1Chapter 20 Audit of the Payroll and Personnel Cycle

Review Questions

20-1 General ledger accounts that are likely to be affected by the payroll and personnel cycle in most audits include the following: Cash Inventory Construction in progress Wages payable ayroll taxes withheld !ccrued payroll taxes Direct labor Salary expense Commission expense ayroll tax expense

20-2 In companies where payroll is a significant portion of inventory" as in manufacturing and construction companies" the improper account classification of payroll can significantly affect asset valuation for accounts such as work in process" finished goods" and construction in process# $or example" if the salaries of administrative personnel are incorrectly charged to indirect manufacturing overhead" the overhead charged to inventory on the balance sheet can be overstated# Similarly" if the indirect labor cost of individual employees is charged to specific %obs or processes" the valuation of inventory is affected if labor is improperly classified# When some %obs are billed on a cost plus basis" revenue and the valuation of inventory are both affected by improperly classifying labor to %obs# 20-3 $ive tests of controls that can be performed for the payroll and personnel cycle are: &# Examine time card for indication of approval to ensure that payroll payments are properly authorized # 'he purpose of this test is to determine that recorded payroll payments are for work actually performed by existing employees (occurrence)# Account for a sequence of payroll checks to ensure existing payroll payments are recorded# 'he purpose of this test is to determine that existing payroll transactions are recorded (completeness)# Examine time cards to ensure that recorded payroll payments are for work actually performed by existing employees # 'he purpose of this test is the same as in item & above# Compare postings to the chart of accounts to ensure that payroll transactions are properly classified# (Classification) Observe when recording takes place to ensure that payroll transactions are recorded on a timely basis# ('iming)

*# +# ,# -#

*./&

20-4 'he percentage of total audit time in the cycle devoted to performing tests of controls and substantive tests of transactions is usually far greater in the payroll and personnel cycle than for the sales and collection cycle because there is relatively little independent third party evidence" such as confirmation" to verify the related payroll accounts# In contrast" the accounts related to the sales and collection cycle can usually be verified for the most part by confirmations from customers# In addition" in the sales and collection cycle" verification of the reali0ability of receivables and sales cutoff tests are important and time/ consuming tasks# 20-5 'he auditor should be concerned with whether the human resources department is following the proper hiring and termination procedures# !n obvious reason for this would be to ensure that there are ade1uate safeguards against hiring and retaining incompetent and untrustworthy people# 'he ramifications of hiring such people can range from simple inefficiency and waste to outright fraud or theft# 2ore importantly" though" it is necessary for the auditor to assure himself or herself that the client is hiring and terminating according to operations standards and procedures# It is necessary to see if the internal controls are working as planned before they can be effectively evaluated# 'o say that the auditor doesn3t care who is hired and who is fired is to suggest that he or she doesn3t care if the internal controls work according to any standards# $ailure to follow proper termination procedures could lead to fraudulent payments for work not performed# 20'o trace a random sample of prenumbered time cards to the related payroll checks in the payroll register and compare the hours worked to the hours paid is to test if payroll checks have been recorded (completeness) and if those employees who worked are being paid for their time actually worked# 4mployees are likely to inform management if they are not paid" or underpaid# 'o trace a random sample of payroll checks from the payroll register and compare the hours worked to the hours paid is to test if the recorded payroll payments are for work actually performed by existing employees (occurrence)# 'his test" in effect" attempts to discover nonexistent employees or duplicate payments" if there are any# $or this reason" the second procedure is typically more important to the audit of payroll# 20-! In auditing payroll withholding and payroll tax expense" the emphasis should normally be on evaluating the ade1uacy of the payroll tax return preparation procedures rather than the payroll tax liability" because a ma%or reason for misstatements in the liability account is incorrect preparation of the returns in the past# If the preparation procedures are inade1uate" and the amounts do not appear reasonable" then the auditor should expand his or her work and recompute the withholding and expense amounts to determine that the proper amount has been accrued# In addition" the auditor should consider the amount of penalties which may be assessed for inade1uate withholdings and include these amounts in the accrual if they are significant#

*./*

20-" Several analytical procedures for the payroll and personnel cycle and misstatements that might be indicated by significant fluctuations are as follows:
A#A$%&'CA$ PR(C)*+R) &# Comparison of payroll expense accounts to amounts in prior years# *# Direct labor divided by sales compared to industry standards in prior years# +# Commission expense divided by sales compared to industry standards" prior years" or sales agreements# ,# ayroll tax expense divided by salaries and wages compared to prior year balances ad%usted for changes in the tax rate and not including officers5 salaries# ,'--&A&),)#& &%P)Cutoff misstatements or improper amounts recorded in a period# Cutoff misstatements or amounts charged to improper payroll accounts# $ailure to record commission on sales" or recording the improper commission amount# $ailure to record payroll taxes or recording of the improper amount#

