Which of the following might an auditor be looking for when examining a bank cutoff statement?

Chapter 23 - Notes

Audit of Cash Balances

Auditor's Assessment of the Cash Account

The appropriate tests for the ending balance in the cash accounts depend heavily on the initial assessment of control risk, tests of controls, and substantive tests of transactions for cash receipts. The company's controls over cash receipts assist the auditor in determining that cash received is promptly deposited, that receipts recorded are proper, that customer accounts are promptly updated, and that the cash cutoff at year-end is proper. If the results of the evaluation of internal control, the tests of controls, and the substantive tests of transactions are adequate, it is appropriate to reduce the tests of details of balances for cash, especially for the detailed tests of bank reconciliations. On the other hand, if the tests indicate that the client's controls are deficient, extensive year-end testing may be necessary.

There is a greater emphasis on the detection of fraud in tests of details of cash balances than for other balance sheet accounts because the amount of cash flowing into and out of the cash account is frequently larger than for any other account in the financial statements. Furthermore, the susceptibility of cash to misappropriation is greater than other types of assets because most other assets must be converted to cash to make them usable.

This emphasis affects the auditor's evidence accumulation in auditing year-end cash as in these examples:

<        Verifying whether cash transactions are properly recorded

<        Testing of bank reconciliations

<        Obtaining bank confirmations

The misstatements that are of the greatest concern to auditors in bank reconciliations are intentional ones to cover up a cash shortage, usually resulting from a defalcation. A fraudulent deposit in transit or an omitted outstanding check will both cover up a cash shortage. Omitted deposits in transit or inclusion of a nonexistent outstanding check are likely misstatements only when the bank balance, after reconciling items are accounted for, is greater than the book balance, a highly unlikely occurrence.

Company Controls over Cash

An example in which the conclusions reached about the controls in cash disbursements would affect the tests of cash balances would be:

If controls over the issuance of blank checks, the review of payees, amounts, and supporting documentation, the signing of checks, and the reconciliation of bank statements and vendors' statements are adequate, the auditor's review of outstanding checks on the year-end bank reconciliation may be greatly reduced. The year-end outstanding checks can be verified by testing a sample of checks returned with the cutoff bank statement rather than tracing all paid outstanding checks and the final monthly checks in the cash disbursements journal to the last month's cleared checks and the bank reconciliation.

The monthly reconciliation of bank accounts by an independent person is an important internal control over cash balances because it provides an opportunity for an internal verification of the cash receipts and cash disbursements transactions, investigation of reconciling items on the bank reconciliation, and the verification of the ending cash balance. Anyone responsible for the following duties would not be considered independent for the purposes of preparing monthly bank reconciliations:

<       Issuance of checks

<       Receipt and deposit of cash

<       Other handling of cash

<       Record keeping

Often the company approach is to reconcile the cash account(S) until the balance agrees. The shortcoming of this approach is that it does not include a review of the items that flow through the account and it opens the door for the processing of improper items. Such items as checks payable to improper parties, reissuance of outstanding checks to improper parties, and kiting of funds would not be discovered with the controller's approach. The reconciliation procedures should include the following:

a.         Examination of all checks clearing with the statement (including those on previous month's outstanding check list) and comparison of payee and amount to the cash disbursements journal.

b.         Test of cash receipts to determine that they are deposited within a reasonable amount of time.

c.         Follow-up on old outstanding checks so that they can be recognized as income after it is determined that they will not be cashed, and no liability exists.

 Extension of Bank Reconciliation to a Proof of Cash

The purpose of the four-column proof of cash is to verify:

<       Whether all recorded cash receipts were deposited.

<       Whether all deposits in the bank were recorded in the accounting records.

<       Whether all recorded cash disbursements were paid by the bank.

<       Whether all amounts that were paid by the bank were recorded as cash disbursements in the accounting records.

