
Formal procedures should be established for carrying out the billing function.
4. A/R records should indicate both control account and a subsidiary ledger.
5. Formal procedures should be established for authorizing and approving the acceptance
of notes receivable

c. Safeguarding Assets and records

1. All cash receipts should be deposited intact daily.

2. Appropriately protected storage facilities for undeposited cash receipts.
3. The accounts receivable records should be stored in a safe or vault designed to protect
those records from damage or alteration when they are not being used.

Internal control components (Internal Control over A/R and Revenue)

1. Control Environment
– Important because of risk of intentional misstatement of revenue
– Independence of audit committee
– Management establishes tone at the top
– Commitment to competence
– Management’s philosophy and operating style

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 – Human resource policies and practices

2. Risk Assessment
– Risk of misstatement of revenue
3. Control Activities
– Division of duties Revenue cycle and relevant control
• Prepare sales order • Maintenance of control accounts
• Approve credit • Maintenance of customers’ ledgers
• Issue merchandise from stock • Approval of sales returns and
• Shipment allowances

• Billing • Authorization of write-offs of

uncollectible accounts
• Invoice verification

The account data in the revenue system include sales or other trade revenues, sales returns and
allowances, sales discounts, the allowance for doubtful accounts, bad debts expense,
receivables and cash receipts from cash sales and collection accounts. Because of the
perceived inclination of management to overstate assets, the auditor is most concerned with
verifying that the receivables element of the system and the offsetting credits to sales are not
overstated.
Revenue Cycle---Documents
• Customer purchase order
• Sales order
• Bill of lading
• Invoice
• Control listing
• Credit memo

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Revenue Cycle Controls
The revenue cycle controls include:
• Segregation of duties--sales and collections
• Matching of sales invoices and shipping documents
• Clerical accuracy checks on invoices
• Credit approval for sales transactions
• Mailing of monthly statements
• Reconciliation of bank accounts
• Use of control listing of cash receipts
• Use of budgets and analysis of variances
• Control over shipping and billing documents
• Use of authorized credit memoranda
• Use of chart of accounts and review of account coding

3.3. Objectives for the Audit of Receivables and Revenue

The auditors strive for attaining following objectives for the audit of receivables and revenues.
1. Use the understanding of the client and its environment to consider inherent risk, including
fraud risks, related to receivables and revenues.
2. Obtain an understanding of internal control over receivables and revenues.
3. Assess the risks of material misstatement and design tests of controls and substantive
procedures that:
a. Substantiate the existence of receivables and the occurrence of revenue
transactions.
b. Establish the completeness of receivables and revenue transactions.
c. Verify the cutoff of revenue transactions.
d. Determine that the client has rights to recorded receivables.
e. Establish the proper valuation of receivables and the accuracy of revenue transactions.
f. Determine that the presentation and disclosure of receivables and revenue are
appropriate.

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Theoretically the audit could depend on a strong system of internal control as a basis for an opinion
on the financial statements, assuming that compliance has been proved through transaction validity
test.
In designing tests of details of balances for accounts receivable, auditors must satisfy each of the
eight balance-related audit objectives first discussed in the introductory part of this course. These
eight general objectives are the same for all accounts. Specifically applied to accounts receivable,
they are called accounts receivable balance-related audit objectives and are as follows:
1. Accounts receivable in the aged trial balance agree with related master file amounts, and the total
is correctly added and agrees with the general ledger. (Test of Valuation and
Accuracy)
2. Recorded accounts receivable exist. (Existence)
3. Existing accounts receivable are included. (Completeness)
4. Accounts receivable are stated at realizable value. (Valuation)
5. Accounts receivable are accurate. (Accuracy)
6. Accounts receivable are correctly classified. (Classification)
7. Cut-off for accounts receivable is correct. (Cut-off)
8. The client has rights to accounts receivable. (Rights)

Brief discussions about these points follow.

1. Accounts Receivable are correctly added and agree with the master file and the general
Ledger
The auditor should verify that the sum of receivable subsidiary ledgers is equal to the total of the
general ledger of Receivables. For this purpose the auditor prepares aged trial balance of receivables.
The auditor should verify that Account Receivables in the aged trial balance equal the total of the
Account Receivables master file, and the total in both is correctly added and agree with the general
ledger. The individual accounts must be summarized correctly into the General Ledger. The auditor
will use the aged trial balance for this test. The total of the aged trial balance must agree with the
general ledger balance and also the total of the Account Receivables subsidiary ledger. Each of the
columns in the aged trial balance must be footed, then cross footed, comparing the total to the
general ledger balance.

