CHAPTER 10
The audit of payroll
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well as the verification of the income statement. A good insight into the risks that are
encountered in payroll system s is an essential part of understanding the w ork programmes
needed to give reassurance to the auditor.
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electronic banking methods. The payroll is prepared using a standard package run on a PC
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SYLLABUS AND STUDY GUIDE COVERAGE
This chapter covers the following elements of the ACCA study guide:
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¨ Describe, illustrate and analyse how internal control systems over the payroll
transaction cycle operate in both large and small entities.
¨ Describe and illustrate the use by auditors of internal control checklists for the
payroll transaction cycle.
¨ Describe and tabulate tests of control of payroll for inclusion in a work program.
¨ Explain and illustrate how structural and operational weaknesses in payroll
systems should be reported to management and how recommendations should be
made.
In order to cover these elements the follow ing topics are included:
Case study - Philip plc (the payroll system)
Using IT for payroll processing
1 Introduction
1.1 The processing of payroll transactions
The stages in a typical payroll system are illustrated below.
Stage 1 Clockcards and timesheets submitted and input
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Stage 2 Gross pay, deductions and net pay calculated
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Stage 3 Other amendments input
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Stage 4 Final payroll calculated and payslips produced
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Stage 5 Payments to employees and tax authorities
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Stage 6 Payroll costs and payments recorded in books
1.2 Testing the payroll system
W e test at Stage 1 to ensure that only bona fide employees are paid for work done.
W e test at Stage 2 to ensure that calculations are accurate.
W e test at Stage 3 to ensure that amendments (eg, starters and leavers) are valid.
W e test at Stage 4 to ensure that the total figures are accurate.
W e test at Stage 5 to ensure that payments are made to those entitled to receive them .
W e test at Stage 6 to ensure that am ounts are correctly posted to nominal ledger accounts.
Once again the control objectives are usually phrased to ensure that something good is
happening or that something bad is not happening.
2 Internal controls in the payroll system
2.1 Internal control objectives
The internal control objectives identified in the payroll cycle are as follows.
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authorised rates of pay and conditions.
¨ W ages and salaries computed should be in agreement with records of work performed ie,
overtime claims, bonus calculations etc.
¨ Payroll is correctly com puted and paid to the appropriate employees.
¨ All records of transactions are accurately maintained within the accounting system.
¨ There are controls to ensure that all payroll deductions (income tax deducted at source,
pension contributions, etc) are computed and paid over on due dates.
2.2 Fundamental controls for a payroll system
A record should be kept for each employee containing, in writing, proof of engagement,
dismissal, changes in rates of pay etc. Any changes in these details should be evidenced in
writing by a responsible official.
There should be procedures for checking or reconciling the payroll records on a week by week,
or month by m onth basis, so that any unexplained deviations are identified.
All time records should be checked and overtime approved by a responsible official.
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com mission payments) should be reconciled and agreed with the relevant accounting records.
2.3 Internal controls over preparation and payment of payroll
The payroll should be checked for accuracy of detail (names, hours paid, rates of pay and
calculations of gross pay) by persons who are independent of the payroll preparation.
Payouts should be w itnessed and evidenced by signature on the employee clock cards.
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Chapter 10 The audit of payroll
Some responsible official (independent of the recording and authorisation function) should
formally approve the payroll by signing it.
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2.4 Custodial controls
W here one employee collects pay on behalf of another, controls should exist to validate that
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Unclaimed wages should be recorded and placed in safe custody by a responsible official.
W here employees are paid in cash the exact sum for net payment should be drawn from the
bank. Unclaimed wages should be re-banked after a reasonable interval (say three weeks).
2.5 Internal controls over accounting for payroll liabilities
Separate control accounts should be maintained for wages and salaries.
Payment of liabilities must be capable of being reconciled with the source payroll (ie, tax and
pension deductions are paid over intact on due dates and the amounts paid should agree with
the amounts on the payroll).
2.6 Supervisory controls
There must be a division of duties between the personnel management functions, the payroll
recording functions, the cash payment functions and the overall supervision of the payroll
system.
Some responsible official should supervise the recording of payroll and the regular discharge
of payroll liabilities.
3 Tests of control and substantive testing
3.1 Tests of control on basic controls
As in other processing cycles (sales and purchases) we can distinguish between w itnessing
procedures and re-performance procedures.
