Chapter 16 Audit of the Payroll and Personnel

Chapter 16: Audit of the Payroll and Personnel Cycle 16 -1 Copyright © 2007 Pearson Education Canada

Chapter 16 objectives w Explain the importance of the payroll and personnel cycle w Describe the functions and records in this cycle w List typical audit tests of controls by assertion w Identify misstatements that payroll analytical review could detect w Discuss the audit of liability accounts in this cycle 2 Copyright © 2007 Pearson Education Canada

Payroll and personnel cycle w Importance of this cycle: – Salaries, wages and employee benefits are a major expense in most organizations – Labour is an important component in the valuation of inventory in manufacturing and construction companies – Large amounts of company resources can be wasted through inefficiency or stolen through fraud 3 Copyright © 2007 Pearson Education Canada

Payroll and personnel functions (Table 16 -1) w Personnel hiring and evaluation w Master file changes (semi-permanent information) w Timekeeping and payroll preparation w Payment of payroll w Employee withholdings and benefit remittances 4 Copyright © 2007 Pearson Education Canada

Methodology for designing tests of controls for the payroll and personnel cycle 5 Copyright © 2007 Pearson Education Canada

Practice problem 16 -15 (p. 493) w Identify controls that could prevent misstatements w Identify audit tests that could help detect misstatements 6 Copyright © 2007 Pearson Education Canada

Payroll tests of control by assertion Transaction-related Key internal audit objective control Common test of control Occurrence: Recorded payroll payments are for work actually performed by existing employees Examine printouts of rejected transactions, or determine whether invalid entries are rejected at point of entry. Only employees existing in the computer data files are accepted when they are entered. 7 Copyright © 2007 Pearson Education Canada

Payroll tests of control by assertion Transactionrelated audit objective Key internal control Common test of control Completeness: Existing payroll transactions are recorded. Payroll cheques are prenumbered and accounted for. Account for a sequence of payroll cheques, or conduct sequence gap tests. 8 Copyright © 2007 Pearson Education Canada

Payroll tests of control by assertion Transaction-related Key internal audit objective control Common test of control Accuracy: Authorization of Compare pay rates Recorded payroll wage rate, salary, with union transactions are for or commission rate. contract, approval the amount of time by board of actually worked directors, or other and at the proper source. pay rate. 9 Copyright © 2007 Pearson Education Canada

Payroll tests of control by assertion Transactionrelated audit objective Key internal control Classification: Adequate chart Payroll of accounts. transactions are properly classified. Common test of control Review chart of accounts. 10 Copyright © 2007 Pearson Education Canada

Payroll tests of control by assertion Transaction-related Key internal audit objective control Common test of control Timing: Payroll transactions are recorded on the correct dates. Compare date of recorded cheque (or automatic withdrawal) in the payroll journal with the date on cancelled cheques or time records. Procedures require recording transactions as soon as possible after the payroll is paid. 11 Copyright © 2007 Pearson Education Canada

Payroll tests of control by assertion Transaction-related audit objective Key internal control Common test of control Posting and summarization: Payroll transactions are properly included in the payroll master file and transactions files; they are properly summarized. Comparison of payroll master file with payroll general ledger totals. Test clerical accuracy by footing the payroll journal and tracing postings to general ledger and the payroll master file. 12 Copyright © 2007 Pearson Education Canada

Relationship between payroll and inventory valuation w 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: – Overstatement of overheads – Incorrect allocation of labour to direct costs 13 Copyright © 2007 Pearson Education Canada

Tests for nonexistent payroll w Audit procedures for payroll are extended when internal controls are inadequate w “Nonexistent” employees could arise in two ways: – Employees who are no longer working for the company – Fictitious employees 14 Copyright © 2007 Pearson Education Canada

