CHAPTER THREE

AUDIT OF THE PAYROLL AND PERSONNEL CYCLE

Objectives

After studying this chapter, you should be able to:

1. Identify the accounts and transactions in the payroll and personnel cycle.
2. Describe the business functions and the related documents and records in the payroll and
personnel cycle.
3. Understand internal control and design and perform tests of controls and substantive tests
of transactions for the payroll and personnel cycle.
4. Design and perform analytical procedures for the payroll and personnel cycle.
5. Design and perform tests of details of balances for accounts in the 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. Improper valuation and allocation of labor can result in a material misstatement of net
income. Payroll is also an area in which large amounts of company resources can be wasted
because of inefficiency or stolen through fraud.

As with the sales and collection cycle, the audit of the payroll and personnel cycle includes
obtaining an understanding of internal control, assessment of control risk, tests of controls and
substantive tests of transactions, analytical procedures, and tests of details of balances. There are
several important differences between the payroll and personnel cycle and other cycles in a typical
audit.

 There is only one class of transactions for payroll. Most cycles include at least two classes
of transactions. Payroll has only one class because the receipt of services from employees
and the payment for those services through payroll occur within a short time period.
  Transactions are far more significant than related balance sheet accounts. Payroll-related
accounts such as accrued payroll and withholding taxes are usually small compared to the
total amount of transactions for the year.
 Internal controls over payroll are effective for almost all companies, even small ones. The
reasons for effective controls are harsh federal and state penalties for error in withholding
and paying payroll taxes and employee morale problems if employees are not paid or are
underpaid.

Because of these three characteristics, auditors typically emphasize tests of controls, substantive
tests of transactions, and analytical procedures in the audit of payroll. Tests of details of balances
often take only a few minutes. Before discussing the tests in the cycle, we review the transactions
and account balances, as well as the documents and records used in the payroll and personnel
cycle.

3.1 Accounts AND Transactions IN 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 fairy sated in accordance with generally accepted
accounting principles.

Accounts in the cycle:

 Cash in bank
 Accrued wages, salaries, bonuses, and
commissions
 Direct labor
 Accrued payroll tax expense
 Withheld income taxes and other
deductions
 Payroll tax expense
 In most systems, the accrued wages and salaries accounts is used only at the end of an
accounting period. Throughout the period, Expenses are charged when the employees are
actually paid rather than when the labor costs are incurred. The accruals for labor are recorded
by adjusting entries at the end of the period for any earned but unpaid labor costs.

3.2 Business Functions in the Cycle and Related Document AND Records

The payroll and personnel cycle begins with the hiring of personnel and ends with payment to
the employees for the services performed and to the government and other institutions for the
withheld and accrued payroll taxes and benefits. In between, the cycle involves obtaining
services from the employees consistent with the objectives of the company and accounting for
the services in a proper manner.

Column 3 of table 6-1 identifies the four business functions in a typical payroll and personnel
cycle. The table also shows the relationships among the business functions, classes of
transactions, accounts and documents and records.

Class of Accounts Business functions Documents and records

transactions

Payroll Payroll cash Personnel and Personnel records

employment
All payroll expense accounts Deduction authorization
form
All payroll withholding accounts
Rate authorization form
All payroll accrual accounts
Timekeeping and Time card
payroll preparation
Job time ticket
Payroll transaction file
Payroll journal or listing
Payroll master file

Payment of payroll Payroll check

Payroll bank account
reconciliation
 Preparation of payroll w-2 form payroll tax
tax returns and returns
payment of taxes

Table 6.1 classes of transactions, Accounts, Business functions, and related documents and
records for the payroll and personnel cycle.
1. Personnel and Employment:

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.

Personnel records: are records that include such data as the date of employment, personnel
investigations, rates of pay, authorized deductions, performance evaluations and terminations of
employment.

Deduction authorization form: A form authorizing payroll deductions, including the number of
exemptions for withholding income taxes and other retirement saving plans.

Rate Authorization form: A form authorization 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.

2. Timekeeping and payroll preparation

This function is of major importance in the audit of payroll because it directly affects payroll
expense for the period. 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 the preparation of payroll records. There must be adequate controls to prevent
misstatements in each of these activities.

Time card: A time card is a document indicating the time the employee started and stopped
working each day and the number of hours the employee worked. For many employees, the time
card is prepared automatically by time clocks or identification card readers. Time cards are
usually submitted weekly. References to time cards in this chapter include both paper and
electronic forms.

