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AUDITING THE PAYROLL CYCLE

An entitys personnel services cycle involves the events and activities
that pertain to executive and employee compensation. The types of
compensation include salaries, hourly and incentive wages,
commissions, bonuses and employee benefits. The major class of
transaction in this cycle is payroll transactions.

NOTE:
2 major types of transactions processed through payroll cycle are:
Payments to employees for services rendered.
Accrual and payment of payroll-related liabilities arising from
employees services.
Accounts affected by these transactions include: salaries and wages;
payroll tax expenses; direct labour; manufacturing overhead (indirect
labour); accrued wages payable; liabilities for amounts witheld from
employees; accrued payroll taxes payable, payroll bank payable etc.
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AUDITING THE PAYROLL CYCLE


Discussion on internal control focuses on payments to employees
including description of how such transactions are processed and
key internal control procedures that should be present to ensure
that no material misstatements occur.

NOTE:
Students are reminded the use of advanced EDP system may
affect the form of documents and the auditors approach to testing
the payroll cycle.
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AUDITING THE PAYROLL CYCLE


Example of documents + records Involved
1. Personnel records (including history, performance evaluation,
salary authorizations)
2. Other deduction authorization forms (Eg: insurance, tax, KWSP)
3. Time card (used to record hours work by employee. Eg: fill in or
time clock)
4. Payroll check (indicates amount paid for services (Eg: gross pay
less any deductions)
5. Payroll register/ journal (summary of all payroll checks issued to
employees)
6. Payroll master file; Payroll master file changes report; Periodic
payroll reports
7. Tax reports and forms
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AUDITING THE PAYROLL CYCLE


Functions in payroll cycle


Personnel Authorization of hiring, firing, wage rate and salary adjustments,
salaries, payroll deductions.
Supervision Review and approval of employees attendance and time
information; monitoring scheduling, productivity, payroll cost
variances.
Timekeeping Processing employees attendance, time information and coding of
account distribution.
Payroll
processing
Computation of gross pay; deductions; net pay, recording and
summarization of payments and verification of account distributions
Disbursement Payment of employees compensation and benefits.
General ledger Proper accumulation; classification; summarization of payroll in
general ledger.
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AUDITING THE PAYROLL CYCLE


Key Segregation of duties + Possible Errors or Irregularities


Segregation of Duties Possible Errors or Irregularities
Supervision function should
be segregated from
personnel records and
payroll processing
functions.
If only one person is responsible, possible fictitious
employees to appear in payroll records; unauthorized
payment to existing or fictitious employees.
Disbursement function
must be segregated from
personnel records,
supervision, payroll
processing functions.
If only one person is responsible for disbursement +
hiring and firing of employees, possible for
unauthorized payroll checks to be issued.
Payroll processing function
should be segregated from
general ledger function.
If only one person is responsible for processing payroll
transactions + general ledger, possible for him to
conceal any defalcation that may be detected by
independent review of accounting entries made to
general ledger.
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AUDITING THE PAYROLL CYCLE


Below are summary of internal control objectives; possible
misstatements; key control procedures for each internal control
objectives; examples of test of controls that can be used for testing
effectiveness of ICS.

Objective Possible Misstatements Control Procedure Test of
Control
Validity Payment made to fictitious
employee; terminated
employees; valid
employees who have not
worked.
Segregation of duties.
Adequate personnel
files.
Initiation of changes in
employment status
reported to HRM.
Time clocks used to
record time.
Time cards approved
by supervisors.
Only employees with
valid employee
numbers paid.
Observation
+ evaluation
of proper
segregation
of duties.
Review of
personnel
files
Review
clients
procedures
for changing
employees
records.
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AUDITING THE PAYROLL CYCLE


Below are summary of internal control objectives; possible
misstatements; key control procedures for each internal control
objectives; examples of test of controls that can be used for testing
effectiveness of ICS.

Objective Possible Misstatements Control Procedure Test of Control
Completen
ess
Employee services
provided but not
recorded.
Pre-numbered time
cards accounted for
by client personnel.
Check of numerical
sequence of time
cards.
Timeliness Payroll transactions
recorded in the wrong
period.
Notices of additions;
terminations; changes
to salaries,
deductions, reported
promptly to payroll
processing function.
Payroll liabilities
recorded soon after
they are incurred.
Review clients
procedures over
changes to master
payroll file.
Review of
procedures for
recording payroll
liabilities.

