Auditing the Payroll Cycle:
My video lectures about auditing the payroll cycle and personnel cycle including tests of controls, substantive tests of transactions and analytical procedures are covered in my auditing course and CPA lessons. Or browse via the menu above.
Auditing payroll and personnel cycle
The payroll and personnel cycle begins with hiring employees and ends with paying them for the services they performed and the government and other institutions for withheld and accrued payroll taxes and benefits. In between, the cycle involves obtaining services from employees consistent with company objectives, and properly accounting for the services.
The human resources department provides an independent source for interviewing and hiring qualified personnel. The department is also an independent source of records for the internal verification of wage information, including additions and deletions from the payroll and changes in wages and deductions.
Human Resource Records
Human resource records include such data as the date of employment, personnel investigations, rates of pay, authorized deductions, performance evaluations, and termination of employment.
Deduction Authorization as part of auditing payroll and personnel cycle
Employees may submit a form or make online selections that authorize payroll deductions, including the number of exemptions for withholding income taxes, 401(K) and other retirement savings plans, health insurance, and union dues.
Rate Authorization as part of auditing payroll and personnel cycle
A form or other electronic record is used to authorize the rate of pay. The source of the information is a labor contract, authorization by management, or in the case of officers, authorization from the board of directors.
Timekeeping and Payroll Preparation as part of auditing payroll and personnel cycle
Timekeeping and payroll preparation are important in the audit of payroll because they directly affect payroll expense for each period. Adequate controls are necessary to prevent misstatements in the following four activities:
Prepare time records by employees
Summarize and calculate gross pay, deductions, and net pay
Payment of payroll
Prepare payroll records
Time Record as part of auditing payroll and personnel cycle
The time record is a document indicating the time the hourly employee started and stopped working each day and the number of hours the employee worked. Time records may be in paper or electronic form, and they may be prepared automatically by time clocks or identification card readers. In many environments, especially retailers, employees enter arrival and departure times using point-of-sale machines that capture time record information daily. In other environments, time records may be submitted weekly.
Salaried or exempt employees usually do not complete time records. They may be required to complete time reports to be compensated for overtime, vacation, or sick days.
Job Time Ticket as part of auditing payroll and personnel cycle
The job time ticket is a form indicating which jobs an employee worked on during a given time period. This form is used only when an employee works on different jobs or in different departments. Job time tickets are often done electronically by a time and expense reporting system.
Payroll Transaction File as part of auditing payroll and personnel cycle
This computer-generated file includes all payroll transactions processed by the accounting system for a period, such as a day, week, or month. The file contains all information entered into the system and information for each transaction, such as employee name and identification number, date, gross and net pay, various withholding amounts, and account classification or classifications. Depending on the company’s needs, the information on the payroll transaction file is used for a variety of records, listings, and reports, such as the payroll journal, payroll master file, and payroll bank reconciliation.
Payroll Journal or Listing as part of auditing payroll and personnel cycle
This report is generated from the payroll transaction file and typically includes the employee name, date, gross and net payroll amounts, withholding amounts, and account classification or classifications for each transaction. The same transactions included in the journal or listing are also posted simultaneously to the general ledger and to the payroll master file.
Payroll Master File as part of auditing payroll and personnel cycle
The payroll master file is a computer file used for recording payroll transactions for each employee and maintaining total employee wages paid for the year to date. The record for each employee includes gross pay for each payroll period, deductions from gross pay, net pay, check number, and date. This master file is updated from payroll transaction files. The total of the individual employee earnings in the master file equals the total balance of gross payroll in various general ledger accounts.
Payment of Payroll as part of auditing payroll and personnel cycle
The approval and distribution of payroll must be carefully controlled to prevent theft. To increase control, payroll disbursements are generally processed separately from other disbursements.
Payment of Payroll as part of auditing payroll and personnel cycle
Payments are issued to employees in exchange for services performed. Payments may be made by check, but are usually deposited directly into employees’ individual bank accounts. The amount paid is the gross pay less taxes and other deductions withheld.
