The objective of this article is to apply the requirements of SAS 300, Accounting and Internal Control Systems and Audit Risk Assessments, (ISA 400, Risk Assessments and Internal Control), and SAS 400 (ISA 500), Audit Evidence, to the verification of the balance of cash on hand and at bank. It will be assumed that the appropriate understanding of the transactions classes of cash receipts and cash payments has been obtained and control risk assessed and tested. The article is divided into three main sections:
1. Identifying the audit objectives applicable to cash balances.
2. Discussing considerations relevant to developing the audit plan for cash.
3. Designing and executing an audit programme for cash.
Cash audit objectives
Cash balances include cash on hand and at bank. Cash on hand includes undeposited receipts and petty cash. Cash at bank includes cash held in current and savings accounts which is available on demand. Unlike any other account balance, cash may be either an asset or a liability. The latter arises where the bank with which the entity holds an account allows the entity to write cheques in excess of the balance in the account up to an agreed limit known as an overdraft. Using the assertions described in SAS 400 (ISA 500) the audit objectives to be achieved in verifying cash balances are identified in
Table 1.
Table 1: Specific audit objectives for cash balances | |
Assertion | Account balance audit objective |
Existence | Recorded cash balances exist at the balance sheet date. |
Completeness | Recorded cash balances include the effects of all cash transactions that have occurred. |
Rights and obligations | The entity has legal title to all cash balances shown at the balance sheet date. |
Valuation | Recorded cash balances are realizable at the amounts stated on the balance sheet. |
Presentation and disclosure | Cash balances are properly identified and classified in the balance sheet. |
Lines of credit, loan guarantees and other restrictions on cash balances are appropriately disclosed. | |
Developing the audit plan Developing the audit plan involves:
- assessing control risk;
- assessing materiality and inherent risk; and
- determining the audit strategy.
Control risk
Although we have assumed that control risks over cash transactions have already been assessed, there are some control procedures that apply directly to the balance. Of those listed in SAS 300 (ISA 400) par. 10, the following fall into this category;
- reconciliations;
- comparing the results of cash, security and stock counts with accounting records;
- comparing internal data with external sources of information.
A preliminary procedure to planning the audit is to consider the effectiveness of such controls designed to ensure the correctness of the recorded balance.
Bank reconciliations
The bank statement is a bank prepared listing of its transactions with the customer, normally issued monthly. Most entities verify their balance of cash at bank by reconciling entries in the cash book with the bank statement. For payments, the procedure is to trace all cheques and other payments processed by the bank to the cash book or, for cheques issued prior to the beginning of the month, to the reconciliation prepared at the end of the previous month. Any cheques in the opening reconciliation or in the cash book that have not been presented to the bank for payment are recorded in the reconciliation as outstanding cheques. Other deductions by the bank from the entity's balance need to be reviewed. These include direct debits, bank charges and reversals of deposits where the cheque deposited is not accepted by the issuer's bank, often referred to as a NSF (not sufficient funds) returned cheque. The cash book usually needs to be adjusted to reflect these items in arriving at the balance of cash per the cash book.
Similarly, comparison is made of deposits. This is much easier as there is usually only a short delay between the date of deposit and the date the deposit appears on the bank statement. Again a list of outstanding deposits is prepared. It should then be possible to draw up a bank reconciliation proving the cash balance by starting with the balance per the bank statement, deducting outstanding cheques, adding back outstanding deposits and arriving at the balance shown in the cash book (or cash at bank account in the general ledger).
The level of substantive procedures performed by the auditors depends on the assessment of control risk over entity prepared reconciliations. The reconciliations should be prepared by persons independent of the handling and recording of cash transactions and approved by a responsible official. If control risk is assessed as low the auditors may test the entity prepared reconciliation. If risk is high, the auditors may need to prepare their own reconciliation.
