Manila * Cavite * Laguna * Cebu * Cagayan De Oro * Davao
Since 1977
AT.3512
Specific Audit Procedures (Part 2)
Personnel/Payroll Cycle
Business Process
1. A separate personnel department (e.g. Human resource
or HR department) maintains complete, up-to-date
records for each employee. Included in such records is
information on level of education, basic payroll
information, experience, and authorization for any
changes in pay rates.
2. Timekeeping and recording
a. The firm’s factory direct labor personnel use a
time clock (or biometric machine) to time in
each and out each working day or shift. Their
employee clock card or record will show the
total hours worked each day.
b. These direct labor personnel also fill out job
time tickets for each job they work on each
day. At the end of each week their supervisor
compares job time tickets with employee clock
cards or records that have already been signed
by the employees.
c. Salaried and other employees fill out weekly
time summaries indicating hours worked.
3. The payroll accounting department will use the
information from timekeeping (for the hours worked by
the employees) and the records from the human
resource department (for the authorized rates of
employees) for the proper computation of the payroll
for the period.
4. Payroll accounting department will prepare the payroll
journal and the unsigned payroll checks (or debit
advice).
5. The checks are then signed by the treasurer and
distributed by an independent paymaster who has no
other payroll functions (or the debit advice is sent to the
bank maintaining the payroll account of the entity).
6. The summary payroll entry is then posted to the general
ledger in the accounting department.
• The internal auditing department periodically compares
the payroll department’s file on each employee with that
in the personnel department’s file to determine that no
unauthorized changes in payroll records have been
made.
• Employees with cash handling and recordkeeping
responsibilities should be covered by fidelity bonds, a
form of insurance which protects an employer against
losses caused by dishonest employees (fidelity bonds
also serve as a control when new employees are hired
since the insurer will typically perform a background
check on prospective employees).
Typical Personnel and Payroll Controls
• Segregate: Timekeeping; Payroll Preparation;
Personnel; Paycheck Distribution
• Time clocks used where possible
• Job time tickets reconciled to time clock cards
• Time clock cards approved by supervisors (overtime
and regular hours)
• Treasurer signs paychecks
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SOLIMAN/UY/AGUILA/RICAFRENTE
October 2023
• Unclaimed paychecks controlled by someone otherwise
independent of the payroll function (locked up and
eventually destroyed if not claimed). In cases in which
employees are paid cash (as opposed to checks)
unclaimed pay should be deposited into a special bank
account.
• Personnel department promptly sends termination
notices to the payroll department.
***
Answer question nos. 1 to 7:
1. Most companies, with the exception of small ones, have
effective controls over the payroll cycle.
Auditors typically test details of account balances in the
audit of payroll.
a. True, False
b. False, True
c. True, True
d. False, False
2. Which of the following departments is most likely
responsible for pay rate changes and changes in
deductible amounts for employees?
a. General Accounting
b. Human Resources
c. Treasury
d. Controller
3. An auditor is vouching a sample of hourly employees
from the payroll master file to approved time clock or
time sheet data in order to provide evidence that:
a. employees work the number of hours for which they
are paid.
b. payments are made at the contractual rate.
c. product cost information is accurate.
d. segregation of duties is present between the payroll
function and the payment function for cash
disbursements.
4. Although significant client business risks affecting
payroll are unlikely for most companies, an area that
would have the most business risk would be:
a. payment of hourly employees.
b. payment of salaried employees.
c. payments to employees for stock options and bonus
plans.
d. payments to employees who have direct deposit of
their payroll checks.
5. Which of the following is a substantive test of
transactions?
a. Review personnel policies.
b. Account for a sequence of payroll checks.
c. Reconcile the disbursements in the payroll journal
with the disbursements on the payroll bank
statement.
d. Examine printouts of transactions rejected by the
computer as having invalid employee IDs.
6. When labor is a material factor in inventory valuation,
the auditor should place special emphasis on testing the
internal controls concerning:
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EXCEL PROFESSIONAL SERVICES, INC.
a. fictitious employees.
b. authorization of wage rates.
c. proper classification of payroll transactions.
d. completeness of recorded transactions.
7. In auditing payroll, which of the following procedures