Salaried employees do not complete time cards. Salaried workers may be required to complete
reports of their time when they are compensated for overtime or take vacation or sick days.

Job Time Ticket: A document indicating jobs on which an employee worked during a given
time period. This form is used only when an employee works on different jobs or in different
departments. Job time tickets may be completed electronically by a time and expense reporting
system.

Payroll Transaction File: A computer-generated file that includes all payroll transactions
processed by the accounting system for a period, such as a day, week, or month. It contains all
information entered into the system and includes information for each transaction, such as
employee name, date, gross and net payments, various withholding amounts, and account
classification or classifications.

The information on the payroll transaction file is used for a variety of records, listings, or reports,
depending on the company’s needs. Examples include the payroll journal, payroll master file,
and payroll bank reconciliation.

Payroll journal or listing: A report generated from the payroll transaction file that typically
includes the employee’s name, date, gross and net payroll amounts, withholding amounts, and
account classification or classifications for each transaction. The same transactions included in
the journal or listing are also posted simultaneously to the general ledger and to the payroll
master file.

Payroll master file: A payroll master file is used for recording each payroll transaction for each
employee and maintaining total employee wages paid for the year to date. The record for each
employee includes gross pay for each payroll period, deductions from gross pay net pay, check
number, and date. The master file is updated from payroll computer transaction files. The total
of the individual employee earnings in the master file equals the total balance of gross payroll in
various general ledger accounts.

3. Payment of payroll
The actual signing and distribution of the checks must be properly handled to prevent their theft.
Separate imprest payroll bank accounts are often used to prevent the payment of unauthorized
payroll transactions.

Payroll check: A check written to the employee for services performed. The check is prepared as
part of the payroll preparation function, but the authorized signature makes the check an asset.
The amount of the check is the gross pay less taxes and other deductions withheld. After the
check is cashed and returned to the company from the bank, it is referred to as a canceled check.
It is now common for payroll to be directly deposited into employees’ bank accounts.

Payroll Bank Account Reconciliation: An important control is the independent reconciliation

of the imprest payroll bank account. An imprest payroll account is separate payroll account in
which a small balance is maintained. The exact amount of each net payroll is transferred by
check or electronic funds transfer from the general account to the imprest account immediately
before distribution of the payroll. The advantages of an imprest account are that it limits the
client’s exposure to payroll fraud, allows the delegation of payroll check-signing duties,
separates routine payroll expenditures from other expenditures, and facilitates cash management.

4. Preparation of payroll tax returns and payment of tax

The timely preparation and mailing of payroll tax returns is required by federal and state payroll
laws. Most computerized payroll systems include the preparation of payroll tax returns using the
information on the payroll transaction and master files. Independent verification of the output by
a competent individual is an important control to prevent misstatements and potential liability for
taxes and penalties.

W-2 form: A form issued for each employee summarizing the earning record for the calendar
year. The information includes gross pay, income taxes withheld. The same information is also
submitted to the internet Revenue Service and state and local tax commissions when applicable.
This information is prepared from the payroll master file and is normally prepared by the
computer.

Payroll Tax Returns: Tax forms submitted to local, state, and federal units of government for
the payment of withheld taxes and the employer’s tax.
 3.3 Methodology for Designing Tests of Controls and Substantive Tests of
Transactions
Now that you are familiar with the business functions and related document and records in the
payroll and personnel cycle, we can discuss the assessment of control risk and the design of tests
of control and substantive tests of transactions for the cycle. Figure 3-1 shows the methodology
for designing tests of controls and substantive tests of transactions for the payroll and personnel
cycle. It is the same methodology as that used in chapter 2 for the sales and collection cycle.
Understand internal control-payroll
and personnel

Assess planed control risk-payroll and

personnel

Determine extent of
testing of controls

Design tests of controls and Audit procedures

substantive tests of
Sample size
transactions for payroll and
personnel to transaction Timing
related audit objectives
Items to select

Figure 3.1 Methodology for designing tests of controls and substantive tests of transactions for
the payroll and personnel cycle

Internal control for payroll is normally highly structured and well controlled in order to control
cash disbursed and to minimize employee complaints and dissatisfaction. Payroll checks and all
related journals and payroll records are usually processed by computer. Because the processing
of payroll is similar for most organizations, and programs need to be modified annually for
changes in withholding schedules, it is common to use an outside payroll service for the
processing of payroll. The auditor can often rely on the internal controls of the service
organization.
It is usually not difficult to establish good control in the payroll and personnel cycle for factory
and office employees, there are usually a large number of relatively homogeneous, small-amount
transactions. There are fewer executive payroll transactions, but they are ordinarily consistent in
timing, content, and amount. Consequently, auditors seldom expect to find exceptions in testing
payroll transactions. Occasionally, control test deviations occur, but most monetary
misstatements are corrected by internal verification controls or in response to employee
complaints.