Cash counts
Since an important control procedure for cash transactions is that all cash be deposited intact daily, entities are unlikely to have substantial cash balances on hand. The only cash balances are likely to be petty cash and change floats which are often immaterial. Petty cash is usually maintained on an imprest system established by transferring a specified amount of cash, such as £200 or £500, to an imprest petty cash fund. When cash is paid out of the fund it is replaced by an authorised voucher. This voucher could be a supplier's invoice or a special petty cash voucher authorised by a responsible official. When the cash is getting low, the vouchers will be used as support for a cheque requisition to replenish the fund. The fund should be maintained at the imprest level in the custody of one individual and periodically independently counted to ensure that cash and vouchers total to the imprest level.
Materiality and risk
For many entities, cash balances represent only a very small proportion of assets. However, the amount of cash flowing through the accounts over a period of time is usually greater than for any other account in the financial statements. Moreover, cash is vital to the survival of the business as a going concern. The inability of an entity to pay its debts as they fall due because of a shortage of cash can render a company insolvent, despite the profitability of its operations. Cash, therefore, has a materiality that is greater, relative to its balance, than any other account balance.
The high volume of transactions contributes to a significant level of inherent risk for cash balance assertions, particularly existence and completeness. In addition, the nature of cash balances makes them susceptible to theft, as numerous kinds of fraudulent schemes involving cash have borne out. In contrast to debtors or stocks, however, the risks pertaining to the rights and obligations, valuation, and presentation and disclosure assertions for cash are minimal due to the absence of complexities involving these assertions.
Audit strategy
Because of the large volume of transactions and the small account balance, the audit strategy is invariably to concentrate on verifying the account balance rather than the transactions. Moreover, because of the significance of cash to an entity's liquidity, auditors tend to plan their procedures to detect much smaller levels of misstatements than for other accounts. In verifying cash, the auditors must remember that the closing balance may be an overdraft. The assertions of existence and completeness are thus equally important, given that the balance may be either an asset or a liability.
Table 2: Possible substantive procedures for cash balance assertions | |||
Category | Substantive procedure | Cash balance audit objective | |
Initial procedures | |||
1 | Perform initial procedures on cash balances and records: | Valuation | |
(a) | trace opening balances to prior year's working papers; | ||
(b) | review activity in general ledger accounts for cash; | ||
(c) | obtain and verify mathematical accuracy of entity-prepared summaries. | ||
Analytical procedures | |||
2 | Perform analytical procedures. | ||
Tests of details of transactions | |||
3 | Perform cash cut-off tests (note — these tests may have been performed as part of the audit programmes for debtors and creditors). | Existence and Completeness | |
Tests of details of balances | |||
4 | Count undeposited cash on hand. | Existence, Completeness, Rights and Valuation | |
5 | Confirm bank balances. | ||
6 | Verify reconciliations as appropriate. | ||
7 | Obtain and use subsequent period's statements. | ||
Presentation and disclosure | |||
8 | Compare report presentation with applicable Accounting Standards. | Presentation and disclosure | |
Designing and executing an audit programme In performing the substantive audit of cash balances, auditors first assess detection risk and then design and perform procedures as necessary to achieve that planned level of detection risk.
Determining detection risk
Because of the significance of cash to the entity's liquidity and the fact that the balance is relatively small, the acceptable level of detection risk in verifying cash balances is invariably set as low.
Designing and performing substantive procedures
A list of possible substantive procedures to achieve the specific audit objectives for cash balances is presented in Table 2. The list is organised in accordance with the general framework for developing audit programmes for substantive procedures which was explained in the article on "Designing audit procedures" in the January 1999 issue of the Student Accountant.
Initial procedures
The starting point for verifying cash balances is tracing the current period's opening balances to the closing audited balances in the prior year's working papers. Next, the current period's activity in the general ledger cash accounts should be reviewed for any significant entries that are unusual in nature or amount and that may require investigation.
Schedules prepared by the entity showing summaries of undeposited cash receipts at different locations and/or summaries of bank balances are obtained. The mathematical accuracy of such schedules should be determined and their agreement with related cash balances in the general ledger checked. This test provides evidence about the valuation assertion.
Analytical procedures
Cash balances do not normally show a stable or predictable relationship with other current or historical financial or operating data. However, cash balances can be compared with amounts expected from cash flow forecasts.
