Answers to Review Questions
12-1 Most entities either computerize their payroll systems or use an outside service bureau because of the routine nature of payroll transactions.
12-2 There are two major types of transactions that are processed through the human resource management process: (1) payments to employees for services rendered and (2) accrual and payment of payroll-related liabilities arising from employees’ services.
The financial statements accounts that are generally affected by the two types of payroll-related transactions are:
Payroll transaction:
• Cash
• Inventory
• Direct and indirect labour expense
• Various payroll-related liability and expense accounts Accrued payroll liability transactions:
• Cash
• Various accruals (e.g. payroll taxes, and pension costs)
12-3 The payroll register, which is also referred to as the payroll journal, is a summary of all payroll payments issued to employees. The payroll master file is the computer file that maintains all the entity’s records related to payroll, including information on each employee such as name, identification number, pay rate and authorized deductions. The payroll master file changes report contains a record of the changes made to the payroll master file.
12-4
The following duties are performed in the personnel, timekeeping and payroll-processing functions:
Personnel: Authorization of hiring, firing, wage rates and salary adjustments, salaries and payroll deductions.
Timekeeping: Processing of employees’ attendance and time information and coding of account distribution.
Payroll processing: Computation of gross pay, deductions, and net pay; recording and summarizing of payments; and verification of account distribution.
12-5
The following table contains the key segregation of duties in the human resource management process and possible errors and fraud that can occur if such segregation of duties is not present.
Segregation of Duties Possible Errors or Fraud as a Result of Conflicts in Duties The supervision function should be
segregated from the personnel records and payroll-processing functions.
Unauthorized payments to existing employees or payments to fictitious employees.
The disbursement function should be segregated from the personnel records, supervision and payroll-processing functions.
Unauthorized payroll disbursements may be made.
The payroll-processing function should be segregated from the general ledger function.
Concealment of a defalcation that would normally be detected by independent review of accounting entries made to the general ledger.
12-6
Two control environment factors that have a pervasive effect on the human resource management process must be considered. First, the entity’s organizational structure, its personnel practices, and its methods used to assign authority and responsibility must be examined. Second, the entity should have sound policies for hiring, training, promoting and compensating employees. These policies should include specific authority and responsibility for hiring and firing of employees, for setting wage rates and making salary changes, and for establishing benefits.
12-7
The key authorization points within the human resource management process include authorization procedures for hiring and terminating employees, setting pay rates, making withholdings, awarding benefits and making payroll payments.
12-8
Client control procedures must exist for the classification assertion to ensure that the appropriate payroll accounts are charged. If payroll is not properly classified between direct and indirect labour, inventory and cost of goods sold may not be properly valued.
12-9
Except for executive compensation, there are generally very few inherent risk factors that affect the human resource management process and its related accounts. Some factors the auditor might consider include the effect of economic conditions on payroll costs, the supply of skilled workers, the frequency of employee turnover, the presence of labour contracts and labour legislation.
Because of the officers may have motive and opportunity to take advantage of their high-ranking offices in the form of excessive compensation, inherent risk is frequently not set at low.
Key risk factors to consider are the level of performance-based compensation and the closeness of key performance measures to compensation/bonus thresholds.
12-10
Two audit procedures that can be performed using CAATs are: (1) testing the computer logic used to calculate payroll amounts and (2) recomputing the calculation of gross pay, deductions and net pay.
12-11 Substantive analytical procedures that can be used to test payroll accounts and payroll-related accrual accounts are:
Payroll expense accounts:
1. Use a reasonableness test to develop an expectation based on number of employees and prior year average compensation per employee category after considering pay rate changes. Compare the expectation to current-year balance and investigate the difference if it is greater than the threshold.
2. Compare payroll costs as a percentage of sales with prior years’ and industry data.
3. Compare labour utilization rates and statistics with industry data.
4. Compare budgeted payroll expenses with actual payroll expenses.
5. Estimate sales commissions by application of commission formulas to recorded sales totals.
Payroll-related accrual accounts:
1. Compare current-period balances in payroll-related accruals with the prior periods’
balances after adjusting for changes in conditions.