Tests of controls and substantive tests of transaction 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.
Furthermore, in most audits, the amounts in the balance sheet accounts are small and can be
verified with relative ease if the auditor is confident that payroll transactions are correctly
entered into the computer and payroll tax returns are properly prepared.

Even though the tests of controls and substantive tests of transactions are the most important
parts of testing payroll, the tests in this area are usually not extensive. In many audits, there is a
minimal risk of material misstatements, even though payroll is often a significant part of total
expenses. There are three reasons for this: Employees are likely to complain to management if
they are underpaid, all payroll transactions are typically uniform and uncomplicated, and payroll
transactions are subject to audit by federal and state government for income tax withholding,
social security, and unemployment taxes.

6.3.1 Understand internal control-payroll and personnel cycle

The purposes of many internal controls and the nature of the tests of controls and substantive
tests of transactions are apparent for most tests. The section that follows discusses some of the
key controls for the payroll and personnel cycle for the assessment of control risk.

Adequate separation of duties: separation of duties is important in the payroll and personnel
cycle, especially to prevent overpayments and payments to nonexistent employees. The human
resources department should be independent of the payroll function and is responsible for
authorizing the addition and termination of employees, as well as changes in pay rates and
deductions. Payroll processing should be separate from the custody of signed payroll checks.

Proper Authorization: As noted earlier, the human resources department should be responsible
for the authorization of additions and deletions of employees from the payroll. Pay rates and
deductions should also be properly authorized. The hours worked by each employee, especially
overtime should be authorized by the employee’s supervisor. Approval may be noted on all time
cards or done on an exception basis for overtime hours only.

Adequate Documents and Records: The appropriate documents and records will depend on the
nature of the payroll system. For example, time cards or records are necessary for hourly
employees but not for salaried employees. Some employees may be compensated based on piece
rate other incentive systems. For many companies, time records must be adequate to accumulate
payroll costs by job or assignment. Prenumbered documents for recording time are less of a
concern in the payroll area because the completeness of payroll is not normally a concern.

Physical Control over Assets and Records: Access to unsigned payroll checks should be
restricted. Checks should be signed by a responsible employee, and payroll should be distributed
by someone independent of the payroll and timekeeping functions. Any unclaimed checks
should be returned for redeposit. If checks are signed by a signature machine should be
restricted.

Independent checks on performance: payroll computation should be independently verified,

including a comparison of batch totals to summary reports. A member of management or other
responsible employee should review the payroll output for any obvious misstatements or unusual
amounts, when manufacturing labor affects inventory valuation or when it is necessary to
accumulate costs by job, adequate controls are necessary to verify the proper assignment of
costs.

To understand internal control for payroll and personnel cycle and also for other cycles the
reader should recognize the following:

Internal controls vary from company to company; therefore, the auditor must identify the
controls, significant deficiencies, and material weaknesses for each organization.
 Controls the auditor intends to use for reducing assessed control risk and the risk must be
tested with tests of controls.
If the client is a public company, the level of understanding controls and extent of tests
of controls must be sufficient to issue an opinion on the effectiveness of internal control
over financial reporting.
Substantive tests of transactions vary depending on the assessed control risk and the other
considerations of the audit, such as the effect of payroll on inventory.
Tests are not actually performed in the same order from company to company. The tests
of controls and substantive tests of transactions are combined when appropriate and are
performed in as convenient a manner as possible, using a performance format audit
program.

6.3.2 Payroll tax forms and payments

Payroll taxes are an important consideration in many companies, both because the amounts are
often material and because the potential liability for failure to file timely tax forms can be severe.

Preparation of Payroll Tax Forms: 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. There is a potential liability for unpaid taxes, penalty, and interest if the
client fails to prepare the tax forms properly.