Tests of details of transactions
A proper cut-off of cash receipts and cash payments at the end of the year is essential to the proper statement of cash at the balance sheet date. Two cash cut-off tests are performed:
Cash receipts cut-off test. The cash receipts cut-off test is designed to obtain reasonable assurance that cash receipts are recorded in the accounting period in which received. If the auditors are present at the year-end date, they can observe that all collections received prior to the close of business are included in cash on hand or in deposits in transit, and are credited to debtors. An alternative to personal observation is to review supporting documentation such as the daily cash summary and validated deposit slip for the last day of the year.
Cash payments cut-off test. The usual method of verifying payments cut-off is by examining the date of presentation of cheques outstanding as at balance sheet date. This test is normally performed as part of the test of the bank reconciliation and the use of the subsequent period's bank statement, and is described below.
Tests of details of balances
Substantive tests for cash balances in this category include:
1. Count cash on hand.
2. Confirm bank balances.
3. Verify bank reconciliations.
4. Obtain and use subsequent period's bank statement.
Count cash on hand
This test is often omitted as the amount of cash on hand is rarely material. If it is performed the following procedures are appropriate:
- control all cash held by the entity until all funds have been counted;
- insist that the custodian of the cash be present throughout the count;
- list each item making up the balance;
- obtain a signed receipt from the custodian on return of the funds;
- ascertain that all undeposited cheques are payable to the order of the entity, either directly or through endorsement;
- trace each item listed to the subsequent bank deposit.
The control of all funds is designed to prevent transfers by entity personnel of counted funds to uncounted funds. Having the custodian present and requiring his or her signature on return of the funds minimises the possibility, in the event of a shortage, of the custodian claiming that all cash was intact when released to the auditors for counting. Tracing items to the subsequent deposit tests the possibility of a teeming and lading fraud.
Confirm bank balances
It is customary for the auditors to confirm cash on deposit and loan balances at balance sheet date directly with the bank. The procedure in the UK is laid down in APB Practice Note 16, Bank Reports for Audit Purposes, based on an agreement with the British Bankers Association. Similar arrangements with the banking industry may exist in other countries. A confirmation request should be sent to all banks with which the entity had dealings at any time during the year. In addition to confirmation of the balance outstanding, the opportunity is also taken to request the bank to furnish other information such as securities held in safekeeping.
The confirming of cash on deposit provides evidence primarily as to the existence of cash at bank (because there is written acknowledgement that the balance exists), and as to rights and obligations (because the balances are in the name of the entity). The response from the bank also provides some evidence for the valuation assertion for cash at bank in that the confirmed balance is used in arriving at the correct cash balance at the balance sheet date. Furthermore, it contributes to the completeness assertion; however, it cannot be relied on entirely because the bank confirmation usually contains a disclaimer in favour of the bank. The bank cannot be held liable if the information supplied is incomplete or inaccurate.
The confirming of overdraft and loan balances provides evidence as to:
- existence, because there is written acknowledgement that the loan balance exists;
- rights and obligations, because the loan is a debt of the entity;
- valuation, because the response indicates the amount of the loan balance.
This test also contributes to the completeness assertion in the same manner as confirming deposit balances.
Verify bank reconciliations
When the entity prepares bank reconciliations on a regular basis that are expected to be reliable, the auditors will test reconciliations prepared as at balance sheet date. The test will normally include:
- comparing the closing bank balance with the balance confirmed by the bank;
- verifying the validity of deposits in transit and outstanding cheques by,
— tracing entries in the bank statement for the last month of the fiscal year to the cash book or bank reconciliation at the beginning of the month, marking them off in the process,
— identifying deposits and cheques recorded in the cash book for the last month of the fiscal year, or in the reconciliation at the beginning of that month not marked as appearing on the bank statement, and tracing them to the closing reconciliation,
— clearing the bank reconciliation to ensure that all applicable outstanding deposits and outstanding cheques are marked as having been traced from the cash book and that none are fictitious. - establishing the mathematical accuracy of the reconciliation;
- vouching other reconciling items such as bank charges to supporting documentation;
- investigating old items such as cheques outstanding for a long period of time and unusual items;
- tracing outstanding cheques and deposits in transit to the subsequent period's bank statement.