Payroll Bank Account Reconciliation as part of auditing payroll and personnel cycle
An independent bank reconciliation is important for all cash accounts, including payroll, for finding errors and fraud. An imprest payroll account is a separate payroll account in which a small balance is maintained. The exact amount of each net payroll is transferred by check or electronic funds transfer from the general account to the imprest account immediately before distribution of the payroll. The imprest account limits the client’s exposure to payroll fraud and separates routine payroll expenditures from other expenditures. It also simplifies reconciliation of the payroll bank account.
Preparation of Payroll Tax Returns and Payment of Taxes
Federal and state payroll laws require the timely preparation and submission of payroll tax returns. Most computerized payroll systems prepare payroll tax returns using information on the payroll transaction and master files. To prevent misstatements and potential liability for taxes and penalties, a competent individual must independently verify the output.
This is a form sent to each employee that summarizes the employee’s earning for the calendar year, including gross pay, income taxes withheld, and FICA (Social Security) withheld. The same information is also submitted to the Internal Revenue Service and state and local tax commissions when applicable. This information is prepared from the payroll master file and is normally computer generated.
Payroll Tax Returns
These are forms submitted to local, state, and federal units of government to show payment of withheld taxes and the employer’s tax. The nature and due dates of the forms vary depending on the type of taxes. These forms are prepared from information on the payroll master file and are usually computer generated. Federal withholding and Social Security payments
Understand Internal Control and Assess Control Risk—Payroll and Personnel Cycle
Internal control for payroll is normally highly structured and well controlled to manage cash disbursed, to minimize employee complaints and dissatisfaction, and to minimize payroll fraud. Because of relatively common payroll concerns from company to company, high-quality computerized payroll accounting programs are available.
Because processing payroll is similar for most organizations, and programs need to be modified annually for changes in withholding schedules, companies commonly use an outside payroll service for processing payroll.
are due semiweekly or monthly, depending on the amount of withholding. Most state unemployment taxes are due quarterly.
Design Tests of Controls and Substantive Tests of Transactions—Payroll and Personnel Cycle
Tests of controls and substantive tests of transactions procedures are the most important means of verifying account balances in the payroll and personnel cycle. These tests are emphasized because of the lack of independent third-party evidence, such as confirmation, for verifying accrued wages, withheld income taxes, accrued payroll taxes, and other balance sheet accounts. Furthermore, in most audits, the amounts in the balance sheet accounts are small and can be verified with relative ease if the auditor is confident that payroll transactions are correctly entered into the computer and payroll tax returns are correctly prepared.
Even though tests of controls and substantive tests of transactions are the most important parts of testing payroll, tests in this area are usually not extensive. Many audits have a minimal risk of material misstatements, even though payroll is often a significant part of total expenses. There are three reasons for this:
Employees are likely to complain to management if they are underpaid.
All payroll transactions are typically uniform and uncomplicated.
Payroll transactions are subject to audit by federal and state governments for income tax withholding, Social Security, and unemployment taxes.
The key controls for the payroll and personnel cycle for assessing control risk are discussed below:
Adequate Separation of Duties
Separation of duties is important in the payroll and personnel cycle, especially to prevent overpayments and payments to nonexistent employees. The payroll function should be kept independent of the human resources department, which controls key payroll activities, such as adding and deleting employees. Payroll processing should also be separate from the issuance of payroll disbursements.
As already noted, only the human resources department should be authorized to add and delete employees from the payroll or change pay rates and deductions. The number of hours worked by each employee, especially overtime, should be authorized by the employee’s supervisor. Approval may be indicated electronically or noted on all time records or done on an exception basis only for overtime hours.
Adequate Documents and Records
The appropriate documents and records depend on the nature of the payroll system. Time records are necessary for hourly employees but not for salaried employees. For employees compensated based on piece rate or other incentive systems, different records are required. For many companies, time records must be adequate to accumulate payroll costs by job or assignment. Prenumbered documents for recording time are less of a concern for payroll because the completeness objective is normally not a concern.
Physical Control Over Assets and Records
Many organizations pay employees through direct deposit. In those situations, access to systems used to authorize payments should be restricted. When payment is made by check, access to unsigned payroll checks should be restricted. Checks should be signed by a responsible employee, and payroll should be distributed by someone independent of the payroll and timekeeping functions. Any unclaimed checks should be returned for redeposit. If checks are signed by a signature machine, access to the machine should be restricted.
