Payroll and Personnel Cycle

Chapter 11 Payroll and Personnel Cycle

LEARNING OBJECTIVES

1.         Describe the related documents applicable to the payroll and personnel cycle.
2.         Understand the assertions of auditing the payroll and personnel.
3.         Determine and apply the internal controls in the payroll and personnel cycle.
4.         Design tests of controls and assess related control risks over the payroll and personnel cycle.
5.         Design analytical procedures for payroll and personnel cycle.
6.         Design substantive tests of transactions over the payroll and personnel cycle.
7.         Design tests of details of balances for accounts in the payroll and personnel cycle.

1. Documents and Records

1.1       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.
1.2       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.
1.3       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.
1.4       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.
1.5       Job time card – a document indicating the particular job on which the worker has spent on during a given period of time.
1.6       Payroll cheque – It is usually issued for factory workers whose wages are not fixed monthly.
1.7       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.
1.8       Payroll journal – a journal for posting total payroll expense for the period to general ledger account.
1.9       Payslip/salary slip – a document prepared individually for all employees for a particular week or month showing the gross pay, deductions and net pay.

2. Control Risks Assessment of Payroll and Personnel Cycle

2.1 Importance of payroll and personnel cycle

2.1.1    The payroll and personnel cycle is important for several reasons:
(a)        Salaries, wages and other staff costs are one of the major expenses in most companies.
(b)        Labour cost is one of the components of inventory costs in manufacturing and construction companies.
(c)        The improper classification and allocation of labour cost may have material misstatement of net income.
(d)        Significant resources can be lost because inefficiency or are susceptible to fraud.

2.2 Assertions used by the auditor in payroll and personnel cycle

2.2.1 Classes of payroll transactions

Assertions	Descriptions
1. Occurrence	Wages and salaries are only paid to non-fictitious employees and for their work performed.
2. Completeness	All existing payroll transactions are recorded in the payroll and accounting records.
3. Accuracy	Wages and salaries should be calculated based on work performed and terms of employment.
4. Cut-off	Payroll transactions should be recorded in the correct period.
5. Classification	Payroll transactions should be properly classified.

2.2.2 Classes of payroll expenses and related accruals

Assertions	Descriptions
1. Existence	Payroll expenses are valid and related accruals are valid liabilities.
2. Rights and obligations	Recorded payroll expenses and related accruals are expenses and obligations of the entity.
3. Completeness	All payroll expenses and related accruals have been recorded.
4. Valuation and allocation	Payroll expenses and related accruals are properly valued and allocated in accordance with accounting standards.

2.2.3 Payroll presentation and disclosure

Assertions	Descriptions
1. Rights and obligations	All disclosed transactions relating to payroll expense and related accruals have occurred and pertain to the entity.
2. Completeness	All payroll expenses and related accruals have been recorded in the financial statements.
3. Classifications	Financial information relating to payroll expense and related accruals is appropriately presented and disclosed.
4. Valuation and allocation	Payroll expenses and related accruals are disclosed fairly and at appropriate amounts.

2.3 Internal controls and test of controls
(Dec 09, Dec 11)
2.3.1 Examples of internal control procedures for payroll and personnel cycle are as follows:

Assertions	Internal Control Procedures	Test of control
1. Occurrence	Proper segregation of duties between processing and personnel functions; adequate personnel files are maintained; and work/time record are approved by person of appropriate level.	Observe and evaluate proper segregation of duties; e.g. persons authorizing employee benefits costs are not responsible for recording. Check the authorization by appropriate for all additions, changes and deletions of personnel records and the authorization for payments of employee benefit costs.
2. Completeness	Updated record for starters and leavers should be maintained by personnel office and payroll processing function is provided with updated information about leavers.	Check the numerical sequence of the time/work records and the reconciliation of payroll summary and starters and leavers recorded in personnel records.
3. Accuracy	Internal verification to ensure that the calculation of wages and salaries is in agreement with records of work performed and terms of employment.	Examine the client’s record to see whether the client has checked the arithmetical accuracy of employee benefit costs to ensure the amounts are in accordance with employment contracts.
4. Cut-off	Notices of additions, terminations, and changes in pay rates, and deductions reported promptly to payroll processing function.	Examine indication of internal verification and test procedures for processing time/work record and for recording liabilities.
5. Classification	Proper internal verification and approval for accounts charged to payroll.	Review client’s procedures and inspect their records to verify there has been proper classification of employee benefit costs.

Question 1
The firm of PPG & Co., in which Frankie Yip is employed, is the external auditor of Delicious Limited (“DL”) which is a company that carries out a fast food business.

Frankie Yip has bee in charge of this audit for a few years. DL had good internal control over employee benefit costs in the past. Frankie has assessed the risk of material misstatement at the occurrence assertion level as low, with an expectation that the relevant internal controls operate effectively during the year.

