What are the keys to auditing payroll correctly? While payroll is often seen as a low-risk audit area, it’s a place where considerable damages can occur (such as the $800,000 theft I witnessed last year). Today, we’ll answer questions such as, “how should I test payroll?” and “when should I perform fraud-related payroll procedures?”
Auditing Payroll — An Overview
In many governments, nonprofits, and small businesses payroll exceeds fifty percent of total expenses. Consequently, it is often a significant transaction area.
In this post, we will cover the following:
- Primary payroll assertions
- Payroll walkthroughs
- Directional risk for payroll
- Primary risks for payroll
- Common payroll control deficiencies
- Risk of material misstatement for payroll
- Substantive procedures for payroll
- Common payroll work papers
Primary Payroll Assertions
The primary relevant payroll assertions are:
I believe—in general—completeness and cutoff (for accrued payroll liabilities) and occurrence (for payroll expenses) are the most important payroll assertions. When a company accrues payroll liabilities at period-end, it is asserting that they are complete and that they are recorded in the right period. Additionally, by recording payroll expenses, the company is saying they are legitimate.
Perform a walkthrough of payroll to see if there are any control weaknesses. Walk transactions from the beginning (the hiring of an employee) to the end (a payroll payment and posting). What questions should you ask? Here are a few.
In performing payroll walkthroughs, ask:
- What is the location of payroll check stock?
- If the company uses direct deposit, who keys the bank account numbers into the payroll system?
- Who determines payroll expense classifications?
- Do larger salary payments require multiple approvals?
- Who processes payrolls and how?
- Who signs checks or makes electronic payments?
- What controls ensure the recording of payroll in the appropriate period?
- Is there adequate segregation of duties for persons:
- Approving payment,
- Processing payroll,
- Recording payroll, and
- Reconciling the related bank statements
- Who can add employees to or remove employees from the payroll system?
- What employees change the master pay rate file?
- Who has the authority to hire employees?
- What is the process for removing employees from the payroll system?
- Who approves salary rates and how?
- Does the company use a budget to track payroll expenses?
- Who reconciles the payroll bank statements and how often?
Moreover, as we ask these questions, we need to inspect documents (e.g., payroll ledger) and make observations (e.g., who signs checks or makes electronic payments?).
If controls weaknesses exist, we create audit procedures to respond to them. For example, if—during the walkthrough—we see that one person prints and signs checks, records payments, and reconciles the bank statement, then we will perform fraud-related substantive procedures.
When payroll fraud occurs, understatements or overstatements of payroll expense may exist.
If a company desires to inflate its profit, it can—using bookkeeping tricks—understate is expenses. As (reported) costs go down, profits go up.
On the other hand, an overstatement of payroll can occur when theft is present. For example, if a payroll accountant pays himself twice, payroll expenses are higher than they should be—assuming the company records both checks.
Another potential for payroll misstatement lies in mistakes. Payroll errors may occur when payroll personnel don’t possess sufficient knowledge to carry out their duties.
So as we perform payroll walkthroughs, we are asking, “What can go wrong—whether intentionally or by mistake?”
Directional Risk for Payroll
The directional risk for payroll is an understatement. So, audit for completeness (and determine that all payroll is in the general ledger). Nevertheless, when theft occurs (e.g., duplicate payments), an overstatement of payroll can occur.
Primary Risks for Payroll
The primary risks for payroll are:
- Payroll is intentionally understated
- Inappropriate parties receive payments
- Employees receive duplicate payments
As you think about these risks, consider the control deficiencies that allow payroll misstatements.
Common Payroll Control Deficiencies
In smaller entities, it is common to have the following control deficiencies:
- One person performs two or more of the following:
- Approves payroll payments to employees,
- Enters time or salary rates in the payroll system,
- Issues payroll checks or makes direct deposit payments,
- Adds or removes employees from the payroll system
- Reconciles the payroll bank account
- A second person does not review the payroll before payment
- No one performs surprise audits of payroll
- Appropriate procedures for adding and removing employees are not present
- No one compares payroll expenses to a budget
So what controls should be in place? Here’s a list of payroll controls from Steve Bragg.
Another key to auditing payroll is understanding the risks of material misstatement.
Risk of Material Misstatement for Payroll
In auditing payroll, the assertions that concern me the most are completeness, occurrence, and cutoff. So my RMM for these assertions is usually moderate to high.
My response to higher risk assessments is to perform certain substantive procedures: namely, a reconciliation of 941s to the payroll in the general ledger. Why? The company has an incentive to file 941s accurately since the returns are subject to audit by governmental authorities. Therefore, if the 941s are correct, then the reconciliation validates payroll.
Theft can occur in numerous ways—such as duplicate payments or ghost employees. If control weaknesses are present in the payroll cycle, consider performing fraud-related procedures.
In a duplicate payment fraud, the thief—usually a payroll department employee—intentionally pays himself twice.
Another fraud threat is that of leaving a terminated employee on the payroll—especially if the company uses direct deposit. A payroll department employee can change a terminated employee’s bank account number to his own. The result? Each payroll he receives two payments (his own and that of the terminated employee still in the system). In the first paragraph of this post, I mentioned an $800,000 payroll theft. This was the method used by the fraudster. The payroll clerk left multiple terminated employees in the system and changed their bank account numbers to her own.
Once your risk assessment is complete, you’ll decide what substantive procedures to perform.
Substantive Procedures for Payroll
My customary tests for auditing payroll are as follows:
- Reconcile 941s to payroll
- Recompute accrued payroll
- Review payroll withholding accounts for appropriateness and vouch subsequent payments for any significant amounts
- Compare payroll to budget and examine any unexplained variances
- When control weaknesses are present, design and perform fraud detection procedures
- Compare accrued vacation to prior periods and current payroll activity
In light of my risk assessment and substantive procedures, what payroll work papers do I normally include in my audit files?
Common Payroll Work Papers
My payroll work papers normally include the following:
- An understanding of payroll-related internal controls
- Risk assessment of payroll at the assertion level
- Documentation of any payroll control deficiencies
- Payroll audit program
- An accrued salaries detail at period-end
- A summary of any significant payroll withholding accounts with supporting information
- A detail of vacation payable (if material) with comparisons to prior periods
- Budget to actual payroll reports
- A reconciliation of 941s to the general ledger
- Fraud-related payroll work papers (when needed)
In summary, today we looked at the keys to auditing payroll. Those keys include risk assessment procedures, determining relevant assertions, creating risk assessments, and developing substantive procedures. My go-to substantive procedure is to reconcile payroll to 941s. I also review payroll withholding accounts, and I recompute the salary accrual. Finally, if merited, I perform fraud-related payroll procedures.
Look for my next post in The Why and How of Auditing. Next week we’ll look at how to audit debt.
If you’ve missed my prior posts in this audit series, click here.
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