When the entity does not prepare a bank reconciliation or when control risk over entity prepared reconciliations is high (such as where it is prepared by the cashier), the auditors may prepare the bank reconciliation. When the auditors suspect possible material misstatements, the auditors may obtain the year-end bank statement directly from the bank for use in preparing the bank reconciliation and not rely on the copy of the bank statement held by the entity. This procedure will prevent the entity from making alterations to the data to cover any misstatements.
Testing or preparing a bank reconciliation establishes the correct cash at bank balance at the balance sheet date. Thus, it is a primary source of evidence for the valuation assertion. This test also provides evidence for the existence, completeness, and rights and obligations assertions.
Obtain and use subsequent period's bank statement
The subsequent period's bank statement would normally be issued at the end of the month following the entity's financial year-end. The entity should be requested to instruct the bank to send a copy of the subsequent period's bank statement directly to the auditors. In tracing outstanding cheques the auditors may find that a prior period cheque not on the list of outstanding cheques has cleared the bank and that some of the cheques listed as outstanding have not cleared the bank. The latter may be due to delays in mailing the cheques by the entity or in depositing the cheques by the payees. The auditors should investigate any unusual circumstances.
When the total of uncleared cheques is material, it may indicate an irregularity known as window dressing. This is a deliberate attempt to enhance an entity's apparent short-term solvency. (Assume, at balance sheet date, that the entity's balances show current assets of £800,000 and current liabilities of £400,000. If £100,000 of cheques to short-term creditors have been prematurely entered, the correct totals are current assets of £900,000 and current liabilities of £500,000, which results in a 1.8:1 current ratio instead of the reported 2:1.) Window dressing is normally perpetrated by writing cheques on the last day of the financial year but not mailing them until several weeks later, when cleared funds are available at the bank to meet those cheques. If none of a sequence of cheques is presented for payment on the bank statement for more than two weeks after the balance sheet date, the auditors should make inquiries of the treasurer. Recipients do not usually delay banking cheques once received and it is normal for most cheques to clear the bank statement within a week of issue.
The tracing of deposits in transit to the subsequent period's bank statement is normally a relatively simple matter because the first deposit on that statement should be the deposit in transit shown on the reconciliation. When this is not the case, the auditors should determine the reasons for the delay from the cashier, and corroborate his or her explanations. Delays in depositing cash receipts could indicate the practice of the fraud known as teeming and lading.
The auditors should also scan the subsequent period's statement for unusual items, being alert for such items as unrecorded bank debits and credits, and bank errors and corrections.
By obtaining the subsequent period's statement directly from an independent source, the auditors secure a high degree of competent corroborating information about the validity of the year-end bank reconciliation and the existence, completeness, rights and obligations, and valuation assertions for cash at bank.
Presentation and disclosure
Cash should be correctly identified and classified in the balance sheet. For example, cash on deposit is a current asset. A bank overdraft is normally reported as a current liability.
The auditors determine the appropriateness of the financial statement presentation from a review of the draft of the entity's financial statements and the evidence obtained from the foregoing substantive procedures. In addition, the auditors should review the minutes of board of directors meetings and inquire of management for evidence of restrictions on the use of cash balances. Conclusion The verification of cash balances is an important part of a financial statement audit. This is because even though the balances as of the balance sheet date may appear immaterial relative to other assets, the amount of cash flowing through the accounts during the audit period can be very material. In addition, cash is susceptible to misappropriation and is involved in many fraudulent schemes teeming and lading. Thus, several types of substantive procedures of cash balances are performed on most audits including, among others, cash cut-off tests, counting cash on hand, confirming balances and other arrangements with banks, reviewing bank reconciliations, obtaining and using subsequent period bank statements, and determining the adequacy of management's disclosures for cash balances.
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