While payroll is often seen as a low-risk area, considerable losses can occur here. So, knowing how to audit payroll is important.  

In this post, I’ll answer questions such as, “how should I test payroll?” And “when should I perform fraud-related payroll procedures?”

Payroll exceeds fifty percent of total expenses in many governments, nonprofits, and small businesses. Therefore, it is often a significant transaction area.

To assist you in understanding how to audit payroll, let me provide you with an overview of a typical payroll process.

First, understand that entities have payroll cycles (e.g., two weeks starting on Monday). Then, payments are made at the end of this period (e.g., the Tuesday after the two-week period). Also, understand that most organizations have salaried and hourly employees. Salaried personnel are paid a standard amount each payroll, and hourly employees earn their wages based on time.

Second, an authorized person (e.g., department head) hires a new employee at a specified rate (e.g., $80,000 per year).

Third, human resources assists the new-hire with the completion of payroll forms, including tax forms and elections to purchase additional benefits such as life insurance. 

Fourth, a payroll department employee enters the approved wage in the accounting system. The employee’s bank account number is entered into the system (if direct deposit is used). 

Fifth, employees clock in and out so that time can be recorded.  

Sixth, once the payroll period is complete, a person (e.g., department supervisor) reviews and approves the recorded time. 

Seventh, a second person (e.g., payroll supervisor) approves the overall payroll. 

Eighth, the payroll department processes payments. Direct deposit payments are made (and everyone is happy). 

In this article, we will cover the following:

• Primary payroll assertions
• Payroll walkthroughs
• Payroll fraud
• Payroll mistakes
• 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

The primary relevant payroll assertions are:

• Completeness
• Cutoff
• Occurrence

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, the company is saying that recorded payroll expenses are legitimate.

To detect threats to these assertions, you must understand the entity’s payroll system. I do so with a payroll walkthrough.

Perform a walkthrough of payroll to see if there are any control weaknesses. How? Walk transactions from the beginning (the hiring of an employee) to the end (a payroll payment and posting). And ask questions such as the following:

• Does the company have a separate payroll bank account?
• How often is payroll processed? What time period does the payroll cover? On what day is payroll paid?
• Who has the authority to hire and fire employees?
• What paperwork is required for a new employee? For a terminated employee?
• Is payroll budgeted?
• Who monitors the budget to actual reports? How often?
• Who controls payroll check stock? Where is it stored? Is it secure? 
• If the company uses direct deposit, who keys the bank account numbers into the payroll system? Who can change those numbers?
• Do larger salary payments require multiple approvals?
• Who approves overtime payments?
• Who monitors compliance with payroll laws and regulations?
• Who processes payroll and how?
• Who signs checks or makes electronic payments? If physical checks are used, are they signed electronically (as checks are printed) or physically?
• How are payroll tax payments made? How often? Who makes them?
• Who creates the year-end payroll tax documents (e.g., W-2s) and how?
• What controls ensure the recording of payroll in the appropriate period?
• Are the following duties assigned to different persons:
• Approval of each payroll,
• Processing and recording payroll, 
• The reconciliation of related bank statements
• Possession of processed payroll checks
• Ability to enter or change employee bank account numbers
• Ability to add employees to the payroll system or to remove them
• Who can add or remove employees from the payroll system? What is the process for adding and removing employees from the payroll system?
• Who can change the master pay rate file? Does the computer system provide an audit trail of those changes?
• Who approves salary rates and how?
• Who reconciles the payroll bank statements and how often?
• Who approves bonuses? 
• What benefits (e.g., retirement accounts) does the company offer? Who pays for the benefits (e.g., employee) and how (e.g., payroll withholding)?
• Who reconciles the payroll withholding accounts and how often?
• Are any salaries capitalized rather than expensed? If yes, how and why?
• Are surprise payroll audits performed? If yes, by whom?
• Does the company outsource its payroll to a service organization? If yes, does the payroll company provide a service organization control (SOC) report? What are the service organization controls? What are the complementary controls (those performed by the employing company)?

