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Chapter 5
Audit of the Payroll and Personnel
Cycle

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved.
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Learning Objectives
20.1 Identify the accounts and transactions in the payroll
and personnel cycle
20.2 Describe the business functions and the related
documents and records in the payroll and personnel
cycle
20.3 Understand internal control and design and perform
tests of controls and substantive tests of transactions
for the payroll and personnel cycle
20.4 Design and perform substantive analytical procedures
and tests of details for accounts in the payroll and
personnel cycle
 5.1 Overview of the cycle 3

Overview of the cycle

• The payroll and personnel cycle involves the employment and payment
of all employees. Labor is an important consideration in the valuation of
inventory in manufacturing, construction, and other industries
– If labor cost is misstated, product/service cost will be misstated ( this
will result in misstatement of FSs)
• The Payroll and personnel cycle begins with hiring of personnel and
ends with:
– Payment for the employees for the services performed
–Payment to the government and other institutions for
the withheld and accrued payroll taxes and benefits
The overall objective in the audit of the Payroll and Personnel Cycle
The overall objective in the audit of the payroll and personnel cycle
is to evaluate whether the account balances affected by the cycle
are fairly stated in accordance with applicable acct. standards
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…5.1 Overview of the cycle

– How the payroll Cycle differs from other

cycles?
 Only one class of transactions exist: this is because the
receipt of services from employees and the payment for those
services through payroll usually occur within a short time
period.
 Transactions are more significant than related balance
sheet accounts. (transactions are many but balances are
small (eg. Accrued salary payables ..)
 Internal controls over payroll are effective for almost all
companies, even small ones. (since payroll related liabilities
are subject to government regulations controls are strong in
many cases)
What is the effect of this difference nature of the cycle on the
audit work
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…5.1 Overview of the cycle

……How the payroll Cycle differs from other cycles?

The unique nature of the cycle make the
auditors:
– To emphasize on tests of controls, substantive tests of
transactions, and analytical procedures in the audit of payroll,
and
– To spend only few minutes for tests of details of balances of
payroll related accounts
…5.1 Overview of the cycle 6
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..5.1 Overview of the cycle

Accounts in the Payroll and Personnel Cycle
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…5.1 Overview of the cycle

Classes of Transactions, Accounts, Business Functions, and Related

Documents and Records for the Payroll and Personnel Cycle
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…5.1 Overview of the cycle

• The four business functions in a typical

payroll and personnel cycle include:
– Human resources
– Timekeeping and payroll preparation
– Payment of payroll
– Preparation of payroll tax returns and payment of
taxes
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……5.1 Overview of the cycle

….Business functions and related documents in the payroll and
personnel cycle
1. Human Resource (HR) and employment
The HR department is a source for:
– Human Resource Records showing date of employment, pay
rate, performance evaluation and so forth that are relevant for
preparation of payroll
– Deduction Authorization Form: A form used to authorize
deduction; eg saving.
– Rate Authorization Form: A form used to authorize the rate of
pay. The rate is taken from employment Contract
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……5.1 Overview of the cycle

….Business functions and related documents in the payroll and
personnel cycle
2. Timekeeping and Payroll Preparation
– It includes the preparation of time cards by employees; the
summarization and calculation of gross pay, deductions and net
pay; the preparation of payroll checks and records.
– These functions are important in the audit of payroll because they
directly affect payroll expense for each period.
– Adequate controls in the following four activities are necessary to
prevent misstatements:
 In preparing time records
 In summarizing and calculating gross pay, deductions, and net
pay
 In payment of payroll
 in Preparing payroll records
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……5.1 Overview of the cycle

• ….Business functions and related documents in
the payroll and personnel cycle
5. Payment of payroll
– 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.
– Payments may be made by check, or deposited directly into
employees’ individual bank accounts.
4. Payment of withholdings to Govt offices
– Government laws require the timely preparation and submission of
payroll tax returns.
– To prevent misstatements, there should be an independent party
that checks the amount of liability
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5.2 Key Internal Control

• Key controls for the payroll and personnel cycle for

assessing control risk include:
– Adequate separation of duties
– Proper authorization
– Adequate documents and records
– Physical control over assets and records
– Independent checks on performance
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… 5.2 Key Control

….
1. Adequate separation of duties
 The payroll function should be kept independent of the HR
department, which controls key payroll activities, such as adding
and deleting employees.
Adding/deleting employees should be separate from preparing
payroll
 Payroll processing should also be separate from the issuance
of payroll disbursements.
Preparing payroll should be separate from payment function
 Checks should be signed by a responsible employee, payment
should be made by someone independent of the payroll and
timekeeping functions.

