Chapter Three:

Audit of Payroll and Personnel cycle

3.1 Overview of the cycle
➢ The payroll and personnel cycle involves the employment and payment of all employees.
➢ Labor is an important consideration in the valuation of inventory in manufacturing,
construction, and other industries.
➢ Payroll is also an area in which company resources can be wasted because of inefficiency
or stolen through fraud.
➢ The audit of the payroll and personnel cycle includes
✓ obtaining an understanding of internal control,
✓ assessing control risk,
✓ tests of controls and substantive tests of transactions,
✓ analytical procedures, and
✓ tests of details of balances.
The overall objective in the audit of the payroll and personnel cycle is, of course, to evaluate whether the
account balances affected by the cycle are fairly stated in accordance with applicable accounting
standards.

➢ In a typical audit, the main differences between the payroll and personnel cycle and other cycles include:
❖ There is only one class of transactions for payroll. Most cycles include at least two classes of
transactions. For example, the sales and collection cycle includes both sales and cash receipts
transactions, and often includes sales returns and charge-off of uncollectible accounts. Payroll
has only one class because the receipt of services from employees and the payment for those
services through payroll usually occur within a short time period.
❖ Transactions are generally far more significant than related balance sheet accounts. Payroll-
related accounts such as accrued payroll and withheld taxes are usually small compared to the
total amount of transactions for the year.
❖ Internal controls over payroll are effective for almost all companies, even small ones. Strict
federal and state regulations encourage effective controls for withholding and paying payroll
taxes. Also, employee morale problems can occur if employees are not paid or are underpaid
Because of these three characteristics, auditors typically emphasize tests of controls, substantive tests of
transactions, and analytical procedures in the audit of payroll. Tests of details of balances take only a few
minutes for most payroll-related accounts.

The accounts and transactions in the payroll and personnel cycle

1
 Accounts and transactions in
the PPC are:

1. Cash in bank
2. Accrued wages,
salaries, bonuses and
Commissions
3. Withhold Income
taxes and other
deductions
4. Accrued Payroll tax
expense
5. Payroll tax expense

2
Business Functions
➢ Human Resources and Employment
The human resources department provides an independent source for interviewing and hiring qualified
personnel. The department is also an independent source of records for the internal verification of wage
information, including additions and deletions from the payroll and changes in wages and deductions.
Human Resource Records: Human resource records include such data as the date of employment, personnel
investigations, rates of pay, authorized deductions, performance evaluations, and termination of employment.
Deduction Authorization Form: This form is used to authorize payroll deductions, including the number of
exemptions for withholding income taxes, and other retirement savings plans, health insurance, and union dues.
Rate Authorization Form: This form is used to authorize the rate of pay. The source of the information is a labor
contract, authorization by management, or in the case of officers, authorization from the board of directors.

➢ Timekeeping and Payroll Preparation

Timekeeping and payroll preparation are important in the audit of payroll because they directly affect payroll
expense for each period. Adequate controls are necessary to prevent misstatements in the following four
activities:
✓ Prepare time records by employees
✓ Summarize and calculate gross pay, deductions, and net pay
✓ Payment of payroll
✓ Prepare payroll records
Time Record The time record is a document indicating the time the hourly employee started and stopped
working each day and the number of hours the employee worked.
Job Time Ticket The job time ticket is a form indicating which jobs an employee worked on during a given time
period.
Payroll Transaction File This computer-generated file includes all payroll transactions processed by the
accounting system for a period, such as a day, week, or month.
Payroll Journal or Listing This report is generated from the payroll transaction file and typically includes the
employee name, date, gross and net payroll amounts, withholding amounts, and account classification or
classifications for each transaction.
Payroll Master File The payroll master file is a computer file used for recording payroll transactions for each
employee and maintaining total employee wages paid for the year to date. The record for each employee
includes gross pay for each payroll period, deductions from gross pay, net pay, check number, and date.
➢ Payment of Payroll
The approval and distribution of payroll must be carefully controlled to prevent theft. To increase control, payroll
disbursements are generally processed separately from other disbursements.
Payments are issued to employees in exchange for services performed. Payments may be made by check, but are
usually deposited directly into employees’ individual bank accounts. The amount paid is the gross pay less taxes
and other deductions withheld.
Payroll Bank Account Reconciliation: An independent bank reconciliation is important for all cash accounts,
including payroll, for finding errors and fraud. An imprest payroll account is a separate payroll account in which a
small balance is maintained. The exact amount of each net payroll is transferred by check or electronic funds
transfer from the general account to the imprest account immediately before distribution of the payroll. The
imprest account limits the client’s exposure to payroll fraud and separates routine payroll expenditures from
other expenditures. It also simplifies reconciliation of the payroll bank account.
➢ Preparation of Payroll Tax Returns and Payment of Taxes
Federal and state payroll laws require the timely preparation and submission of payroll tax returns. Most
computerized payroll systems prepare payroll tax returns using information on the payroll transaction and
master files. To prevent misstatements and potential liability for taxes and penalties, a competent individual
must independently verify the output.