2. Test reasonableness on accrual balances.
12-12
For the accrued payroll tax account, the auditor obtains a detailed account analysis schedule.
The credits to the account represent the recognition of payroll tax expense at the end of each pay period. These amounts can be traced to the various payroll tax returns or other documentation filed by the entity and should agree to the amount of payroll tax expense included in the income statement. The debits to the account represent payments made to the relevant government agencies. These payments can be verified by tracing the amounts to the cash disbursements journal.
12-13
Disclosure items for the human resource management process and related accounts include:
• Pension disclosures.
• Postretirement benefits disclosures.
• Profit-sharing plans.
• Deferred-compensation arrangements.
Solutions to Problems 12-14
a. Weaknesses in the internal control system are the following:
• Lack of approval of the foreman’s clock card by an appropriate supervisor is an unsound practice. Employees should not be permitted to maintain their own time records and submit them without approval.
• The computation of regular and overtime hours prepared by payroll clerk no. 2 that is used in the preparation of the payroll register is not compared with the summary of regular and overtime hours prepared by the foreman.
• Arithmetic computations and rates of pay used in the preparation of the payroll register are not checked by a person who is independent of their preparation, and payroll register columns are not verified (re-added) by a person other than the preparer of the payroll register.
• Payroll cheques are not reconciled to the payroll register in order to prevent improper disbursements.
• A signature-stamp machine should not be in the custody of any payroll clerk who has access to unsigned cheques.
• An officer of the company does not approve payroll.
• Since the paymaster should be independent of the payroll process, signed payroll cheques should not be distributed by the foreman.
• Unclaimed payroll cheques should be in the custody of an employee who is independent of the payroll process.
• The comparison of regular and overtime hours indicated on payroll cheques with regular and overtime hours indicated on clock cards should not be performed by the clerk who is responsible for the original computation of regular and overtime hours indicated on clock cards.
• The clerk who is responsible for preparing the payroll register should not perform the comparison of gross and net payroll indicated on payroll cheque with gross and net payroll indicated in the payroll register.
b. One should inquire whether:
• Payroll clerk no. 2 checks clock cards for the foreman’s written approval.
• Approved overtime is indicated on clock cards.
• Employment, wage and related data in payroll files are periodically crosschecked with personnel files for agreement.
• A timekeeper observes the punching of clock cards.
• Other mitigating internal control measures (e.g. bonding, required vacations and so forth) are in existence.
12-15
McCarthy should consider performing the following procedures in the audit of Kent Company’s payroll transactions:
1. Select a sample of payments to employees from the payroll register and compare each selected transaction to the related documents and records, and examine:
• Evidence in support of authorization of pay rate.
• Evidence in support of time on which compensation was based, such as approved time cards or attendance records.
• Evidence in support of proper authorization of payroll withholdings.
• Evidence in support of account distribution.
• The clerical accuracy of the transaction.
• The entry to the employee’s records used to summarize employee compensation for payroll reporting purposes.
.
2. Obtain the payroll register for a selected period and
• Test the arithmetic accuracy of the payroll register.
• Determine whether payroll was approved in accordance with management’s prescribed procedures.
• Trace totals per the register to postings in the general ledger.
3. Observe the distribution of payroll cheques.
4. Review the accounting for unclaimed wages.
5. Observe a sample of employees in the performance of their duties.
6. Perform analytical procedures.
12-16
a. In order to verify the information in the input form, James should:
• Compare the names, identification numbers, and withholding data on the input form with the forms to authorize the withholding of income taxes.
• Compare names with employment authorizations.
• Compare pay rates with wage authorizations and union contracts.
• Compare numbers of hours worked (regular and overtime) with approved time sheets or other supportive records; recompute regular and overtime hours.
• Inspect employee authorization forms for ‘special deductions.’
b. James should perform the following procedures in the examination of the 24 November, 2005, payroll register:
• Compare information on the input form with information in the payroll register and information on issued payroll cheques (e.g. spelling of names, correctness of identification numbers, hours, rates and deductions).
• Test payroll deductions by using withholding tax tables to recompute social security and withholding taxes.
• Manually compute gross and net pay and compare with computer printed figures.
