Auditing and Assurance Concepts and Applications 1

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Substantive Test of Cash

Module 006: Substantive Test of Cash

Course Learning Outcomes:

1. Enumerate the assertions about classes of transactions and events for the
period under audit, assertions about account balances at the period end,
and assertions about presentation and disclosure.
2. Determine the account balances audit objectives for each assertion
category.
3. Demonstrate mastery on the audit procedures for cash.

Introduction
Cash is one of the most important assets of a business. Almost all the entity’s transactions
ultimately result in either receipt or payment of cash. Cash usually includes cash in bank,
cash on hand and cash equivalents. Cash equivalents are short-term, highly liquid
instruments that are both easily convertible to known amount of cash. Examples of cash
and cash equivalents are petty cash fund, payroll fund, money orders, cashier’s checks,
treasury bills and others.
Because of the very nature of cash, it is considered a high-risk area – most vulnerable to
misappropriation than other assets – that requires good internal controls and careful
monitoring. Due to its high degree of inherent risk, more audit time is devoted to the audit
of the account than is indicated by its peso amount.

Management Assertions
When auditing an account balance, the auditor should use assertions for classes of
transactions, account balances, and presentation and disclosures in sufficient detail to form
a basis for the assessment of risks of material misstatement and the design and
performance of further audit procedures.
The auditor uses assertions in assessing risks by considering the different types of
potential misstatements that may occur, and thereby designing audit procedures that are
responsive to the assessed risks.
Assertions used by the auditor fall into the following three broad categories:
1. Assertions about classes of transactions and events for the period under audit:
a. Occurrence – transactions and events that have been recorded have occurred
and pertain to the entity.
b. Completeness – all transactions and events that should have been recorded
have been recorded.

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 c. Accuracy – amounts and other data relating to recorded transactions and
events have been recorded appropriately.
d. Cutoff – transactions and events have been recorded in the correct
accounting period.
e. Classification – transactions and events have been recorded in the proper
accounts.
2. Assertions about account balances at the period end:
a. Existence – assets, liabilities, and equity interests exist.
b. Rights and obligations – the entity holds or controls the rights to assets, and
liabilities are the obligations of the entity.
c. Completeness – all assets, liabilities and equity interests that should have
been recorded have been recorded.
d. Valuation and allocation – assets, liabilities, and equity interests are included
in the financial statements at appropriate amounts and any resulting
valuation or allocation adjustments are appropriately recorded.
3. Assertions about presentation and disclosure:
a. Occurrence and rights and obligations – disclosed events, transactions, and
other matters have occurred and pertain to the entity.
b. Completeness – all disclosures that should have been included in the
financial statements have been included.
c. Classification and understandability – financial information is appropriately
presented and described, and disclosures are clearly expressed.
d. Accuracy and valuation – financial and other information are disclosed fairly
and at appropriate amounts.
Assertions about classes of transactions and events for the period under audit pertains to
assertions in the statement of comprehensive income while assertions about account
balances at the period end pertains to assertions in the statement of financial position.
Assertions about presentation and disclosure can be found in all the component of the
complete set of financial statements.
However, the following assertions are at times used interchangeably for both income
statement items and balance sheet items because essentially they have the same objective:
Income statement assertion Balance sheet assertion
Occurrence Existence
Accuracy Valuation or allocation
Cut-off Existence/occurrence and completeness
For example, the cut-off assertion addresses the issue that transactions and events should
have been recorded in the correct accounting period, however, it also addresses:
 The existence or occurrence assertion when the auditor concerns transactions of the
subsequent period being recorded in the current period
 The completeness assertion when the auditor concerns transactions for the current
period being recorded in the subsequent period.

