Chapter 9 Audit of the Payroll and Personnel Cycle

1. Objectives

1.1 To describe the documents and records that are usually found in the payroll and personnel cycle. 1.2 To state the general audit procedures for the test of internal controls of this cycle. 1.3 To mention the substantive tests used for the payroll and personnel cycle.

Payroll and Personnel Cycle

Documents Audit Testing Substantive and and Tests Records Internal Control

Transaction-related Internal Audit Control Objectives Functions

2. Documents and Records

2.1 Personnel records – a document that records an employee’s data such as the date of employment, rates of pay, authorized deductions, performance appraisal and termination of employment, etc. 2.2 Deductions authorization form – a form signed by the employee authorizing deduction from his wages or salaries for contribution to superannuation (退休金) plan, loan repayment or others. 2.3 Rate authorization form – a document authorizing the rate of pay (per hour, day, month) of the employee by management, or, in the case of top management, by the board of directors. 2.4 Time card – a document indicating the starting and the ending time within which the worker works each day. It is usually used for daily or hourly paid worker for calculating the total hours of work each day. 2.5 Job time card – a document indicating the particular job on which the worker has spent on during a given period of time.

N9-1 2.6 Payroll cheque – It is usually issued for factory workers whose wages are not fixed monthly. 2.7 Bank transfer advice – a written advice to the company’s bank showing the names of employees, their respective monthly salaries, bank account numbers and the total amount to be transferred from the company’s payroll account to the employees’ accounts. 2.8 Payroll journal – a journal for posting total payroll expense for the period to general ledger account. 2.9 Payslip/salary slip – a document prepared individually for all employees for a particular week or month showing the gross pay, deductions and net pay.

3. Audit Testing and Internal Control

3.1 Transaction-related audit objectives (control objectives) for payroll transactions

Control objectives Description Existence Wages and salaries are only paid to existing employees. Completeness All existing payroll transactions are recorded in the accounting records Accuracy Wages and salaries computed should be in agreement with records of work performed. Timing Payroll transactions are recorded on the correct dates and paid over to the appropriate bodies on a timely basis. Classification Payroll transactions are properly classified to payroll account. Posting and summarization All payrolls are properly posted to the correct accounting records and correctly summarized.

3.2 This is a summary of the payrolls cycle, showing the possible problems and the related controls:

N9-2 3.3 The table shows the various stages of the payroll cycle, together with: (a) The risks (what could go wrong). (b) Control procedures (so that things don’t go wrong)

Process Risks Possible control procedures Salary info  Staff punch clock cards  All timesheets signed off as correct by collected from for friends. line managers. clock card,  Timesheets claim false  Clock card machine in open view. timesheets, etc. hours.  Clocking in/out supervised.  Overtime is claimed that  Clock cards kept somewhere secure was never worked. when not in use.  Clock cards sequenced, and sequence checked each day.  Clock cards checked to personnel

N9-3 records, to ensure no fake employees.  All overtime authorized in advance, and reviewed when claimed. Adjustments  Start/leaving dates wrong.  Take references, and check made for:  Staff who leave continue qualifications, of new staff. starters, to get paid.  New staff sign personnel form, with leavers, pay  Payroll details changed to photo. rises, overtime redirect money.  Random headcounts.  Fake pay rises put  Leavers’ form, signed by leaver and through. manager.  New employees do not  Personnel records kept secure. exist.  All pay data on computer password protected.  Regular check of pay data to personnel files. Gross wages  Inaccurate calculations  Random check of calculations by calculated manager.  Use computerized payroll package. Payroll  Incomplete set of  Payslips numbered, and checked back produced with payslips. to calculations and personnel files. pay list for  Pay list incorrect.  Pay list reviewed by managers to bank ensure figures look reasonable.  Pay list authorized before sending to bank. Employees paid  Employees paid late.  Use payroll control account, and  Where staff paid in cash, follow up on differences. it is stolen.  Avoid paying in cash.  Employee counts wages, and signs for them.  Only actual employee can receive and sign for wages.  Uncollected wages kept in safe until collection.

3.4 Control activities over payroll transactions – three major functions in a typical payroll and personnel cycle (see Appendix I for the audit program sample)

N9-4 Control Activities Test of Control 1. Maintaining personnel records and hiring employees  Review organization chart –  Personnel department is ensure the separation of duties responsible for interviewing and between personnel, time-keeping hiring qualified employees. and payroll payment functions.  Separate record kept for individual (existence) employee.  Review personnel records to verify  Proper procedures for hiring and all employment, termination or terminating employees. changes in rate pay are authorized.  Persons responsible for time cards, (existence and accuracy) payroll records or cheques should  Review personnel policies to not be allowed to get access to identify whether personnel files personnel records. are updated on a timely basis. 2. Timekeeping and payroll preparation  Examine time cards and payroll  Collect clock card in a regular summary for indication of approval. period for checking and calculation. (existence)   Ensure all clock cards are real. Examine authorization on the  Proper approval for the clock card payroll summary. (posting and and payment amount. summarization)  Account for a sequence of payroll cheques. (completeness)  Discuss with employees and observe reconciliation. (posting and summarization) 3. Processing payment of payroll   Payroll cheques should be witnesses Examine procedures manual for and evidenced by signature of the distribution process. (existence) receiver.  Observe distribution of payroll  Any unclaimed cheques should be cheques. (existence) returned to the payroll supervisor at  Discuss with responsible for once and is proper custody of them. handling of unclaimed cheques.  Limit the monthly amount of (existence, timing and accuracy) payment.