-# Comparison of accrued payroll and payroll tax accounts to prior years# 6# 'he percentage of labor included in work in process and finished goods inventories compared to prior years# 8# !nalysis of direct labor variances#

$ailure to record payroll accruals or recording improper amounts at the end of a period# 7se of improper labor standards" or classification misstatements# 7se of improper labor standards" or classification misstatements#

20-. !n auditor should perform audit tests primarily designed to uncover fraud in the payroll and personnel cycle when he or she has determined that internal controls are deficient (or the opportunity exists for management to override the internal controls) or when there are other reasons to suspect fraud# !udit procedures that are primarily for the detection of fraud in the payroll and personnel cycle include: &# 4xamine cancelled payroll checks for employee name" authori0ed signature" and proper endorsement (especially for second endorse/ ments) to discover checks going to nonexistent employees# 'he endorsement should be compared to signatures on W/, forms# 'race selected transactions recorded in the payroll %ournal or listing to the human resources department files to determine whether the employees were actually employed during the period# Select several terminated employees from payroll records to determine whether each former employee received his or her termination pay in accordance with company policy and to determine that the employee3s pay was discontinued on the date of termination#

*# +#

*./+

20-. /continued0 ,# -# 4xamine the subse1uent payroll periods of terminated employees to ascertain that the employees are no longer being paid# 9e1uest a surprise payroll payoff to observe if any unclaimed checks result" which will necessitate extensive investigation#

20-10 'he Payroll aster !ile is maintained for each employee indicating the gross pay for each payment period" deductions from the gross pay" the net pay" the check number" and the date# 'he purpose of this record is to provide detailed information for federal and state income tax purposes" and to serve as the final record of what each employee was actually paid# 'he "#$ !orm is issued to each employee at the end of each calendar year and indicates his or her gross pay" income taxes withheld" and $IC! withheld for the year# In serving as a summary of the employee3s earnings record" the W/* form conveniently provides information necessary for the employee to fill out his or her income tax returns# ! Payroll %ax &eturn is the form re1uired by and submitted to the local" state and federal governments for the payment of withheld taxes and the employer3s portion of $IC! taxes and state and federal unemployment compensation taxes# 20-11 Where the primary ob%ective is to detect fraud" the auditor will examine the following supporting documents and records: &# *# +# Cancelled payroll checks for employee name" authori0ed signature and proper endorsement" watching specifically for unusual or recurring second endorsements# ayroll %ournal or listing" tracing transactions to the personnel files to determine whether the employees were actually employed during the payroll period# ayroll %ournal or listing and individual payroll records" selecting terminated employees to determine whether each terminated employee received his or her termination pay in accordance with company policy and whether each employee was paid in the subse1uent payroll period# ayroll checks" observing each employee as he or she picks up and signs for his or her check# 'ime cards" testing them for reasonableness or observing whether they are being punched by the proper employees#

,# -# 20-12

'ypes of authori0ations in the payroll and personnel cycle are: &# *# +# Deduction authori0ation" without which the wrong amount (or no deduction) may be deducted from the employee3s paycheck# 9ate authori0ations" without which the employee may be getting paid at the wrong rate# 'ime card authori0ation" without which the employee may be getting paid for the wrong 1uantity of hours worked#

*./,

20-12 /continued0 ,# -# 6# ayroll check authori0ation" without which unauthori0ed funds may be paid out# Commission rate authori0ation" without which the salespeople might be improperly compensated for their sales efforts# !uthori0ation to hire a new employee" without which nonexistent or un1ualified personnel may be added to the payroll#

20-13 It is common to verify total officers3 compensation even when the tests of controls and substantive tests of transactions results in payroll are excellent because the salaries and bonuses of officers must be included in filings with the S4C and I9S (e#g#" the $orm &./: 9eport" proxy" and the federal income tax return) and because management may be in a position to pay themselves more than the authori0ed amount" since the controls over the officers3 payroll are typically weaker and therefore easier to override than those of the normal payroll# 'he usual audit procedure used to verify the officers3 compensation is to obtain the authori0ed salary of each officer from the minutes of the board of directors and compare it to the related earnings record# 20-14 !n imprest payroll account is a separate payroll bank account in which a constant balance" either 0ero or small" is maintained# When a payroll is paid" the exact amount of the net payroll is transferred by check or electronic funds transfer from the general account to the imprest account# 'he purpose and advantage of an imprest payroll account is that it limits the company3s exposure to payroll fraud by limiting the amount that may be misappropriated# 20-15 Several audit procedures the auditor can use to determine whether recorded payroll transactions are recorded at the proper amounts are: &# *# +# ,# -# 6# 9ecompute hours worked from time cards# Compare pay rates with union contract" approval by the board of directors" or other source# 9ecompute gross pay# Check withholdings by reference to tax tables and authori0ation forms in personnel files# 9ecompute net pay# Compare cancelled check with payroll %ournal or listing for amount#