Valuation vs Allocation
Although these two assertions are considered similar and both relate to the account
balances at period end, these can be distinguished as follows:
 Valuation applies to both initial and subsequent measurement of an asset or liability
(e.g., initial valuation of financial assets, subsequent valuation of inventories, etc.)
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Substantive Test of Cash

 Allocation relates more on subsequent measurement of depreciable, amortizable

and depletable asset (e.g., allocation of the cost or depreciable amount of an asset
over its expected useful life).
Audit Objectives
When auditing cash and cash equivalents, the principal objective for the substantive tests is
to determine the following:
Assertion Category Account Balances Audit Objectives
Existence All cash on the statement of financial position at a given date
is held by the entity or by others (e.g., a bank) for the entity.
Completeness All cash owned by the entity at the reporting date is included
on the statement of financial position.
Valuation and Allocation Cash, including bank balances, is stated at realizable value
and agrees with supporting schedules.
Rights and Obligations The entity owns, or has a legal right to, and has unrestricted
use on all the cash on the statement of financial position at
the reporting date.
Presentation and Cash, including bank balances, is properly classified,
Disclosure described, and disclosed in the financial statements, including
notes, in accordance with PFRS.

Lines of credit, loan guarantees, compensating balance

agreement, and other restrictions (liens) on cash balances are
appropriately identified and disclosed.

Audit Procedures for Cash

The auditor’s primary substantive procedures for cash balances and transactions will
typically include the following:
1. Sending confirmation to banks or financial institutions;
2. Conducting surprise cash counts;
3. Obtaining and testing bank reconciliation and if appropriate, preparing proof of
cash;
4. Obtaining bank cutoff statement and tracing bank transfers;
5. Performing cash cutoff tests;
6. Checking the appropriate valuation of cash; and
7. Performing analytical procedures to assess the reasonableness of reported cash.
Audit procedures presented in this module merely illustrate typical audit procedures (i.e.,
primary substantive procedures) for audits of merchandising and manufacturing entities. It is
also primarily designed for audits of corporation; however, some discussions are made for
partnership and sole proprietorship businesses. In actual practice, audit programs must be
tailored to each client’s risk and internal control. The audit procedures comprising audit
programs may substantially vary from engagement to the next.

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Assertions mentioned in this textbook relate to primary assertion addressed by the audit
procedures discussed. However, some other assertions may also be addressed.

Bank Confirmations
Primary audit objectives: Existence, Valuation, Rights and Obligations, Presentation and
Disclosure
The primary procedure when testing the existence and rights and obligations in relation to
the reported cash in bank is through confirmation of the balances of the company’s
accounts with banks or financial institutions. Confirmation of bank balances also provides
evidence of the accuracy of gross valuation of cash in bank. Although in some entities, cash
on hand and cash in bank are immaterial compared to other assets, one objective when
confirming bank accounts is to search for undisclosed liabilities and commitments.
When determining whether to confirm a bank account, the materiality of the account
balance is not a consideration. Instead, the auditor should consider factors such as the
volume of transactions passing through the account and the purpose of the account (for
example, the main bank account for a trading operation or a deposit account cleared to the
main account daily). It is unlikely that the auditor would not confirm an account that has a
high volume of transactions and is the key account for a trading operation. The auditor
should also include for confirmation those accounts that have been closed during the
period.
The request for a bank confirmation should be issued on auditor’s letterhead and sent to all
banks where the client has dealings. The request should be clear and concise and may
include balances and other information and request confirmation, or to request detail of
balances and other information. The following information is ordinarily included in the
confirmation request:
1. Balances due to or from the bank, the letter may give the account number,
description and currency, and should request information on nil balances and
accounts closed during the period;
2. Terms and repayments conditions of loan and overdrafts;
3. Collateral given, maturity and interest terms, unused facilities, lines of credit and
any rights of offset or other rights;
4. Assets held in safe custody and any encumbrances over them;
5. Asset repurchase and resale agreements and options;
6. Contingent liabilities such as bills, acceptance, guarantees, and endorsements;
7. Listings of authorized account signers; and
8. Standby contracts, forward currency and other such arrangements.
Control over the content and dispatch of requests for confirmation is the responsibility of
the auditor. However, the client will need to authorize disclosure of the relevant
information. Replies should be sent directly to the auditor who should enclose a stamped
or business reply envelope addressed to the office of the auditor to facilitate a speedy
response.
On receipt, the auditor should review the returned bank confirmations for details of
security, guarantees and restrictions over the entity’s use of its cash, and agree details of all
such items with the entity. The auditor should review documents such as minutes and
agreements., during the course of audit to establish the existence of any restrictions over
the entity’s use of its cash.
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Substantive Test of Cash

