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Aeb SM CH20 1
Aeb SM CH20 1
com
Chapter 20
Audit of the Payroll and
Personnel Cycle
Review Questions
20-1
General ledger accounts that are likely to be affected by the payroll and
personnel cycle in most audits include the following:
Cash
Inventory
Construction in progress
Wages payable
Payroll taxes withheld
Accrued payroll taxes
Direct labor
Salary expense
Commission expense
Payroll tax expense
20-2
In companies where payroll is a significant portion of inventory, as in
manufacturing and construction companies, the improper account classification
of payroll can significantly affect asset valuation for accounts such as work in
process, finished goods, and construction in process. For example, if the salaries
of administrative personnel are incorrectly charged to indirect manufacturing
overhead, the overhead charged to inventory on the balance sheet can be
overstated. Similarly, if the indirect labor cost of individual employees is charged
to specific jobs or processes, the valuation of inventory is affected if labor is
improperly classified. When some jobs are billed on a cost plus basis, revenue
and the valuation of inventory are both affected by improperly classifying labor to
jobs.
20-3
Five tests of controls that can be performed for the payroll and personnel
cycle are:
1.
2.
3.
4.
5.
20-1
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20-4
The percentage of total audit time in the cycle devoted to performing
tests of controls and substantive tests of transactions is usually far greater in the
payroll and personnel cycle than for the sales and collection cycle because there
is relatively little independent third party evidence, such as confirmation, to verify
the related payroll accounts. In contrast, the accounts related to the sales and
collection cycle can usually be verified for the most part by confirmations from
customers. In addition, in the sales and collection cycle, verification of the realizability
of receivables and sales cutoff tests are important and time- consuming tasks.
20-5
The auditor should be concerned with whether the human resources
department is following the proper hiring and termination procedures. An obvious
reason for this would be to ensure that there are adequate safeguards against
hiring and retaining incompetent and untrustworthy people. The ramifications of
hiring such people can range from simple inefficiency and waste to outright fraud
or theft. More importantly, though, it is necessary for the auditor to assure himself
or herself that the client is hiring and terminating according to operations
standards and procedures. It is necessary to see if the internal controls are
working as planned before they can be effectively evaluated. To say that the
auditor doesn't care who is hired and who is fired is to suggest that he or she
doesn't care if the internal controls work according to any standards. Failure to
follow proper termination procedures could lead to fraudulent payments for work
not performed.
20-6
To trace a random sample of prenumbered time cards to the related
payroll checks in the payroll register and compare the hours worked to the hours
paid is to test if payroll checks have been recorded (completeness) and if those
employees who worked are being paid for their time actually worked. Employees
are likely to inform management if they are not paid, or underpaid. To trace a
random sample of payroll checks from the payroll register and compare the hours
worked to the hours paid is to test if the recorded payroll payments are for work
actually performed by existing employees (occurrence). This test, in effect, attempts
to discover nonexistent employees or duplicate payments, if there are any. For
this reason, the second procedure is typically more important to the audit of
payroll.
20-7
In auditing payroll withholding and payroll tax expense, the emphasis should
normally be on evaluating the adequacy of the payroll tax return preparation
procedures rather than the payroll tax liability, because a major reason for
misstatements in the liability account is incorrect preparation of the returns in the
past. If the preparation procedures are inadequate, and the amounts do not
appear reasonable, then the auditor should expand his or her work and
recompute the withholding and expense amounts to determine that the proper
amount has been accrued. In addition, the auditor should consider the amount of
penalties which may be assessed for inadequate withholdings and include these
amounts in the accrual if they are significant.
20-2
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20-8
Several analytical procedures for the payroll and personnel cycle and
misstatements that might be indicated by significant fluctuations are as follows:
ANALYTICAL PROCEDURE
MISSTATEMENT TYPES
20-9
An auditor should perform audit tests primarily designed to uncover fraud
in the payroll and personnel cycle when he or she has determined that internal
controls are deficient (or the opportunity exists for management to override the
internal controls) or when there are other reasons to suspect fraud. Audit procedures
that are primarily for the detection of fraud in the payroll and personnel cycle
include:
1.