20-1 !ttributes sampling can be used in the payroll and personnel cycle in performing tests of controls and substantive tests of transactions with the following ob%ectives: &# *# +# ,# 'ime card hours agree with payroll computations# ;vertime hours are approved# $oreman approves all time cards# <ourly rates agree with personnel files and union contracts#

*./-

20-1 /continued0 -# 6# 8# =# ># Gross pay calculation is verified# 4xemptions taken agree with W/,# Income tax" other deductions" and net pay calculations are verified# !uthori0ations are available for voluntary withholdings and miscellaneous deductions# aycheck endorsement is same as signature on W/, form#

'he fre1uency of control deviations or monetary errors must be estimated prior to performing the tests# 'his estimate together with the acceptable risk of assessing control risk too low (!9!C9) and the tolerable exception rate will enable the auditor to determine the sample si0e re1uired# ;nce the tests are performed on the sample" evaluation of the results will indicate whether the exception rate is lower than" e1ual to" or higher than that anticipated# 'he auditor must then use this %udgment to decide the appropriate action to take# ,ultiple Choice Questions 1ro2 CPA )3a2inations a# a# (*) (,) b# b# (&) (,) c# c# (+) (,)

20-1! 20-1"

*iscussion Questions and Pro4le2s

20-1.
&RA#-AC&'(#R)$A&)* A+*'& (56)C&'7) &# 9ecorded payroll transactions are stated at the proper pay rates (accuracy)# *# 9ecorded payroll transactions exist (occurrence)# -+5-&A#&'7) A+*'& PR(C)*+R) Compare rates in payroll %ournal or listing to rates in personnel files# Compare termination dates from personnel files to date of last paycheck#

&)-& (1 C(#&R($ 4xamine authori0ations in personnel files#

P(&)#&'A$ ,'--&A&),)#& 4mployees are paid the wrong rate#

4xamine personnel files for termination notices#

4mployees are improperly terminated and payment continues#

*./6

20-1. /continued0
&RA#-AC&'(#R)$A&)* A+*'& (56)C&'7) +# <ours worked are correctly recorded (accuracy)# -+5-&A#&'7) A+*'& PR(C)*+R) 9andomly sample workers and trace to time cards for hours worked# !naly0e payroll records of a sample of employees for reasonableness# 9ecompute employees3 pay" compare pay rates to personnel files" and hours worked to time cards# 'race entries from %ob summaries to time cards" %ob cards" etc# 'race payroll checks to employees" to determine if employee exists# 4xamine cancelled checks for endorsements" and compare to personnel file# 4xamine cancelled checks for endorsements" and compare to personnel file#

&)-& (1 C(#&R($ 4xamine time cards and observe preparation#

P(&)#&'A$ ,'--&A&),)#& Incorrect recording of time#

,# 9ecorded payroll payments are for work actually performed by existing employees (occurrence)# -# 9ecorded payroll transactions are for proper rate and amount (accuracy)#

4xamine time cards for approval#

Incorrect times are used in computing employees3 pay#

4xamine payroll %ournal or listing for indication of internal verification#

4mployees5 pay is miscalculated#

6# 'ime records are properly classified by %ob (classification)# 8# 9ecorded payroll checks are for work performed by existing employees (occurrence)# =# ayments are made to actual employees (occurrence)#

4xamine system of identifying %obs by number#

Direct labor is charged to wrong %obs#

;bserve and discuss payroll system with employees#

ayroll payments are made to nonexistent employees#

;bserve payments and discuss with employees#

ayments are made to wrong employees#

># 9ecorded payroll transactions are for work performed by existing employees (occurrence)#

;bserve distribution of paychecks and recording of unclaimed wages#

7nclaimed paychecks are cashed by the wrong people#

*./8

20-20
&%P) (1 &)-&
&# Substantive test of transactions *# 'est of control +# Substantive test of transactions ,# Substantive test of transactions -# Substantive test of transactions 6# 'est of control 8# Substantive test of transactions