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2. Verification of Existence of Receivable balance

The actual existence of a receivable as an asset depends on the clients having a valid claim for the
amount shown in the account. Confirmation is the primary auditing procedure in verifying existence
of receivables. This procedure is judged to be so important that it is required by generally accepted
auditing standards, unless it is impossible or impractical to perform. Confirmation helps us answer
the question: Do the A/R really exist? It also provides evidence related to valuation/allocation.
Acknowledgement of the debt by the customer is some evidence that it may be collected. Also, it
helps to determine whether there was proper cut-off of the accounts.
Confirmations provide reliable external evidence about the:
– Existence of recorded accounts receivable, and
– Completeness of cash collections, sales discounts, and sales returns and allowances,
Confirmations are required by GAAS unless one of the following is present:
– Receivables are not material
– Use of confirmations would be ineffective (the auditor considers that response rates are
likely to be inadequate or unreliable)
– Environment risk is assessed as low and sufficient evidence is available from using other
substantive tests (inherent and control risk are low, meaning that other evidence can be
regarded as sufficient)

Of course, confirmations are so widely used in auditing that the auditor must be very sure that he/she
can defend his action in court if accounts receivable are not confirmed.

Types of Confirmations
Two methods in which the client makes the formal request are:
1. Positive confirmation – requests addressed to the debtor asking for a reply.
– Basically, positive confirmation is letter sent to debtors asking them to confirm directly to the
auditor the amount of the balances in their respective accounts.
– Customers are asked to agree the amount on the confirmation with their accounting records and
to respond directly to the auditor whether they agree with the amount or not.
– The auditor wants a response regardless of whether the customer agrees or disagrees with the
stated balance.
– Positive confirmation requires a response.

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 – If customer does not respond, auditor must use alternative procedures.
– As a practical matter, the auditor will often send positive confirmation to accounts with large
balance.
– Positive confirmations are more reliable, partly because the auditor will follow-up confirmations
which are not returned.

2. Negative confirmation – asks debtors to advise the auditors only if the balance shown is incorrect
(asks for a response only if the debtor disagrees with recorded amount).

– Customers are asked to respond only if they disagree with the balance (non-response is
assumed to mean agreement).
– Negative confirmation requests are often simply stamped or glued into the client's regular
monthly statement to the customer before it is sent out.
– If a negative confirmation is not returned, the auditor assumes it is because the debtor agrees
with the balance. Since negative confirmations are often simply ignored by the recipient, that
assumption may not be correct.
– Negative confirmations are less reliable, but are cheaper to send. It is less expensive since
there are no additional procedures if customer does not respond.
– A formal letter is not required, and no time is spent following up. Therefore, confirmations
that are more negative can be sent for the same cost.
– May be used when all of the following are present
• Confirming a large number of small customer balances.
• Environment risk for receivables is assessed as low.

Flowchart of the Confirmation Process

Page 30
 positive confirmations
and extent

Identify the information Perform

to be confirmed alternative
procedures for Resolve exceptions
Select the accounts non-
for confirmation respondents

Document the procedures and results

11-25

3. Existing accounts receivable are included

The objective of this test is to verify that all transactions affecting receivables occurred in the period
are recorded, that is, the auditor examines if there is no unrecorded transaction (sales on account that
increases accounts receivable). The understatement of sales and accounts receivable is best
uncovered by substantive tests of transactions for shipments made but not recorded (completeness
objective for tests of sales transactions) and by analytical procedures.
The auditor will want to be aware of the possibility of understatement in examining the aged TB
when doing accuracy test, in case a problem exists that was not uncovered in the audit of sales. If a
balance is left off aged TB, the aged TB should be different from the general ledger control account.
If all sales to a particular customer are omitted from the A/R, then this probably won't be discovered
through confirmation (Customers aren't likely to respond to a zero balance - rather they rejoice at
their good fortune!). Such an omission may also be found by analytical procedures.