Witnessing procedures include the following.
¨ Review ing employee files to verify that all engagements, dismissals or status changes are
in writing and authorised by a responsible official.
¨ Examining records of bonus payments, overtime payments etc for agreement with related
accounting records and authorisation by a responsible official.
¨ W itnessing payout procedures.
Re-performance procedures include the following.
¨ Selecting a sample of employees and re-performing calculations of gross pay, bonus,
overtime, tax deductions etc.
¨ Verifying payroll changes w ith payroll file.
¨ Tests on preparation and accounting controls.
3.2 Tests of control on specific controls
Witnessing procedures include the following.
¨ Review ing payrolls to verify that all checks on calculation, preparation and authorisation
have been done.
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Chapter 10 The audit of payroll
¨ Comparing payroll totals with paid cheques for cash drawn, checking that net am ounts
have been exactly drawn.
¨ Examining the banking of unclaimed wages.
¨ Verifying that liability accounts have been set up for tax and pension contributions and
that such sum s are paid over on due dates.
¨ Ensuring that adequate procedures exist for analysing payroll to the appropriate nominal
ledger sections.
Re-performance procedures include the following.
¨ Verifying cash drawn for a sample of weekly payments w ith payrolls and ensuring that all
cash is properly accounted for.
¨ Verifying the calculations and entries of payroll liabilities and identifying settlement
amounts.
¨ Tracing entries to nominal ledger to obtain assurance on analysis and recording
procedures.
3.3 Substantive testing
The main substantive tests in this area are as follow s.
¨ Testing the casts and cross-casts on payrolls.
¨ Checking postings (via journal vouchers) to nom inal ledger expense accounts and liability
accounts.
¨ Vouching payments to tax authorities, pension fund, etc.
¨ Tracing make up of payroll items to employee records.
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records.
3.4 Case study: the payroll system
Philip plc is a manufacturing company employing a total of 300 persons, 200 of these being
workers who are paid weekly in cash. All w orkers are required to record their times of arrival
and departure using a clock card w hich is inserted in a time recording clock.
At weekly intervals the cards are collected and passed to the works office where the clerks total
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and the add list are then passed to Elizabeth in the wages department who enters the names
and hours worked on the payroll sheet, and agrees the add list total.
The payroll sheets are then passed to Roderick who keeps the payroll records. He enters the
rate of pay and calculates the gross pay. He also computes the tax deduction, w hich he enters
on the payroll. He passes the payroll back to Elizabeth w ho calculates the net am ount and
totals all the columns on the payroll.
The completed payroll is then passed to Charles, the accountant, who scans the payroll,
compares the totals with the previous week, and initials the payroll. Charles raises a cheque
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The cashier draws a cheque for the net amount of the payroll which is then signed by tw o
directors. The cheque is given to a representative of Crypto Nat Security Services plc w ho
draws the m oney from the bank and delivers it under guard to Elizabeth. The cashier,
Theobald, then puts the m oney into pay envelopes along with a payslip.
The sealed envelopes and relevant clock cards are then used for payouts. Each w orker obtains
his m oney once he has identified himself and signed his clock card. Unclaimed wages are held
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for three weeks before being rebanked.
Required
Devise an audit program me to satisfy yourself that wages are properly computed, and that
accounting records are reliable and accurate.
3.5 Suggested solution
Tests of control on wages system:
Witnessing tests
Ensure that:
¨ all clock cards add up, and hash totals agree for each batch.
¨ rates of pay agree with authorised payroll records.
¨ any alterations to payroll records are made in writing and suitably authorised.
¨ clock cards agree with the personnel department list of full-time employees.
¨ all absentee reports sent to personnel departments are checked to ensure that no payment
is made in respect of that period.
¨ signed clock cards are examined as evidence of payment.
¨ all payrolls are countersigned by the accountant.
Re-performance tests
Check the following:
¨ calculation of hours w orked and gross pay.
¨ calculation of income tax deductions and net pay.
¨ casts and cross-casts.
¨ verification of coin and notes analysis per payout.
Substantive tests on wages system:
Vouch paid cheques with net total on the payroll.
Vouch journal entries for recording gross cost and liability accounts for tax deductions with
payroll.
Test cash payments with vouchers for tax deductions.