&RA#-AC&'(#-R)$A&)* A+*'& (56)C&'7)/-0

'o determine if monthly payroll costs have been correctly allocated (accuracy)# 'o determine if recorded payroll transactions are for work actually performed by existing employees (occurrence)# 'o determine if employees are paid for the hours they have worked (accuracy)# 'o determine if the appropriate person is paid and amount and time are correct (accuracy and timing)# 'o determine if the correct %ob is charged for labor and if the amount is recorded correctly for each %ob (classification and accuracy)# 'o determine if all payroll checks are recorded (completeness)# 'o determine whether terminated employees were subse1uently paid for work not performed (occurrence)# 'o determine whether an obligation may exist for unpaid severance pay (completeness)#

20-21
R)C(,,)#*)* C(#&R($
&# !pproval of time cards by foreman and observation of use of time clock by the foreman#

-+5-&A#&'7) A+*'& PR(C)*+R)

;bserve employees punching in?only one card per employee?to see whether any employee punches two cards (normally not an effective or practical audit procedure)# erform payroll payoff" re1uiring identification from all employees prior to payment# Compare total hours worked from payroll %ournal or listing to total hours worked as recorded on %ob cost tickets# 'race labor distribution to supporting %ob input forms# erform payoff as described in * above# 9ecompute federal withholding taxes and trace to employee earnings record# 9econcile the disbursements in the payroll %ournal or listing to the disbursements on the payroll bank statement#

*#

aychecks distributed by someone other than the foreman# ay employees only for time charged to %obs# 9econcile payroll expense to amounts charged to %obs#

+#

,# Internal verification of classification# -# ayroll checks not returned to payroll clerk after signing#

6# Internal verification of calculations and amounts# 8# ayroll checks are prenumbered and accounted for# 7se an imprest bank account where the amount to be deposited is taken from the payroll %ournal or listing#

*./=

20-22
APP$'CA5$) &RA#-AC&'(#-R)$A&)* (R 5A$A#C)-R)$A&)* A+*'& (56)C&'7)/-0 A@! !ccuracy# Detail tie/in# Completeness# osting and summari0ation# Completeness" accuracy and cutoff# ;ccurrence" timing and accuracy# A@! !ccuracy# A@! Completeness# ;ccurrence and accuracy (if totals are compared)#

&%P) (1 &)-& &# *# +# ,# -# 6# 8# =# ># &.# &&# &*# (+) (&) (,) (&) (*) (,) (*) (+) (&) (+) (,) (&)@(*) (&)" (*) (if totals are compared)

20-23 ! flowchart of steps for each type of test is given below (re1uirements a" b" and c):
&)-&- (1 C(#&R($(R -+5-&A#&'7) &)-&(1 &RA#-AC&'(#6 + =

&)-&- (1 *)&A'$(1 5A$A#C)* > 8 , &

*./>

20-24

a#

b#

Brendin3s approach to determining why this year3s payroll tax expense was so high suffers from two serious deficiencies: $irst" it lacks relevance" and second" it is too narrowly focused# 'he approach lacks relevance in that he is testing payroll withholding which is not the same as payroll tax expense# Some payroll taxes are related to withholding such as $IC!" but income tax withheld does not give rise to an expense" and certain payroll taxes" such as unemployment compensation" are not withheld# 'he approach is too narrowly focused in that the analytical test results could have resulted from a misstatement of the payroll itselfC Brendin does not appear to be considering this possibility# ! more suitable approach for determining whether payroll tax was properly stated in the current year would be to evaluate the reasonableness of the total payroll" reconcile the payroll to amounts shown on payroll tax reports" and check computations as shown on those reports for reasonableness#

20-25
a8 '#&)R#A$ C(#&R($ *)1'C')#C% 48 &%P) (1 ,'--&A&),)#& 'he foreman may hire un1ualified employees" friends or possibly a fictitious person to be paid through the payroll system# 'he foreman may provide inappropriate pay rates or pay rates that are split between an employee and the foreman# 4mployees" including the foreman" can take extra time cards and clock in for other employees or fictitious employees# 'he foreman can include fictitious time cards for check preparation#

&#

'he foreman should not hire employees#

*#

'he foremen should not recommend wages for employees# 'ime cards should not be left in a box that employees have access to# 'he foreman collects and approves the time cards as well as the duties described in &/+# (Aote: It is appropriate for the foreman to approve times cards if he has none of the other duties described in &/+#) 'here is no internal verification of the payroll clerk5s input of names or hours into the payroll system#

+#

,#

-#

'he payroll clerk can make mistakes entering the hours or names#

*./&.