Separation of duties is needed to prevent:

– Overpayments and
– payments to nonexistent employees.
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… 5.2 Key Controls

2. Proper authorization
– The HR Dept should authorize:
 Addition and deletion of employees from the payroll,
 Change of pay rates and
 deductions
– The employee’s supervisor should authorize:
 The number of hours worked by each employee, and
 overtime,
.Without having authorization, the payroll clerk can not do the above
mentioned functions
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…… 5.2 Key Control

5. Adequate documents and records
– The type of record depends on the payroll system
 Time records are necessary for hourly employees but not for
salaried employees.
 The records for piece rate workers is also different.
 Time records are usually adequate to accumulate payroll costs by
job or assignment
 Time records may not be pre-numbered since completeness is
not the main concern in this cycle
Payroll Tax Forms and Payments of Payroll tax
-Adequate documentation is necessary for payroll tax
– The auditor should check the accuracy of computation of payroll
taxes and other withholdings since these amounts are usually
material and the penalty if there is failure in this area
– The auditor should also check whether the client has fulfilled its legal
obligation in settling withholdings on time
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…… 5.2 Key Control

4. Physical control over assets and records
 Safe custody and the restricted issue of clock cards and security
passes.
 Access to unsigned payroll checks should be restricted., Safe
custody of payroll documents
 Any unclaimed checks/amounts not paid should be deposited to
the bank
5. Independent checks on performance
– Payroll computations should be independently verified
– In manufacturing firms, the accumulation and assignment of labor
costs to products needs adequate control since it affects the
inventory valuation process.
Calculations and cost classifications (as direct/indirect) must be
internally verified (with automated or manual system).
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..5.2 Key Internal Control

• Control Objectives
– Employees are hired only as necessary
– Employees are paid correct rates
– Hours worked are accurately recorded
– Overtime is authorised
– Net pay and deductions are accurately calculated
– Payments are made correctly to employees, the government and
others, on a timely basis
– Employees leaving are promptly removed form the wages system
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..5.2 Key Internal Control

…Control Objectives for each stage in the system
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.5.3
Tests of Controls (TOC) and Substantive Tests (ST) of
Payroll and personnel cycle

Methodology for Designing Controls and Substantive Tests of

Transactions for Payroll and personnel cycle :
As in the other cycles, Four steps are involved:
1. Understanding internal control for payroll transactions
2. Assessing planned control risk for payroll transactions
3. Determining extent of testing controls for payroll transactions
4. Design tests of controls and substantive tests of transactions for
payroll to meet transaction related audit objectives
However, emphasis will be on step 4 (tests of controls and substantive tests
of transactions ) , since other risks are relatively low in this cycle
Why risk of material misstatement is low in payroll cycle? Three
reasons:
1. Employees are likely to complain to management if they are underpaid.
2. All payroll transactions are typically uniform and uncomplicated
5. Payroll transactions are subject to audit by governments for income tax
withholding & pension deductions .
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5.3 Tests of Controls (TOC) and Substantive Tests (ST) of

..
Payroll and personnel cycle

…Methodology for Designing Controls and Substantive Tests of

Transactions for Payroll and personnel cycle :
Four steps …:
1. Understanding internal control for payroll transactions
– In many organizations, internal control for payroll is normally
highly structured and well controlled
• to manage cash disbursed,
• to minimize employee complaints and dissatisfaction,
• to minimize payroll fraud
• to minimize penalties, since payroll related liabilities are
subject to government regulations, hence, controls are
strong in many cases
• The auditor can often rely on the internal controls of the service
organization if the service organization’s auditor issues a report on the
service organization’s internal control. (This is when payroll preparation is
outsourced)
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5.3 Tests of Controls (TOC) and Substantive Tests (ST) of

..
Payroll and personnel cycle
Methodology for Designing Controls and Substantive Tests of Transactions for
Payroll and personnel cycle :
…Four steps are involved:
Step 4. Design tests of controls and substantive tests of transactions for
payroll to meet transaction related audit objectives
– 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.
– 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 because of low risk in the cycle.
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.. 5.3 Tests of Controls (TOC) and Substantive Tests (ST)
of Payroll and personnel cycle
..Methodology for Designing Controls and Substantive Tests of Transactions
for Payroll and personnel cycle :
…Step 4. Design tests of controls and substantive tests of transactions
for payroll to meet transaction related audit objectives

The design for the methodology for the audit of sales

transactions can be summarized in table with five columns:
Column 1:Transaction related objectives
Column 2:Key internal controls (Auditors focus on controls with the greatest
effect on the particular transaction related objective. Controls can be
manual or automated)
Column 3:Tests of controls - key controls stated in column 2 will be tested
using different procedures (observation, inspection of documents to check
authorization/approval,…., re-performace & inquiry)to evaluate their
effectiveness in meeting the audit objectives stated in column 1
Column 4:Weaknesses (if tests of key controls show weakness, it is stated
in this column )
Column 5:Substantive tests of transactions (misstatements in transaction
amounts are checked by applying substantive tests for each transaction
related.
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..5.3 Tests of Controls (TOC) and Substantive Tests (ST)

of Payroll and personnel cycle
.
Auditors extend audit procedures for payroll under two cases:
1. If labor cost is significant portion of product cost (eg. In manufacturing
and construction)
– Incorrect classification of labor cost results in
overstatement/understatement of product cost which can misstate
the financial statement
– In such cases auditors should emphasize on testing internal controls
over proper classification of payroll transactions.
2. When there is a possibility of material fraudulent payroll transactions,
such as nonexistent employees or fraudulent hours.