3
W-2 Form This is a form sent to each employee that summarizes the employee’s earning for the calendar year,
including gross pay, income taxes withheld, and FICA (Social Security) withheld.
Payroll Tax Returns These are forms submitted to local, state, and federal units of government to show
payment of withheld taxes and the employer’s tax. The nature and due dates of the forms vary depending on the
type of taxes. These forms are prepared from information on the payroll master file and are usually computer
generated.

3.2 Key Internal Control

Methodology for designing tests of controls and substantive tests of transactions for
the payroll and personnel cycle
This is the way for assessing control risk and the design of tests of controls and substantive tests of transactions
for the cycle.
The methodology for designing tests of controls and substantive tests of transactions for the payroll and
personnel cycle is the same as that used in the sales and collection cycle and in for the acquisition and payment
cycle:
➢ understand internal control,
➢ assess planned control risk,
➢ determine the extent of testing of controls, and
➢ design tests of controls and substantive tests of transactions to meet transaction-related audit objectives.

Internal control for payroll is normally highly structured and well controlled to manage cash disbursed, to
minimize employee complaints and dissatisfaction and to minimize payroll fraud.
Tests of controls and substantive tests of transactions procedures are the most important means of verifying
account balances in the payroll and personnel cycle. These tests are emphasized because of the lack of
independent third-party evidence, such as confirmation, for verifying accrued wages, withheld income taxes,
accrued payroll taxes, and other balance sheet accounts.
Even though tests of controls and substantive tests of transactions are the most important parts of testing
payroll, tests in this area are usually not extensive. Many audits have a minimal risk of material misstatements,
even though payroll is often a significant part of total expenses. There are three reasons for this:
1. Employees are likely to complain to management if they are underpaid.
2. All payroll transactions are typically uniform and uncomplicated.
3. Payroll transactions are subject to audit by federal and state governments for income tax withholding,
Social Security, and unemployment taxes.
Understand Internal Control — Payroll and Personnel Cycle
Internal controls vary from company to company; therefore, the auditor must identify the controls, significant
deficiencies, and material weaknesses for each organization.
➢ Controls the auditor intends to rely on to reduce assessed control risk must be tested with tests of
controls.
➢ If the auditor is reporting on the effectiveness of internal control over financial reporting, the level of
understanding controls and extent of tests of controls must be sufficient to issue an opinion on the
effectiveness of internal control over financial reporting.
➢ Substantive tests of transactions vary depending on the assessed control risk and the other
considerations of the audit, such as the effect of payroll on inventory.
➢ Tests are not actually performed in the order given in Table 20-2. The tests of controls and substantive
tests of transactions are combined when appropriate and are performed in as convenient a manner as
possible, using a performance format audit program.

The key controls for the payroll and personnel cycle for assessing control risk:

4
➢ Adequate Separation of Duties
➢ Proper Authorization
➢ Adequate Documents and Records
➢ Physical Control Over Assets and Records
➢ Independent Checks on Performance

5
6
3.3 Tests of Controls & Substantive Tests of Transactions
3.4. Tests of Details of Balances