20-25 /continued0
a8 '#&)R#A$ C(#&R($ *)1'C')#C% 6# 'he controller compares two output records and fails to compare the output to any input records# 'he foreman receives the payroll checks for distribution# 'he foreman mails checks to absent employees# 'he controller hires and approves wages for salaried employees and signs their checks# 48 &%P) (1 ,'--&A&),)#& 'he controller will not find any existing mistakes made by the payroll clerk#

8#

'he foreman can keep checks for which he has submitted time cards for nonexistent employees# Aonexistent or former employees who had someone else prepare their time cards will receive a check in the mail# 'he controller can submit information for a nonexistent employee" open a checking account in the person5s name and receive the direct deposit# She can also submit the improper salary rate to the payroll clerk and split the payment with the employee# 'he controller can include any pay rates she desires" for herself or others" including fictitious employees and friends who will split the amounts with her# 'he payroll clerk can add fictitious names for either salaried or hourly employees# She can set up a checking account in the same manner discussed in ># 'he person is unlikely to be 1ualified to do 1uality bank reconciliation and will thereby be unlikely to find the frauds included previously#

=#

>#

&.#

'he controller has sole access to pay rates#

&&#

'he payroll clerk can add names to the payroll records#

&*#

!n accounting clerk does the bank reconciliation each month#

*./&&

20-2

a# b#

'he purpose of a surprise payroll payoff is to determine whether or not nonexistent personnel are included in the payroll# rocedures other than a surprise payroll payoff that can be used to discover nonexistent employees are: &# *# 4xamine cancelled payroll checks for employee name" authori0ed signature" and proper endorsement that agrees with the employee3s signed W/, form# Select several terminated employees from payroll records to determine whether each former employee received his or her termination pay in accordance with company policy and was not paid in subse1uent payrolls#

c#

When the payroll payoff is taking place" the client should observe these control procedures: &# *# !ll employees must prove identity# 7nclaimed paychecks must be further investigated# 7nclaimed paychecks might be accounted for by employees who are sick or on vacation# !fter all present employees have received their checks" the remaining paychecks should be traced to the personnel files to determine if these employees were ever employed by the client# 'hereafter" if practical" the remaining checks should be held until the employees can be present with proper identification to claim the check#

d# 20-2!

See c#* above#

*)PAR&,)#& Warehouse and Shipping Department

)9&)#& (1 '#CR)A-) (R *)CR)A-) '# PA%R($$ )9P)#-) 4xtensive Increase

)9P$A#A&'(# 1(R )9P)C&)* C:A#;) '# *)PAR&,)#&<- PA%R($$ )9P)#-) 4ach online sale must be individually processed for shipment to single" stand/alone customers# 'he time and effort to process" package" and ship goods to each online customer will significantly increase the warehouse and shipping department payroll expense#

*./&*

20-2! /continued0
)9&)#& (1 '#CR)A-) (R *)CR)A-) '# PA%R($$ )9P)#-) Dittle Change

*)PAR&,)#& I' Department

)9P$A#A&'(# 1(R )9P)C&)* C:A#;) '# *)PAR&,)#&<- PA%R($$ )9P)#-) Because the company outsourced the creation and support of the online sales system" payroll expense would likely increase minimally (e#g#" some increase would occur despite the outsourcing)# <owever" consulting expense would be expected to increase extensively# Because online sales are applied to customer credit cards" most of the collection of the receivables would be handled by the credit card agencies" not by !rcher 7niform5s accounts receivable department# Some increase in payroll expense may occur" if there are disputes between !rcher 7niforms and the credit card agencies over the amounts processed throughout the month# !dditional time may be re1uired to reconcile the processing of cash payments by the credit card agencies and the recording of sales in !rcher 7niform5s financial statements# !ssuming total sales significantly increase due to the new online offering" the volume of inventory purchases will increase# 'his increase in inventory purchasing will result in an increase in vendor payments to be processed# 'hus" payroll expense for the accounts payable department may increase moderately# Some efficiencies may be obtained by processing larger bulk orders in a single vendor payment# <owever" new products may be offered and additional vendors may be used" which in turn will increase the volume of processing re1uired in accounts payable# !ssuming total sales significantly increase due to the new online offering" the volume of inventory purchases to be received and processed into the inventory warehouse will correspondingly increase# 2ost of the work associated with the new online sales offerings will be the responsibility of other employees#

!ccounts 9eceivable Department

Dittle to 2oderate Increase

!ccounts ayable Department

2oderate Increase

9eceiving Department

4xtensive Increase

4xecutive 2anagement

Dittle Change

*./&+

20-2! /continued0
)9&)#& (1 '#CR)A-) (R *)CR)A-) '# PA%R($$ )9P)#-) 2oderate Increase