Required:
(a)     What are the five major types of control activities?                                           (5 marks)
(b)     What are possible control activities that may exist in controlling employee benefit costs? Provide one example for each type of control activity.                                      (5 marks)
(c)     For the occurrence assertion of employee benefit costs, what are the four principal types of further audit procedures that can be performed as test of controls? Provide four further audit procedures as tests of controls.                                                      (8 marks)
(d)     Provided that Frankie adopts the reliance approach and the tests of controls results are satisfactory, what is the principal type of further audit procedure that will be performed as a substantive procedure for the occurrence assertion?                                   (2 marks)
(HKIAAT PBE Paper III Auditing and Information Systems December 2009 Q4)

4. Substantive Procedures for Payroll and Personnel Transactions

4.1 Analytical procedures

4.1.1

Examples of the analytical procedures for payroll and personnel payments

(a)        Compare current-year balances in payroll expense account with prior years’ balances after adjustment for changes and number of employees.
(b)        Compare payroll costs as a percentage of sales with prior years’ and industry data.
(c)        Compare budgeted payroll expense with actual payroll expenses.
(d)        Compare current-year balances in payroll related accruals with prior years’ balances after adjusting for changes in conditions.
(e)        Compare labour cost as a component of inventory cost with that of previous years.
(f)        Estimate sales commissions by applying commission formulas to recorded sales totals.
(g)        Test reasonableness of accrual balances.

4.2 Substantive procedures – payroll transactions
(Dec 13)
4.2.1 Examples of substantive tests for payroll transactions are as follows:

Assertions	Substantive procedures
1. Occurrence	Review the payroll summary, payroll journal and general ledger for unusual items and check to the supporting documents.
2. Completeness	Reconcile the total disbursement in the payroll journal with the payments on the bank statement and cash disbursement journal.
3. Accuracy	Agree pay rates on the payroll summary with payroll record; examine evidence of internal verification; and recompute the mathematical accuracy of selected payroll transactions.
4. Cut-off	Compare dates of acknowledgement receipt by employees or bank transfer to date of transaction in payroll journal.
5. Classification	Select transactions from the payroll journal and check their classification with chart of accounts.

4.2.2 The main issue of internal controls over payroll and personnel cycle is the potential fraud of unauthorized payments to fictitious employers or the payment of wages or salaries without work performed. The following audit procedures are designed to identify this type of fraud.
(Jun 11)

Types of fraud	Substantive procedures
1. Non-existence employees	Tracing the selected transactions recorded in the payroll journal to the personnel department to determine whether the employees were actually employed during the payroll period.
2. Terminated employees	Selecting several files from the personnel records for employees who were terminated in the current year to determine whether each received his or her termination pay in accordance with company policy. Examining the payroll records in the subsequent period to ascertain that the employee is no longer being paid.
3. Unclaimed wages	Requesting a surprise payroll payoff where each employee must pick up and sign for his or her cheque in the presence of a supervisor and the auditor. Investigating those unclaimed wages to determine whether an unclaimed cheque is fraudulent.
4. Fraudulent hours	Reconciling the total hours paid according to the payroll record with an independent record of the hours worked. Examining evidence of proper authorization for payroll since it is ordinarily easier for the client to prevent this type of defalcation by adequate controls than for the auditor to detect it.

Question 2
Mr. Sata Wataru advised Peter that the amount of salaries for this year is much higher than last year and there is not much increase in course revenue earned. He wonders whether there is any fraud of unauthorized payments to fictitious employees or the payment of salaries without work performed. Peter determines to carry out additional procedures in this area. State the relevant audit procedure to identify the following types of fraud.
(i)      Non-existence employees                                                                                   (2 marks)
(ii)     Terminated employees                                                                                        (2 marks)
(iii)    Unclaimed wages                                                                                                (2 marks)
(iv)    Fraudulent hours                                                                                                 (2 marks)
(HKIAAT PBE Paper III Auditing and Information Systems June 2011 Q1(e)

4.3 Substantive procedures – payroll expense and accruals balances

Assertions	Substantive procedures
1. Existence	Vouch selected payroll accruals from payroll summary to the supporting documents such as personnel file, work/time record, etc.
2. Rights and obligations	Review supporting documents to determine that the entity has obligation to pay.
3. Completeness	Search for unrecorded payroll liabilities and check the calculation of commission payable or entitlement of commission accrued against the terms of employment and company policy.
4. Valuation and allocation	Test reasonableness of accrued payroll expenses and compare amounts accrued to supporting documents.
5. Presentation and disclosures	Discuss with management and review benefit contracts for proper disclosure of payroll accruals.

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Payroll and Personnel Cycle

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