Arens AAS17 sm 19 auditing PDF

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Copy right © 2020 Pearson Education Ltd.Chapter 19Audit of the Payroll andPersonnel Cycle Concept ChecksP. 6 26 Trans actions for the payroll and pers onnel c yc le are generally far m ore signific ant than for payroll-related balanc e s heet acc ounts bec aus e entities pay payroll related expens ...

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Chapter 19 Audit of the Payroll and Personnel Cycle 

Concept Checks

P. 6 26 1. Trans actions for the payroll and pers onnel c yc le are generally far more signific ant than for payroll-related balanc e s heet acc ounts becaus e entities pay payroll related expens es throughout the year typically on a bi -w eekly or monthly basis. Thus , liability acc ounts related to payroll generally only repres ent amounts ass ociated with the las t pay period, while payroll related expens es repres ent amounts inc urred throughout the entire year. 2. The human resourc es department provides an independent s ourc e for the hiring and firing of pers onnel and the verific ation of wage information, inc luding c hanges in w ages and deductions . The primary role of the employee’s primary s upervis or is to verify that the hours rec orded on time records w ere ac tually w orked by the employee. The payroll mas ter file is a computer file us ed for rec ording payroll trans actions for each em ployee and maintaining total employee w ages paid for the year to date.

P. 6 36 1. Five tests of controls that can be performed for the payroll and personnel cycle are: 1.

2.

3. 4. 5.

Examine time record for indication of approval to ensure that payroll payments are properly authorized. The purpose of this test is to determine that recorded payroll payments are for work actually performed by existing employees (occurrence). Account for a sequence of payroll checks to ensure existing payroll payments are recorded. The purpose of this test is to determine that existi ng payroll transactions are recorded (completeness). Examine time records to ensure that recorded payroll payments are for work actually performed by existing employees. The purpose of this test is the same as in item 1 above. Compare postings to the chart of accounts to ensure that payroll transactions are properly classified. (Classification) Observe when recording takes place to ensure that payroll transactions are recorded on a timely basis. (Timing)

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19-1

Concept Check, P. 6 90 (continued) 2. 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.



Review Questions

19-1 The overall objective in the audit of the payroll and personnel cycle is to evaluate whether the account balances affected by the cycle are fairly stated in accordance with generally accepted accounting principles. 19-2 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. 19-3 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 p urpose 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 indi cates 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 FIC A taxes and state and federal unemployment compensation taxes. 19-4 Human resource records include data such as the date of employment, personnel investigations, rates of pay, authorized deductions, performance evaluations, and termination of employment are some of the typical human resource records data maintained by the huma n resources department.

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19-2

19-5 There are several reasons why control risk is often assessed as low for the payroll and personnel cycle. First, payroll is a fairly standardized procedure used in nearly all businesses. As a result, common practices are typically in place, including common software. Many businesses also use payroll processing companies that add independent verification to payroll transactions. Payroll typically involves government entities (e.g. local, state, and federal tax authorities, social security, the state unemployment insurance office, etc.) which also add additional oversight to the payroll process. Finally, employees themselves serve as a control since they probably review their paychecks and payroll documents carefully each pay period and notify the company in case of discrepancies. 19-6 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 a re 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 i s 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. 19-7 To trace a random sample of prenumbered time cards to the related payroll payments in the payroll register and compare the hours worked to the hours paid is to test if payroll payments 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 vouch a random sample of payroll payments from the payroll register and compare the hours worked to the hours paid i s 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. 19-8 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 year-end balances in payroll-related accounts are often immaterial. Also, there is relatively little independent third-party evidence, such as confirmations, 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. Copy right © 2020 Pearson Education Ltd.

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19-9

Three common types of fraudulent payroll activities include: 1. issuing payroll to nonexistent employees, 2. fraudulent payroll hours, and 3. fraudulent expense reports.

