ACCT 1163 – Professional Elective (Operations Audit)

2nd Semester Academic Year 2022-2023

Lesson 15, Week 15: Auditing Payroll

Topics: a. Internal controls over payroll

b. Audit program for payroll
c. Internal control of accounts purchases and accounts payable
d. Procedures/approach in auditing purchases and accounts payable
i. Understanding of the client and its environment
ii. Understanding of internal control over purchases and accounts
payable
iii. Assessing the risks of material misstatement and designing further
audit procedures
iv. Performing further audit procedures—tests of controls
v. Perform further audit procedures—substantive procedures for
purchases and accounts payables

Learning Outcomes: At the end of this module, you are expected to:
1. Know the different activities involved in payroll.
2. Understand the risks and internal controls over pyroll
3. Understand the different internal controls over payroll.
4. Understand the different audit procedures (test of controls and substantive
procedures) in auditing payroll.

Lesson Proper:

The payroll in many companies is the largest operating cost and therefore deserves the close attention of
management as well as the auditors. In the past, payroll frauds were common and often substantial. Today,
however, such frauds may be more difficult to conceal for several reasons: (1) extensive segregation of duties
relating to payroll; (2) the use of computers, with proper controls, for preparation of payrolls; and (3) the necessity
of filing frequent reports to the government listing employees' earnings and tax withholdings.

INTERNAL CONTROL OVER PAYROLL

The establishment of strong internal control over payroll remains important for several reasons. Although payroll
frauds are less frequent today, the possibility of large-scale payroll fraud still exists. Such frauds may involve
listing fictitious persons on the payroll, overpaying employees, and continuing employees on the payroll after their
separation from the company. A second reason for emphasizing internal control over payroll is that a great mass
of detailed information concerning hours worked and rates of pay must be processed quickly and accurately if
workers are to be paid promptly and without error. Good employee relations demand that direct deposits to
employee bank accounts or paychecks be processed on time and be free from error. As pointed out in previous
chapters, internal control is a means of securing accuracy and dependability in accounting data as well as a
means of preventing fraud.

To control payroll costs means to avoid waste and to obtain efficient production from the dollars expended for
services of employees. As a means of establishing control over payroll costs, many companies delegate to
department heads and other supervisors responsibility for the control of costs in their respective units of the
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business. Budgets are prepared using estimates of departmental labor costs for the coming period. As the year
progresses and actual labor costs are compiled, the controller submits monthly reports to top management
comparing the budgeted labor costs and the actual labor costs for each department. The effectiveness of this
control procedure will depend largely upon the extent to which top management utilizes these reports and takes
action upon variances from the budget.

Most important of all controls over payroll is the division of payroll work among several departments of the
company. Payroll activities include the functions of (1) employment (human resources), (2) timekeeping, (3) payroll
preparation and record keeping, and (4) distribution of pay to employees. For effective internal control, a separate
department of the company should handle each of these functions. These several phases of payroll activities will
now be considered individually.

Employment (Human Resources)

The first significant step in establishing strong internal control over payroll should be taken by the human resources
department when a new employee is hired. At this point, the authorized rate of pay should be entered on a pay-
rate record. The employee also should sign a payroll deduction authorization specifying any amounts to be
withheld and a withholding tax exemption certificate. These records should be kept in the human resources
department, but a notice of the hiring of the new employee, the rate of pay, and the payroll deductions should be
sent to the payroll department. When a computer is used, this information will be keyed into an employee payroll
master file. The human resources department, the payroll department, or data processing will enter the data into
the computer system.

Under no circumstances should a name be added to the payroll without having received the formal authorization
notice from the human resources department. When an employee's rate of pay is changed, the new rate should
be entered on the pay-rate record (often computerized) that is maintained in the human resources department. An
authorization for the new rate should be sent to the payroll department before the change can be made effective
on the payroll. Upon termination of an employee, notice of termination should be sent from the human resources
department to the payroll department. The work of the payroll department and the propriety of names and pay
raises used in preparing the payroll, therefore, rest upon formal documents or computer input originating outside
the payroll department.