4. Verification of Valuation of Receivable balance

Accounting standards require that companies state accounts receivable at the amount that will
ultimately be collected. The realizable value of accounts receivable is equal to gross accounts
receivable less the allowance for uncollectible accounts. Under GAAP, short term receivables are
reported at net realizable value. Therefore, auditing procedures to meet this objective are directed
towards determining whether or not the client’s provision for uncollectible accounts and notes is
adequate.
Valuation/allocation: It is important for the auditor to verify that transactions have been
appropriately cut-off at the end of each period. A lager claim against the goods purchased is
established generally at the point where title passes. The title passage, in turn, is determined by the
FOB point. These tests try to make sure that current period transactions are not recorded in a
subsequent period, and the subsequent period transactions are not recorded in the current period.

Page 31
They are most relevant for cash receipts and sales. The reason is that if large subsequent period sales
are recorded in the current period, they can materially overstate sales. If sales are materially
overstated, net income and assets are overstated, hence two financial statements are affected.
The auditor must decide whether the allowance is reasonable, given the available facts. Four factors
should be weighed by the auditor in determining the correct amount - economic conditions, sales
volume, credit policy, and collection history.
Many questions will be asked by the auditor in determining the reasonableness of the allowance. Is
the balance of the allowance account reasonable compared to previous years, compared to current
year write - offs, compared to the age of accounts receivable, and in light of general economic
conditions? The age and amount of current past due accounts should be compared with those of
previous years, and the percentage of total A/R in each age category should be calculated. Generally,
the longer a receivable is outstanding, the less likely it is to be collected. The auditor should also
review correspondence with customers, and interview the credit manager regarding specific
accounts. Before an account is to be written off, there is often a strong letter to the customer
demanding payment. When the auditor is satisfied with the balance of the allowance account, Bad
Debt Expense for the year can be easily calculated.
5. Accounts receivable are correctly classified
Statement presentation is mainly giving precise and sufficient disclosure about the accounts to the
users of the information. This has to do with whether the Account Receivables are correctly
classified and presented on the balance sheets, and any related disclosures appear in the notes to the
financial statements, according to GAAP. If Account Receivables are not properly classified, this
probably is best found by scanning the aged TB. Examples of amounts sometimes improperly
classified as Accounts Receivable include longer-term notes receivable, and large credit balance in
Account Receivables. If the amount of credit balance of Accounts Receivable is significant, this type
of balance should be reclassified to A/P.
Specific circumstances which require disclosure are receivables from related parties and receivables
which have been pledged as collateral. In presenting receivables in the balance sheet, it is important
to verify that an appropriate distinction has been made between current and non-current receivables
and that appropriate disclosures have been made related to any contingent claims against receivables.
6. Verification of Rights/Ownership of Receivables
The existence of typical documentary support in the form of sales invoices, shipping documents,
notes, etc provides evidence of existence of receivables. However, the auditor is always concerned
with contingencies that may cloud the ownership rights of the client. Examples are, receivables may

Page 32
be pledged or Notes might have been discounted. A careful review of the board meeting minutes,
discussions with the client, or the bank's confirmation letter are more likely to reveal this situation-
whether receivable are pledged or not. The auditor will also request a representation letter from the
client that all such contingent claims against receivables have been disclosed in the financial
statements. Due to the matching principle associated with the financial reporting process, it is
important for the auditor to verify transactions that have been appropriately cut-off at the end of each
period.

7. Cut-off for Accounts Receivable Is Correct

Cut-off misstatements exist when current period transactions are recorded in the subsequent period
or vice versa. The objective of cut-off tests, regardless of the type of transaction, is to verify whether
transactions near the end of the accounting period are recorded in the proper period. Cut-off
misstatements can occur for sales, sales returns and allowances, and cash receipts.
a. Sales Cut-off: Check that sales of the period are recorded in the period/year in which title to
the sold goods is transferred (point of sale method).
An auditor can easily test this by comparing recorded sales with the related shipping
documents for the last few days of the current period and the first few days of the subsequent
period.
b. Sales Returns and Allowances Cut-off. Accounting standards require that sales returns and
allowances be matched with related sales if the amounts are material. For example, if current
period shipments are returned in the subsequent period, the sales return should appear in the
current period (the returned goods should be treated as current period inventory).

3.4 Audit Program for Receivable/Sales (Receivables Audit Steps)

(I) Internal Control considerations- Tests of Controls

Perform following tests of controls.
a. Examine significant aspects of a sample of sales transactions.
b. Compare a sample of shipping documents to related sales invoices.
c. Review the use and authorization of credit memoranda.
d. Reconcile selected cash register tapes and sales tickets with sales journals.
e. Test IT application controls.
f. Examine evidence of review and approval of revenue estimates.