Independent Checks on Performance
Payroll computations should be independently verified, including comparison of batch totals to summary reports. A member of management or other responsible employee should review the payroll output for any obvious misstatements or unusual amounts. When manufacturing labor affects inventory valuation or when it is necessary to accumulate costs by job, adequate controls are necessary to verify the proper assignment of costs.
Payroll Tax Forms and Payments
Payroll taxes and other withholdings are important in many companies, both because the amounts are often material and because the potential liability for failure to timely file tax forms can be severe.
As a part of understanding internal control, the auditor should review the preparation of at least one of each type of payroll tax form that the client is responsible for filing. The potential for liability for unpaid taxes, penalty, and interest arises if the client fails to prepare the tax forms correctly. The payroll tax forms are for such taxes as federal income and FICA withholding, state and city income withholding, and federal and state unemployment.
A detailed reconciliation of the information on the tax forms and the payroll records may be necessary when the auditor believes the tax returns may be incorrectly prepared. Indications of potential misstatements in the returns include the payment of penalties and interest in the past for improper payments, new personnel in the payroll department who are responsible for the preparation of the returns, the lack of internal verification of the information, and cash flow problems for the client.
It is desirable to test whether the client has fulfilled its legal obligation in submitting payments for all payroll withholdings as a part of the payroll tests even though the payments are usually made from general cash disbursements. The withholdings of concern in these tests include taxes, 401(K) and other retirement savings, union dues, insurance, and payroll savings.
Auditors must first determine the client’s requirements for submitting the payments, which can be determined by referencing such sources as tax laws, union contracts, and agreements with employees. Once auditors know the requirements, they can easily determine whether the client has made timely payments at correct amounts by comparing the subsequent cash disbursement with the payroll records.
Auditors often extend their payroll audit procedures if payroll significantly affects the valuation of inventory, or when the auditor is concerned about the possibility of material fraudulent payroll transactions, such as nonexistent employees or fraudulent hours.
When payroll is a significant portion of inventory, which is common for manufacturing and construction companies, the improper account classification of payroll can materially affect asset valuation for accounts such as work in process, finished goods, or construction in process. For example, the overhead charged to inventory at the balance sheet date can be overstated if the salaries of administrative personnel are inadvertently or intentionally charged to indirect manufacturing overhead. Similarly, the valuation of inventory is affected if the direct labor cost of individual employees is incorrectly charged to the wrong job or process. When jobs are billed on a cost-plus basis, revenue and the valuation of inventory are both affected by charging labor to incorrect jobs.
Issuing payroll disbursements to individuals who do not work for the company (nonexistent employees) often results from the continuance of an employee on payroll after employment was terminated. Usually, the person committing this type of embezzlement is a payroll clerk, supervisor, fellow employee, or perhaps the former employee. Under some systems, a supervisor can clock in daily for an employee and approve the time card at the end of the time period. If the supervisor also distributes paychecks or if payroll is deposited directly into employees’ accounts, considerable opportunity exists for embezzlement.
To detect embezzlement, auditors may compare the names on cancelled checks or the account into which payroll has been deposited with time records and other records for authorized signatures and reasonableness of the endorsements. Audit software can be used to compare all account numbers into which payroll is deposited to search for duplicates. It is also common to scan endorsements on cancelled checks for unusual or recurring second endorsements as an indication of a possible fraudulent check. Examining checks that are recorded as voided is also desirable to make sure that they have not been fraudulently used.
To test for nonexistent employees, auditors can trace selected transactions recorded in the payroll journal to the human resources department to determine whether the employees were actually employed during the payroll period. If paid by check, the endorsement on the cancelled check written out to an employee can be compared with the authorized signature on the employee’s withholding authorization forms.
A procedure that tests for proper handling of terminated employees is to select several files from the human resource records for employees who were terminated in the current year to determine whether each received termination pay consistent with company policy. Continuing payments to terminated employees can be tested by using audit software to compare termination dates according to the human resources department to payroll disbursement dates in the payroll journal to verify the employee is no longer being paid. Naturally, this procedure is not effective if the human resources department is not informed of terminations.
