LECTURE- 7

AUDIT OF THE PAYROLL AND

PERSONNEL CYCLE

DR. EBRAHIM ASSAKAF

LECTURE -07 LEARNING OBJECTIVES

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 substantive analytical procedures and tests
of details of accounts in the payroll and personnel cycle.
 OBJECTIVE 1
Identify the accounts and
transactions in the payroll and
personnel cycle.
 ACCOUNTS AND TRANSACTIONS IN THE PAYROLL
AND PERSONNEL CYCLE
The payroll and personnel cycle involves the employment
and payment of all employees.
The main differences between the payroll and personnel
cycle and other cycles include:
• There is only one class of transactions for payroll.
• Transactions are generally far more significant than related
balance sheet accounts
• Internal controls over payroll are effective for almost all
companies, even small ones.
Typical accounts in the payroll and personnel cycle are
shown in Figure 20-1.
 OBJECTIVE 2
Describe the business functions and
the related documents and
records in the payroll and personnel
cycle.
 BUSINESS FUNCTIONS IN THE CYCLE AND RELATED
DOCUMENTS AND RECORDS

The payroll and personnel cycle

- Begins with hiring employees
- Ends with paying them for the services they performed
- Includes payment to the government and other institutions for
withheld and accrued payroll taxes and benefits.
Human Resources: This department is an independent source for hiring
qualified personnel and a source for verification of wage information,
including deletions from payroll and changes in wages and deductions.
• Human resource records include date of employment, background checks,
rates of pay, authorized deductions, evaluations, and terminations.
 BUSINESS FUNCTIONS IN THE CYCLE AND RELATED
DOCUMENTS AND RECORDS (CONT.)

Timekeeping and Payroll Preparation: These functions are important

in the audit of payroll because they directly affect payroll expense.
The following documents are involved in timekeeping and payroll:
• Time Record: Document indicating the time the hourly employee started
and stopped working.
• Job Time Ticket: Form indicating which jobs employees worked on during a
given time period.
• Payroll Transaction File: Computer-generated file including all payroll
transactions processed during a given time period.
• Payroll Journal or Listing: Generated from the payroll transaction file
showing payroll details for each employee.
• Payroll Master File: Record of every payroll check, including gross pay,
deductions, and net pay for each employee.
 BUSINESS FUNCTIONS IN THE CYCLE AND
RELATED DOCUMENTS AND RECORDS (CONT.)
Payment of Payroll: The approval and distribution of payroll must be carefully
controlled to prevent theft. To increase control, payroll disbursements are
usually processed separately from other disbursements.
• Payment of payroll may be made by check, but more often are deposited directly
into employees’ bank accounts.
Payroll Bank Account Reconciliation: An imprest payroll account is a separate
payroll account in which a small balance is maintained and the exact amount
of payroll is transferred immediately before distribution of payroll.
Preparation of Payroll Tax Returns and Payment of Taxes: Federal and state
laws require timely preparation and payment of payroll taxes.
 OBJECTIVE 3
Understand internal control and
design and perform tests of
controls and substantive tests of
transactions for the payroll and
personnel cycle.
METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS

The methodology for designing tests of controls and substantive tests of

transactions is the same as for the sales and collection cycle:
• Understand internal control
• Assess planned control risk
• Determine the extent of testing of controls
• Design tests of controls and substantive tests of transactions to
meet transaction-related audit objectives
Types of audit tests for the payroll and personnel cycle are shown in
Figure 20-2.
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS (CONT.)

Understand Internal Control and Assess Control Risk—Payroll

and Personnel Cycle:
Internal control for payroll is normally highly structured and
well controlled. As a result, control risk is often assessed as low
for this cycle.
Key controls in the payroll and personnel cycle are summarized
in Table 20-2 on page 668.
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS (CONT.)

