Auditing the Payroll Cycle

Transactions

• Personnel services or payroll cycle involves the activities that pertain to executive and employee compensation.

• The type of compensation include salaries, hourly and incentive (piecework) wages, commissions, bonuses, stock options, and employee benefits (e.g., health insurance and paid vacations).

Audit Objectives

1. Existence or occurrenceTransactions:

Recorded payroll expenses and payroll tax expenses relate to compensation for services rendered during the periodAccounts balances:

Accrued payroll and payroll tax liability balances represent amounts owed at the balance sheet date.

Audit Objectives

2. CompletenessTransactions:

Recorded payroll expenses and payroll tax expenses include all such expenses incurred for personnel services during the year.Accounts Balances:

Accrued payroll and payroll tax liabilities include all amounts owed to personnel and governmental agencies at the balance sheet date.

Audit Objectives

3. Rights and obligationsTransactions:All recorded transactions represent the obligations or the rights of the entity.Accounts Balances:

Accrued payroll and payroll tax liabilities are obligations of the reporting entity.

Audit Objectives

4. Valuation or allocationTransactions:Payroll expenses and payroll tax expenses are accurately computed and recorded.

Accounts Balances:

Accrued payroll and payroll tax liabilities are accurately computed and recorded.Factory labor distributions are correctly computed and recorded.

Audit Objectives

5. Presentation and disclosureTransactions:Payroll expenses and payroll tax expenses are properly identified and classified in the income statement.Accounts Balances:

Accrued payroll and payroll tax liability accounts are properly identified and classified in the balance sheet.The financial statements include appropriate disclosures for pension and other benefit plans.

Inherent Risks

1. Employees involved in preparing and paying the payroll may process data for fictitious employees and divert the paychecks to their own use.

2. Management may overtly misclassify or “pad” labor cost in government contract work to defraud the agency.

3. Pay periods may be weekly, bimonthly, or monthly, and in each case the volume of payroll transactions may be high.

Inherent Risks4. Gross earnings may be based on time and/or

productivity, thus the computations may be complex and inherent risk for the valuation or allocation assertion may be high.

5. When there is frequent turnover of personnel, there is the risk that a terminated employee is continued on the payroll.

6. Company’s benefit plans that involve stock options, stock appreciation rights, or pension plans involve both significant measurement and disclosures issues.

Analytical ProceduresRatio Formula Audit Significance

Average payroll cost per employee classification

Total payroll costs for an employee group divided by the number of employees in the group

Reasonableness test of gross payroll for group of employees.

Revenue per employee

Total revenue : the number of full time employees

This is may be a measure of productivity per employee. This is particularly important in services industries and would be compared with industry statistics.

Analytical ProceduresRatio Formula Audit Significance

Total payroll costs as a percentage of revenues

Total payroll expenses : total revenues

Reasonableness test of payroll costs. This is often compared with industry statistics.

Payroll tax expense as a percen-tage of gross payroll

Total payroll tax expenses : gross payroll

Reasonableness test of payroll taxes. This can often be compared with standard tax rates.

Analytical ProceduresRatio Formula Audit Significance

Comparison payroll expenses with prior-year balances or budgets.

Current-year payroll expenses : prior-year payroll expenses

Reasonableness test for payroll expenses if the ratio is significantly different from 1.0.

Compare current-year payroll liability with prior-year payroll liability.

Current-year payroll tax liability : prior-year payroll tax liability adjusted for growth in payroll volume

Reasonableness test for payroll liability if the ratio is significantly different from 1.0

Analytical Procedures

Ratio Forumula Audit Significance

Compute ratio of payroll tax expense to total payroll expenses

Payroll tax expense : total payroll expense

Reasonableness test for payroll tax expense based on prior-year ratio of payroll tax expense to total payroll.

Employee benefits expenses as a percent of gross payroll

Total benefits expenses : gross payroll

Reasonableness test of benefits expenses. This is often compared with industry statistics..

Documents and Records

1. Personnel authorization. Memo issued by personnel department indicating the hiring of an employee and each subsequent change in the employee’s status for payroll purposes.

2. Clock card. Form used by each employee to record hours worked daily during a pay period.

3. Time ticket. Form used to record time worked by an employee on specific jobs.

4. Payroll register.

Documents and Records

5. Imprest payroll bank account6. payroll check7. Labor cost distribution summary8. Payroll tax returns9. Employee personnel file10. Personnel data master file11. Employee earnings master file

Payroll Functions

1. Initiating payroll transaction, including: (a) hiring employees, (b) authorizing payroll changes.

2. Receipt of services, including: preparing attendance and timekeeping data.

3. Recording payroll transactions, including: preparing and recording the payroll.

4. Paying payroll, including: (a) paying the payroll and protecting unclaimed wages, (b) filing payroll tax returns.

Substantive Tests

The Types of Procedures:

1. Initial Procedures

2. Analytical Procedures

3. Tests of Details of Transactions

4. Tests of Details of Balances

5. Tests of Details of Balances: Accounting Estimates

6. Presentation and Disclosure

Substantive Tests

Initial Procedures

• Obtain understanding of business and industry and determine:– The significance of payroll costs to the

business.– Key economic drivers that influence

payroll costs.– The extent to which the client has

defined benefit pension plans or uses other incentive compensation plans.

Substantive TestsInitial Procedures• Perform initial procedures on payroll

balances and records that will be subjected to further testing.

– Trace beginning accrued payroll balances to prior year’s working papers.

– Review activity in payroll accounts and investigate entries that appear unusual in amount and source.

– Verify total of payroll registers and other subsidiary ledgers for agreement with general ledger balances.

Substantive TestsAnalytical Procedures• Perform analytical procedures

– Review industry experience and trends– Examine analysis of payroll costs– Review relationship of payroll costs to

recent production sales activities.

Tests of Details of Transactions• On a test basis, vouch payroll transactions to

supporting documentation.• On a test basis, vouch payroll tax transactions to

supporting documentation.

Substantive TestsTests of Details of Transactions

• Verify officer compensation to board of director authorization.

• On a test basis, trace data from time cards and contracts to the payroll register.

• Test payroll cut-off at the end of the month (year) based on time periods worked and payroll accrual if month (year) end and the end of the payroll period do not match up.

Substantive TestsTests of Details of Balances

• Recalculate accrued payroll liabilities at year-end to underlying payroll records.

• Recalculate accrued payroll tax liabilities and vouch to subsequent cash disbursements.

• Determine the accrued payroll payables are the obligations of the entity.

Substantive TestsTests of Details of Balances: Accounting Estimates•Determine method of accounting of stock options, and recalculate stock option expense (or disclosure information)

Presentation and Disclosure•Compare statement presentation to GAAP

– Review presentation and disclosure– Estimate completeness of presentation and

disclosure– Evaluate classification and understandability.

Thank You