will normally require the least amount of auditor time
under normal circumstances?
a. Tests of controls
b. Substantive tests of transactions
c. Analytical procedures
d. Tests of details of balances
***
Inventory/Production Cycle (or Inventory and
Warehousing Cycle)
Business Process
Inventories and production fit under the first two
cycles. However, due to the unique nature of inventories,
separate coverage is warranted. Two cases will be
considered here: a nonmanufacturing entity and a
manufacturing entity.
Trading/Retail
1. A retailer is an entity who purchases products from a
wholesaler and then sells the goods to the public.
2. As in the acquisitions and payments cycle, purchase
requisitions and purchase orders are used and
controlled to purchase the inventory items that are of a
“finished goods” nature.
3. Likewise, when ordered goods are received, a receiving
report is filled out by personnel in the receiving
department.
4. Perpetual inventory records are maintained for large
amount items. The entity has calculated economic
reorder points and quantities. When quantities on hand
reach the reorder point, a purchase requisition is
prepared and sent to the purchasing department that
places the order.
5. At the end of the year, a physical inventory is taken
during which items on hand are counted. In the case of
items for which perpetual records exist, the perpetuals
are corrected for any errors—large errors should be
explained. For items without perpetual records, the
total on hand is used to adjust the cost of goods sold at
year-end (Beginning inventory + Purchases – Ending
inventory = Cost of goods sold).
Manufacturing
1. The case of the manufacturing entity is somewhat more
involved.
a. There are three types of inventory accounts
involved.
b. First, supplies and raw materials are purchased
from suppliers in much the same manner as
described above for the nonmanufacturing
firm.
c. Second, work in process is the combination of
raw materials, direct labor, and factory
overhead.
d. Third, when the items in process have been
completed, they are inspected and transferred
at their cost (typically standard cost) to finished
goods.
e. Finally, when the goods are sold, the entry is to
credit finished goods and to debit cost of goods
sold.
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2. Work in process is controlled through use of a standard
cost system as described in cost accounting courses.
a. Raw materials are those that typically can be
directly identified with the product (e.g.,
transistors in a radio).
b. Direct labor is also identified with the product
(e.g., assembly line labor).
c. Overhead includes materials not specifically
identified with the product (amount of glue
used) and supervisory, non-administrative
labor.
d. Variances may be calculated for all three
components—raw materials, direct labor, and
overhead. Variances will be allocated between
cost of goods sold and ending inventory
(finished goods and work in process) based on
the proportion of items sold and those
remaining in inventory, although any
“abnormal” waste will be directly
expensed. This allocation is necessary because
generally accepted accounting principles
require that the entity report inventory based
on the lower of actual cost and net realizable
value—not standard cost.
Typical Inventory and Production Controls
• Perpetual inventory records for large items
• Prenumbered receiving reports prepared when
inventory received; receiving reports accounted for
• Adequate standard cost system to cost inventory items
• Physical controls against theft
• Written inventory requisitions used
• Proper authorization of purchases and use of
prenumbered purchase orders
***
Answer question nos. 8 to 14:
8. Inventory is a complex area to audit for all but which of
the following reasons?
a. Inventory is often in different locations.
b. There are several acceptable valuation methods and
some entities use different methods for different
types of inventory.
c. Inventory is often the largest account on the
balance sheet.
d. Inventory valuation includes few estimates.
9. Which of the following controls would be appropriate
regarding the release of materials from a stockroom?
a. Production employees request materials be
delivered to their work areas as they need them.
b. Stockroom employees deliver materials to work
areas throughout the day to maintain acceptable
levels of safety stock — no written records are
maintained.
c. Production employees submit approved requisition
forms to the stockroom for materials needed.
d. Production employer in need of materials should
personally pick up needed materials from the
stockroom.
10. Which one of the following analytical procedures would
be most useful in alerting the auditor to the possibility
of obsolete inventory?
a. Compare gross margin percentage with previous
years'.
b. Compare unit costs of inventory with previous
years'.
c. Compare inventory turnover ratio with previous
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EXCEL PROFESSIONAL SERVICES, INC.