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 (II)Substantive Audit Procedures for Receivable/Sales

Perform following major Substantive procedures for receivables and revenue.

1. Obtain an aged trial balance of trade accounts receivable and analyses of other accounts
receivable and reconcile to ledgers.
2. Obtain analyses of notes receivable and related interest.
3. Inspect notes on hand and confirm those with holders.
4. Confirm receivables with debtors.
5. Review the year-end cutoff of sales transactions.
6. Perform analytical procedures for accounts receivable, notes receivable, and revenue.
7. Review significant year-end sales contracts for unusual terms.
8. Test the valuation of notes receivable, computation of interest income, interest receivable,
and amortization of discount or premium.
9. Evaluate the propriety of the client’s accounting methods for receivables and revenue.
10. Evaluate accounting estimates related to revenue.
11. Determine the adequacy of the client’s allowance for uncollectible accounts.
12. Ascertain whether any receivables have been pledged.
13. Investigate any transactions with or receivables from related parties.
14. Evaluate the business purpose of significant and unusual sales transactions.
15. Evaluate financial statement presentation and disclosures of receivables and revenue.

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End of Chapter Notes!
CHAPTER 4 4. AUDIT OF INVENTORIES AND COST OF
SALES

Chapter Outline

Meaning of Inventories and the Significance of Audit of Inventories

Functions making up the Inventory and Warehousing Cycle

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 Audit objectives for Inventories/Cost of Sales

Audit Program for Inventories/Cost of Sales

Verification of Inventories

4.1 Meaning of Inventories and the Significance of Audit of Inventories

Inventories are goods held for resale in the ordinary course of business or goods that will be used
or consumed in the production of goods to be sold. They are mainly divided into two major
categories:

 Inventories of merchandising businesses

 Inventories of manufacturing businesses

Source of Inventories Inventories

include:
 Goods on hand ready for sale.
 Goods in the process of production.
 Goods to be consumed directly or indirectly in production such as raw materials,
purchased parts, and supplies.

In auditing the purchases, cost of sales and cash disbursements system and related balances, the
auditor must be concerned with verification of transaction validity, existence, ownership, cutoff,
valuation and appropriate statement presentation. The primary asset accounts associated with the
cost of sales system are inventories.
Audit of cost of goods sold can be directly tied to the audit of inventory. If beginning and ending
inventories have been verified and acquisitions have been tested, cost of goods sold can be directly
calculated. Auditor should also apply analytic to cost of goods sold to see if there are any significant
variations - either overall or by product line.

Special significance of Audit of Inventories

The audit of inventory is quite complex and time consuming part for the following reasons:

Page 36
1. Inventory is generally a major item on the balance sheet and it is often the largest item making
up the accounts included in the working capital. I.e., inventories often represent the largest
current asset of a company.
2. The inventory may be in different locations, which makes physical counting difficult. I.e.,
determining the quantities of inventories may require specialized techniques.
3. The diversity of items in inventory creates another difficulty for auditors.
4. The valuation of inventory is also difficult due to such factors as obsolescence and the need to
allocated manufacturing costs to inventories. I.e., the valuation of goods on hand and in process
often presents complex and difficult issues.
5. There are several acceptable inventory valuation methods but any given client must apply a
method consistently from year to year.
6. Misstatements of inventories directly affect cost of goods sold and, therefore, net income.
7. Management fraud has often involved the fraudulent overstatement of inventories.

Risks of Material Misstatements

i. Inventories constitute a large asset and are very susceptible to major errors and fraud.
ii. The accounting profession allows numerous alternative methods for valuation of
inventories, and different methods may be used for various classes of inventories.
iii. The determination of inventory value directly affects the cost of goods sold and has a major
impact on net income for the year.
iv. The determination of inventory quality, condition, and value is inherently a more complex
and difficult task than is the case with most other elements of financial position.
4.2 Functions making up the Inventory and Warehousing Cycle

Inventory takes many different forms, depending on the nature of the business. For retail or
wholesale businesses, the largest account in the financial statements is often merchandise inventory
available for sale. To study the inventory and warehousing cycle, we will use an example of a
manufacturing company, whose inventory may include raw materials, purchased parts and supplies
for use in production, goods in the process of being manufactured, and finished goods available for
sale. Still, most of the principles discussed apply to other types of businesses as well.