In some cases, the auditor may request a surprise payroll payoff. This is a procedure in which all employees must pick up and sign their checks or direct deposit payroll records in the presence of a supervisor and the auditor. Any checks that have not been claimed must be subject to an extensive investigation to determine whether an unclaimed check is fraudulent. Surprise payoff is often expensive, but it may be the only likely means of detecting an embezzlement.
Fraudulent hours occur when an employee reports more time than was actually worked. Because of the lack of available evidence, it is usually difficult for an auditor to discover fraudulent hours. One procedure is to reconcile the total hours paid according to the payroll records with an independent record of the hours worked, such as those often maintained by production control. Audit software can be used to test the reasonableness of hours worked or total pay for each employee and unusual amounts identified for follow-up testing. Similarly, it may be possible to observe an employee clocking in more than one time card under a buddy approach. However, it is ordinarily easier for the client to prevent this type of embezzlement by adequate controls than for the auditor to detect it.
Reimbursements for travel and entertainment expenses are a part of the acquisition and payment cycle; however, auditors often perform additional procedures as part of payroll and personnel testing. Management falsification of expense reports can be an indicator of disregard for internal controls and the potential for fraud in other areas as well. As a result, auditors should pay particular attention to travel and entertainment expense reports for officers and directors and should perform testing by verifying proper approval and the business purpose of the travel, examining supporting receipts, and determining whether the reimbursements are within company guidelines
Methodology For Designing Substantive Analytical Procedures and Tests of Details of Balances
Design and perform substantive analytical procedures and tests of details for accounts in the payroll and personnel cycle.
During the first two phases of the audit, auditors assess control risk and perform tests of controls and substantive tests of transactions. After completing these tests and assessing the likelihood of misstatement in financial statement accounts in the payroll and personnel cycle, the auditor follows the methodology for designing tests of details of balances.
Most companies have a large number of transactions involving payroll, often with large total amounts. However, balance sheet accounts are normally insignificant, except for labor charged to inventory.
Aside from the potential for fraud, inherent risk is typically low for all balance-related audit objectives. There is inherent risk of payroll fraud because most transactions involve cash. Therefore, auditors often consider the occurrence transaction-related objective important. Also, for manufacturing companies with significant labor charged to inventory, the potential exists for misclassification between payroll expense and inventory, or among categories of inventory. As a part of gaining an understanding of the client, the auditor may identify complex payroll-related issues, such as stock-based compensation plans, that may increase inherent risks related to the accounting and disclosure of those arrangements.
Earlier in this chapter, we discussed assessing control risk and the related tests of controls and substantive tests of transactions.
The use of substantive analytical procedures is as important in the payroll and personnel cycle as it is in every other cycle.
The verification of the liability accounts associated with payroll, often termed accrued payroll expenses, is ordinarily straightforward if internal controls are operating effectively. When the auditor is satisfied that payroll transactions are being correctly recorded in the payroll journal and the related payroll tax forms are being accurately prepared and taxes promptly paid, the tests of details of balances should not be time consuming.
The two major balance-related audit objectives in testing payroll liabilities are:
Accruals in the trial balance are stated at the correct amounts (accuracy).
Transactions in the payroll and personnel cycle are recorded in the proper period (cutoff).
The primary concern in both objectives is to make sure that there are no understated or omitted accruals. Next, we examine the major liability accounts in the payroll and personnel cycle.
Payroll taxes withheld but not yet paid to the government can be tested by comparing the balance with the payroll journal, the payroll tax form prepared in the subsequent period, and the subsequent period cash disbursements. Other withheld items such as retirement savings, union dues, savings bonds, and insurance can be verified in the same manner. If internal controls are operating effectively, cutoff and accuracy can easily be tested at the same time by these procedures.
The accrual for salaries and wages arises whenever employees are not paid for the last few days or hours of earned wages until the subsequent period. Salaried personnel usually receive all of their pay except overtime on the last day of the month, but often, several days of wages for hourly employees are unpaid at the end of the year.
The correct cutoff and accuracy of accrued salaries and wages depend on company policy, which should be followed consistently from year to year. Some companies calculate the exact hours of pay that were earned in the current period and paid in the subsequent period, whereas others compute an approximate proportion. For example, if the subsequent payroll results from three days of employment during the current year and two days of employment during the subsequent year, the use of 60 percent of the subsequent period’s gross pay as the accrual is an example of an approximation.