*)PAR&,)#& 2arketing

)9P$A#A&'(# 1(R )9P)C&)* C:A#;) '# *)PAR&,)#&<- PA%R($$ )9P)#-) 'he extent of increase in payroll expense for this department will be dependent on the amount of advertising that !rcher 7niforms creates to promote its new Web site# !ssuming some advertising is created" there would be a moderate increase in marketing payroll expense# ;ther advertising expenses may increase for ads generated through external ad agencies and through Web site ad contracts#

20-2"

a#

!n audit program to verify sales commission expense is as follows: &# Select a sample of office copies of sales invoices# a# Check commissions rate to commissions rate file# b# Check computation of sales commissions# c# 4xamine invoices for internal verification by accounts receivable clerk# d# 'race sales commission amounts to sales commission ledger# $oot the sales commission ledger for one or more months" and trace the total to the general ledger# Compare totals for periods in the sales commission ledger to period balances of sales commission expense#

*# +# b#

!n audit program to verify accrued sales commissions is: &# *# Compare the accrual with that of the previous year# Investigate any significant change# Compare the amount of commissions paid to the salesmen on the fifteenth of the month following year/end to the total accrued commissions at year/end# ;btain a reconciliation and explanation for any reconciling items# Send confirmations to salesmen for the larger amounts of accrued commissions and a sample of the smaller amounts#

+#

*./&,

Case a# Conventional forms and documents in a payroll system include the following:

20-2.

ersonnel records Deduction authori0ation forms 9ate authori0ation forms 'ime cards and %ob time tickets ayroll checks ayroll %ournal or listing and labor distribution 4arnings record W/* form ayroll tax returns

In using the computer service center" it appears that there is no loss in documentation in substanceC however" the earnings record is not printed out each pay period" thus" the current version is usually in machine readable form # ('his assumes that authori0ation forms exist although they are not discussed in the case#) 'he fact that the earnings record is in magnetic form is not a problem" as long as the service bureau has ade1uate backup and recovery controls# 'he above analysis reflects the fact that Deggert3s internal controls in the payroll area are generally good# 'here is good segregation of duties between the resident and Clark" assuming both are trustworthy" honest people# rocedures" forms" records" and reports are comprehensive and well/designed# 'he only potential deficiency in internal control is that errors in details could be made by the service bureau and not necessarily be caught# It is difficult to imagine that these would be material#

*./&-

20-2. /continued0 b#
PA%R($$ &RA#-AC&'(#R)$A&)* A+*'& (56)C&'7) &# 9ecorded payroll payments are for work performed by existing employees (occurrence)#

PR(C)*+R)a# ;bserve existence of personnel files in resident3s care# b# ;bserve use of time clock and control of time cards by clerk# c# 4xamine time cards for resident3s approval# d# ;bserve distribution of payroll checks by resident# e# 4xamine cancelled checks for proper endorsement# f# Compare cancelled checks with personnel records# g# 4xamine cancelled check for resident3s signature#

&%P) (1 PR(C)*+R) 'est of control 'est of control 'est of control 'est of control Substantive test of transactions Substantive test of transactions 'est of control 'est of control and substantive test of transactions 'est of control

*# 4xisting payroll transactions are recorded (completeness)#

a# !ccount for the numerical se1uence of payroll checks# b# ;bserve preparation of payroll bank reconciliation by resident# a# ;bserve use of time clock and control of time cards by Clark# b# ;bserve Clark rechecking hours# c# 9ecompute gross pay" deductions and net pay# d# 'race rates and authori0ations to personnel file# e# 4xamine payroll %ournal or listing for approval by Clark# f# Compare rates in payroll %ournal or listing with personnel files to determine that rate actually paid is authori0ed#

+# 9ecorded payroll transactions are for the amount of time actually worked and at the proper pay rateC withholdings are properly calculated (accuracy)#

'est of control

'est of control Substantive test of transactions Substantive test of transactions 'est of control Substantive test of transactions

*./&6

20-2. /continued0
PA%R($$ &RA#-AC&'(#R)$A&)* A+*'& (56)C&'7) ,# ayroll transactions are properly classified (classification)#

PR(C)*+R)a# 9eview chart of accounts# b# 4xamine payroll %ournal or listing for approval by Clark# c# Compare classification with chart of accounts or procedures manual# a# ;bserve collection and processing of time cards by Clark# b# 4xamine payroll %ournal or listing for approval by Clark# c# ;bserve posting of ledger by Clark# d# ;bserve preparation of payroll bank reconciliation by resident# e# Compare date of check recorded in payroll %ournal with date on cancelled checks and time cards#

&%P) (1 PR(C)*+R) 'est of control 'est of control Substantive test of transactions 'est of control