2.
3.
20-3
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20-9 (continued)
4.
5.
20-10 The Payroll Master File is maintained for each employee indicating the
gross pay for each payment period, deductions from the gross pay, the net pay,
the check number, and the date. The purpose of this record is to provide detailed
information for federal and state income tax purposes, and to serve as the final
record of what each employee was actually paid.
The W-2 Form is issued to each employee at the end of each calendar
year and indicates his or her gross pay, income taxes withheld, and FICA withheld
for the year. In serving as a summary of the employee's earnings record, the W-2
form conveniently provides information necessary for the employee to fill out his
or her income tax returns.
A Payroll Tax Return is the form required by and submitted to the local,
state and federal governments for the payment of withheld taxes and the employer's
portion of FICA taxes and state and federal unemployment compensation taxes.
20-11 Where the primary objective is to detect fraud, the auditor will examine
the following supporting documents and records:
1.
2.
3.
4.
5.
20-12
20-4
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20-12 (continued)
4.
5.
6.
20-13 It is common to verify total officers' compensation even when the tests of
controls and substantive tests of transactions results in payroll are excellent
because the salaries and bonuses of officers must be included in filings with the
SEC and IRS (e.g., the Form 10-K Report, proxy, and the federal income tax
return) and because management may be in a position to pay themselves more
than the authorized amount, since the controls over the officers' payroll are
typically weaker and therefore easier to override than those of the normal payroll.
The usual audit procedure used to verify the officers' compensation is to
obtain the authorized salary of each officer from the minutes of the board of
directors and compare it to the related earnings record.
20-14 An imprest payroll account is a separate payroll bank account in which a
constant balance, either zero or small, is maintained. When a payroll is paid, the
exact amount of the net payroll is transferred by check or electronic funds transfer
from the general account to the imprest account. The purpose and advantage of
an imprest payroll account is that it limits the company's exposure to payroll fraud
by limiting the amount that may be misappropriated.
20-15 Several audit procedures the auditor can use to determine whether
recorded payroll transactions are recorded at the proper amounts are:
1.
2.
3.
4.
5.
6.
20-16 Attributes sampling can be used in the payroll and personnel cycle in
performing tests of controls and substantive tests of transactions with the following
objectives:
1.
2.
3.
4.
20-5
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20-16 (continued)
5.
6.
7.
8.
9.
20-17
a.
(2)
b.
(1)
c.
(3)
20-18
a.
(4)
b.
(4)
c.
(4)
20-19
TRANSACTIONRELATED AUDIT
OBJECTIVE
TEST OF
CONTROL
POTENTIAL
MISSTATEMENT
SUBSTANTIVE
AUDIT
PROCEDURE
1. Recorded payroll
transactions are
stated at the
proper pay rates
(accuracy).
Examine
authorizations in
personnel files.
Employees are
paid the wrong
rate.
Compare rates
in payroll
journal or listing
to rates in
personnel files.
2. Recorded payroll
transactions exist
(occurrence).
Examine
personnel files for
termination
notices.
Employees are
improperly
terminated and
payment
continues.
Compare
termination
dates from
personnel files
to date of last
paycheck.
20-6
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20-19 (continued)
TRANSACTIONRELATED AUDIT
OBJECTIVE
TEST OF
CONTROL
POTENTIAL
MISSTATEMENT
Examine time
cards and observe
preparation.
Incorrect recording
of time.
Randomly
sample workers
and trace to
time cards for
hours worked.
4. Recorded payroll
payments are for
work actually
performed by
existing employees
(occurrence).
Examine time
cards for
approval.
Analyze payroll
records of a
sample of
employees for
reasonableness.
5. Recorded payroll
transactions are
for proper rate and
amount (accuracy).
Examine payroll
journal or listing
for indication of
internal verification.
Employees pay is
miscalculated.