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AUDITING THE PAYROLL CYCLE


Below are summary of internal control objectives; possible
misstatements; key control procedures for each internal control
objectives; examples of test of controls that can be used for testing
effectiveness of ICS.

Objective Possible Misstatements Control Procedure Test of Control
Authorizatio
n
Unauthorized payments
made to employees.
Payment made to
employees at rate in
excess of authorized
amount or for unauthorized
employee benefits.
Authorization
procedures for:
hiring + firing
Time worked
Wage; salaries;
and commission
rates
Benefits
Issuance of
payroll cheque
Review
authorization
procedures for
each point of
authorization in the
payroll cycle.
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AUDITING THE PAYROLL CYCLE


Below are summary of internal control objectives; possible
misstatements; key control procedures for each internal control
objectives; examples of test of controls that can be used for testing
effectiveness of ICS.

Objective Possible Misstatements Control Procedure Test of Control
Valuation Employee compensation
and payroll deductions are
computed incorrectly.
Verification of
payroll amounts +
benefit
calculations.
Review payroll
register for unusual
amounts.
Use of payroll
budgets with
review by
department
supervisors.
Review clients
verification
procedures.
If EDP-prepared,
use CAAT to test
computer
programme logic
for calculating
amount.
Review clients
budgeting
procedures.
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AUDITING THE PAYROLL CYCLE


Below are summary of internal control objectives; possible
misstatements; key control procedures for each internal control
objectives; examples of test of controls that can be used for testing
effectiveness of ICS.

Objective Possible Misstatements Control Procedure Test of Control
Classificati
on
Payroll transactions not
properly classified.
Chart of accounts
Independent
approval and
review of accounts
charged for
payroll.
Use of payroll
budgets with
review by
department
supervisors.
Review charts of
accounts
Review
procedures for
classifying payroll
costs
Review of clients
budgeting
procedures.
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AUDITING THE PAYROLL CYCLE


Below are summary of internal control objectives; possible
misstatements; key control procedures for each internal control
objectives; examples of test of controls that can be used for testing
effectiveness of ICS.

Objective Possible Misstatements Control Procedure Test of Control
Posting and
summarizati
on
Payroll transactions not
posted correctly to the
payroll journal.
Amounts from payroll
journal not posted
correctly to general
ledger.
Changes to
master payroll file
verified through
before + after
reports.
Payroll master file
(payroll register)
reconciled to
general ledger
payroll accounts.
Examination of
reconciliation of
before + after
reports to payroll
master file.
Review of
reconciliation of
payroll master file
to general ledger
payroll accounts.
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AUDITING THE PAYROLL CYCLE


Substantive tests of transactions is done to detect monetary
misstatements in the individual transactions processed through the
payroll cycle. Normally conducted in conjunction with test of
controls. Examples:

Objective Substantive test of transactions
Validity

Test of a sample of payroll cheques for the presence of
an authorized time card.
Completeness Tracing of a sample of time cards to the payroll register.
Accuracy Test of postings to the payroll register for a sample of
payroll cheques.
Valuation

Re-computation of mathematical accuracy of a sample of
payroll cheques. CAATs may be used to test logic of
computer programmes for proper calculation of gross
pay; deductions; net pay.
Classification Verification of classification of charges for a sample of
payroll cheques.
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AUDITING THE PAYROLL CYCLE


Tests of Accounts Balances Payroll Expense Account + Accrued
Payroll Liabilities

Objective Tests of Account Balances
Validity

Vouching of selected amounts from the account analysis
schedules for the accruals to supporting documentation (corporate
benefit policies; payroll tax returns etc)
Completenes
s
Search for unrecorded liabilities.
Cut-off Examination of supporting documents for accrual in order to
determine proper period for recording expense.
Ownership

Review of supporting documentation to determine that the entity is
liable for the liability.
Accuracy Obtaining of account analysis schedule for accrued payroll
liabilities; footing of schedules; agreeing of total to general ledger.
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AUDITING THE PAYROLL CYCLE


Tests of Accounts Balances Payroll Expense Account + Accrued
Payroll Liabilities

Objective Tests of Account Balances
Valuation

Performance of reasonableness tests on accrued payroll
expenses.
Comparison of amounts accrued to supporting documentation
such as payroll tax returns.
Classification Review of accrued payroll liabilities for proper classification
between short-term and long-term liabilities.
Disclosure Inquiry about accruals to ensure that they are properly disclosed.
Review of benefit contracts for proper disclosure of pension and
post retirement benefits.