After the auditor has determined the company’s policy for accruing wages and knows that it is consistent with that of previous years, the appropriate audit procedure to test for cutoff and accuracy is to recalculate the client’s accrual. The most likely misstatement of any significance in the balance is the failure to include the proper number of days of earned-but-unpaid wages.
The same concepts used in verifying accrued salaries and wages are applicable to accrued commissions, but the accrual is often more difficult to verify because companies often have several different types of agreements with salespeople and other commission employees. For example, some salespeople might be paid a commission every month and earn no salary, whereas others will get a monthly salary plus a commission paid quarterly. In verifying accrued commissions, it is necessary first to determine the nature of the commission agreement and then test the calculations based on the agreement. The auditor should compare the method of accruing commissions with that of previous years for purposes of consistency.
In many companies, the year-end unpaid bonuses to officers and employees are such a major item that the failure to record them will result in a material misstatement. The verification of the recorded accrual can usually be accomplished by comparing it with the amount authorized in the board minutes.
The consistent accrual of these liabilities relative to those of the preceding year is the most important consideration in evaluating the fairness of the amounts. The company policy for recording the liability must first be determined, and then the recorded amounts must be recalculated. The company policy should be in accordance with accounting standards for compensated absences.
Payroll taxes, such as FICA and state and federal unemployment taxes, can be verified by examining tax forms prepared in the subsequent period to determine the amount that should have been recorded as a liability at the balance sheet date.
Several accounts on the income statement are affected by payroll transactions. The most important are officers’ salaries and bonuses, office salaries, sales salaries and commissions, and direct manufacturing labor. Often, costs may be broken down further by division, product, or branch. Fringe benefits such as medical insurance may also be included in the expenses.
Auditors should need to do relatively little additional testing of the income statement accounts in most audits beyond substantive analytical procedures, tests of controls, substantive tests of transactions, and related tests of liability accounts already discussed. Extensive additional testing should be necessary only when auditors uncover significant deficiencies or material weaknesses in internal control, significant misstatements in the liability tests, or major unexplained variances in the substantive analytical procedures. Nevertheless, some income statement accounts are often tested in the payroll and personnel cycle. These include officers’ compensation, commissions, payroll tax expense, total payroll, and contract labor.
It is common to verify whether the total compensation of officers is the amount authorized by the board of directors, because their salaries and bonuses must be included in the company’s Form 10-K filed with the SEC and federal income tax return. Verification of officers’ compensation is also warranted because some individuals may be in a position to pay themselves more than the authorized amount. The usual audit test is to obtain the authorized salary of each officer from the minutes of the board of directors meetings and compare it with the related earnings record.
Auditors can verify commission expense with relative ease if the commission rate is the same for each type of sale and the necessary sales information is available in the accounting records. The total commission expense can be verified by multiplying the commission rate for each type of sale by the amount of sales in that category. If the desired information is not available, it may be necessary to test the annual or monthly commission payments for selected salespeople and trace those to the total commission payments.
A test closely related to the one for payroll taxes is the reconciliation of total payroll expense in the general ledger with the payroll tax returns and the W-2 forms. The objectives of the test are to determine whether payroll transactions were charged to a non-payroll account or not recorded in the payroll journal at all. Because the payroll tax records and the payroll are both usually prepared directly from the payroll master file, the misstatements, if any, are likely to be in both records. Tests of controls and substantive tests of transactions are a better means of uncovering these two types of misstatements in most audits.
To reduce payroll costs, many organizations contract with outside organizations to provide staffing. The individuals providing the services are employed by the outside organization. For example, companies frequently contract with information technology services firms to handle the company’s IT management and staffing functions. The fees paid to the outside organization are tested by comparing the amounts with the signed contract arrangement between the company and the outside services firm.
Required disclosures for payroll and personnel cycle transactions and balances are not extensive. However, some complex transactions, such as stock options and other executive officer compensation plans, may require footnote disclosure. Auditors may combine audit procedures related to the four presentation and disclosure objectives with tests of details of balances for liability and expense accounts.