This is how auditors verify cash balances
Yesterday, I called up an accountant at Deloitte, Touche and Tohmatsu in Houston, just to familiarize myself with the process for verifying a cash balance.
They start out by identifying the bank or bank(s) that hold the cash for the company. Then, they get a signed letter from the company giving them permission to gain access to the company's financial statements. Then, they send that letter to the bank, with return receipt requested, and the bank sends them the financial statements.
I asked, well how do you know that the company didn't just forge those financial statements and send them to you? First, the financial statements are postmarked from the bank's address. Second, because *they* sent the request to the bank, if the company were to try to send them a fake statement, then they would end up getting two statements--the actual statement sent by the bank, and the fake statement sent by company. The statements are also stamped and specially sealed.
So the only way the company could pull a fast one is if the bank didn't exist, or if the company conspired with the bank.
If the bank didn't exist, the audit team would easily see that, because they verify the bank's address when they send the mail, and because they have relationships with the banks, working with them everyday, so some noname bank with an address that they cannot verify would be a major red flag. Remember their mindset--they want to find problems. The more they catch, the better they look as auditors.
For the company to conspire with the bank, the whole bank would have to be in on it. You can't just find a single person to handle the incoming request, because you don't know if that person will receive the request and send out the record. You would need a supervisor or someone way high up to coordinate things.
I asked if these standards apply in China, and the auditor said that if Deloitte is signing off that the audit has been conducted IAW U.S. GAAP, then absolutely. Now, he pointed out that Chinese GAAP may be different.
Note that sometimes the cash balance in the bank differs from the amount listed on the balance sheet. That's because there may be outstanding checks the company sent out that have yet to be cashed. The way the company handles that is they take the book and spot check back a month or two. So in other words, you tell me that you sent a check to someone to pay a bill, and you deducted that from your cash balance. The auditor will then note the check number and, at a later date, will verify that the transaction occurred. Note also that any check the company has yet to receive and successfully cash is an A/R, so this process only applies to cash outflows from the company.
So I think Viking's point is a valid one. There is no faking cash, and so cash needs to be one of the ways that we navigate ourselves through the space. Companies with high A/R's, consistent cashless earnings, and so forth, are a huge no-no.
If you look at historical frauds, they always involve murky non-cash items on the balance sheet. Case in point: Enron (ENE), where they were marking contracts to their own financial models, and basically deciding how much they were earning out of thin air. Every quarter, without fail, they would post negative operating cash flow.