-#

ayroll transactions are recorded on the correct dates (timing)#

'est of control 'est of control 'est of control

Substantive test of transactions

6#

ayroll transactions are properly included in the employee earnings recordC they are properly summari0ed#

a# ;bserve re/adding of payroll %ournal or listing and posting by Clark# b# 4xamine payroll %ournal or listing for approval by Clark# c# ;bserve posting of ledger by Clark# d# 'race postings from payroll %ournal to general ledger#

'est of control

'est of control 'est of control Substantive test of transactions

c#

rocedures in performance format: &# 2ake observations of the following activities by 2ary Clark: a) Control" collection and processing of time cards# b) 9echecking of hours on time cards# c) rocessing and approval of payroll %ournal or listing# d) osting of general ledger#

*./&8

20-2. /continued0 *# 2ake observations of the following activities by the resident: a) 2aintenance of personnel files# b) Distribution of paychecks# c) rocessing and approval of payroll %ournal or listing# d) osting of general ledger# 2ake observations of the following general matters and activities: a) 7se of time clock by employees# b) 4xistence and use of ade1uate chart of accounts# Select a sample of payroll check numbers and: a) !ccount for existence and recording of paychecks# b) 4xamine paychecks for resident3s signature# c) 4xamine checks for proper endorsement# d) Compare cancelled checks with personnel records# e) Compare date on check with date recorded in payroll %ournal or listing and on the time card# Select a sample of payroll entries from the payroll %ournal or listing and perform the following steps: a) ;btain time cards" examine for resident3s approval" and trace hours to payroll %ournal or listing# b) 4xamine personnel files and authori0ation for rates and deductions# c) 9ecompute gross pay" deductions" and net pay# d) Compare account classification with chart of accounts or procedures manual# Select a sample of payroll %ournals and perform the following steps: a) 4xamine payroll %ournal for approval by Clark# b) 'race postings to general ledger#

+#

,#

-#

6#

d#

! sampling data sheet follows# Aote that this sampling data sheet was prepared using attributes sampling# 'he only difference between this approach and a nonstatistical approach is the determination of sample si0e# 7nder nonstatistical sampling" students5 sample si0es will vary#

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20-2. /continued0
P$A##)* A+*'& *)-CR'P&'(# (1 A&&R'5+&)&# *# ayroll check number accounted for ayroll check signed by resident )P)R> .E .E &E &E .E &E .E &)R>> -E ,E 6E 6E 6E ,E -E ARACR>> -E -E -E -E -E -E -E '#'&'A$ -A,P$) -'=)>>> -> 8, 8= 8= ,> &-6 ->

+# 'ime card approved by resident ,# 'ime card hours agree with payroll %ournal or listing -# 6# ersonnel file is complete ay rate and deductions supported by authori0ation

8# Gross pay" deductions" and net pay correctly computed F FF FFF

'hese amounts are arbitrary to complete data sheet# Information to determine actual appropriate amounts is not given in problem# 'hese amounts are %udgments and are not the only acceptable amounts# Determined from attributes sampling tables#

'nternet Pro4le2 -olution? Ris@s of (utsourcinA the Payroll 1unction

20-1 2any businesses outsource the payroll function# In this web article" the I9S provides information on outsourcing payroll duties for employers who outsource the payroll function: (see http:@@www#irs#gov@businesses@small@article@.""idG&86>,+"..#html)# In another page" the I9S provides information on employment tax fraud investigations: (see http:@@www#irs#gov@compliance@enforcement@article@.""idG&=8*8.".. #html) &# If the third party makes the payroll tax payments" are they responsible for any deficiencies or failure to make paymentsH Answer? 'he employer" not the third party" is ultimately responsible for the deposit and payment of federal tax liabilities# 4ven thought the third party is making the deposits" the employer is the responsible party# If the third party fails to make the federal tax payments" the I9S may assess penalties and interest on the employer5s account# *./&>

