Risk of Material Misstatement for Cash

Overview

Risk of material misstatement is the combination of inherent risk and control risk. In this case, the risk of material misstatement for cash is the inherent risk of cash that it could be materially misstated due to fraud or error but the client’s controls could not prevent, detect or correct the misstatement.

Inherent risk level in a company is usually based on the nature of the business itself; it tends to be high in a business with a complexity of transactions that require a high level of judgment and those that are susceptible to fraud.

Likewise, the company that has high transactions and volume of cash tends to be inherently risky than those that have fewer transactions and less volume of cash. And if combined with week internal control procedure for cash in place, the company will have a high-level risk of material misstatement for cash.

Control risk level depends on how effective the company controls are in prevent, detect or correct the misstatement. Likewise, the company with strong controls related to cash handling and cash management tends to have low control risk on the cash account. In this case, the company can reduce the risk of material misstatement for cash a lot despite its inherent risk for cash is high.

Audit Assertions for Cash

Auditors usually evaluate the class of transaction or account balance whether it is materially misstated by testing the various audit assertions. In this case, the five audit assertions for cash include in the table below:

Audit Assertions for Cash
Existence	Cash balances shown on the balance sheet actually exist at the balance sheet date.
Completeness	All cash balances and related transactions that should have been recorded have been recorded
Valuation	Cash balances shown on the balance sheet reflect their true economic values.
Rights and obligations	The company has tittle to the cash accounts as at the balance sheet date
Presentation and disclosure	Cash has been properly classified on balance sheet and sufficient disclosure has been made in the note to financial statements.

Usually, existence and completeness are the assertions which auditors usually concern most about. Existence concern whether cash recorded actually exists in real life. This is the major concern that auditors usually have with the cash account as the risk of material misstatement for cash related to existence could be due to fraud.

Completeness is also relevant here as all cash transactions may not be recorded. For example, employees may have received the cash from sales but they do not record in the accounting record for having the intention to manipulate and steal the cash.

Other assertions such as valuation may be important in the circumstance that the company has business activities in different countries that use different currencies. So, the risk of material misstatement for cash here is about the translation of foreign currencies back to the original or functional currency.

Presentation and disclosure usually concern with those of cash restrictions that have not been properly disclosed in the note to financial statements.

Risk of Material Misstatement: Inherent Risk for Cash

The inherent risk for cash is the susceptibility of cash account to misstatement. Likewise, the inherent risk for cash will directly impact the risk of material misstatement for cash.

The following are the primary inherent risks of cash that could occur:

• Cash could be manipulated and stolen by management and employees. The fraud related to cash is usually due to three factors including incentive, opportunity, and rationalization, which is also referred to as the triangle of fraud.
• Cash is susceptible to error due to high transactions and volume as either incomes or expenses tend to be related to cash.
• Not all cash transactions are recorded due to error or fraud (e.g. error such as bank reconciliation items or fraud such as cash received from customers was stolen by employees)
• Money laundering due to the cash can be easily transferred from one location to another

The inherent risk for cash is usually assessed as high for the following reasons:

Reasons why cash is inherently risky
High Volume of Activity	Usually, cash has a high volume of activities during the period comparing to other accounts. This is due to either incomes or expenses are likely to involve in cash in the business transactions. Hence, the high volume of transactions tends to make cash more susceptible to error compared to other accounts in financial statements.
Ease of Transferability	The process of cash transfer, either between company branches or countries, is much easier compared to other assets such as property or machinery. This could lead to fraud or illegal activity such as money laundering if no proper controls are in place.
Most Liquidity Asset	Cash is the most liquid asset in the balance sheet comparing to other assets. Hence, it is most susceptible to fraud as it is easily taken out or transferred between one bank account to another with the electronic transfer.
Debt Covenant	Most of the time, cash is tied to the debt covenants when the company borrows money from the banks or other lenders. This will put pressure on the management of the company in handling the cash in the company. For example, debt covenants might require the company to maintain a certain percentage of cash compared to its total assets or its equity. In the case of a cash shortage, the management may try to manipulate the cash account to meet the requirement of the covenants. This is a serious case as the company may face going concern issues if there is a breach of covenants and lenders demand all their money back at once.
Prone to Theft	Cash is most prone to theft either from internal staff or external people if there are no proper controls in place. Though, the main concern related to cash thief here is the internal thief as it is usually related to the triangle of fraud whenever fraud and theft happen.