Two types of misstatements that the four-column proof of cash is meant to uncover are:

<       Cash received that was not recorded in the cash receipts journal

<       Checks that cleared the bank but have not been recorded in the cash disbursements journal

Bank Confirmations (not required by GAAS, but normally done) and Confirmations of Accounts Receivable (not required by GAAS, but normally done)

Bank confirmations differ from positive confirmations of accounts receivable in that bank confirmations request several specific items of information, namely:

1.         The balances in all bank accounts.

2.         Restrictions on withdrawals.

3.         The interest rate on interest-bearing accounts.

4.         Information on liabilities to the bank for notes, mortgages, or other debt.

Positive confirmations of accounts receivable request of the buyer to confirm an account balance stated on the confirmation form or designate a different amount with an explanation. The auditor anticipates few exceptions to accounts receivable confirmations, whereas with bank confirmations he expects differences that the client must reconcile. Bank confirmations should be requested for all bank accounts, but positive confirmations of accounts receivable are normally requested only for a sample of accounts. If bank confirmations are not returned, they must be pursued until the auditor is satisfied as to what the requested information is. If positive confirmations of accounts receivable are not returned, second and maybe third requests may be made, but thereafter, follow-ups are not likely to be pursued. Alternative procedures, such as examination of subsequent payments or other support of customers' accounts may then be used.  The reason why more importance is placed on bank confirmations than accounts receivable confirmations is that cash, being the most liquid of assets, must be more closely controlled than accounts receivable. In addition, other information�such as liabilities to the bank must be known for purposes of the financial statements. Finally, there are usually only a few bank accounts and most bank accounts have a large volume of transactions during the year.

Audit Cutoff Tests 

A cutoff bank statement is a partial period bank statement with the related cancelled checks, duplicate deposit slips, and other documents included in bank statements, which is mailed by the bank directly to the auditor. The purpose of the cutoff bank statement is to verify the reconciling items on the client's year-end reconciliation with evidence that is inaccessible to the client.

Whenever a cutoff bank statement is not received directly from the bank, the auditor may verify the bank statement for the month subsequent to year-end. The audit procedures used for the verification are as follows:

1.         Foot all of the cancelled checks, debit memos, deposits, and credit memos.

2.         Check to see that the bank statement balances when the totals in 1 are used.

3.         Review the items included in 1 to make sure they were cancelled by the bank in the proper period and do not include any erasures or alterations.

The purpose of this verification is to test whether the client's employees have omitted, added, or altered any of the documents accompanying the statement.

Auditors are usually less concerned about the client's cash receipts cutoff than the cutoff for sales, because the cutoff of cash receipts affects only cash and accounts receivable and not the income statement, whereas a misstatement in the cutoff of sales affects accounts receivable and the income statement.  For the purpose of detecting a cash receipt cutoff misstatement, there are two useful audit procedures. The first is to trace the deposits in transit to the cutoff bank statement to determine the date they were deposited in the bank account. Because the recorded cash will have to be included as deposits in transit on the bank reconciliation, the auditor can test for the number of days it took for the in-transit items to be deposited. If there is more than a two or three day delay between the balance sheet date and the subsequent deposit of all deposits in transit, there is an indication of a cutoff misstatement. The second audit procedure requires being on the premises at the balance sheet date and counting all cash and checks on hand and recording the amount in the audit files. When the bank reconciliation is tested, the auditor can then check whether the deposits in transit equal the amount recorded.

 Imprest Account

An imprest bank account for a branch operation is one in which a fixed balance is maintained. After authorized branch personnel use the funds for proper disbursements, they make an accounting to the home office. After the expenditures have been approved by the home office, a reimbursement is made to the branch account from the home office's general account for the total of the cash disbursements. The purpose of using this type of account is to provide controls over cash receipts and cash disburse�ments by preventing the branch operators from disbursing their cash receipts directly, and by providing review and approval of cash disbursements before more cash is made available.

 Types of Frauds involving Cash

Lapping is a defalcation in which a cash shortage is concealed by delaying the crediting of cash receipts to the proper accounts receivable. The first step in the fraud is to withhold cash remitted by a customer from a bank deposit. A few days later, because the customer must receive credit for the remittance, the first customer's account is credited with an amount from a remittance made by a second customer. The process requires the continuous shifting of shortages from account to account and the crediting of subsequent receipts to the wrong accounts receivable.