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The inventory and warehousing cycle can be thought of as comprising two separate but closely
related systems, one involving the physical flow of goods and the other the related costs. Six
functions make up the inventory and warehousing cycle. Each of these is discussed next.
1. Process Purchase Orders
2. Receive Raw Materials
3. Store Raw Materials
4. Process the Goods
5. Store Finished Goods
6. Ship Finished Goods

The following figure shows the above six functions in the inventory and warehousing cycle and
below the figure brief discussions have been made for each function.

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 1. Process Purchase Orders
The inventory and warehousing cycle begins with the acquisition of raw materials for production.
Adequate controls over purchasing must be maintained whether inventory purchases are raw
materials for a manufacturer or finished goods for a retailer. Purchase requisitions are forms used to
request the purchasing department to order inventory. These requisitions may be initiated by
stockroom personnel as raw materials are needed, by automated computer software when raw
materials reach a predetermined level, by orders placed for the materials required to produce a
customer order, or by orders initiated on the basis of a periodic raw materials count.
2. Receive Raw Materials
Receipt of the ordered materials, which is also part of the acquisition and payment cycle, involves
the inspection of material received for quantity and quality. The receiving department prepares a
receiving report that becomes a part of the documentation before payment is made. After inspection,
the material is sent to the storeroom and copies of the receiving documents, or electronic
notifications of the receipt of goods, are typically sent to purchasing, the storeroom, and accounts
payable. Control and accountability are necessary for all transfers.
3. Store Raw Materials
Once received, materials are normally stored in a storeroom. When another department needs
materials for production, personnel submit a properly approved materials requisition, work order, or
similar document or electronic notice that indicates the type and quantity of materials needed. This
requisition document is used to update the perpetual inventory master files and record transfers from
raw materials to work in process accounts. These updates occur automatically in organizations with
integrated inventory management and accounting software systems.
4. Process the Goods
Processing inventory varies greatly from company to company. Companies determine the finished
goods items and quantities they will produce based on specific orders from customers, sales
forecasts, predetermined finished goods inventory levels, and economical production runs. A
separate production control department is often responsible for determining the type and quantities to
produce.
An adequate cost accounting system is an important part of the processing of goods function for all
manufacturing companies. The system shows the relative profitability of the products for
management planning and control and values inventories for preparing financial statements. Two

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primary types of cost systems exist: job cost systems and process cost systems, but there are many
variations and combinations of these systems.
Cost accounting records consist of master files, spreadsheets, and reports that accumulate material,
labour, and overhead costs by job or process as those costs are incurred. When jobs or products are
completed, the related costs are transferred from work-in-process to finished goods based on
production department reports.
5. Store Finished Goods
When finished goods are completed, they are placed in the stockroom to await shipment. In
companies with good internal controls, finished goods are kept under physical control in a separate,
limited-access area. The control of finished goods is often considered part of the sales and collection
cycle.
6. Ship Finished Goods
Shipping completed goods is part of the sales and collection cycle. The actual shipment of goods to
customers in exchange for cash or other assets, such as accounts receivable, creates the exchange of
assets necessary for meeting revenue recognition criteria. For most sales transactions, the actual
shipment becomes the trigger for recognizing the related accounts receivable and sales in the
accounting system. Thus, shipments of finished goods must be authorized by a properly approved
shipping document.

4.3 Audit objectives for Inventories/Cost of Sales

1. Use the understanding of the client and its environment to consider inherent risks, including
fraud risks, related to inventories and cost of goods sold.
2. Obtain an understanding of internal control over inventories and cost of goods sold.
3. Assess the risks of material misstatement and design tests of controls and substantive
procedures that:
a. Substantiate the existence of inventories and the occurrence of transactions affecting cost of
goods sold.
b. Establish the completeness of recorded inventories.
c. Verify the cutoff of transactions affecting cost of goods sold.
d. Determine that the client has rights to the recorded inventories.

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 e. Establish the proper valuation of inventories and the accuracy of transactions affecting cost
of goods sold.
f. Determine that the presentation and disclosure of information about inventories and cost of
goods sold are appropriate, including disclosure of the classification of inventories,
accounting methods used, and inventories pledged as collateral for debt.