years'. • Debt and equity transactions are properly approved by

d. Compare current year manufacturing costs with the company’s board of directors.
previous years'. • An independent trustee handles bond transactions.
• A stock registrar and a stock transfer agent handle
11. From which of the following evidence-gathering audit
capital stock transactions.
procedures would an auditor obtain most assurance
• Canceled share certificates are defaced (cancelled) to
concerning the existence of inventories?
prevent their reissuance.
a. Observation of physical inventory counts
b. Written inventory representations from
***
management
Answer question nos. 15 to 19:
c. Confirmation of inventories in a public warehouse
d. Auditor's recomputation of inventory extensions
15. Which of the following statements is correct regarding
the capital acquisition and payment cycle?
12. When a physical count of inventory is performed at an
a. Bonds are frequently issued by companies in small
interim date, the auditor observes it at that time and
amounts.
tests the perpetual records for transactions:
b. There are relatively few transactions and each
a. throughout the year.
transaction is typically highly material.
b. which are a representative sample of the period
c. A primary emphasis in auditing debt is on existence.
under audit.
d. Audit procedures for notes payable and interest
c. from the date of the count to year-end.
income are often performed simultaneously.
d. from the date of the count to the end of the audit
field work.
16. The auditor's independent estimate of interest expense
from notes payable uses average interest rates and:
13. If an auditor were concerned with obtaining evidence
a. average notes payable outstanding.
about the appropriateness of the value of inventory,
b. year-end notes payable outstanding.
which of the following tests would be most appropriate?
c. only notes payable above the level of materiality.
a. Compilation tests
d. only notes payable to major lenders.
b. Price tests
c. Confirmation of inventory held by outside parties
17. When there are not numerous transactions involving
d. Physical examination of the inventory
notes payable during the year, the normal starting point
for the audit of notes payable is:
14. You are gathering evidence for the audit objective that
a. a schedule of notes payable and accrued interest
existing inventory items are included in the inventory
prepared by the audit team.
listing schedule. The audit procedure that would provide
b. a schedule of notes payable and accrued interest
you with the best evidence to confirm this objective is:
obtained from the client.
a. trace from inventory tags to the inventory listing
c. a schedule of only those notes with unpaid balances
schedule and make sure the inventory tag is
at the end of the year prepared by the client.
included.
d. the notes payable account in the general ledger.
b. trace the inventory totals to the general ledger.
c. perform tests of lower-of-cost-or-market.
18. In auditing debits and credits to retained earnings,
d. account for unused tags shown in the auditor's
OTHER than net income and dividends, the auditors first
documentation to make sure no tags have been
concern is:
added.
a. whether the transactions should have been included
in retained earnings.
***
b. whether the transactions have been accurately
recorded.
Financing Cycle (or Financing and Repayment Cycle)
c. whether the transactions are classified correctly in
the footnotes.
Business Process
d. whether the transactions existed as of the balance
sheet date.
1. This cycle includes issuance and repurchase of debt
(bank loans, mortgages, bonds payable) and shares of
19. When conducting the audit of stockholders' equity it is
stocks, and payment of interest and dividends.
normal practice to verify all capital stock transactions:
2. Debt and capital stock transactions should be
a. only when the client is small.
authorized by the board of directors.
b. that are in excess of a material amount.
3. Often an independent trustee issues bonds, monitors
c. if there aren't very many during the year.
company compliance with the provisions of the debt
d. regardless of the controls in existence, because of
agreement, and pays interest.
their materiality and permanence in the records.
4. For share capital transactions, corporations may either
employ an independent stock registrar and a stock
***
transfer agent, or handle their own transactions.
5. Generally, internal control is stronger when a stock
Audit of Financial Instruments
registrar and a stock transfer agent are used. A stock
registrar’s primary responsibility is to verify that stock
• Definition and classification of financial instruments:
is issued in accordance with the authorization of the
Financial instruments encompass a wide range of
board of directors and the articles of incorporation; the
assets, liabilities, and equity instruments. They include
stock transfer agent’s primary responsibility is
cash, investments, derivatives, loans, and debt
maintaining detailed stockholder records and carrying
securities. It is crucial for auditors to understand the
out transfers of stock ownership.
nature and classification of financial instruments to
effectively plan and execute the audit procedures.
Typical Financing Controls

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EXCEL PROFESSIONAL SERVICES, INC.

• Risk assessment: Auditors need to assess the risks a. the client's bank loans with due date, interest rate,
associated with financial instruments. This involves and collateral requested.
understanding the inherent risks of specific b. the client's credit history as regards to paying back
instruments, such as credit risk, market risk, and loans.
liquidity risk. Additionally, auditors must consider the c. the client's managements bank account
client's internal controls and processes related to information.
financial instruments to identify potential control risks. d. the client's business prospects.
• Audit procedures: There are various audit procedures
that auditors can employ to gather evidence and 22. Auditors are likely to prepare a proof of cash when the
evaluate the fairness of financial instruments. These client has:
procedures include examining documentation, a. material control weaknesses in cash receipts and
confirming balances with third parties, testing valuation cash disbursements.
models, assessing the adequacy of disclosures, and b. material control weaknesses in accounts receivable
performing analytical procedures. and revenue.
• Fair value measurement: Financial instruments are c. material control weaknesses in accounts payable
often measured at fair value, which presents challenges and inventory.
for auditors due to the subjectivity involved. Auditors d. material control weaknesses in payroll.
should evaluate management's fair value estimates,
review valuation methodologies, and consider the 23. A major consideration in the audit of the general cash
appropriateness of assumptions used. They may also balance is the possibility of fraud. The auditor must
engage valuation specialists to assist in assessing the extend his or her procedures in the audit of year-end
reasonableness of fair value measurements. cash to determine the possibility of a material fraud
• Disclosures: Financial instrument disclosures are when there are:
essential for providing transparency and enabling users a. large cash balances at the end of the year.
of financial statements to make informed decisions. b. large cash receipts and disbursements during the
Auditors should ensure that the disclosures comply with year.
relevant accounting standards and regulations. They c. no imprest accounts used for payroll.
should also evaluate the adequacy and clarity of d. inadequate internal controls.
disclosures to avoid potential misinterpretations.
24. Listing all bank transfers made a few days before and
*** after the balance sheet date and tracing each to the
Answer question nos. 20 to 25: accounting records for proper recording is a useful
approach to test for:
20. Which of the following misstatements is most likely to a. kiting.
be uncovered during an audit of a client's bank b. lapping.
reconciliation? c. income smoothing.
a. Duplicate payment of a vendor's invoice d. channel stuffing.
b. Billing a customer at a lower price than indicated by
company policy 25. The majority of financial instruments are valued using:
c. Failure to record a collection of a note receivable by a. cost.
the bank on the client's behalf b. fair value estimates.
d. Payment to an employee for more than the hours c. lower of cost or market.
actually worked d. realizable value.

21. In addition to confirming bank balances of your audit ***End***

client, a bank confirmation would normally contain:

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