Loan agreements between financial institutions and their customers may provide that the
cash that is deposited in the financial institutions is pledged as security for the loans. In this
case, the auditor should check whether the amount pledged is properly disclosed in the
notes to financial statements.

Cash Count
Primary audit objectives: Existence, Valuation, and Rights
Cash on hand ordinarily consists of undeposited cash receipts, petty cash funds, and change
funds. Cash count can be wither conducted before or after the reporting date. In other
words, cash counts should be conducted through the year and should cover all branches
and, if possible, all tellers or cash custodian.
The auditor should plan to count all cash and should consider the following:
1. Surprise cash count. Cash counts must be performed without the custodian being
informed in advance (i.e., on a surprise basis);
2. Control all cash funds, including marketable securities and other negotiable assets
to prevent any ‘transfers’ or ‘substitution’ of floats to hide discrepancies, until the
completion of the count;
3. Count in the presence of the custodian to ensure the auditors cannot be blamed for
any shortage;
4. List each item in the fund showing the denominations of notes and coins;
5. The custodian should sign the record as evidence of the return of all funds; and
6. Agree the total to the cash book balance and investigate any differences.

Test on Bank Reconciliation

Primary audit objectives: Existence, Valuation, Completeness, and Rights
Bank reconciliation is customarily prepared monthly by the client as part of its internal
control over cash. When auditing bank reconciliations, the auditor would obtain a copy of
bank reconciliation prepared by the client. After obtaining a copy of bank reconciliation
prepared by the client, the auditor should:
1. Verify the cash balance used in the bank reconciliation:
a. Trace balance per books in the ledger, cash receipts and cash disbursement
journal.
b. Trace balance per bank in the balance per bank statement, reply to bank
confirmation and cutoff bank statement.
2. Check the accuracy of the footing in the bank reconciliation.
3. Obtain supporting documents for any book and bank reconciling items:
a. Bank reconciling items can be verified by obtaining “bank cutoff statement”.
A bank cutoff statement is normally prepared 8-10 business days after the
reporting date. Most items that were outstanding at year-end would have
cleared when the cutoff statement is prepared (outstanding checks and
deposits in transit).

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 b. For book reconciling items, the auditor would normally examine the bank
statement provided and examine any other supporting documents.
4. Examine whether there is an adjusting entry to reflect the book reconciling items.

When testing bank reconciliation, the auditors should place more importance on items that
may be omitted in the bank reconciliation to conceal cash shortage or misappropriation of
cash and any unusual transactions. The item normally omitted is outstanding checks. The
auditor also needs to investigate any long outstanding checks for a year or more. Note that
checks not encashed for a period exceeding six months from issue is not necessarily
outstanding. The auditor should consider the accounting policy of the company in
classifying checks as outstanding, if any.
Any large or unusual transactions, especially checks payable to directors, officers,
employees, affiliated companies, or cash should be carefully reviewed by the auditors to
determine whether the transactions were properly authorized, recorded and are
adequately disclosed in the financial statements as required by PAS 4 Related Party
Transactions.