Vouch unclaimed wages to unclaimed wages account.
Review weekly wages totals and note any significant changes; enquire into these.
Check casts and cross-casts of relevant ledger accounts.
3.6 Starters and leavers test
The examiner has tested som e areas a number of times. A favourite area appears to be testing
employee existence where, apart from the more standard issues, students have been required
to discuss a starters and leavers test.
The purpose of this test is to ensure that employees are not paid before they start, nor after they
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Pick tw o payrolls a reasonable period apart (at least three months) and compare the names.
Some will be on both payrolls ie, continuous employment.
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Chapter 10 The audit of payroll
Some will be on the first but not on the second ie, leavers.
Some will be on the second but not on the first ie, starters.
Then ensure that the starters and leavers have been paid for the correct periods by checking
that their payroll and actual dates of joining/leaving correspond.
4 Using IT in the payroll system
4.1 Introduction
IT can be used very effectively in order to automate the payroll system. Payroll involves
compliance with complex law s and regulations. Payroll adm inistration also involves meeting
various deadlines. Failure to meet these deadlines can involve fines and penalties. Large
companies saw the benefit of computerisation many years ago. Small companies have
benefited from the development of inexpensive software packages that can be run on a
personal computer (PC) platform. Software providers such as Sage plc provide a cost effective
software system for smaller enterprises.
The software system generates the following:
¨ Payrolls at monthly or weekly intervals.
¨ Payslips.
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¨ Annual returns for compliance with tax regulations.
Handling large amounts of cash is risky because of the problems of loss caused by theft. M any
companies have used their PC system s to automate the payment of wages in cashless form.
The payroll software allows the user to collate a list of employees with the net pay and bank
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using the BACS system. This ensures that cleared funds are readily available to the employee
on the designated pay date. The risk of loss of cash is also avoided.
4.2 Internal control issues
The IT processing method outlined above depends upon a system of internal controls which
are in addition to those mentioned earlier in this chapter.
¨ Restriction of access to workstations
Only payroll staff should have access to the hardware devices and access should be
controlled by passwords or similar controls.
¨ Control over changes to rates of pay and conditions
Staff should document all authorisations for changes in pay rates, payments of bonuses or
overtime as appropriate.
¨ Host to terminal identifiers
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identify the workstation as a valid transmitter of data.
¨ Encryption systems
All data transfers over public data highways should be protected by encryption system s.
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means.
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Finally, the outputs produced by the software system must meet the standards of the
Government Agencies concerned with the collection of tax contributions. M any of these
bodies now capture data using optical character recognition (OCR) techniques and have
been know n to refuse data that was, for some reason, rejected by their data capture
devices.
Practice question 1 (The answer is in the final chapter of this book)
W ages and salaries
The following questions have been selected from an internal control questionnaire for wages
and salaries.
Yes No
Does an appropriate official authorise rates of pay?
Are written notices required for em ploying and terminating employment?
Are formal records such as time cards used for time keeping?
Does anyone verify rates of pay, overtime hours and com putations of gross
pay before wage payments are made?
Does the accounting system ensure the proper recording of payroll costs in
the financial records?
Required
(a) Describe the internal control objective being fulfilled if the controls set out in the above
questions are in effect. (5 marks)
(b) Describe the audit tests which w ould test the effectiveness of each control and help
determine any potential material error. (10 marks)
(c) Identify the potential consequences for the company if the above controls were not in
place. (5 marks)
You may answer in colum nar form under the follow ing headings.
¨ ICQ question
¨ Internal control objective
¨ Audit tests
¨ Potential consequences
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Approach to the question
This is quite an old question and the format is unlikely to come up again. It is, however, good
practice for identifying key controls, relevant tests and the consequences if the controls do not
exist.
Practice question 2 (The answer is in the final chapter of this book)
Bingham
You have been asked by the senior in charge of the audit of Bingham M anufacturing Lim ited to
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Chapter 10 The audit of payroll
system. Employees of Bingham M anufacturing are paid on the basis of hours w orked and
quantities produced. The hours w orked are recorded on clock cards and the quantities
produced are confirmed by the supervisor. W ages are paid in cash each Friday for the previous
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separate from the wages department.