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, during the walkthrough, if we see that one person prints and signs checks, records payments, and reconciles the bank statement, then we will plan fraud-related substantive procedures.

As we perform payroll walkthroughs, we are asking, “What can go wrong—whether intentionally or by mistake?”

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 its expenses. As (reported) costs go down, profits go up.

On the other hand, overstatements 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.

Mistakes also lead to payroll misstatements. Payroll errors can occur when payroll personnel lack sufficient knowledge to carry out their duties. Additionally, misstatements occur when employees fail to perform internal control procedures such as reconciling bank statements. 

The directional risk for payroll is an understatement. So, audit for completeness (determining that all payroll is recorded). Nevertheless, when payroll theft occurs (e.g., duplicate payments), overstatements can occur. 

The primary payroll risks include:

1. Payroll is intentionally understated
2. Inappropriate parties receive payments
3. Employees receive duplicate payments

As you think about these risks, consider the control deficiencies that allow payroll misstatements.

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
• No one reviews and approves recorded time
• No one reviews and approves payroll before processing
• No one performs surprise audits of payroll
• Appropriate procedures for adding and removing employees are not present
• No one reviews the removal of terminated employees from payroll 
• No one compares payroll expenses to a budget

(Here are suggestions to make your payroll controls stronger.)

Another key to auditing payroll is understanding the risks of material misstatement.

In auditing payroll, the assertions that concern me the most are completeness, occurrence, and cutoff. So my risk of material misstatement for these assertions is usually moderate to high.

My response to higher risk assessments is to perform certain substantive procedures: namely, a reconciliation of payroll in the general ledger to quarterly 941s. Why? The company has an incentive to accurately file 941s since the returns are subject to audit by governmental authorities. So, if the 941s are correct, the reconciliation provides support for recorded payroll.

Additionally, consider theft which can occur in numerous ways, such as duplicate payments or ghost employees. 

In a duplicate payment fraud, the thief, usually a payroll department employee, pays himself twice. 

Ghost employees exist when payroll personnel leave a terminated employee on the payroll. Why would someone in the payroll department intentionally leave a terminated employee in the payroll system? To steal the second payment. How? By changing the terminated employee’s direct deposit bank account number to his own. The result? He receives two payments (his own and that of the terminated employee). 

Once your payroll risk assessment is complete, decide what substantive procedures to perform.

My customary tests for auditing payroll are as follows:

1. Reconcile 941s to payroll
2. Recompute accrued payroll liability (amount recorded at period-end)
3. Review payroll withholding accounts for appropriateness and vouch subsequent payments for any significant amounts
4. Compare payroll expenses (including benefits) to budget and examine any unexplained variances
5. When control weaknesses are present, design and perform procedures to address the related risks
6. 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?

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
• 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 payroll in the general ledger to quarterly 941s 
• Fraud-related payroll work papers (when needed)

In this article we looked at the keys to auditing payroll. Those keys include risk assessment procedures, determining relevant assertions, assessing risks, and developing substantive procedures. My go-to substantive procedure is to reconcile payroll to 941s. I also review payroll withholding accounts and recompute salary accruals. Comparisons of payroll expenses are useful. Finally, if merited, I perform fraud-related payroll procedures.

In the next post we’ll look at how to audit debt.

Accounts payable is usually one of the more important audit areas. Why? Risk. First, it’s easy to increase net income by not recording period-end payables. Second, many forms of theft occur in the accounts payable area.

In this post, I’ll answer questions such as, “how should we test accounts payable?” And “should I perform fraud-related expense procedures?” We’ll also take a look at common payables-related risks and how to respond to them.

What is a payable? It’s the amount a company owes for services rendered or goods received. Suppose the company you are auditing receives $2,000 in legal services in the last week of December 2019, but the law firm sends the related invoice in January 2020. The company owes $2,000 as of December 31, 2019. The services were provided, but the payment was not made until after the year-end. Consequently, the company should accrue (record) the $2,000 as payable at year-end.