Proof of Cash
Based on the understanding of the auditor on internal controls, the auditor may assess
internal control over cash receipts and cash disbursements as weak or ineffective. When
such a case exists, the audit may consider preparing proof of cash as an additional audit
procedure aside from testing bank reconciliation. Proof of cash, which is also called four-
column bank reconciliation, is prepared to reconcile not only the account balance but
also the account transactions occurring during a specified period. Specifically, proof of cash
is used to identify:
1. Cash receipts and disbursements recorded in the accounting records, but not on the
bank statement;
2. Cash deposits and disbursements recorded on the bank statement, but not on the
accounting records; and
3. Cash receipts and disbursement recorded at different amounts by the bank in the
accounting records.
A proof of cash is essentially a fraud detection procedure that may be used by the auditor
and the client, for any months during the year.

Tracing Bank Transfers

Primary audit objectives: Existence, Completeness, and Rights
Many businesses maintain checking accounts with a number of banks and often find it
necessary to transfer funds from one bank to another. When a check drawn on one bank is
deposited in another, normally three working days will pass before the check clears the
bank on which it is drawn. During this period, the amount of the check is included in the
balance on deposit at both banks, thereby causing overstatement of cash balances. Due to
this effect of the clearing period, an employee ay take advantage of this period and
manipulate bank transfers to conceal cash shortage. This scheme is called kiting. To be
able to detect this fraudulent scheme, the auditor ordinarily performs the following
procedures:
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Substantive Test of Cash

1. Obtain a bank cutoff statement directly from the bank;

2. Prepare a schedule of bank transfers showing all transfers between the client’s bank
accounts during the last week of the audit period and the first week of the
subsequent period. The schedule should be prepared using cash receipts and
payments journals, year-end reconciliation, year-end bank statement, and cutoff
bank statement; and
3. Trace all checks, deposits, and other cash changes from the cutoff statement to cash
receipts and disbursements records, paying particular attention to dates and
amounts.
The following rules should be observed by the auditor when tracing bank transfers:
1. Book entries for receiving and disbursing should have been within same month;
2. Book entries compared with the bank entries may be made in an earlier month but
not in a later month; and
3. The receiving per bank should not be in an earlier date than the disbursement per
book.

Cash Cut-off Tests

Primary Audit Objectives: Existence, Rights, and Completeness
The auditor should perform cutoff procedures on cash receipts, disbursements and
transfers to determine if these transactions are reflected in the proper period. Normally,
the desire to show a more favorable current ratio may cause some entities to record cash
disbursed in the first few days of a new accounting period as disbursements of the
preceding period. This scheme is called window dressing.
When testing cutoff of cash receipts and cash disbursements at the reporting date, audit
procedure might include:
1. Comparing deposits on the bank statements immediately before and after the
reporting date with entries in the cash receipts journal to establish the
reasonableness of the deposits in transit at the reporting date; and
2. Comparing the dates of the disbursement and receipt of intercompany payments of
interbank transfers immediately before and after the reporting date to establish that
both receipts and disbursements were recorded in the proper periods.

Cash Valuation
Primary Audit Objectives: Valuation, Presentation, and Disclosure
Some companies may maintain its bank account in foreign currencies for some business
purposes. If the bank account being reconciled is in a foreign currency, the auditor should
test the conversion of the cash balance to the presentation currency (e.g., Philippine peso)
to determine whether cash is stated at its realizable value. The auditor ordinarily should:
1. Obtain the period-end foreign exchange rate from an independent source;
2. Re-perform the conversion of the cash balance to the currency using this rate; and

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 3. Compare the resultant amount to the account balance in the general ledger and
accounting for any differences.
Cash deposits in closed bank
In some cases, a company may also have bank deposits on banks that have closed during
the fiscal period. In considering the amounts to be reported in the statement of financial
position, the auditor should consider that deposits in closed bank may be covered under
Philippine Deposits Insurance Corporation (PDIC). Ordinarily, the auditor should also
ensure that cash in closed bank should not be included as part of “cash and cash
equivalents”, rather it should be part of non-trade receivable.