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wages system. This has allowed an employee in the wages department to perpetrate a fraud by
creating fictitious employees on the payroll and misappropriating the wages. Some of your
audit tests have been designed to detect w hether this fraud is still taking place.
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com mence employment or after they have left.
Required
(a) State the principal controls you w ould expect to exist in a wages system and explain
their purpose. (5 marks)
(b) Assum ing you decide not to attend the wages payout, suggest other techniques you
can use to check the existence of employees. (5 marks)
(c) Describe how you will carry out a starters and leavers test. (4 marks)
(d) Describe the analytical review techniques you can use in auditing the wages system.
This should include suggesting any ratios you would calculate. (6 marks)
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Approach to the question
The main problem here is lack of knowledge of a starters and leavers test.
Also, once again, time allocation between question parts is vital as well as keeping within time
for the question as a whole.
Practice question 3 (The answer is in the final chapter of this book)
Burnden Limited
Burnden Lim ited manufactures a range of components and spare parts for the textile industry.
The company employs 150 hourly-paid w orkers and 20 administrative staff, including the
three directors of the company. There are tw o wages clerks w ho deal with the weekly payroll
of the hourly-paid employees. They are directly responsible to the assistant accountant.
The company uses a computerised time clock at the factory gate to record the hours w orked by
the production employees. Each employee has a card with a magnetic strip with his ow n
identification code on it. This card is inserted in the com puterised time clock on the arrival and
departure of each worker, whereupon it records on the card the hours worked. The cards are
collected weekly by the wages clerks, w ho simply insert them individually into the
microcomputer, which then reads them and prepares the payroll. The production manager
keeps the unused clock cards in a locked cabinet in his office.
W ages are paid one week in arrears. The wages clerks compile the payroll by means of the
microcomputer system, and pass the payroll to the assistant accountant w ho scrutinises it
before drawing the wages cheque, w hich is passed to one of the directors for signature. Any
pay increases are negotiated locally by representatives of the employees. If any alterations are
required to the standing data on the microcomputer, then the wages clerks amend the records.
For example, w hen a wage increase has been negotiated, the rates of pay are changed by the
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wages clerks.
The cheque is drawn to cover net wages and the cashier makes arrangements for collecting the
cash from the bank. The wages clerks then make up the wages envelopes. W henever there is
assistance required on preparing wages, the assistant accountant helps the wages clerks. The
payment of wages is carried out by the production manager w ho returns any unclaimed wages
to the wages clerks who keep them in a locked filing cabinet. Each employee is expected to
collect his unclaimed wages personally.
New production employees are notified to the wages department verbally by the production
manager and when employees leave, a note to that effect is sent to the wages department by
the production manager. All statutory deductions are paid to the appropriate authorities by the
chief accountant.
Administrative staff are paid monthly by credit transfer to their bank account. The payroll is
prepared by the assistant accountant and the bank credit transfers are authorised by a director.
Any increases in the salaries of the administrative staff are notified to the assistant accountant
verbally by the chief accountant. The employment of administrative staff is authorised by the
financial director.
You have recently been appointed the auditor of Burnden Lim ited for the year ended 31
December 20X8 and have just started your interim audit. You are about to com mence your
audit evaluation and testing of the wages system.
Required
(a) Describe the weaknesses in the present wages and salaries system, and suggest, w ith
reasons, improvements w hich could be made to the system (assuming that the only
controls are those set out above). (12 marks)
(b) List the audit tests you w ould perform to satisfy yourself that wages and salaries were
completely and accurately recorded. (8 marks)
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Approach to the question
This is a relatively standard weaknesses and recommendations question. The split page
approach could again be used.
You should avoid the temptation to list all potential weaknesses in any wages system by
confining yourself to those given in the question scenario.
5 Summary
Tests of control can be devised to cover all stages of the payroll system.
¨ Completion of clock cards.
¨ Calculation of gross pay, deductions and net pay.
¨ Treatment of payroll amendments (eg starters and leavers).
¨ Calculation of final payroll.
¨ Payments to employees, tax authorities, etc.
¨ Recording of payroll details.
Substantive testing, including analytical review, may also be relevant to the audit of payroll
costs and liabilities.
As with the sales and purchases system s, when the auditor finds weaknesses in the payroll
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Chapter 10 The audit of payroll
system (eg an internal control not functioning effectively) he should report that fact to
management in accordance with ISA 260.
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