A detailed reconciliation of the information on the tax forms and the payroll records may be
necessary when the auditor believes that there is a reasonable chance that the tax returns may be
improperly prepared. Indications of potential misstatements in the returns include the payment
of penalties and interest in the past for improper payments, new personnel in the payroll
department who are responsible for the preparation of the returns, the lack of internal verification
of the information, and the existence of serious cash flow problems for the client.

Payment of the Payroll Taxes Withheld and Other Withholdings on a timely Basis: It is
desirable to test whether the client has fulfilled its legal obligation in submitting payment for all
payroll withholding as a part of the payroll tests even though the payment are usually made from
general cash disbursements. The auditor must first determine the client’s requirements for
submitting the payments. The requirements are determined by reference to such sources as tax
laws union contracts, and agreements with employees. After the auditor knows the requirements,
it is easy to determine whether the client has paid the proper amount on a timely basis by
comparing the subsequent cash disbursement with the payroll records.

3.3.3 Inventory and fraudulent payroll considerations

Auditors often extend their procedures considerably in the audit of payroll under the following
circumstances: when payroll significantly affects the valuation of inventory and when the auditor
is concerned about the possibility of material fraudulent payroll transactions.

Relation between Payroll and Inventory Valuation: In audits in which payroll is a significant
portion of inventory, a common 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.
Similarly, the valuation of inventory is affected if the direct labor cost of individual employees is
improperly charged to the wrong job or process.

Tests for Nonexistent Payroll: Because auditors have significant responsibility for the detection
of fraud, they must extend audit procedures when they become concerned about the possibility of
material fraud. There are several ways in which employees can significantly defraud a company
in the payroll area. This discussion is limited to tests for the two most common types:
nonexistent employees and fraudulent hours.

The issuance of payroll checks to individual who do not work for the company (non existent
employees) often results from the continuance of an employee’s check after employment has
been terminated. Usually, the person committing these types of defalcation is a payroll clerk,
foreman, follow employee, or perhaps the former employee. For example, under some systems a
foreman could clock in daily for an employee and approve the time card at the end of the time
period. If the foreman also distributes paychecks, considerable opportunity for defalcation
exists.

Certain procedures can be performed on cancelled checks as a means of detecting defalcation. A

procedure use on payroll audits is to compare the names on cancelled checks with time, cards
and other records for authorized signatures and reasonableness of the endorsements. It is also
common to scan endorsements on cancelled, checks for unusual or recurring second
endorsements as an indication of a possible fraudulent check. The examination of checks that
are recorded as voided is also desirable to make sure that they have not been fraudulently used.

A test for nonexistent employees is to 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. The endorsement on the cancelled check written out to an employee
can be compared with the authorized signature on the employee’s withholding authorization
forms.

Fraudulent hours occur when an employee reports more time than was actually worked. Because
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.

3.4 Methodology for Designing Tests of Details of Balances

1. Identify client business risks affecting payroll (Phase I)

Significant client business risk affecting payroll are unlikely for most companies. However,
client business risk may exist for complex compensation arrangements, including bonus and
stock option plans and other deferred compensation arrangements. For example, many
technology companies provide extensive stock options as part of their compensation packages
for key employees that significantly impact compensation expense and shareholder’s equity.

2. Set Tolerable misstatement and assess inherent risk (Phase II)

Except for the potential for fraud, inherent risk is typically low for all balance-related audit
objectives. There is an inherent risk of payroll fraud because most transactions involve cash.
The existence objective is therefore often considered to be important. Also, for manufacturing
companies with significant labor charged to inventory, there is potential for misclassification
between payroll expense and inventory or among categories of inventory.

3. Assess control risk and perform related tests (Phase I&II)

Assessing controls risk and the related tests of controls and substantive tests of transactions have
been discussed extensively in earlier sections of the chapter and are not repeated here.

4. Perform analytical procedures (Phase III)

The use of analytical procedures is as important in the payroll and personnel cycle as it is in
every other cycle.

5. Design & perform tests of details of balances for liability & expense accounts (PhaseIII)

The verification of the liability accounts associated with payroll, often termed accrued payroll
expenses, is ordinarily straightforward if internal controls are operating effectively. When the
auditor is satisfied that payroll transactions are being properly recorded in the payroll journal and
the related payroll tax forms are being accurately prepared and promptly paid, the tests of details
of balances should not be time-consuming.

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), and (2) transactions in the payroll and
personnel cycle are recorded in the proper period (cutoff). The primary concern in both
objectives is to make sure that there are no understated or omitted accruals.