Analytical Procedures on Cash

Aside from the substantive test of balances and transactions, the auditor may need to
perform analytical procedures to obtain evidence of reasonableness of the cash reported in
the financial statements. The auditor may:
1. Compare the listing of cash accounts with those of prior periods and investigate any
unexpected changes (e.g., credit balances, unusual large balances, new accounts,
closed accounts) or the absence of expected changes;
2. Review interest received and/or paid in relation to the average cash balances
and/or bank overdrafts; and
3. Investigate any unusual fluctuations and significant difference.
It may be clarified that the foregoing is only an illustrative list of analytical review procedures
which an auditor may employ in carrying out an audit of cash and cash equivalents. The exact
nature of analytical review procedures to be applied in a specific situation is a matter of
professional judgment of the auditor.

Additional Audit Consideration

Bank Overdrafts
Bank overdrafts arise when bank balances are overdrawn, it should be reported as current
liabilities and should not be netted to other bank accounts with positive balance, unless it is
part of the company’s cash management or the amount involved is immaterial. When
verifying bank overdrafts, the auditor performs same procedure when verifying cash
balances, which is performing bank confirmations.

Special Audit Consideration

1. Kiting. Kiting is an irregularity whereby an overstatement of cash is created by a
cash transfer between bank accounts. It is usually characterized by recording the
transfer to the other bank as cash receipts but the disbursement is not recorded.
From an internal control point of view, kiting occurs due to lack of segregation of
duties between accounting and cash custody. To detect kiting, the auditor may test
the cutoff bank statement and trace bank transfers as discussed earlier in this
module.
2. Lapping. Lapping is done by misappropriating collections from one customer and
concealing this defalcation by applying a subsequent collection made from another
customer. This scheme is used to conceal cash shortage. As discussed earlier in this
module, lapping can be detected by bank confirmation, surprise cash count and
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comparing details of cash receipts journal entries with the details of corresponding
daily deposit slips.
3. Window dressing. Window dressing is any deliberate misstatement of the assets,
liabilities, equity, income and expenses. It is usually accomplished by:
a. Recording as of the last day of the accounting period collections made
subsequent to the close of the period
b. Recording as of the last day of the accounting period payments of accounts
made subsequent to the close of the period.
To detect this scheme, the auditor will ordinarily verify cash cutoff or cash
receipts and disbursements (please refer to the discussion in the Cash Cut-off
Tests).

Summary of Audit Procedures Classified Per Assertion

Assertion Category Primary Audit Procedures
Existence  Sending confirmation to banks or financial institutions
 Surprise cash count
 Obtaining and testing bank reconciliation and
preparing proof of cash (if appropriate)
 Obtaining bank cutoff statement and tracing bank
transfers
 Cash cut-off test
Completeness  Obtaining and testing bank reconciliation and
preparing proof of cash (if appropriate)
 Obtaining bank cutoff statement and tracing bank
transfers
 Cash cut-off test
Valuation and Allocation  Sending confirmation to banks or financial institutions
 Surprise cash count
 Obtaining and testing bank reconciliation and
preparing proof of cash (if appropriate)
 Checking the appropriate valuation of cash
Rights and Obligation  Sending confirmation to banks or financial institutions
 Surprise cash count
 Obtaining and testing bank reconciliation and
preparing proof of cash (if appropriate)
 Obtaining bank cutoff statement and tracing bank
transfers
 Cash cut-off test
Presentation and  Sending confirmation to banks or financial institutions
Disclosure  Checking the appropriate valuation of cash

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References and Supplementary Materials
Books and Journals
1. Cabrera, M.E. (2017) Applied Auditing. Manila: GIC Enterprises & Company,
Incorporated
2. Asuncion, D.J.., Escala, RF., Ngina, M.A. (2018) Applied Auditing. Aurora Hill, Baguio
City: Real Excellence Publishing

Online Supplementary Reading Materials

1. https://www.accountingtools.com/articles/what-is-substantive-testing.html
2. http://www.aasc.org.ph/downloads/PSA/publications/PDFs/PSA-520-Redrafted.pdf