Design Tests of Controls and Substantive Tests of Transactions—

Payroll and Personnel Cycle:
Tests of controls and substantive tests of transactions in this cycle
are usually not extensive for these reasons:
1. Employees are likely to complain to management if they are
underpaid.
2. All payroll transactions are typically uniform and uncomplicated.
3. Payroll transactions are subject to audit by federal and state
governments for income tax withholding, Social Security, and
unemployment taxes.
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS (CONT.)
Key internal controls for payroll and personnel cycle for assessing
control risk:
• Adequate Separation of Duties: Payroll function should be kept
independent of the human resources department.
• Proper Authorization: Human resources should authorize additions and
deletions to payroll.
• Adequate Documents and Records: What is adequate depends on the
nature of the company’s payroll.
• Physical Control over Assets and Records: Access to unsigned payroll
checks should be restricted, as should access to direct deposit
information.
• Independent Checks on Performance: A member of management or other
responsible employee should review payroll for obvious misstatements.
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS (CONT.)
Payroll Tax Forms and Payments: The auditor should review the
preparation of at least one of each type of payroll tax form during the
understanding of internal control phase of the audit.
Timely Payment of Payroll Taxes and Other Withholdings: The auditor
should also test whether the client has fulfilled its legal obligation in
submitting payments for all withholdings on a timely basis.
Inventory and Fraudulent Payroll Considerations: If payroll affects the
valuation of inventory, the auditor often extends payroll audit
procedures. This is common for manufacturing and construction
companies.
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS (CONT.)
Inventory and Fraudulent Payroll Considerations (cont):
Relationship Between Payroll and Inventory Valuation: When
payroll is a significant portion of inventory, the improper classification
of payroll can materially affect asset valuation for work in process and
finished goods, or construction in process. Auditors should emphasize
internal control over proper classification of payroll transactions.
Fraudulent Payroll Considerations:
• Test for nonexistent employees
• Test for fraudulent hours
• Fraudulent expense reports
 OBJECTIVE 4
Design and perform substantive
analytical procedures and tests
of details of accounts in the payroll
and personnel cycle.
 METHODOLOGY FOR DESIGNING SUBSTANTIVE
ANALYTICAL PROCEDURES AND TESTS OF
DETAILS OF BALANCES
The methodology for designing substantive analytical procedures and
tests of details of balances is the same as for the sales and collection
cycle:
• Identify Client Business Risks Affecting Payroll (Phase I)
• Set Performance Materiality and Assess Inherent Risk (Phase I)
• Assess Control Risk and Perform Related Tests (Phases I and II)
• Perform Substantive Analytical Procedures (Phase II)
Substantive analytical procedures for the balance sheet and income
statement accounts in the payroll and personnel cycle are illustrated in
Table 20-3.
 METHODOLOGY FOR DESIGNING SUBSTANTIVE
ANALYTICAL PROCEDURES AND TESTS OF
DETAILS OF BALANCES (CONT.)
Design and Perform Tests of Details of Balances for Liability and
Expense Accounts (Phase II): The audit of liability accounts
associated with payroll, often termed accrued payroll expenses, is
ordinarily straightforward if internal controls are operating
effectively.
Two major balance-related audit objectives in testing payroll
liabilities:
1. Accruals in the trial balance are stated at the correct amounts
(Accuracy).
2. Transactions in the payroll and personnel cycle are recorded in the
proper period (Cutoff).
 METHODOLOGY FOR DESIGNING SUBSTANTIVE
ANALYTICAL PROCEDURES AND TESTS OF
DETAILS OF BALANCES (CONT.)

Design and Perform Tests of Details of Balances for Liability and

Expense Accounts (Phase II) (cont.):
The major liability accounts in the payroll and personnel cycle:
• Amounts Withheld from Employees’ Pay
• Accrued Salaries and Wages
• Accrued Commissions
• Accrued Bonuses
• Accrued Vacation Pay, Sick Pay, or Other Benefits
• Accrued Payroll Taxes
 METHODOLOGY FOR DESIGNING SUBSTANTIVE
ANALYTICAL PROCEDURES AND TESTS OF
DETAILS OF BALANCES (CONT.)

Design and Perform Tests of Details of Balances for Liability and

Expense Accounts (Phase II) (cont.):
The major expense accounts in the payroll and personnel cycle:
• Officers’ Compensation
• Commissions
• Payroll Tax Expense
• Total Payroll
• Contract Labor
Presentation and Disclosure Objectives: Usually not extensive, though
some complex transactions, such as stock options and executive officer
compensation plans, may require footnote disclosure.