This is when payment is made for individuals that do not work for the
company.
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….. 5.3 Tests of Controls (TOC) and Substantive Tests (ST) of

Payroll and personnel cycle
..Methodology for Designing Controls and Substantive Tests of
Transactions for Payroll and personnel cycle :
…extended tests
How Payment to non existent employees may occur?
It may be caused by:
– Failure to cancel the name employees whose contract is
terminated
– Collusion among supervisors and employees whose contract is
terminated (The supervisor may sign on the time card and
especially when the amount is deposited to employees account,
the possibility for embezzlement is high)
Audit test for Nonexistent Employees
1. The auditor traces selected transactions recorded in the payroll
journal to the human resources department to determine whether
the employees were actually employed during the payroll period
.
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….. 5.3 Tests of Controls (TOC) and Substantive

Tests (ST) of Payroll and personnel cycle
…Audit test for Nonexistent Employees
2. The auditor will 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, if their names are canceled from the payroll list.
– However, 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, a procedure in which all employees must pick up and
sign their check or direct deposit payroll record 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.
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….. 5.3 Tests of Controls (TOC) and Substantive Tests

(ST) of Payroll and personnel cycle
Audit Tests for Fraudulent Hours
– 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.
– Similarly, it may be possible to observe an employee clocking in
more than one time card for their friends who are absent.
– However, it is ordinarily easier for the client to prevent this type of
embezzlement by adequate controls than for the auditor to detect
it.
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.5.3 Tests of Controls (TOC) and Substantive Tests (ST) of

Payroll and personnel cycle

• Auditors often find data analytic tools useful in the audit

of payroll transactions
• Auditors can leverage the power of technology to
examine large populations of employee-related data files
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Let’s Discuss
• Distinguish between the following payroll audit procedures
and state the purpose of each:
• (1) trace a random sample of prenumbered time cards to
the related payments in the payroll register and compare
the hours worked with the hours paid, and
• (2) vouch a random sample of payments from the payroll
register to the related time cards and compare the hours
worked with the hours paid.
– Which of these two procedures is typically more
important in the audit of payroll? Why?
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5.4 Tests of Details of Balances

• The methodology for deciding the appropriate tests of
details of balances for payroll liability accounts include:
– Identify client business risks affecting payroll (Phase I)
– Set performance materiality and assess inherent risk
(Phase I)
– Assess control risk and perform related tests (Phases I
and II)
– Perform substantive analytical procedures (Phase III)
– Design and perform tests of details of balances for
liability and expense accounts (Phase III)
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5.4 Tests of Details of Balances

Methodology for Designing Tests of Balances for Payroll Liabilities

Identify client business risks affecting payroll (Phase I)

– Client business risk may exist for complex compensation
arrangements, such as bonus and stock option plans and other
deferred compensation arrangements
– Other events such as renegotiation of union contracts and
discrimination claims may also exist.
– The auditor should understand the likelihood of these events and
determine their potential effects on the financial statements, including
footnote disclosures
– When complex arrangements such as stock option, the auditor is
required to emphasize on presentation and disclosure (a balance
related objective) to minimize risk of lack of disclosure.
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5.4 Tests of Details of Balances

….Methodology for Designing Tests of Balances for Payroll Liabilities

– Set performance materiality and assess inherent risk

(Phase I)
– In setting tolerable misstatement and assessment of inherent risk, in
many cases controls in this cycle are effective thus for all balance
related objectives inherent risk is low
– For risks related to payments for non existent employees, auditors
can emphasize on occurrence transaction related objective.
– For risks related to improper classification of labor costs, auditors
can emphasize on classification transaction related objective
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5.4 Tests of Details of Balances

….Methodology for Designing Tests of Balances for Payroll Liabilities

• Assess control risk and perform related tests (Phases I and II)

• In the assessment of control risk, and design of tests of

controls and substantive tests of transactions, the focus of
the auditor is on testing the effectiveness of key controls
such as
• separation of duties,
• authorization,
• maintenance of documentation and records,
• physical controls, and
• availability of independent review.
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….Methodology for Designing Tests of Balances for Payroll

Liabilities Perform substantive analytical procedures (Phase III)
Substantive Analytical Procedures for the Payroll and Personnel
Cycle
Auditors perform analytical procedures to identify areas that needs
additional investigation
Substantive Analytical Procedure Possible Misstatement
Compare payroll expense account balance Misstatement of payroll expense accounts
with previous years (adjusted for pay
rate increases and increases in volume).
Compare direct labor as a percentage of Misstatement of direct labor and inventory
sales with previous years.
Compare commission expense as a Misstatement of commission expense and
percentage of sales with previous years. commission liability
Compare payroll tax expense as a Misstatement of payroll tax expense and
percentage of salaries and wages with payroll tax liability
previous years (adjusted for changes in
the tax rates).
Compare accrued payroll tax accounts Misstatement of accrued payroll taxes and
with previous years. payroll tax expense
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Summary of Types of Audit Tests for the

Payroll and Personnel Cycle
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End of Chapter 5:

Questions