4.4 Audit Program for Inventories/Cost of Sales

The auditor needs to design an appropriate audit program for inventories/cost of sales as follows.
(I) Internal Control Consideration- Tests of Controls (Verification of Transaction
validity)
The primary objective of an auditor is to verify effectiveness of internal of the client to enhance
efficient and effective utilization of inventory. The auditor depends primarily on the reliability of the
system of internal control in judging whether inventory, cost of sales and cash disbursement
transactions have been appropriately recorded, classified and accumulated in the accounting records.

During the preliminary study and evaluation of the system of internal controls, the reliability of the
system can be evaluated in general by verifying the extent to which it included the desirable internal
control characteristics. If selected controls are found to be weak, related substantive tests over
inventory and related accounts should be expanded.
Internal Control over inventory includes
 Documentation of authorization and approval procedures
 Appropriate separation of responsibilities
 Safeguarding assets and records: Inventory Balances

a. Documentation of authorization and approval procedures

The more important procedures for inventory and cost of sales require that:
1. A properly approved purchase requisition be originated as the first document in support of
materials acquisition.
2. Purchase orders, originated in response to properly approved purchase requisitions, be
sequentially numbered and a procedure be established to account for the use of each of the
purchase order forms.
3. Debit memos, issued in connection with purchase returns and allowances, be sequentially
numbered and controlled in the same manner as are purchase orders.

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 4. Sequentially numbered vouchers be prepared and properly approved in support of all cash
disbursements. When a check is issued against a properly approved voucher, the voucher
should be cancelled by being stamped “paid” and should be initialed by the person signing
the check in payment of it.
5. A voucher register be maintained to record all approved vouchers.
6. Properly controlled, sequentially numbered receiving report forms be used to acknowledge
receipt of goods from vendors.
7. Job order cost sheets or cost of production reports be used to account for goods in the
process of being manufactured.
8. Subsidiary perpetual inventory records be maintained for raw materials and finished goods.
9. Bills of material or raw material requisitions be used to account for materials issued into
production.
10. Properly controlled, sequentially numbered paychecks be used to pay all employees.
b. Appropriate separation of responsibilities
The appropriate separation of responsibilities should be checked by making inquiries, observing
procedures, and examining policy and procedures manuals. This requires that many functions be
assigned to different employees to protect resources and provide reliable financial data, as follows:
1. Persons preparing and approving the vouchers for payment should have no other
responsibilities relating to cash payments.
2. The person authorized to sign checks should have no responsibilities relating to the
preparation of vouchers and should have no access to cash receipts or the cash records.
3. The authority to borrow should be separated from the cash handling transactions.
4. The stores ledger clerk should not have access to the store room or to the handling of
inventory items.
5. The various authorization and approval functions associated with payments of accounts
should be divided among a number of different persons.
6. Persons having a responsibility for the purchase of goods or services should have no access to
cash.

c. Safeguarding assets and records: Inventory Balances

All assets and records associated with the cost of sales system should be appropriately protected
from physical loss or alteration. This requires that:

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 1. All payments be made by use of pre-numbered checks.
2. The inventory storage areas should be fitted to the goods stored in them.
3. Inventory records should be stored so as to protect them from damage or alteration.

(II) Substantive Audit Procedures for Inventories/Cost of Sales

Perform following Substantive procedures for inventories/cost of goods sold.

1. Obtain listings of inventory and reconcile to ledgers.
2. Evaluate the client’s planning of physical inventory.
3. Observe the taking of physical inventory and make test counts.
4. Review the year-end cutoff of purchases and sales transactions.
5. Obtain a copy of the completed physical inventory, test its clerical accuracy, and trace test
counts.
6. Evaluate the bases and methods of inventory pricing.
7. Test the pricing of inventories.
8. Perform analytical procedures.
9. Determine whether any inventories have been pledged and review purchase and sales
commitments.
10. Evaluate financial statement presentation of inventories and cost of goods sold, including
the adequacy of disclosure.