N9-5 3.5 Test your understanding 1 Judy is the senior-in-charge of the audit of ABC Textile Ltd. which employs over 500 employees. Among the employees, about 100 are salaried staff who are paid at each month end. The other 400 staffs are workers who are paid according to the number of hours worked. An audit program is prepared and only covered the following internal control objectives on the payroll and personnel cycle:

(i) Payrolls are correctly calculated. (ii) All payroll transactions are correctly recorded in the books of account.

During the planning stage, Judy notices that the payroll expense for the current year has been increased by 50%. The financial controller explains that the increase was due to increase in rates of pay and increase in number of workers.

During the documentation of the payroll system, Judy also notices that ABC textile Ltd. does not have control over attendance of salaried staff. The workers are required to punch their clockcards with the machine, but some of the clockcards are marked manually by workers. The financial controller explains that there was shortage of clockcard machines and too many workers rushed in at the same time, so that they just picked up their own card and marked the card manually. Further more, the personnel records are kept and maintained by the payroll department which also carries out the preparation of payroll, filling in and distribution of wages packets. There is no requirement for the workers to acknowledge receipts of wages packets.

An application form is required to apply for annual leave by salaried staff. The form is completed by the employee and passed to the personnel department for filling in the number of leave days entitlement. The form will then be passed to the relevant manager for approval. After the approval, the manager returns the form to the employee first so that the employee would know whether or not the leave has been granted. The employee will then return the approved form to the personnel department for the leave record.

Required:

(a) List four other internal control objectives on the payroll and personnel

N9-6 cycle. (4 marks) (b) Identify the internal control weaknesses of the payroll and personnel cycle and make recommendations for improvement. (12 marks) (c) Briefly describe the audit objectives on testing payroll records of starters and leavers and audit procedures your would carry out to accomplish the audit objectives. (4 marks) (Total 20 marks) (Adapted HKAAT June 1995)

3.6 Substantive tests Audit objectives Audit procedures Existence  Review the payroll journal, general ledger and payroll summary for large or unusual amounts.  Review the personnel records. Accuracy  Compare pay rates on payroll summary to payroll records.  Recomputed the wages and salaries compared with payroll summary and trace postings to general ledger. Completeness  Reconcile the total disbursement in the payroll journal with amount recorded in the payroll bank account. Timing  Trace from the general ledger account to bank statement for the amount paid, noting date of presentation.  If receive cheques, compare date of acknowledging receipt to date of record in the payroll journal. Classification  Select transactions from payroll and compare their classification with chart of accounts to ensure they are properly classified. Cut-off  Check the pay date of staff salaries.  Understand the payment policy, some pay once a month, some pay once every two weeks, etc. Analytical procedures  Compare payroll expense account with previous years.  Compare labour cost as a % of sales with

N9-7 previous years.  Compare the labour cost as a component of inventory costs with previous years.

N9-8 APPENDIX I – AUDIT PROGRAM – TEST OF CONTROLS FOR PAYROLLS

CLIENT NAME:

DATE OF FINANCIAL STATEMENTS:

Performed Workpaper By Reference Audit Objectives: To obtain an understanding of the design or operation of internal control relating to payrolls in order to assess their effectiveness in preventing or detecting material misstatements in financial statement assertions.

1. Select a sample of payroll transactions for the period under audit and perform the following:

a. Examine evidence of wage rate authorization (e.g., memo in personnel files, union contracts).

b. Examine evidence in support of payment (e.g., approved time cards and attendance records).

c. Examine authorization by employee for payroll deductions and withholdings.

d. Test the arithmetical accuracy of gross pay, deductions, and net pay.

e. Examine canceled check, noting date, amount, payee, authorized signature, and agreement of check endorsement to signature.

f. Trace check number, amount, payee, and date to the payroll register.

N9-9 Performed Workpaper By Reference g. Examine the signed receipt for employees paid in cash and compare the amount with the payroll register and the signature to the W-4 form.

h. Trace postings to the employee’s earnings records.

i. Determine the reasonableness of account classification.

2. Select a sample of payroll registers for the period under audit and perform the following:

a. Foot and crossfoot the payroll register.

b. Trace totals from the payroll register to postings of expense distribution and withholdings in the general ledger.

c. Scan the payroll register for large or unusual entries.

d. Trace the net pay amount to the paid check used to transfer cash to the payroll bank account.

e. Trace payroll withholdings and payroll tax liability to the applicable payroll tax returns and to the check remitting payroll taxes to the taxing authorities.

Based on the procedures performed and the results obtained, it is my opinion that the objectives listed in this audit program have been achieved.

Performed by Date

Reviewed and approved by Date

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