Adequate internal control demands that the addition and removal of names from the company payroll, as well as
rate changes and reclassification of employees, be evidenced by written approval of an executive in the human
resources department and by the head of the operating department concerned. To permit the payroll department
to initiate changes in pay rates or to add names to the payroll without formal authorization from the human
resources department increases the likelihood of fraud.

Timekeeping

The function of timekeeping consists of determining the number of hours (or units of production) for which each
employee is to be paid. The use of electronic time-recording equipment is of considerable aid in establishing
adequate internal control over the time-keeping function. In addition, supervisors should maintain contact with
subordinates and prepare time reports summarizing the use of labor.

Internal control can be improved by the practice of regular comparison of the time reports prepared by timekeepers
or supervisors with time clock records showing the arrival and departure times of employees. If pay is based on
piecework, a comparison may be made between the reports of units produced and the quantities that are added
to the perpetual inventory records.

Salaried employees receiving a fixed monthly or weekly salary may not be required to use time clocks. Some
companies require salaried employees to fill out a weekly or semi-monthly report indicating the time devoted to
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various activities. If a salaried employee is absent, the department head usually has authority to decide whether
a pay reduction should be made.

Payroll Preparation and Record Keeping

In a manual system, the payroll department has the responsibility for computing the amounts to be paid to
employees and for preparing all payroll records. It is important that the payroll department not perform the related
functions of timekeeping, employment, or distribution of pay to employees. The output of the payroll department
may be thought of as (1) the payroll checks or direct deposits (or pay envelopes, if wages are paid in cash); (2)
individual employee statements of earnings and deductions; (3) a payroll journal; (4) an employees ledger,
summarizing earnings and deductions for each employee; (5) a payroll distribution schedule, showing the
allocation of payroll costs to direct labor, overhead, and various departmental expense accounts; and (6) quarterly
and annual reports to the government showing employees' earnings and taxes withheld. If the client utilizes a
centralized computer, many of these functions may be delegated to data processing.

In a computerized system, the payroll is calculated by the computer, using the work hours reported by the
timekeeping department and the authorized pay rates and payroll deductions reported by the human resources
department. In addition to preparing the payroll journal, the payroll department prepares the payroll checks or the
pay envelopes, if wages are paid in cash. Checks are then forwarded to the treasurer for signature.

Regardless of the system used, the auditors should expect the client's system to include such basic records as
time cards, payroll journals, labor distributions, and employee earnings records. In a computerized system, some
or all these documents may exist only in computer-readable form.

Distributing Pay: Direct Deposit, Paychecks, or Cash

The distribution of pay through direct deposit, paychecks, or pay envelopes (with cash enclosed) should be
performed by an individual who performs no other payroll activity. If pay is deposited directly into employee bank
accounts, controls over that process are necessary, such as authorization of deposits by personnel in the
treasurer's department. If pay is distributed as paychecks or pay envelopes, the task should be that of the
paymaster.

Most companies that pay employees by check or direct deposit use a special payroll bank account. A voucher for
the entire amount of the weekly payroll may be prepared in the general accounting department based on the
payroll summary prepared in the payroll department. This voucher is sent to the treasurer, who issues a check on
the general bank account for the amount of the payroll. The check is deposited in the special payroll bank account
and checks or direct deposits to individual employees are drawn on the account. It also is the practice of some
companies to require dual signatures on large checks and to have printed on the check a statement that this type
of check is not valid if issued for an amount in excess of a specified dollar amount.

If employees are paid in cash, the paymaster will use a copy of the payroll journal and the information on the
payroll envelopes (both prepared by the payroll department) to fill the payroll envelopes with cash. The paymaster
will require proof of identity when distributing checks or cash to employees and require them to sign a receipt for
any cash received. All checks or pay envelopes for an absent employee should be retained and neither returned
to the payroll department nor turned over to another employee for delivery.

