Internal Controls | Payroll System

Summary

This video discusses internal controls for the payroll cycle, emphasizing the auditor's role in understanding and testing the design of these controls. Key topics include the importance of segregation of duties, the risks of weak controls, and practical examples of control failures. It also highlights entity-level controls, such as monitoring payroll liabilities and ensuring proper authorization for adding or removing employees. A detailed list of potential internal controls is provided, focusing on areas like occurrence, accuracy, and classification. The video stresses the need for both effective design and operation of payroll controls to prevent material misstatements.

Takeaways

• 😀 Internal controls in the payroll cycle are crucial for preventing misstatements and ensuring financial integrity.
• 😀 Auditors must first understand the design of internal controls through a walkthrough of the client's payroll cycle, from hiring to journal entry.
• 😀 Entity-level controls, such as an active audit committee and written policies for employee management, are essential for a strong internal control environment.
• 😀 Segregation of duties is the most important control to prevent fraud, ensuring that no single employee handles multiple critical payroll functions.
• 😀 A lack of segregation of duties, such as an employee both adding fictitious employees and processing payroll, can lead to significant financial fraud.
• 😀 Small businesses often struggle with segregation of duties, but the owner’s involvement in different payroll functions can help mitigate the risks.
• 😀 Implementing a changes report to track changes in employee status or payroll information helps prevent fraudulent activities.
• 😀 Supervisors should approve timesheets to ensure that employees are paid for actual hours worked, preventing potential payroll fraud.
• 😀 Sending earning statements, such as W-2 forms in the US, to employees helps identify potential issues like fictitious employees remaining on payroll.
• 😀 Proper authorization is key to ensuring that only valid employees are added to the payroll and that their work hours are accurately recorded.

Q & A

Why is it important for auditors to understand the design of internal controls in the payroll cycle?

Auditors must understand the design of internal controls to assess if they are effectively preventing or detecting material misstatements. This is critical for evaluating the integrity of the payroll process and ensuring the accuracy of financial reporting.

What is the purpose of a walkthrough in the context of auditing internal controls?

A walkthrough involves the auditor going through each step of the payroll cycle, from hiring to the recording of journal entries. This helps the auditor understand the design of controls and identify any potential areas where misstatements could occur.

What are some examples of entity-level controls auditors should look for?

Examples include the active involvement of the audit committee in financial reporting, the existence of written policies for adding and removing employees from the payroll system, and proper monitoring of payroll liabilities, especially regarding executive compensation.

What is the significance of segregation of duties in payroll processing?

Segregation of duties prevents one person from having control over multiple steps in the payroll process. This reduces the risk of fraud, such as creating fictitious employees or pocketing payroll checks.

Why is having one person responsible for multiple payroll tasks problematic?

When one person is responsible for multiple tasks, such as adding employees, approving time sheets, and processing payroll, it opens the door to fraud. For example, a dishonest employee could create fake employees and steal their paychecks without detection.

How does segregation of duties help prevent fraudulent activity in payroll?

Segregation of duties ensures that no single person has control over all aspects of payroll, such as employee additions, time sheet approvals, payroll processing, and paycheck distribution. This division of responsibilities makes it harder for fraud to go unnoticed.

What role does a 'changes report' play in preventing payroll fraud?

A changes report tracks any modifications to employee details, such as address changes. It ensures that unauthorized changes, like redirecting paychecks to an employee's personal address, are detected and investigated.

Why is it important to verify time sheets and who should be responsible for approving them?

Time sheets should be verified by a supervisor to ensure that employees are paid for actual work performed. This prevents fraudulent claims for hours not worked and ensures the accuracy of payroll expenses.

What is the potential issue with an employee receiving a W-2 (or equivalent earning statement) for wages they did not earn?

If a fired employee remains on the payroll or if a fictitious employee is added, they might receive a W-2 indicating earnings they did not receive. This could lead to tax complications for the employee and fraud concerns for the company.

How can auditors ensure the accuracy of payroll costs?

Auditors can compare actual payroll costs to budgeted figures or standard labor costs. A significant deviation could indicate errors or fraud in the payroll process, which would require further investigation.