Recompute
employees'
pay, compare
pay rates to
personnel files,
and hours
worked to time
cards.
Examine system
of identifying jobs
by number.
Direct labor is
charged to wrong
jobs.
Trace entries
from job
summaries to
time cards, job
cards, etc.
7. Recorded payroll
checks are for
work performed by
existing employees
(occurrence).
Observe and
discuss payroll
system with
employees.
Payroll payments
are made to
nonexistent
employees.
Trace payroll
checks to
employees,
to determine
if employee
exists.
8. Payments are
made to actual
employees
(occurrence).
Observe
payments and
discuss with
employees.
Payments are
made to wrong
employees.
Examine
cancelled
checks for
endorsements,
and compare to
personnel file.
9. Recorded payroll
transactions are
for work performed
by existing
employees
(occurrence).
Observe
distribution of
paychecks and
recording of
unclaimed wages.
Unclaimed
paychecks are
cashed by the
wrong people.
Examine
cancelled
checks for
endorsements,
and compare to
personnel file.
20-7
SUBSTANTIVE
AUDIT
PROCEDURE
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20-20
TYPE OF TEST
1. Substantive test
of transactions
2. Test of control
3. Substantive test
of transactions
4. Substantive test
of transactions
5. Substantive test
of transactions
6. Test of control
7. Substantive test
of transactions
20-21
RECOMMENDED CONTROL
20-8
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20-22
TYPE OF TEST
APPLICABLE TRANSACTION-RELATED OR
BALANCE-RELATED AUDIT OBJECTIVE(S)
1.
(3)
N/A
2.
(1)
Accuracy.
3.
(4)
Detail tie-in.
4.
(1)
Completeness.
5.
(2)
6.
(4)
7.
(2)
8.
(3)
N/A
9.
(1)
Accuracy.
10.
(3)
N/A
11.
(4)
Completeness.
12.
(1)/(2)
(1), (2) (if totals
are compared)
20-23 A flowchart of steps for each type of test is given below (requirements a,
b, and c):
TESTS OF CONTROLS
OR SUBSTANTIVE TESTS
OF TRANSACTIONS
TESTS OF DETAILS
OF BALANCES
4
1
20-9
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20-24
a.
b.
20-25
a.
INTERNAL
CONTROL DEFICIENCY
b.
TYPE OF MISSTATEMENT
1.
2.
3.
4.
5.
20-10
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20-25 (continued)
a.
INTERNAL
CONTROL DEFICIENCY
b.
TYPE OF MISSTATEMENT
6.
7.
8.
9.
10.
11.
12.
20-11
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20-26
a.
b.
2.
c.
When the payroll payoff is taking place, the client should observe
these control procedures:
1.
2.
d.
20-27
DEPARTMENT
Warehouse
and Shipping
Department
EXTENT OF
INCREASE OR
DECREASE IN
PAYROLL
EXPENSE
Extensive
Increase
EXPLANATION FOR
EXPECTED CHANGE IN
DEPARTMENTS PAYROLL EXPENSE
Each online sale must be individually processed
for shipment to single, stand-alone customers.
The time and effort to process, package, and
ship goods to each online customer will
significantly increase the warehouse and shipping
department payroll expense.
20-12
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20-27 (continued)
DEPARTMENT
EXTENT OF
INCREASE OR
DECREASE IN
PAYROLL
EXPENSE
IT Department
Little Change
Accounts
Receivable
Department
Little to
Moderate
Increase
Accounts
Payable
Department
Moderate
Increase
Receiving
Department
Extensive
Increase
Executive
Management
Little Change
EXPLANATION FOR
EXPECTED CHANGE IN
DEPARTMENTS PAYROLL EXPENSE
Because the company outsourced the creation
and support of the online sales system, payroll
expense would likely increase minimally (e.g.,
some increase would occur despite the
outsourcing). However, consulting expense
would be expected to increase extensively.
20-13
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20-27 (continued)
DEPARTMENT
Marketing
20-28
a.