Summary of Major Substantive Tests of Inventories

Substantive Test Preliminary Audit Objectives
Obtain listings of inventory and reconcile to ledgers Clerical Accuracy
Evaluate the client’s planning of physical inventory Existence and rights
Completeness
Observe the taking of the physical inventory Valuation
Review the year end cut-off of purchase and sales Existence and rights
transactions Completeness
Obtain a copy of the completed physical inventory and Clerical accuracy
test its accuracy
Evaluate the bases and methods of inventory pricing Valuation
Determine whether any inventories have been pledged Valuation
and review commitments Presentation and disclosure

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Evaluate financial statement presentation and Presentation and disclosure
disclosure
4.5 Verification of Inventories

1. Verification of Existence: Inventory Balance

Auditors must observe the client taking a physical inventory count to determine whether recorded
inventory actually exists at the balance sheet date and is correctly counted by the client. Physical
examination is an essential type of evidence used to verify the existence and count of inventory
When inventories exist and are material to the financial statements taken as a whole the auditor must
generally be present to observe and to take some test counts when the client physically counts the
inventory.
Observation of inventory ordinarily begins with an inspection of the client’s physical inventory
instructions. To making this inspection, the auditor should be alert for weaknesses that could allow
particular elements of the inventory to be counted twice or possibly be omitted during the inventory
taking process.

In some situations it may be impossible or impracticable for the auditor to observe and test count
inventories at the balance sheet date. In these situations, if the client has maintained proper perpetual
records, the auditor may still be able to verify the existence of year-end inventories by the use of
alternative procedures. These procedures must be performed as soon as possible after the balance
sheet date and include the following:
1. Review of client inventory instructions.
2. Inquiry of the client as to how counts were made.
3. Inspection of physical inventory records, noting that the proper procedures were performed
and adjustment were made where necessary.
4. Test counting of selected items, tracing the movement of inventories back through the
perpetual records by use of issue slips and receiving reports, and then reconciling the
resultant calculations with amounts shown on the perpetual records as of the balance sheet
date.

2. Verification of Valuation: Inventory Balance

The verification of inventory valuation generally begins when the auditor investigates the valuation
method used by the client. The auditor must then determine whether that method produces, within

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the limits of materiality, a valuation that is in accordance either with one of the generally accepted
cost-flow assumptions or with the lower of cost or market valuation procedures.
Specifically, the investigation of inventory valuation (pricing) often will emphasize the following
questions:
i. What method of pricing (costing) does the client use? Inventories should be priced in
accordance either with one of the generally accepted cost-flow assumptions (FIFO, LIFO,
and Weighted Average) or with the lower of cost or market valuation (LCM) procedures.
ii. Is the method of pricing the same as that used in prior years?
iii. Has the method selected by the client been applied consistently and accurately in practice?

The auditor will then, on a test basis, inspect the values assigned to various inventory items. The
cost assigned to inventories should be the invoice cost less cash discounts taken. In verifying the
valuation of work in process and finished goods inventories, it is important for the auditor to inspect
the supporting records found within the cost accounting subsystem.

If the client is a retail store, the valuation involves vouching not only the unit cost of goods but also
the retail price. During the observation of inventory it is important for the auditor to give special
attention to inventory items that may be damaged, shopworn or obsolete. Slow moving (obsolete)
items are most likely to be discovered by examining the perpetual inventory records.

3. Verification of Ownership of inventory: Inventory Balance

The verification of ownership requires the auditor to inspect, on test basis, the documents underlying
to the acquisition of individual inventory items including purchase orders, receiving reports and
vender invoices. With respect to consigned goods, the auditor should inquire about them and secure
an inventory representation letter stating that such goods have been excluded from the inventory
accounts. He or she can then examine the final inventory listing to verify that such goods have, in
fact, been excluded from inventories.

4. Verification of cut off (Periodicity): Inventory Balance

Cut off errors occur near the beginning or end of the audit period when entries involving the
acquisition or disposal of merchandise are included as transactions in the wrong period. In verifying
proper cutoff the auditor must inspect the underlying documents relating to both purchases and sales
made near the end of the period under audit and during the first few days of the succeeding period.
This procedure is performed to determine that the transaction has been recorded in the proper period

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and that he client held legal title to the goods as of the balance sheet date. Ordinarily, merchandise
acquisitions should be recorded at the date the title to the goods passes to the purchaser, i.e., the FOB
shipping point.

5. Verification of Statement Presentation

The verification of statement presentation primarily involves seeing that the disclosure requirement
relating to inventory has been met. The auditor must inquire of the client as to whether any part of
the inventory has been pledged as security against creditor claims. If so, the auditor must ascertain
that the amount of the pledged inventory has been appropriately disclosed in the balance sheet. It is
also necessary for the financial statement to disclose the method used in valuing the inventory.
Furthermore, in case of manufacturing firm, appropriate distinction should be made between
inventories of raw materials, work in process and finished goods.

End of Chapter Notes!

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