In determining whether payables exist, I like to ask, “if the company closed down at midnight on the last day of the year, would it have a legal obligation to pay for a service or good?” If the answer is yes, then record the payable even if the invoice is received after the year-end. Was a service provided or have goods been received by year-end? If yes (and the amount has not already been paid), accrue a payable.

In this chapter, we will cover the following:

• Primary accounts payable and expense assertions
• Accounts payable and expense walkthroughs
• Directional risk for accounts payable and expenses
• Primary risks for accounts payable and expenses
• Common accounts payable and expense control deficiencies
• Risks of material misstatement for accounts payable and expenses
• Search for unrecorded liabilities
• Auditing for accounts payable and expense fraud
• Substantive procedures for accounts payable and expenses
• Typical accounts payable and expense work papers

The primary relevant accounts payable and expense assertions are:

• Existence
• Completeness
• Cutoff
• Occurrence

Of these assertions, I believe completeness and cutoff (for payables) and occurrence (for expenses) are usually most important. When a company records its payables and expenses by period-end, it is asserting that they are complete and that they are accounted for in the right period. Additionally, the company is implying that amounts paid are legitimate.

As we perform walkthroughs of accounts payable and expenses, we are looking for understatements (though they can also be overstated as well). We are asking, “what can go wrong?” whether intentionally or by mistake?

In performing accounts payable and expense walkthroughs, ask questions such as:

• Who reconciles the accounts payable summary to the general ledger?
• Does the company use an annual expense budget?
• Are budget/expense reports provided to management or others? Who receives these reports?
• What controls ensure the recording of payables in the appropriate period?
• Who authorizes purchase orders? Are any purchases authorized by means other than a purchase order? If yes, how?
• Are purchase orders electronic or physical?
• Are purchase orders numbered?
• How does the company vet new vendors?
• Who codes invoices (specifies the expense account) and how?
• Are three-way matches performed (comparison of purchase order with the receiving document and the invoice)?
• Are paid invoices marked “paid”?
• Does the company have a purchasing policy?
• Can credit cards be used to bypass standard purchasing procedures? Who has credit cards and what are the limits? Who reviews credit card activity?
• Are bids required for certain types of purchases or dollar amounts? Who administers the bidding process and how?
• Do larger payments require multiple approvals?
• Which employees key invoices into the accounts payable module?
• Who signs checks or makes electronic payments?
• Who is on the bank signature card?
• Are signature stamps used? If yes, who has control of the signature stamps and whose signature is affixed?
• How are electronic payments made (e.g., ACH)?
• Is there adequate segregation of duties for persons:
  • Approving purchases,
  • Paying payables,
  • Recording payables, and
  • Reconciling the related bank statements
• Which persons have access to check stock and where is the check stock stored?
• Who can add vendors to the payables system?
• What are the entity’s procedures for payments of travel and entertainment expenses? 
• Who reconciles the bank statements and how often?

As we ask these questions, we inspect documents (e.g., payables ledger) and make observations (e.g., who signs checks or makes electronic payments?). So, we are inquiring, inspecting, and observing. 

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 (more about this in a moment).

The directional risk for accounts payable and expenses is an understatement. So, perform procedures to ensure that invoices are properly included. For example, perform a search for unrecorded liabilities (see below).

The primary risks for accounts payable and expenses are:

1. Accounts payable and expenses are intentionally understated 
2. Payments are made to inappropriate vendors
3. Duplicate payments are made to vendors 

In smaller entities, it is common to have the following control deficiencies:

• One person performs two or more of the following:
• Approves purchases,
• Enters invoices in the accounts payable system,
• Issues checks or makes electronic payments, 
• Reconciles the accounts payable bank account,
• Adds new vendors to the accounts payable system
• A second person does not review payments before issuance
• No one performs surprise audits of accounts payable and expenses 
• Bidding procedures are weak or absent
• No one reconciles the accounts payable detail to the general ledger
• New vendors are not vetted for appropriateness
• The company does not create a budget
• No one compares expenses to the budget
• Electronic payments can be made by one person (with no second-person approval or involvement)
• The bank account is not reconciled on a timely basis
• When bank accounts are reconciled, no one examines the canceled checks for appropriate payees (the dollar amount on the bank statement is agreed to the general ledger but no one compares the payee name on the cleared check to the vendor name in the general ledger)