• Compare payroll summary totals with other pay periods and investigate any unusual variations among periods.
• Check footings and crossfootings in the payroll register.
• Perform other related basic auditing procedures that may be deemed necessary in accordance with the circumstances.
Solutions to Discussion Cases where only letters are required to be entered, e.g. letters A-Z in employee name.
• Special-character check: Ensures that only specific special characters are entered into and accepted by the system where only those special characters are required to be entered, e.g. hyphens between numbers in identification number.
• Sign check: Ensures that positive or negative signs are entered into and accepted by the system where only such signs are required to be entered or that the absence of a positive or negative sign appears where such an absence is required, e.g. hours worked.
• Arithmetic check: Ensures the validity of the result of a mathematical computation, e.g.
total employees for period equal number of employee numbers in system.
• Validity check: Ensures that only authorized data codes will be entered into and accepted by the system where only such authorized data codes are required, e.g.
authorized employee account numbers.
• Limit (reasonableness) check: Ensures that only data within predetermined limits will be entered into and accepted by the system, e.g. rate per hour cannot be lower than the minimum set by law or higher than the maximum set by management.
• Self-checking digit: Ensures that only specific code numbers prepared by using a specific arithmetic operation will be entered into and accepted by the system, e.g.
employee numbers generated by the modulus 11 method with prime-number weighting.
• Size check: Ensures that only data using fixed or defined field lengths will be entered into and accepted by the system, e.g. number of dependents requires exactly two digits.
• Missing-data check: Ensures that no blanks will be entered into and accepted into the system when data should be present, e.g. an ‘S’ or ‘M’ is entered in response to ‘single or married?’
• Overflow check: Ensures that no digits are dropped if a number becomes too large for a variable during processing, e.g. hourly rates ‘on size errors’ are detected
• Control-total check: Ensures that no unauthorized changes are made to specified data or data fields and all data have been entered.
• Logic check: Ensures that spurious data are rejected, e.g. no negative regular hours.
12-18
Data on employees’ compensation expense, total number of employees and salaries of the executive officers are usually found in the company’s annual report. A rough estimate of the average employee’s salary can be computed by dividing the estimated employee compensation expense by the estimated total number of employees. The salary for one officer divided by the average salary equals the proportion of executive salary to average employee salary.
You may find that proportion of executive compensation to average salary is high, e.g.
ratios of ten to one or higher. It is argued that this proportion should be high because of the value of the executive’s strategic influence on the company. Whether or not this is true depends
entirely on the circumstances of the company. Recently there has been increased public outrage at the large disparity between top executive salary and that of the average employee.
a. It is argued that if executive compensation is tied to the value of the stock price then executives will perform better, because their interests will be aligned with those of the company’s stockholders. Also by using stock based compensation, companies are free to use the cash that would have been used as compensation to fund other areas of the company. This strategy is frequently employed by technology companies seeking rapid growth. Also the applicable financial reporting framework may not require options to be expensed directly to the income statement.
The biggest disadvantage is the potential greed associated with high levels of stock-option compensation. When the executive stands to gain tens or hundreds of millions by achieving earnings targets, the executive’s self interests provides incentives for earnings management or fraud in order to meet or beat earnings forecasts.
b. Potential audit procedures may include:
• Analytical procedures can be used to benchmark compensation levels to other companies in the industry and to examine trends over time.
• Evaluate whether there is proper objectivity in establishing compensation (i.e. is there a compensation committee independent of management).
Examine minutes of board of directors and compensation committee for approval of executive compensation and information on other cash transfers (e.g. loans, expense reimbursement).
• Use CAAT to search for payments to executives, or parties related to executives.
• If fraud or embezzlement is suspected, hire a private investigator to evaluate if executive is seemingly living beyond their compensation level.
Solution to Internet Assignment
12-19 A search of the Internet showed a number of sites that contained information on the retail industry. For some of these sites, however, the user must be a member to obtain information. A number of the major audit firms’ home pages contained information on the retail industry. Lastly, some financial services companies, such as Standard & Poors have sites that contain links to the retail industry.
CHAPTER 13
AUDITING THE INVENTORY MANAGEMENT PROCESS