It is useful to note that inherent risk is outside the control of auditors, so they can only assess and determine if the inherent risk for cash is low, moderate or high. And if the level of inherent risk here is high, the level of risk of material misstatement for cash is likely to be high unless the control risk is very low.

Fraud Risk for Cash

In assessing the fraud risk for cash, auditors usually consider the three factors of fraud which is also known as a triangle of fraud. These include incentive, opportunity, and rationalization.

Trainable of Fraud
Incentive	This is the case when the staff of the company thinks they should be incentivized. This is usually related to fraud committed by the person who thinks they are being paid too low which is not enough for their hard work or they are having a personal problem. For example, the staff involving in cash transactions think their payment is too low or they are having a personal problem, so they commit fraud by stealing cash as an incentive to compensate for their work or their personal problem.
Opportunity	This is related to the week controls of cash which gives the opportunity to the person related to cash transactions to commit fraud. In this case, the persons commit fraud are usually not due to their personal problem or their thinking of being paid too low but due to the opportunity is given to them to commit fraud. For example, there is only one person receiving cash and recording it in the accounting system. Hence, that person alone may commit fraud by not record in the system or record less amount of cash received from customers. This is due to the person has the opportunity to do so.
Rationalization	This is related to fraud committed by the staff which they think it is fine to do so. This is usually due to the poor environment in the company especially those related to tone at the top. For example, the management take out the cash without properly recording or there were cases of misappropriations of cash before, but they were ignored by management due to various reasons. Hence, it leads to staff rationalize that committing fraud by stealing some cash is fine.

Risk of Material Misstatement: Control Risks for Cash

Control risk is the risk that internal controls cannot prevent, detect or correct material misstatement that could occur on financial statements. Usually, when the inherent risk for cash is high, auditors would try to assess if the internal control is strong, so that they can tick the control risk as low and reduce the risk of material misstatement for cash.

Similar to inherent risk, auditors cannot modify the control risk that the client has; they can only assess whether it is low, moderate or high and perform their work based on the level of risk they have with the client’s cash account. Also, as risk of material misstatement for cash is the combination of inherent risk and control risk, auditors cannot control or modify the level of risk of material misstatement for cash either.

The level of control risk for cash depends on how strong and effective the internal controls on cash that the client has in place. The segregation of duties and authorization are usually the most important internal controls for cash as well as many other financial line items.

For example, the control risk is usually high if there is no proper segregation of duties and authorization controls in the company. If the control risk and inherent risk for cash are high, the risk of material misstatement for cash will be undoubtedly high. Since auditors cannot modify the risk of material misstatement for cash, they can only try to lower the detection risk so that their audit risk can be acceptably low in this case.

Besides the segregation of duties and authorization controls, there are many more internal control procedures that can help reduce the control risk in the client. Below are the common control procedures for cash that can help prevent or detect error or fraud in the cash account:

Control Procedures for Cash
Segregation of duties	Example: Two processes such as receiving cash from customers and recording to cash receipt journals are performed by different persons.
Authorization	Example: Payment to the supplier is requested by an accountant, reviewed by a senior accountant and approved by a financial manager or CFO.
Restrict access to cash	Example: Only persons with cash handling responsibility have access to the cash.
Restrictive customer’s cheque	Example: Only cheques that are restrictive to the company’s bank account are accepted. In this case, the cheque can only be deposited to the company’s bank account, not any other person’s account.
Independent bank reconciliation	Example: Bank reconciliation is performed every month by the accountant after receiving the bank statement from the bank.
Daily cash reconciliation	Example: Cash receipt journal is reconciled to accounts receivable daily. This helps to minimize the risk of error or fraud.
Daily bank in	Example: Cash received in the business is deposited to the bank daily. This reduces the risk of cash loss due to overnight cash handling by any personnel.
Prenumbered document	Example: All cash receipts are prenumber. This helps ensures the completeness of the cash received in the business.
Periodic internal audit	Example: Internal auditors perform the evaluation of internal controls and management of cash regularly.