Audits over payroll issued to nonexistent employees include, verifyi ng names on cancelled checks or accounts into which they are deposited, checking for check endorsements, tracing selected transactions recorded in the payroll to human resources records, confirming whether any payroll is made to terminated employees, or personally deli vering payroll checks and requiring employees to sign for their payroll checks. Audits over payroll hours may include verifying the total hours of payroll with the total hours authorized by management for different functions, or for overtime pay. Software can also be used to calculate reasonable hours and pay. Another procedure is to audit the time clock to see if employees are able to clock in for others, or if sufficient controls are in place to prevent fraudulent hours being recorded. Reimbursements for expenses incurred by employees are typically tested with the payroll and personnel testing. Audits over travel and entertainment reimbursements can verify whether proper approval is received for the expenses, whether expenses have a valid business purpose and are for reasonable amounts, and verify whether sufficient supporting documentation is submitted prior to reimbursement. 19-10 Companies typically withhold a portion of employee payrolls and make payments to appropriate entities. These withholdi ngs include taxes on income, medicare, or social security that are paid to various government entities. Union dues are paid to the union and retirement savings paid to pension funds or individual retirement accounts. The auditor must be familiar with the requirement and timing of such payments when auditing the payroll and personnel cycle. For example, the audi tor should be familiar with local withholding rules, union and other contracts, retirement and pension arrangements, etc. 19-11 Five common tests of controls related to the transaction-related audit objective, that recorded payroll payments are for work actually performed by existing employees (occurrence) include: 1. 2. 3. 4. 5.

Examining time records for indication of approvals. Examining time records for reasonable total work hours. Reviewing human resource policies over employee records. Examine human resource files that employees are authorized to work. Review organization charts and observe employees to ensure appropriate separation of duties. Copy right © 2020 Pearson Education Ltd.

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19-12 Attributes sampling can be used in the payroll and personnel cycle in performing tests of controls and substantive tests of transactio ns with the following objectives: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Time record hours agree with payroll computations. Overtime hours are approved. Foreman approves all time cards. Hourly rates agree with personnel files and union contracts. Gross pay calculation is verified. Exemptions taken agree with W-4. Income tax, other deductions, and net pay calculations are verified. Authorizati ons are available for voluntary withholdings and miscellaneous deductions. Paycheck endorsement is same as signature on W-4 form.

The frequency of control deviations or monetary errors must be estimated prior to performing the tests. This estimate together with the acceptable risk of overreliance (ARO) and the tolerable exception rate will enable the auditor to determine the sample size required. Once the tests are performed on the sample, evaluation of the results will indicate whether the exception rate is lower than, equal to, or higher than that anticipated. The auditor must then use his or her judgment to decide the appropriate action to take. 19-13 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 e xpand 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 that may be assessed for inadequate withholdings and include these amounts in the accrual if they are sig nificant. 19-14 Several analytical procedures for the payroll and personnel cycle and misstatements that might be indicated by significant fluctuations are as follows: SUBSTANTIVE AN ALYTICAL PROCEDURE

MISSTATEMENT TYPES

1. Comparison of payroll expense accounts to amounts in prior years.

Cutoff misstatements or improper amounts recorded in a period.

2. Direct labor divided by sales compared to industry standards in prior years.

Cutoff misstatements or amounts charged to improper payroll accounts.

3. Commission expense divided by sales compared to industry standards, prior years, or sales agreements.

Failure to record commission on sales, or recording the improper commission amount.

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19-14 (continued) SUBSTANTIVE AN ALYTICAL PROCEDURE

MISSTATEMENT TYPES

4. Payroll tax expense divided by salaries and wages compared to prior year balances adjusted for changes in the tax rate and not including officers’ salaries.

Failure to record payroll taxes or recording of the improper amount.

5. Comparison of accrued payroll and payroll tax accounts to prior years.

Failure to record payroll accruals or recording improper amounts at the end of a period.

6. The percentage of labor included in work in process and finished goods inventories compared to prior years.

Use of improper labor standards, or classification misstatements.

7. Analysis of direct labor variances.

Use of improper labor standards, or classification misstatements.

