How to Audit Payroll Expense?

Auditing payroll is the process that auditors use to test the true and fair view of the payroll balance on the income statement.

Payroll expense presented on the income statement, it represents the cost that the company spends on the employee.

It is the compensation that a company spends on employees in exchange for their employment over a period of time.

Payroll is one of the significant expenses that company spends to support its operation. It is a compulsory expense that company can not avoid unless they outsource everything. Most of the company hire employees to work in various departments. They need staff to work in the production, marketing, accounting, and other departments.

When the company expands its operation, it will increase the payroll as well. The big business operation will require more people both front and back office.

Most of the time, the auditor will scope the payroll expense as it is a large portion of the operating expenses. However, it is most likely considered a low risk due to its straightforward nature.

Risk Associated with Payroll Expense

Payroll is the major expense for most of the company, so the risk is high if anything wrong happens to the balance. It will have a significant impact on the whole financial statement.

The risk associated with auditing payroll expenses happens when the auditor cannot detect or prevent risk. It is the result of inherent risk, control risk, and detection risk.

  • Inherent risk: It is the risk that attaches to the account balance based on the nature of the account, and business complexity. It is the auditor’s judgment over the account base on various factors. Auditor has nothing to do with the inherent risk.
  • Control Risk: The risk that company internal control fails to detect and prevent material misstatement from happening. It depends on the control design by client management and implementation. An auditor can only validate the effectiveness of internal control.
  • Detection Risk: It is the risk that auditors fail to detect material misstatement in the payroll expense. An auditor can reduce the risk by increasing the testing sample.

Auditor can only have an impact on the detection risk. They can increase the testing and sample to reduce the risk. It is necessary to increase the testing to reduce the detection risk when the account is high risk and the control is high.

It is not necessary to increase the testing while the account is not risky and the client has proper control. An auditor can reduce the testing to save time and effectiveness.

Audit Assertion for Payroll Expense

Audit assertion is the characteristic of an account that the auditor needs to test to ensure the amount record is correct. The audit assertion is separate between income statement items and balance sheet items.

Payroll expense is the income statement account, so the auditor has to test the following assertions:

  • Cut-Off: Payroll expense is the income statement line item, so it must comply with accrued accounting method. The company must record the expense which really happens during the accounting period. The expense has to record on income statement even the company has not yet made payment.
  • Occurrence: The transaction record represent the business activity. The payroll expense shows the record of transactions that really happens during the year. It will be a fraud if the company records an expense that is not occurring.
  • Accuracy: The payroll expense record must be the same as the amount spent on the employees. The amount recorded and the amount spent must be the same.
  • Completeness: All the expenses that happen in the period must be fully recorded. Not a single transaction is left behind.
  • Classification: The business expense is supposed to be present in the correct classification. The payroll is the main operating expense that has to be present on its own line. It will be a problem if company shows it in the other expense.

Substantive Analytical Procedure for Payroll Expense

The analytical procedure is the process the auditor use high-level analysis to perform an overall assessment to ensure the balance of payroll expense. Each balance always has a connection between other accounts due to double entry. Moreover, the account also has a connection with non-financial data. The payroll expense will increase when the company increases production as they require to hire more people.

Auditor performs an analytical procedure for payroll expenses by comparing the balance from one month to another. The payroll that company spends on employees is supposed to be consistent unless there are changes in total number of employees.

The employee will receive the same salary for the year unless there is an increment or new promotion. The increment rate will depend on the management approval and it is also within the expectation as well.

Besides that, the auditor can measure the payroll cost by comparing it with the operational size. It also aligns with the monthly revenue as well. The payroll should remain the same if the operation size remains the same.

Auditor can access the payroll cost for a month and multiple with 12 months to get the total amount of payroll per year. This amount should be comparable with the payroll cost on the income statement. There may be variance that raises from the annual increment, bonus, or new employees.

The auditors must investigate the payroll cost that has significant variance compared to their independent expectations. The investigation will lead to the conclusion in the payroll expense account.

The analytical procedure will provide auditors with the reasonableness of the amount recorded on the income statement.

Test of Detail for Payroll Expense

Test of detail is the audit procedure that auditors use to verify the detailed transactions record of the client’s financial statement.

As the name suggests, auditors use various testing procedures to test the financial assertion that is compatible with the account.

When auditor uses a test of detail to verify the payroll cost, they will check the below assertion.

  • Cut-off: It is the financial statement assertion that ensures the transactions are recorded in the correct period. The auditor must ensure that the expenses are recorded in the period that they incur.

During the year, the payroll expenses are only 12 months, nothing less nothing more. If there are some unpaid payroll expense at the end of the period, auditor has to check if the company make proper accrued. The same as payroll expense at the beginning of the year, it must not cover the prior-year expense. Auditor intention is to ensure that the payroll expense on financial statement represents the expense within the period only.

  • Occurrence: The accounting record in the income statement really represent the business transactions. There are no fake transactions are allowed to be included in the report. Auditors perform testing to check if all the transactions really happen.

Regarding the nature of payroll expense, company expects to pay for the employee who performs work during the month and year. We can review employment contracts to ensure there are really doing the work. We also can spot check the employee headcount in any particular period and compare it to the payroll listing, it should be reasonable to prior months’ listing. Auditor can also use professional judgment to compare the operation size to the staff’s headcount.

  • Accuracy: the transaction record on the financial statement have to be accurate. The amount record is the same as the supporting document, real business transaction, and so on.

Auditor has to compare the transaction to the original supporting document. To ensure the accuracy of payroll, we have to compare the payroll listing to the amount on the trial balance.

The payroll list consists of payments to each staff and it contains all components such as basic salary, performance bonus, overtime, and so on. The auditor must go deep by checking each component.

The basic salary can be checked again in the employment contract or increment letter. The bonus must be included in the annual approved listing. The overtime can be found in the employee timesheet and so on.

  • Completeness: The auditor can test if the recorded balance is completed or not. Auditor can request the payroll listing during the year and reconcile it with the balance on income statement. It will help to ensure completeness and the reliability of the listing.
  • Classification: is the presentation of account on both income statement and balance sheet. The payroll expense has to be reported in the correct account under operating expense in the income statement. Some payroll expenses may be recorded as the cost of goods sold depending on the nature of the business, it has to be consistent.