Kiting is a procedure used to conceal cash shortages from employers and auditors, to conceal bank overdrafts from the bank or banks affected, or to pad a cash position. All kiting procedures are designed to take advantage of the "float" period during which a check is in transit between banks.  A shortage in the cash in bank account may be concealed by depositing in the bank a transfer check drawn on another bank. The transfer check, not recorded as a deposit or a cash disbursement, brings the bank account into agreement with the books of account. The check is recorded a few days later and the shortage "reappears" unless the process is repeated. A similar effect may be obtained by depositing unrecorded fictitious N.S.F. checks.  If a depositor desires to write a check for which he does not have funds on deposit, he can deposit a transfer check large enough to cover the payment, even though the transfer check itself creates an overdraft. The transfer process may be repeated indefinitely or may be terminated by a deposit of sufficient funds to cover the overdraft. Because the purpose of this procedure is to conceal an overdraft from the bank, the transfer check may or may not be recorded on the books on the date that it was drawn.  Kiting to pad a cash position typically occurs at the end of a fiscal period; a check transferring funds from one bank to another is deposited and recorded on the date drawn but is not recorded as a cash disbursement until the following period. In this case, the credit on the books would probably be made to a revenue account and the subsequent debit to an expense account.

Auditor Techniques to detect Lapping and Kiting

The following audit procedures would be used to uncover lapping:

<        Confirm accounts receivable and give close attention to exceptions made by customers about payment dates. The confirmation procedure is better applied as a surprise at an interim date so that if a person is engaged in lapping, he or she will not have been able to bring the "lapped" accounts up to date. If the confirmations are always prepared at year-end, the audit step may be anticipated by the person doing the lapping and the shortage given a different form such as kiting of checks.

<        Make a surprise count of the cash and customers checks on hand. The deposit of these funds should be made under the auditor's control, and the details of the deposit should later be compared with the cash receipts book and the accounts receivable records.

<        Compare the details of remittance lists (if prepared), stamped duplicate deposit slips, and entries in the cash receipts book. Because deposit slips are easily altered, some auditors prepare duplicate deposit slips for deposits made a few days before and after the audit date and have these slips authenticated by the bank. These authenticated duplicate deposit slips are compared to remittance lists and to entries in the cash book.

<        Compare the check vouchers received with the customers' checks with stamped duplicate deposit slips, the entries in the cash book, and postings to the accounts receivable records. If the client stamps the voucher with the date it was received, the auditor should make careful comparisons of the stamped dates to the dates recorded in the cash receipts journal.

Kiting might be uncovered by the following audit procedures:

<        As a surprise count of cash and customers' checks on hand is made as a test for lapping, determine that checks representing transfers of funds are properly recorded on the books.

<        Prepare a schedule of the interbank transfers made for a few days before and after the audit date. The schedule should show, for each check, the date that the cash disbursement was recorded on the books, and the dates of withdrawal and deposit shown on the bank statements.

<        Obtain cutoff bank statements directly from the bank covering the seven to ten day period after the balance sheet date. Examine the checks returned with the cutoff statements and pay attention to dates of the transactions stamped by the banks on the backs of the checks. These stamped dates should not be earlier than the dates of the checks or the dates of cash disbursements recorded on the books. Protested (N.S.F.) checks should be investigated to determine they are not fictitious checks deposited temporarily to cover a shortage.

Miscellaneous

Assuming a client with excellent internal controls uses an imprest payroll bank account, the verification of the payroll bank reconciliation ordinarily takes less time than the tests of the general bank account even though the number of payroll checks exceeds those written on the general account because an imprest payroll account has no activity other than payroll checks drawn and deposits made to reestablish the standard minimum account balance. Furthermore, most employees cash their checks quickly, so there usually are few outstanding checks, especially older ones, and no other reconciling items. On the other hand, the general bank account will include all regular activity plus bank charges, notes, other liabilities, etc., which must be reconciled and verified.

The verification of petty cash reimbursements consists of footing the petty cash vouchers supporting the amounts of the reimbursements, accounting for a sequence of petty cash vouchers, examining the petty cash vouchers for authorization and cancellation, and examining the supporting documentation attached to the vouchers for reasonableness. The balance in the fund is verified by a count of the petty cash. Testing of petty cash transactions is more important than the ending balance in the account, because even if the amount of the petty cash fund is small, there is potential for a large number of improper transactions if the fund is frequently reimbursed.

Why does an auditor obtain a cutoff bank statement when auditing a bank account?

How does the auditor test for sales cutoff?

How does an auditor examine cutoff related to cash?

What is cutoff in accounting?