PRE 2 AUDITING AND ASSURANCES : CONCEPTS AND APPLICATIONS 1 Detection Risk and the Nature, Time, Extent of the

the Nature, Time, Extent of the Substantive Test Procedures

Module 1

Lecture Guide 1 : Risk Based Audit

An audit approach for one client may not exactly be the same for another client even if
these clients belong to the same industry. To obtain sufficient evidence as a basis for
the audit opinion, assessment of risk should not be ignored since this will result to
inefficiency or ineffective audit or both.

Audit risk (AR) is the risk (likelihood) that the auditor may unknowingly fail to modify Module 2
the opinion on financial statements that are materially misstated (e.g., an unqualified
opinion on misstated financial statements.) Lecture Guide 2 : Audit of Cash and Cash Equivalent

The AUDIT RISK MODEL decomposes overall audit risk into three components:
inherent risk (IR), control risk (CR), and detection risk (DR) : AR = IR x CR x DR
Nature and Sources of Cash
Cash is the standard medium of exchange in business transactions. It includes bank
notes (paper bills or currencies), coins, checks, bank drafts, money orders and
demand deposits. Companies maintain several ledger accounts for cash in order to
provide management with adequate details concerning cash balances. This may
include petty cash fund, revolving fund, cash on hand and cash in bank for each
account maintained in every bank.

Cash
 not just include currency and coins but also those acceptable by bank for deposit
or immediate encashment such as checks, bank drafts and money orders
 measured at face amount
 if in foreign currency, measured at current exchange rate
 any excess should be invested in revenue earning investment
 deposits in foreign investment which are subject to foreign exchange restriction, if
material should be classified separately among noncurrent assets and the
Steps in Using the Audit Risk Model
restriction clearly indicated
1. Set the desired level of audit risk
2. Assess the level of inherent risk
- Cash on Hand – collection not yet deposited.
3. Assess the level of control risk
- Cash in Bank – cash deposited in banks, maybe savings or current account.
4. Determine the acceptable level of detection risk
5. Design substantive Equity

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- Cash Fund – cash set aside for certain purpose such as petty cash fund (small
amount of expenses) and revolving fund. Can be under the imprest fund system or
fluctuating fund system.
Cash Audit Objectives :
The objectives of the audit of the cash account are to ensure that :
1. There are adequate internal control structure policies and procedures over cash.
2. All cash that should be in the custody of the client exist or is actually on hand or
deposited at the bank.
3. All the cash in the custody of the client is properly recorded.
4. The cash in the custody of the client is properly disclosed in the financial
statement.
Audit Procedures for Cash
1. Inspect savings account passbook and certificates of deposits.
 Reconcile with book balances.
 Update interest earned posting on passbooks, if necessary.
 Compare balances with bank confirmation reply.
2. Confirm bank balance by direct correspondence with all banks in which the client
has had deposits and loans during the year.
3. Obtain bank reconciliation statement.
 Check arithmetical accuracy of reconciliation.
 Trace balance per book to the general ledger balance of cash account.
 Trace balance per bank to bank statement and compare with amount
confirmed by bank.
 Establish authenticity of reconciling items by reference to their respective
sources, like :
- Bank debit or credit advices.
- Duly approved journal vouchers.
 Investigate checks outstanding for a long period of time.
- Consider adjustment, especially if the check is already stale.
- Consider the possibility of an erroneous preparation of the check.
 Investigate any unusual reconciling items.
 Where internal control over cash is weak, consider preparing a proof of cash
reconciliation.
4. Obtain cut off bank statement showing the client's transactions with the bank at
least one week after the reporting date, and :
 Trace year-end reconciling items, like :
- Deposit of the year-end undeposited collections.
- Completeness of year-end outstanding checks.
- Corrections of bank errors.
 Examine supporting documents of year-end outstanding checks that did
not clear in the cutoff bank statement.
 Test reasonableness of cutoff by :
- Comparing dates of checks returned with cutoff bank statement to
dates of recording in the cash disbursements register.
- Tracing receipts recorded a few days before the reporting date to
bank deposits.
5. Conduct a cash count of undeposited collections, petty cash, and other funds.
 Obtain custodian's signature to acknowledge return of items counted.
 Reconcile items counted with general ledger balances.
 Trace undeposited collections counted to bank reconciliation.
 Follow up dispositions of items in cash counted :
- Undeposited collections should be traced to bank deposits.
- Checks accommodated in petty cash should be deposited after the
count to establish their validity.
- IOUs in the petty cash should be confirmed and traced to collections
in the next payroll period.
- Expense vouchers should be traced to the succeeding replenishment
voucher.
 Coordinate cash count with count of marketable securities and other
negotiable assets of the client.
 Obtain confirmation of year-end fund balances of cash not counted in
branches or other offices.
6. Obtain a list of interbank transfers of funds a few days before and after the
reporting date.
 Vouch supporting documents.
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  Ascertain that the related receipts and disbursements were booked by
the client within the same day or at least within the same month.
7. Determine any restrictions on availability of cash.
8. Determine propriety of financial statement presentation and adequacy of
disclosures.
SPECIAL AUDIT CONSIDERATION
1. Kiting is a form of fraud that overstates cash by causing it to be simultaneously
included in two or more bank accounts.
2. Bank transfer schedule. A bank transfer schedule shows the dates of all
transfers of cash among the client’s various bank accounts. Know that its primary
purpose is to help auditors to detect kiting. The schedule is prepared by using
bank statement for the periods before and after year-end and by using the firm’s
cash receipts and disbursements journal.
5. Standard confirmation form. Auditors use a standard form to obtain
information from financial institutions (Standard Form to Confirm Account
Balance Information with Financial Institutions). The form requests information
on two types of balances - deposits and loans. The form requests financial
institutions to indicate any exceptions to the information noted, and to confirm
any additional account or loan balance information that comes to their attention
while completing the form. Know that the form is designed to substantiate
evidence primarily on the existence assertion, and not to discover or provide
assurance about accounts not listed on the form (evidence on the completeness
assertion is not elicited.)

3. Bank reconciliation. Auditors generally either a two-or four-column bank

reconciliation for the difference between the cash per bank and per books. The
four-column approach (also called a proof of cash) will allow the auditor to
reconcile.
a. All cash receipts and disbursements recorded on the books of those on the
bank statement ; and
b. All deposits and disbursements recorded on the bank statement to the books.

A four-column reconciliation will not allow the auditor to verify whether :

a. Checks written have been for the wrong amounts and so recorded on both the
books and the bank statement and
b. Unrecorded checks or deposits exist that have not cleared the bank.

4. Bank cutoff statements. A cutoff statement is a bank statement for the first 8-10
business days after year-end. Know that its primary purpose is to help auditors
verify reconciling items on the year-end bank reconciliation. Tests performed
using a cutoff statement include verifying the outstanding checks have been
completely and accurately recorded as of year-end, and that deposits in transit
have cleared within a reasonable period. The statement is sent directly by the
bank to the auditor.
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