CHAPTER 19 – THE PAYROLL AND PERSONNEL CYCLE (PPC) BUSINESS FUNCTIONS IN THE CYCLE AND RELATED

DOCUMENTS AND RECORDS

- Involves the employment and payment of all
employees. - Begins with hiring employees and ends with paying
them for the services they performed and the
Audit Includes:
government and other institutions for withheld and
1. Obtaining an understanding of internal control accrued payroll taxes and benefits.
2. Assessing control risk
Business Functions
3. Tests of controls and substantive tests of transactions
4. Substantive analytical procedures 1. Human Resources
5. Tests of details of balances a. Provides an independent source for
interviewing and hiring qualified personnel
Difference between Payroll and Personnel and Other Cycles
b. Internal verification of wage information
1. There is only one class of transactions for payroll, i. Additions from the payroll
others involve at least 2. ii. Deletions from the payroll
2. Transactions are generally far more significant than iii. Changes in wages
related balance sheet accounts. iv. Deductions
3. Internal controls over payroll are effective for almost - Documents
all companies, even small ones due to strict federal o Human resource records – includes data
and state regulations. such as
▪ Date of employment
Auditors typically emphasize:
▪ Personnel investigations
1. Tests of controls ▪ Rates of pay
2. Substantive tests of transactions ▪ Authorized deductions
3. Substantive analytical procedures ▪ Performance evaluations
▪ Termination of employment
ACCOUNTS AND TRANSACTIONS IN THE PAYROLL AND o Deduction Authorization – employees may
PERSONNEL CYCLE
submit a form or make online selections that
- Overall objective is to evaluate whether the account authorize payroll deductions including:
balances affected by the cycle are fairly stated in ▪ Number of exemptions for
accordance with applicable accounting standards. withholding income taxes
▪ 401(k) and other retirement savings
Typical Accounts: plan
1. Cash in bank ▪ Health insurance
2. Accrued wages, salaries, bonuses, and commissions ▪ Union dues
3. Withheld income taxes and other deductions o Rate Authorization – a form or other
4. Accrued payroll tax expense electronic record is used to authorize the rate
5. Direct labor of pay. Source of the information:
6. Payroll tax expense ▪ Labor contract
▪ Authorization by management
In most systems, accrued wages and salaries account is used ▪ Authorization from the BOD (in the
only at the end of an accounting period. case of officers)
- Recorded by adjusting entries at the end of the period 2. Timekeeping and Payroll Preparation
for any earned-but-unpaid labor costs a. Directly affect payroll expense for each period
b. Adequate controls are necessary to prevent
misstatements in the ff 4 activities:
i. Prepare time records by employees