When wages are paid in cash, any unclaimed wages should be deposited in the bank and credited to a special
liability account. Subsequent disbursement of these funds to employees then will be controlled by the necessity of
drawing a check and preparing supporting documents. The dangers inherent in permitting unclaimed pay
envelopes to be retained by the paymaster, returned to the payroll clerk, or intermingled with petty cash are
apparent.

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Documentation of Internal Control for Payroll

Typical of the questions to be posed by the auditors prior to the completion of an internal control questionnaire, a
systems flowchart, or other record of payroll controls are the following:
 Are employees paid by check or direct deposit?
 Is a payroll bank account maintained on an imprest basis?
 Are the activities of timekeeping, payroll compilation, payroll check signing, and paycheck distribution
performed by separate departments or employees?
 Are all operations involved in the preparation of payrolls subjected to independent verification before the
paychecks are distributed?
 Are employee time reports approved by supervisors?
 Is the payroll bank account reconciled monthly by an employee having no other payroll duties?

AUDIT PROGRAM FOR PAYROLL

After obtaining an understanding of the client and its environment, including internal control, the auditors will
assess the risks of material misstatement and design further audit procedures, including:
1. Perform tests of controls over payroll transactions for selected pay periods, including the following specific
procedures:
a. Compare names and wage or salary rates to records maintained by the human resources
department.
b. Compare time shown on payroll to time cards and time reports approved by supervisors.
c. If payroll is based on piecework rates rather than hourly rates, reconcile earnings with production
records.
d. Determine basis of deductions from payroll and compare with records of deductions authorized by
employees.
e. Test extensions and footings of payroll.
f. Compare total of payroll with total of payroll checks issued.
g. Compare total of payroll with total of labor cost summary prepared by cost accounting department.
h. If wages are paid in cash, compare receipts obtained from employees with payroll records.
i. If wages are paid by check, compare paid checks with payroll and compare endorsements to
signatures on withholding tax exemption certificates.
j. If wages are paid by direct deposit, compare listing of employee payments with payroll and direct
deposit authorizations.
k. Observe the use of time clocks by employees reporting for work and investigate time cards not used.

2. Perform analytical procedures to test the reasonableness of payroll expense; for example, develop an
expectation about the amount of payroll expense by multiplying the amount of one pay period by the
number of pay periods in the year.
3. Investigate any extraordinary fluctuations in salaries, wages, and commissions.
4. Obtain or prepare a summary of compensation of officers for the year and compare to contracts, minutes
of directors' meetings, or other authorization.
5. Test the period end accrual of payroll expense.
6. Test computations of compensation earned under profit-sharing or bonus plans.
7. Test commission earnings by examination of contracts and detailed supporting records.
8. Test pension obligations by reference to authorized pension plans and supporting records.

FIGURE 1 Objectives of Major Substantive Procedures for Payroll

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 Figure 1 relates these procedures to their primary audit objectives.

In addition to the preceding procedures, the auditors may plan a surprise observation of a regular distribution of
paychecks to employees. The auditors' objective in observing the distribution of checks or cash to employees on a
regular payday is to determine that every name on the company payroll is that of a bona fide employee presently on
the job. This audit procedure is especially desirable if the various phases of payroll work are not sufficiently
segregated by departments to afford good internal control. The history of payroll frauds shows that permitting one
person to have custody of employment records, time cards, paychecks, and employees' earnings records has often
led to the entering of fictitious names on the payroll and to other forms of fraud, such as use of excessive pay rates
and continuance of pay after the termination of an employee. When performing this procedure, the auditors first will
determine that they have possession of all the checks or envelopes comprising the payroll. They will then accompany
representatives of the client around the plant as all the checks or envelopes are distributed to employees. It is
essential that the auditors establish the identity of each employee receiving payment.

REFERENCES

1. McGraw Hill. (2023, April 28). Principles of Auditing and Other Assurance Services. McGraw Hill Connect.
https://highered.mheducation.com/sites/0077418654/student_view0/ebook/chapter16/chbody1/the_audit_of_payroll.htm

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