Examples of testing for employees who no longer work for the company w Comparison of cancelled cheque data to source documents such as authorized time cards w Review of cheque endorsements for unusual signatures (e. g. a company name or absence of a signature) w The above tests are not practical for clients with direct deposit payments: instead, the auditor could use generalized audit software to compare bank account numbers on deposits (e. g. looking for duplicates) 15 Copyright © 2007 Pearson Education Canada

Methodology for designing tests of details of balances for payroll liabilities 16 Copyright © 2007 Pearson Education Canada

Payroll liabilities – materiality considerations w Most organizations have a large number of transactions involving payroll, often involving large amounts w However, balance sheet accounts (liabilities) are normally insignificant, except for amounts charged to inventory 17 Copyright © 2007 Pearson Education Canada

Payroll liabilities – inherent risk considerations w Inherent risk of fraud exists because most transactions involve cash w Occurrence objective is often considered most important w For manufacturing companies with significant labour component to inventory, need to consider potential for misclassification between payroll and inventory categories 18 Copyright © 2007 Pearson Education Canada

Payroll liabilities – control risk considerations w Internal controls for payroll transactions and withholdings are normally good w Many companies use outside service centres for processing payroll: need to consider controls at these locations 19 Copyright © 2007 Pearson Education Canada

Practice problem 16 -21 (p. 495) w Identification of expectations with respect to analytical review w Audit procedures by audit assertion 20 Copyright © 2007 Pearson Education Canada

Analytical procedures (Table 16 -3) Analytical procedure Possible misstatement detected in Compare payroll expense Payroll expense accounts account balance with previous years (adjusted for pay rate increases and increases in volume) 21 Copyright © 2007 Pearson Education Canada

Analytical procedures (Table 16 -3) (cont’d) Analytical procedure Possible misstatement detected Compare direct labour as Direct labour a percentage of sales with previous years Compare commission expense as a percentage of sales with previous years Commission expense 22 Copyright © 2007 Pearson Education Canada

Analytical procedures (Table 16 -3) (cont’d) Analytical procedure Possible misstatement detected Compare payroll benefits expense as a percentage of salaries and wages with previous years Compare accrued payroll benefits accounts with previous years Payroll benefits expense and payroll benefits liability Accrued payroll benefits and payroll benefits expense 23 Copyright © 2007 Pearson Education Canada

Tests of detail for amounts withheld from employees’ pay w Compare the balance with the payroll journal, the withholding remittance form of the subsequent period, and the subsequent period cash disbursement w If internal controls are operating effectively, this addresses cutoff and accuracy 24 Copyright © 2007 Pearson Education Canada

Tests of detail for accrued salaries and wages w Correct cutoff and valuation depends on company policies (should be followed consistently from year to year) w Test for cutoff and valuation by evaluating the reasonableness of the method and then recalculating the client’s accrual 25 Copyright © 2007 Pearson Education Canada

Tests of detail for accrued commissions w Accrual may be difficult to verify because there may be different types of agreements with salespeople and other commissioned employees w Determine the nature of the commission agreement and then test the calculations based on the agreement w Compare the method of accruing to prior years 26 Copyright © 2007 Pearson Education Canada

Tests of detail for accrued bonuses w Exclusion of year end accrued bonuses may be highly material w Compare the amount to authorizations in the minutes of the board of directors 27 Copyright © 2007 Pearson Education Canada

Tests of detail for accrued vacation pay, sick pay, or other benefits w Determine the policy, or procedures used in the prior year, or legal requirements (such as for pension and unemployment insurance) w Recalculate the recorded amounts in accordance with the method required 28 Copyright © 2007 Pearson Education Canada

Practice problem 16 -22 (p. 495) w Audit procedures for a complex vacation pay accrual w Use of generalized audit software to assist with the process 29 Copyright © 2007 Pearson Education Canada

Tests of detail for expense accounts w Normally, little additional testing of the income statement accounts is done beyond the analytical procedures, tests of controls, or related tests of liabilities 30 Copyright © 2007 Pearson Education Canada