When segregation of duties is lacking, consider whether someone can use the expense cycle to steal funds. How? By making payments to fictitious vendors, for example. Or intentionally paying a vendor twice--and then stealing the second check. (See the section titled Auditing for Accounts Payable and Expense Fraud below.)

In smaller engagements, I usually assess control risk at high for each assertion. When I assess control risk at less than high, I have to test controls to support the lower risk assessment. Therefore, assessing risks at high is usually more efficient (than testing controls).

When control risk is assessed at high, inherent risk becomes the driver of the risk of material misstatement (control risk X inherent risk = risk of material misstatement). 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 search for unrecorded liabilities and detailed expense analyses. The particular expense accounts that I examine are often the result of my preliminary planning analytics. 

How does one perform a search for unrecorded liabilities? Use these steps:

1. Obtain a complete check register for the period subsequent to your audit period
2. Pick a dollar threshold ($10,000) for the examination of subsequent payments
3. Examine the subsequent payments (above the threshold) and related invoices to determine if the payables are suitably included or excluded from the period-end accounts payable detail
4. Inquire about any unrecorded invoices

As the RMM for completeness increases, vouch payments at a lower dollar threshold.

How should you perform a detailed analysis of expense accounts? First, compare your expenses to budget—if the entity has one—or to prior year balances. If you note any significant variances (that can’t be explained), then obtain a detail of those particular expense accounts and investigate the cause.

Theft can occur in numerous ways—such as fictitious vendors or duplicate payments. If control weaknesses are present, consider performing fraud-related procedures. When fraud-related control weaknesses exist, assess the RMM for the occurrence assertion at high. Why? There is a risk that the expense (the occurrence) is fraudulent. 

So, how should you respond to such risks?

An example of a fraud-related test is one for duplicate payments. How?

• Obtain a check register in Excel
• Sort by the vendor
• Scan the check register for payments made to the same vendor for the same amount
• Inquire about payments made to the same vendor for the same amount

In a duplicate payment fraud, the thief intentionally pays an invoice twice. He steals the second check and converts it to cash.

This is just one example of expense fraud. There are dozens of such schemes. 

(See White Collar Crime is Knocking at Your Door: Are You Prepared?)

My customary audit tests are as follows:

1. Vouch subsequent payments to invoices using the steps listed above (in Search for Unrecorded Liabilities)
2. Compare expenses to budget and examine any unexplained variances
3. When control weaknesses are present, design and perform fraud detection procedures

If there are going concern issues, you may need to examine the aged payables listing. Why? Management can fraudulently shorten invoice due dates. Doing so makes the company appear more current. For example, suppose the business has three unpaid invoices totaling $1.3 million that were due over ninety days ago. The company changes the due dates in the accounts payable system, causing the invoices to appear as though they were due just thirty days ago. Now the aged payables listing looks better than it would have. 

My accounts payable and expense work papers usually include the following:

• An understanding of internal controls as they relate to accounts payable and expenses
• Risk assessment of accounts payable and expenses at the assertion level
• Documentation of any accounts payable and expense control deficiencies
• Accounts payable and expense audit program
• An aged accounts payable detail at period-end
• A search for unrecorded liabilities work paper
• Budget to actual expense reports and, if unexpected variances are noted, a detailed analysis of those accounts 
• Fraud-related expense work papers (if significant control weaknesses are present)

So, now you know the why and how of auditing accounts payable and expenses.

In some entities such as governments, payroll makes up over 50% of total expenses. Consequently, knowing how to audit payroll expenses is of great importance. My next post is titled The Why and How of Auditing Payroll. So, stay tuned.

See my prior posts in The Why and How of Auditing.