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 occurrence
Transactions:
Recorded payroll expenses and payroll tax
expenses relate to compensation for
services rendered during the period
Accounts balances:
Accrued payroll and payroll tax liability
balances represent amounts owed at the
balance sheet date.
Audit Objectives
2. Completeness
Transactions:
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 obligations
Transactions:
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 allocation
Transactions:
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 disclosure
Transactions:
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 Risks
4. 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 Procedures
Ratio
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
Total revenue : the
number of full time
employees
Reasonableness test of
gross payroll for group of
employees.
Revenue per
employee
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 Procedures
Ratio
Formula
Total payroll Total payroll
costs as a expenses : total
percentage revenues
of revenues
Audit Significance
Reasonableness
test of payroll costs.
This is often
compared with
industry statistics.
Payroll tax Total payroll tax Reasonableness
expense
expenses : gross test of payroll taxes.
as a percen- payroll
This can often be
tage of
compared with
standard tax rates.
gross
payroll
Analytical Procedures
Ratio
Formula
Comparison
payroll
expenses with
prior-year
balances or
budgets.
Compare
current-year
payroll liability
with prior-year
payroll liability.
Current-year payroll Reasonableness test
expenses : prior-year for payroll expenses if
payroll expenses
the ratio is significantly
different from 1.0.
Current-year payroll
tax liability : prioryear payroll tax
liability adjusted for
growth in payroll
volume
Audit Significance
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
Employee
benefits
expenses as
a percent of
gross payroll
Payroll tax expense Reasonableness test
: total payroll
for payroll tax expense
expense
based on prior-year
ratio of payroll tax
expense to total
payroll.
Total benefits
Reasonableness test
expenses : gross
of benefits expenses.
payroll
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.
6.
7.
8.
9.
10.
11.
Imprest payroll bank account
payroll check
Labor cost distribution summary
Payroll tax returns
Employee personnel file
Personnel data master file
Employee earnings master file
Payroll Functions
1.
2.
3.
4.
Initiating payroll transaction, including: (a)
hiring employees, (b) authorizing payroll
changes.
Receipt of services, including: preparing
attendance and timekeeping data.
Recording payroll transactions, including:
preparing and recording the payroll.
Paying payroll, including: (a) paying the
payroll and protecting unclaimed wages,
(b) filing payroll tax returns.
Substantive Tests
The Types of Procedures:
1.
2.
3.
4.
5.
Initial Procedures
Analytical Procedures
Tests of Details of Transactions
Tests of Details of Balances
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 Tests
Initial 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 Tests
Analytical 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 Tests
Tests 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 Tests
Tests 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 Tests
Tests 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