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 ii. Summarize and calculate gross pay,
deductions, and net pay
iii. Payment of payroll
iv. Prepare payroll records
- Documents
o Time record – document indicating:
▪ Time the hourly employee started
▪ Hour stopped
▪ Number of hours the employee
worked
o Job time Ticket – form indicating which jobs
an employee worked on during a given time
period.
▪ Used only when an employee woks
on different jobs or departments
o Payroll Transaction File – computer-
generated file includes all payroll transactions
processed by the accounting system for a
period. Contains all information entered into
the system and information for each
transaction such as:
▪ Employee name and ID number
▪ Date
▪ Gross and net pay
▪ Various withholding amounts
▪ Account classification/s
o Payroll Journal or Listing – generated from
the payroll transaction file and typically
includes:
▪ Employee name
▪ Date
▪ Gross and net payroll amounts
▪ Withholding amounts
▪ Account classification/s for each
transaction
o Payroll Master File – computer file for
recording payroll transactions for each
employee and maintaining total employee
wages paid for the year to date.
▪ Gross pay for each payroll period
▪ Deductions from gross pay
▪ Net pay
▪ Check number
▪ Date
3. Payment of Payroll
a. Approval and distribution of payroll must be
carefully controlled to prevent theft.
b. To increase control, payroll disbursements
are generally processed separately from
other disbursements.
- Documents
o Payment of Payroll – issued to employees in
exchange for services performed. May be
made by check but are usually deposited
directly into their individual bank accounts.
▪ Amount paid is the gross less taxes
and other deductions withheld
o Payroll Bank Account Reconciliation –
independent bank reconciliation is important
for all cash accounts, including payroll, for
finding errors and fraud.
▪ Impress Payroll Account – limits the
client’s exposure to payroll fraud
and separates routine payroll
expenditures from other
expenditures
4. Preparation of Payroll Tax Returns and Payment of
Taxes
a. Federal and state payroll laws require the
timely preparation and submission of payroll
tax returns.
b. To prevent misstatements and potential
liability for taxes and penalties, a competent
individual must independently verify the
output.
- Documents
o W-2 Form – a form sent to each employee
that summarizes the employee’s earnings for
the calendar year. This information is
prepared from the payroll master file and is
normally computer generated.
▪ Gross pay
▪ Income taxes withheld
▪ FICA (Social security) withheld
o Payroll Tax Returns – submitted to local,
state, and federal units of government to
show payment of withheld taxes and the
employer’s tax. Prepared from information on
the payroll master file and are usually
computer generated.
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METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND o Controls the auditor intends to rely on to
SUBSTANTIVE TESTS OF TRANSACTIONS reduce assessed control risk must be tested
with tests of controls.
1. Understand internal control
o If the auditor is reporting on the effectiveness
2. Assess planned control risk
of internal control over financial reporting, the
3. Determine the extent of testing of controls
level of understanding controls and extent of
4. Design tests of controls and substantive tests of
tests of controls must be sufficient to issue
transactions
an opinion on the effectiveness of internal
Understand Internal Control and Assess Control Risk control over financial reporting.
o Substantive tests of transactions vary
- Internal control for payroll normally is highly structured
depending on the assessed control risk and
and well controlled to manage cash disbursed, to
other considerations of the audit, such as the
minimize employee complaints and dissatisfaction,
effect of payroll on inventory.
and to minimize payroll fraud.
- Because processing payroll is similar for most Key Controls for Assessing Control Risk
organizations, and programs need to be modified Table 1: Summary of Transaction-Related Audit Objectives
annually for changes in withholding schedules,
companies commonly use an outside payroll service.
- Most monetary misstatements are corrected by
internal verification controls or in response to
employee complaints

Design Tests of Controls and Substantive Tests of Transactions

- Most important means of verifying accounts balances

in the payroll and personnel cycle.
- Emphasized because of the lack of independent third-
party evidence such as:
o Confirmation for verifying:
▪ Accrued wages
▪ Withheld income taxes
▪ Accrued payroll taxes
▪ Other balance sheet accounts
- Amounts in the balance sheet accounts are small and
can be verified with relative ease.
- Although important, tests are usually not extensive
because:
o Employees are likely to complain to
management if they are underpaid.
o All payroll transactions are typically uniform
and uncomplicated.
o Payroll transactions are subject to audit by 1. Adequate Separation of Duties – to prevent
federal and state governments for income tax overpayments and payments to nonexistent
withholding, social security, and employees. Should be separate from:
unemployment taxes. a. Human resources department
- Recognize the following: b. Issuance of payroll disbursements
o Internal controls vary from company to 2. Proper Authorization – only the HR department should
company. be authorized to add and delete employees from the