'nternet Pro4le2 20-1 /continued0 *# What should be the employer address used for correspondence with the I9SH Why do you think this provision existsH Answer? If there are any issues with an account" the I9S will send correspondence to the employer at the address of record# 'he I9S strongly recommends that the employer not change their address of record to that of the payroll service provider# 'hat way" the employer can stay informed of matters involving their business# +# 9ead the fiscal year *..> investigation entitled I$ormer ;wner of ayroll Company Sentenced to &. Jears in rison#K What was the number of clients and the amount of payroll taxes that this payroll operator was charged with charged with failing to remit# Answer? 'he investigation report noted the following: 9ichley" the owner of ayroll Data Services Inc# ( DS)" Ipleaded guilty on !pril &&" *..= to three counts of mail fraud" four counts of tax evasion" and one count of money laundering# 9ichley admitted that between Lanuary *... and !pril *..+" he received approximately M,#+ million of employment taxes from at least +6 DS clients by falsely representing that he would pay the funds to the I9S on the companies5 behalf# 9ather than remitting the employment taxes to the I9S" 9ichley used the money for other purposes" including buying multiple luxury vehicles" spending M+6."... in hotels and casinos in Das Negas" and buying a residence in Dawrenceburg" Indiana# 9ichley also filed false employment tax returns on behalf of his clients" and false personal income tax returns" in an effort to conceal his embe00lement scheme#K ,# 9eview other investigations in *..> and *..=# !re there other cases of fraud involving payroll service providersH Answer? In addition to the case involving ayroll Data Services Inc# noted in O+ above (in the *..> report)" the following three cases reported in the *..= investigation report involve a payroll service provider:

&hree Payroll -ervicinA 5usiness )3ecutives -entenced for their Roles in )2ploy2ent &a3 1raud -che2e ;n September *," *..=" in Salt Dake City" 7tah" three executives and primary owners of rovident 2anagement Group ( 2G)" which at different times operated in !merican

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'nternet Pro4le2 20-1 /continued0 $ork" rovo" Salt Dake City" and 2esa" were sentenced for their roles in an employment tax fraud scheme# Scott 2# Boley" of 2esa" !ri0ona" was sentenced to +. months in prisonC Douglas 2orby" of ;gden" 7tah" was sentenced to +6 months in prisonC and 9obert Dangford" formerly of 2esa but now living in Illinois was sentenced to 8. months in prison# !ll three must serve three years of supervised release upon the completion of their prison time and ordered to pay M*"*+."8&6 in restitution# 2orby and Boley pleaded guilty 2arch ," *..=" to one count of conspiracy for their roles in the scheme# Dangford pleaded guilty 2arch &+" *..=" to conspiracy" mail fraud" and willful failure to pay over tax monies# In their plea agreements" the defendants admitted that one of the services their company provided for its clients was the collection and payment of federal payroll taxes to the Internal 9evenue Service (I9S)# <owever" the checks to pay the corresponding taxes were never sent to the I9S# 2G had the I9S delin1uency notices mailed to the company address and never forwarded them to their clients to avoid the clients5 discovery of the growing tax delin1uencies# $rom about Lune +." *..&" to about $ebruary &" *..+" 2G operated both a trust account and a general account and money was regularly transferred from the trust account to the general account where it was not segregated or protected from uses other than the payment of federal payroll taxes# 'he executives of the company used client funds designated for federal tax withholding payments to meet ongoing business expenses# 'he defendants also created the false impression with their clients that money given to them had been used to pay taxes#

'ndiana (wner of Payroll -ervice 5usiness -entenced for 1ailinA to Pay (ver &a3es ;n Lune +" *..=" in South Bend" Ind#" David Dee Lones was sentenced to +. months in prison and ordered to pay M8,="*88 in restitution to his victims for failing to forward payroll taxes to the I9S# Lones owned and operated !ffiliated ayroll Services" Inc#" a business that provided payroll services" including the payment of payroll taxes for clients# !ccording to court documents" Lones collected approximately M,-="... from his clients and did not forward the tax money to the I9S# Instead" he diverted the employment tax money for his own personal use#

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(wner of Pay Plus Payroll Ad2inistrators -entenced for )vasion of Pay2ent of Payroll &a3es ;n Aovember *" *..8" in 'ampa" $la#" 9obert :enneth Dromm" owner of ay lus ayroll !dministrators" Inc# ( ay lus)" was sentenced to ,= months in prison to be followed by three years of supervised release# Dromm pleaded guilty on !ugust &8" *..8 to one count of tax evasion# !ccording to court documents" ay lus collected funds from its corporate clients and agreed to file payroll tax returns ($orms >,&) with the Internal 9evenue Service (I9S) and pay to the I9S its clients5 payroll taxes# During the period between &>>> and *..," Dromm embe00led the funds of the company which he knew represented the payroll tax payments of ay lus5 clients# <e engineered a scheme through which he collected those funds and used them for personal purposes but did not turn them over to the I9S# During the tax years in 1uestion" as a result of this scheme" Dromm embe00led almost M+ million in this manner and ultimately evaded the payment to the I9S of approximately M&#6 million in employment tax funds which he and his company owed to the I9S on behalf of his clients#

(#ote: Internet problems address current issues using Internet sources# Because Internet sites are sub%ect to change" Internet problems and solutions may change# Current information on Internet problems is available at www#pearsonhighered#com@arens#)

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