Moderate
Increase
EXPLANATION FOR
EXPECTED CHANGE IN
DEPARTMENTS PAYROLL EXPENSE
The extent of increase in payroll expense for this
department will be dependent on the amount of
advertising that Archer Uniforms creates to
promote its new Web site. Assuming some
advertising is created, there would be a moderate
increase in marketing payroll expense. Other
advertising expenses may increase for ads
generated through external ad agencies and
through Web site ad contracts.
2.
3.
b.
EXTENT OF
INCREASE OR
DECREASE IN
PAYROLL
EXPENSE
3.
20-14
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Case
20-29
a.
Personnel records
Deduction authorization forms
Rate authorization forms
Time cards and job time tickets
Payroll checks
Payroll journal or listing and labor distribution
Earnings record
W-2 form
Payroll tax returns
20-15
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20-29 (continued)
b.
PAYROLL
TRANSACTIONRELATED
AUDIT OBJECTIVE
PROCEDURES
TYPE OF
PROCEDURE
Test of control
Test of control
Test of control
Test of control
Substantive test of
transactions
Substantive test of
transactions
Test of control
2. Existing payroll
transactions are
recorded
(completeness).
b. Observe preparation of
payroll bank reconciliation by
President.
Test of control
3. Recorded payroll
transactions are for
the amount of time
actually worked
and at the proper
pay rate;
withholdings are
properly calculated
(accuracy).
Test of control
Test of control
Substantive test of
transactions
Substantive test of
transactions
Test of control
Substantive test of
transactions
1. Recorded payroll
payments are for
work performed by
existing employees
(occurrence).
20-16
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20-29 (continued)
PAYROLL
TRANSACTIONRELATED
AUDIT OBJECTIVE
4. Payroll transactions
are properly
classified
(classification).
5. Payroll transactions
are recorded on the
correct dates
(timing).
6. Payroll transactions
are properly
included in the
employee earnings
record; they are
properly
summarized.
c.
PROCEDURES
TYPE OF
PROCEDURE
Test of control
Test of control
Substantive test of
transactions
Test of control
Test of control
Test of control
d. Observe preparation of
payroll bank reconciliation by
President.
Test of control
Substantive test of
transactions
Test of control
Test of control
Test of control
Substantive test of
transactions
20-17
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20-29 (continued)
d.
2.
3.
4.
5.
6.
A sampling data sheet follows. Note that this sampling data sheet
was prepared using attributes sampling. The only difference between
this approach and a nonstatistical approach is the determination of
sample size. Under nonstatistical sampling, students sample sizes
will vary.
20-18
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20-29 (continued)
PLANNED AUDIT
DESCRIPTION OF ATTRIBUTES
EPER*
TER**
ARACR**
INITIAL
SAMPLE
SIZE***
0%
5%
5%
59
0%
4%
5%
74
1%
6%
5%
78
1%
6%
5%
78
0%
6%
5%
49
1%
4%
5%
156
0%
5%
5%
59
*
**
***
20-1
Many businesses outsource the payroll function. In this web article, the IRS
provides information on outsourcing payroll duties for employers who outsource
the payroll function:
(see http://www.irs.gov/businesses/small/article/0,,id=176943,00.html).
In another page, the IRS provides information on employment tax fraud
investigations:
(see http://www.irs.gov/compliance/enforcement/article/0,,id=187270,00
.html)
1.
If the third party makes the payroll tax payments, are they responsible
for any deficiencies or failure to make payments?
Answer:
The employer, not the third party, is ultimately responsible for the
deposit and payment of federal tax liabilities. Even thought the third
party is making the deposits, the employer is the responsible party.
If the third party fails to make the federal tax payments, the IRS
may assess penalties and interest on the employers account.
20-19
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3.
4.
20-20
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20-21
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(Note: Internet problems address current issues using Internet sources. Because
Internet sites are subject to change, Internet problems and solutions may change. Current
information on Internet problems is available at www.pearsonglobaleditions.com/arens.)
20-22