CHAPTER THREE

AUDIT OF PAYROLL AND PERSONNEL

CYCLE
 Introduction
 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.
 Thus, improper valuation and allocation of
labor can result in a material misstatement of
net income. Payroll is also an area in which
company resources can be wasted because of
inefficiency or stolen through fraud.
Introduction …
 Payroll is the compensation a business must pay to its employees for a set

period or on a given date.

 It is usually managed by the accounting or human resources department of a

company.
 A payroll is a list of employees of a company who are entitled to receive

compensation as well as other work benefits, as well as the amounts that each

should obtain.
 Along with the amounts that each employee should receive for time worked or

tasks performed, payroll can also refer to a company's records of payments that

were previously made to employees, including salaries and wages, bonuses,

and withheld taxes, or the company's department that deals with compensation.
Overview of the Payroll cycle
 The payroll and personnel cycle involves the
employment and payments for all employees,
regardless of classification or methods
determining compensation.
 The employees include executives on straight
salary plus bonus, office workers on monthly
salary with or without overtime, salespeople on
a commission basis, and factory and unionized
personnel paid on hourly basis.
Payroll and personnel cycle: Definition
 Payroll and personnel cycle—the transaction
cycle that begins with the hiring of personnel,
includes obtaining and accounting for
services from the employees, and ends with
payment to the employees for the services
performed and to the government and other
institutions for withheld and accrued payroll
taxes and benefits.
Objective of Payroll 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
IFRSs.
Payroll Activities
 The HRM/payroll cycle is a recurring set of business activities and

related data processing operations associated with effectively

managing the employee work force.

 This topic focuses primarily on the payroll system.
 Some of the major important activities include the following tasks:
1. Recruitment and hiring

2. Training

3. Job assignment

4. Compensation (payroll)

5. Performance evaluation, and

6. Discharge of employees, due to voluntary or involuntary termination

Accounts in the Payroll and
Personnel Cycle
Objective of IC in HRM/payroll cycle
 The auditor should ensure that the HRM/payroll cycle
provides adequate internal controls to meet the following
objectives:
◦ Payroll transactions are properly authorized

◦ Recorded payroll transactions are valid

◦ Authorized payroll transactions are recorded

◦ Payroll transactions are accurately recorded

◦ Applicable government regulations regarding remittance of

taxes and filing of payroll and HRM reports are met

◦ Assets (both cash and data) are safeguarded from loss or theft

◦ HRM/payroll cycle activities are performed efficiently and

effectively
 Accounts and Classes of
Transactions in Payroll Cycle
The accounts that are included in payroll and personnel
cycle are:
 salaries and wages expense accounts;
 employer payroll taxes expenses and fringe benefits;
 accrued salaries and wages payable
 payroll taxes payable (withheld income taxes and other
deductions)
 Cash in bank (Credit), and
 Direct labour.
Threats in the payroll and personnel
Cycle
 The threats in the payroll and personnel cycle
includes:
◦ Hiring of unqualified or larcenous employees
◦ Violation of employment law
◦ Unauthorized changes to the master payroll file
◦ Inaccurate time data
◦ Inaccurate processing of payroll
◦ Theft or fraudulent distribution of paychecks, and
◦ Loss or unauthorized disclosure of payroll data
IC to be checked in this cycle
 The auditor should check the existence of the
following control procedures.
◦ sound hiring practices (verification of job
applicant’s skills, references, and employment
history).
◦ thorough documentation of hiring procedures.
◦ segregation of duties.
Reasons for Auditing this cycle
 The salaries, wages, employer taxes, and other employer costs
are a major expenses in all companies;
 Labor is such an important consideration in valuation of
inventory in manufacturing and construction companies that an
improper classification and allocation of labour can result in
material misstatement of net income;
 Finally, payroll is an area in which large amounts of company
resources can be wasted because of inefficiency or are stolen
through fraud.
Business Functions in the Payroll and Personnel Cycle, Related
Documents and Records, and Internal Controls

 Human resource management

 timekeeping and payroll preparation
 Time record
 payment of payroll
 preparation of payroll tax returns and
payment of taxes
A. Human Resources
 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.

i. Human resource records - include such data as the date of employment, personnel

investigations, rates of pay, authorized deductions, performance evaluations, and termination

of employment.

ii. Deduction authorization- Employees may submit a form or make online selections that

authorize payroll deductions, including the number of exemptions for withholding income

taxes, and other retirement savings plans, health insurance, and union dues.

iii. Rate authorization -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.

 B. Timekeeping and payroll preparation
 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
C. Time record
 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.

 The documents include: time card, job time ticket, summary

payroll report, payroll journal and payroll master file.

D. 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.
 Payment of payroll 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.
E. 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.
 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.

 Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales
The methodology for obtaining an understanding of internal control and designing tests
of controls and substantive tests of transactions for sales are:
o Understand internal control over payroll and personnel Cycle
o Assess planned control risk related to payroll and personnel Cycle
o Evaluate cost-benefit of testing controls, and
o Design tests of controls and substantive tests of transactions for payroll and
personnel Cycle to meet transaction-related audit objectives regarding:
o Audit Procedures
o Sample Size
o Items to select
o Timing
Methodology for Designing Tests of
Controls and Substantive Tests ..
 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:
1. Employees are likely to complain to management if they are underpaid.

2. All payroll transactions are typically uniform and uncomplicated.

3. Payroll transactions are subject to audit by federal and state

governments for income tax withholding, Social Security, and
unemployment taxes.
 A. Understand internal control over payroll
and personnel Cycle
 to obtain an understanding of internal control for sales,

auditors:
◦ study the client’s flowcharts or other control documentation,
◦ make inquiries of the client using an internal control
questionnaire (ICQ), and
◦ perform walkthrough tests of payroll and personnel Cycle.
 B. Assess Planned Control Risk for
payroll and personnel Cycle
the auditor uses the information obtained in understanding internal control to asses

control risk. There are four essential steps to this assessment. These steps are:

1. the auditor needs a framework for assessing control risk. The framework for all

classes of transactions is the six transaction-related audit objectives (Existence,

Completeness, accuracy, Classification, timing and posting and summarization).

2. the auditor must identify the key internal controls and weaknesses for payroll

and personnel Cycle.

3. Third, after identifying the controls and weaknesses, the auditor associates them

with the objectives.

4. the auditor assesses control risk for each objective by evaluating the controls

and weaknesses for each objective.

Key Control Activities for the payroll
and personnel cycle
1. Adequate Separation of Duties - is important in the payroll and personnel cycle,

especially to prevent overpayments and payments to nonexistent employees.

2. Proper authorization- 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.

3. Adequate Documents and records - The appropriate documents and records

depend on the nature of the payroll system.

4. 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.

5. Independent Checks on performance- Payroll computations should be

independently verified, including comparison of batch totals to summary reports.

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.
 IC test over Payroll tax form and payment
 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.
 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.

 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.
 Inventory and Fraudulent payroll
Considerations
 In audits in which payroll is a significant portion of inventory, a frequent

occurrence for manufacturing and construction companies, the improper

account classification of payroll can significantly 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.

 When labor is material factor in inventory valuation, there should be special

emphasis on testing the internal controls over proper classification of payroll

transactions. Consistency from period to period, which is essential for

classification, can be tested by reviewing the chart of accounts and procedures

manuals.
 Tests for Nonexistent employees
 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.

 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.

Tests for Nonexistent employees…

 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.
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.
 Fraudulent expense reports
 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.
 Auditor should give 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 for payroll

 The methodology for deciding the appropriate tests of

details of balances for payroll liability accounts is the
same as that followed in Chapter 2 for accounts
receivable.
◦ Identify Client Business risks affecting payroll (phase I)

◦ Set performance Materiality and assess Inherent risk (phase II)

◦ assess Control risk and perform related tests (phases I and II)

◦ Design and perform tests of Details of Balances for Liability

and expense accounts (phase III)
 Substantive Analytical Procedures for the Payroll and
Personnel Cycle

Substantive Analytical Procedure Possible Misstatement

Compare payroll expense account balance with Misstatements of payroll expense accounts
previous years (adjusted for pay rate increases and
increases in volume)
Compare direct labor as a percentage of sales with Misstatements of direct labor and inventory
previous years

Compare commission expenses as a percentage of sales Misstatements of commission expense and

with previous years. commission liability

Compare payroll tax expense as a percentage of salaries Misstatements of payroll tax expenses and
and wages with previous years (adjusted for changes in payroll tax liability
the tax rates)

Compare accrued payroll tax accounts with previous Misstatements of accrued payroll taxes and
years payroll tax expense
 Design and perform tests of Details of
Balances for Liability and expense accounts
(phase III)
 The two major balance-related audit
objectives in testing payroll liabilities are:
1. Accruals in the trial balance are stated at the
correct amounts (accuracy).
2. Transactions in the payroll and personnel cycle
are recorded in the proper period (cutoff).
Major liability accounts in the payroll
and personnel cycle
 The major liability accounts in the payroll and
personnel cycle are:
◦ Amounts Withheld from employees’ pay.
◦ Accrued Salaries and Wages
◦ Accrued Commissions
◦ Accrued Bonuses
◦ Accrued Vacation pay, Sick pay, or Other benefits
◦ Accrued payroll taxes
 Tests of Details of Balances for
expense accounts
 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.
 Expense Accounts in Payroll and
Personnel Cycle
 The expense accounts in
payroll accounts in the payroll
and personnel accounts are:
◦ officers’ compensation,
◦ commissions,
◦ payroll tax expense,
◦ total payroll, and
◦ contract labor.
 Presentation and Disclosure Objectives
in Payroll and Personnel Cycle
 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.
End of CH3


Thank You for Your Attention