19-15 Substantive analytical procedures and the possible misstatement for the payroll and personnel cycle include the following: SUBSTANTIVE ANALYTICAL PROCEDURES

POSSIBLE MISSTATEMENT

1. Compare payroll expense account balance Misstatement of payroll expense with previous years (adjusted for pay rate accounts. increases and increases in volume). 2. Compare direct labor as a percentage of sales with previous years.

Misstatement of direct labor and inventory.

3. Compare commission expense as a percentage of sales with previous years.

Misstatement of commission expense and commission liability.

4. Compare payroll tax expense as a percentage of salaries and wages with previous years (adjusted for changes in the tax rates).

Misstatement of payroll tax expense and payroll tax liability.

5. Compare accrued payroll tax accounts with previous years.

Misstatement of accrued payroll taxes and payroll tax expense.

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Discussion Questions and Problems 19-16 a. The documents and records matched with the related business functions include: PAYROLL RELATED BUSINESS FUNCTIONS

DOCUMENTS AND RECORDS

Human resources and employment

  

Human resource records Deduction authorization forms Rate authorization forms

Timekeeping and payroll

    

Time records Job time tickets Payroll transaction file Payroll journal or listing Payroll master file

Payment of payroll

 

Payroll direct deposit or check Payroll bank account reconciliation

Preparation of payroll tax returns and payment of taxes

 

W-2 forms Payroll tax returns

b. Brief descriptions of the following documents and records, and their importance in the audit of payroll is discussed below:  Time records are documents that indicate the overall duration (starting and stopping time) an employee has worked each day. This information is used to calculate the number of working hours to determine the appropriate amount of pay. Time records may be on paper (such as punch cards) or computer files.  The Payroll Transaction Files is an accounting record that provides details of all the payroll related transactions for a specified period of time. The file includes information on all the employees, their wage or salary amount, the appropriate withholdings, payments made to employees, and dates of transactions. Payroll transaction files are often generated over set periods such as daily or weekly.  The Payroll Master File is related to the Payroll Transaction Files, but cumulates the payroll related amounts for the fiscal year to date. The Payroll Master File amounts balance with the various payroll related general ledger accounts.

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19-17 KEY INTERNAL CONTROLS

a. RELATED AUDIT OBJECTIVE

b. COMMON TEST OF CONTROL

1. There is separation of duties among resources, timekeeping, and payroll disbursements.

Recorded payroll payments are for work actually performed by existing employees (occurrence).

Review organization char, discuss with employees, and observe duties being performed.

2. Bank accounts are independently reconciled.

Existing payroll Discuss with employees transactions are recorded and observe reconciliation. (completeness).

3. Wage rate, salary, or commission rate is properly authorized.

Recorded payroll Examine payroll records for transactions are for the indication of authorization. amount of time actually worked and are at the proper pay rates (accuracy).

4. Disbursements are authorized before issuance.

Recorded payroll payments Examine payroll records for are for work actually indication of approval. performed by existing employees (occurrence).

5. Payroll master file contents are internally verified

Payroll transactions are Examine indication correctly included in the internal verification. payroll master file and are correctly summarized (posting and summarization).

of

6. Account classifications are internally verified.

Payroll transactions are Examine indication correctly classified internal verification. (classification).

of

7. Dates are internally verified.

Payroll transactions are Examine indication recorded on the correct internal verification. dates (timing).

of

8. Adequate human resource files are maintained.

Recorded payroll payments Review human resource are for work actually policies. performed by existing employees (occurrence).

9. Payroll checks are prenumbered and accounted for.

Existing payroll Account for a sequence of transactions are recorded payroll checks. (completeness).

10. Payroll master file totals are compared with general ledger totals.

Payroll transactions are correctly included in the payroll master file and are correctly summarized (posting and summarization).

Examine initialed summary total reports indicating that comparisons have been made.

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19-18 a. RECOMMENDED CONTROL

b. SUBSTANTIVE AUDIT PROCEDURE

1. Internal verification of classification.

Trace labor distribution to supporting job input forms.
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