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 payroll system or change pay rates and deductions. Inventory and Fraudulent Payroll Considerations
The following should be authorized by the supervisor:
- Auditors often extend their payroll audit procedures if
a. Overtime
payroll significantly affects the valuation of inventory,
b. Number of hours worked
or when the auditor is concerned about the possibility
3. Adequate Documents and Records – appropriate
of material fraudulent payroll transactions such as
documents and records depend on the nature of the
nonexistent employees or fraudulent hours.
payroll system such as:
a. Time records
1. Relationship Between Payroll and Inventory Valuation
b. Documents for employees on piece rate
- When payroll is a significant portion of inventory, the
c. Documents for other incentive systems
improper account classification of payroll can
4. Physical Control Over Assets and Records –
materially affect asset valuation for accounts such as:
restrictions on systems used to different modes of
a. Work in process
payments such as
b. Finished goods
a. Direct deposit
c. Construction in process.
b. Checks
5. Independent Checks on Performance – payroll *When labor is a material part of inventory valuation, auditors
computations should be independently verified should emphasize testing internal controls over proper
including comparison of batch totals to summary classification of payroll transactions. Consistency from period to
reports. A member of management or other period is essential for classification and can be tested by tracing
responsible employee should review the payroll output job tickets or other evidence.
for any obvious misstatements or unusual amounts.
2. Tests for Nonexistent Employees
Payroll Tax Forms and Payments - issuing payroll disbursements to individuals who do
not work for the company often results from the
- Important in many companies because the amounts
continuance of an employee on payroll after
are often material and because the potential liability
employment was terminated. Usually committed by:
for failure to timely file tax forms can be severe.
a. Payroll clerk
1. Preparation of Payroll Tax Forms – as a part of
b. Supervisor
understanding internal control, the auditor should
c. Fellow employee
review the preparation of at least one of each type of
d. Former employee
payroll tax form that the client is responsible for filing
- To detect embezzlement, auditors must compare the
2. Timely Payment of the Payroll Taxes Withheld and
names on cancelled checks or the account into which
Other Withholdings – it is desirable to test whether
payroll has been deposited with time records and
the client has fulfilled its legal obligation in submitting
other records for authorized signatures and
payments for all payroll withholdings as a part of the
reasonableness of the endorsements.
payroll tests even though the payments are usually
o If fraud is suspected, the auditor may access
made from general cash disbursements.
online banking records to review
a. Auditors must first determine the client’s
endorsements on cancelled checks of
requirements for submitting the payments,
suspected disbursements for unusual or
which can be determined by referencing such
recurring second endorsements as an
sources as tax laws, union contracts, and
indication of a possible fraudulent check.
agreements with employees.
- 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 is consistent with
company policy.

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- In some cases, the auditor may request a surprise
payroll payoff. (Often expensive but may be the only
likely means of detecting embezzlement)
o 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.
o Unclaimed checks must be subject to an
extensive investigation to determine whether
an unclaimed check is fraudulent.
3. Tests for Fraudulent Hours
- Occur when an employee reports more time than was
actually worked.
- It is usually difficult for an auditor to discover
fraudulent hours due to lack of available evidence.
- Possible procedures:
o 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.
o Observe an employee clocking in more than
one time card under a buddy approach.
4. Fraudulent Expense Reports
- Reimbursement 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.
- Auditors should pay particular attention to travel and
entertainment expense reports for officers and
directors and should perform testing by
o Verifying proper approval and business
purpose of the travel.
o Examining supporting receipts
o Determining whether the reimbursements
are within company guidelines
METHODOLOGY FOR DESIGNING SUBSTANTIVE ANALYTICAL
PROCEDURES AND TESTS OF DETAILS OF BALANCES
- 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 FS Accounts in the
payroll and personnel cycle, the auditor follows the
methodology for designing tests of details of balances.
- The methodology for deciding the appropriate tests of
details of balances for payroll liability accounts is the
same as for accounts receivable (Chapter 15) and
acquisition and payment balance sheet accounts
(Chapter 17 & 18).
Identify Client Business Risks Affecting Payroll (Phase 1)
- Significant client business risks affecting payroll are
unlikely for most companies.
- May exist for complex compensation arrangements
including:
o Bonus and stock option plans
o Other deferred compensation arrangements
Set Performance Materiality and Assess Inherent Risk (Phase 1)
- Balance sheet accounts are normally insignificant,
except for labor charged to inventory.
- Inherent risk is typically low for all balance related
audit objectives.
- There is inherent risk of payroll fraud because most
transactions involve cash.
- Auditors often consider the occurrence transaction
related objective important.
- 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 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.
Assess Control Ris and Perform Related Tests (Phase 1 and 2)
- Table 1
Perform Substantive Analytical Procedures (Phase 3)
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 - Important in the payroll and personnel cycle as it is in followed consistently from year to
every cycle. year.
- Table 2 illustrated SAP for the balance sheet and ▪ The most likely misstatement of any
income statement accounts in the PPC significance in the balance is the
Table 2: SAP for Payroll and Personnel Cycle failure to include the proper number
of days of earned but unpaid wages.
o Accrued Commissions – 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
Design and Perform Tests of Details of Balances for Liability and employees.
Expense Accounts (Phase 3) ▪ The auditor should evaluate the
consistency of the method of
- The verification of the liability accounts associated
accruing commissions with that of
with payroll, often termed accrued payroll expenses,
previous years.
ordinarily is straightforward if internal controls are
o Accrued Bonuses – the year-end unpaid
operating effectively.
bonuses to officers and employees are such
- Two major balance-related audit objectives in testing
a major item that the failure to record them
payroll liabilities:
will result in a material misstatement. Can be
o Accruals in the trial balance are stated at the
accomplished by Comparing it with the
correct amounts (accuracy).
amount authorized in the board minutes.
o Transactions in the PPC are recorded in the
▪ Auditors also consider whether
proper period (cutoff).
bonus terms and amounts require
*The primary concern in both objectives is to make
disclosure in the footnotes or other
sure that there are no understated or omitted accruals.
annual findings with the SEC.
- Major liability accounts in the PPC
o Accrued Vacation Pay, Sick Pay, or Other
o Amounts Withheld from Employees’ Pay –
Benefits – the consistent accrual of these
payroll taxes withheld but not yet paid to the
liabilities relative to those of the preceding
government can be tested by comparing the:
year is the most important consideration in
▪ Balance with the payroll journal
evaluating the fairness of the amounts.
▪ Payroll tax for prepared in the
o Accrued Payroll Taxes – can be verified by
subsequent period
examining tax forms prepared in the
▪ Subsequent period cash
subsequent period to determine the amount
disbursements
that should have been recorded as a liability
*If internal controls are operating effectively,
at the balance sheet date.
cutoff and accuracy can easily be tested at
o Tests of Details of Balances for Expense
the same time by these procedures.
Accounts – several accounts on the income
o Accrued Salaries and Wages – arises
statement are affected by payroll
whenever employees are not paid for the last
transactions. The most important are:
few days or hours of earned wages until the
▪ Officers’ salaries and bonuses
subsequent period.
▪ Office salaries
▪ The correct cutoff and accuracy of
▪ Sales salaries and commissions
accrued salaries and wages depend
▪ Direct manufacturing labor
on company policy, which should be

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*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.
o Officers’ Compensation – it is common to
verify whether the total compensation of
officers is the amount authorized by the BOD,
because their salaries and bonuses must be
included in the company’s Form 10-k filed
with the SEC.
▪ Also warranted because some
individuals may be in a position to
pay themselves more than the
authorized amount
▪ Usual audit test is to obtain the
authorized salary of each officer
from the minutes of the BOD
meetings and compare it with the
related earnings record
o Commission – 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.
▪ Multiplying the commission rate for
each type of sale by the amount of
sales in that category
▪ If 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
o Payroll Tax Expense – can be tested by:
▪ First reconciling the total payroll on
each payroll tax form with the total
payroll for the entire year.
▪ Total payroll taxes can then be
recomputed by multiplying the
appropriate rate by the taxable
payroll.
*On most audits, the calculation is not necessary
unless SAP indicate a problem that cannot be resolved
through other procedures.
*When necessary, the test ordinarily is done in
conjunction with tests of payroll tax accruals and can
be completed using audit software.
o Total Payroll – 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.
▪ TOC and Substantive Tests of
Transactions are a better means of
uncovering these two types of
misstatements in most audits.
o Contract Labor – many organizations contract
with outside organizations to provide staffing.
The individuals providing the services are
employed by the outside organization.
▪ The fees paid to the outside
organization are tested by
comparing the amounts with the
signed contract agreement
o Balance-Related Presentation Objective –
required disclosures for PPC transactions and
balances are not extensive. Complex
transactions such as the ff may require
disclosure:
▪ Stock options
▪ Other executive officer
compensation plans
*As auditors examine contracts and other types of
compensation and bonus plan documents when performing
audit procedures related to payroll and personnel, they also
consider whether any terms and provisions in those documents
are relevant for footnote disclosure.
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