Essay: Internal Controls In Payroll System: Strengths And Deficiencies.

You are an audit senior of Simple Audits Limited and are in the process of reviewing the systems testing completed on the payroll cycle of Big Industries Limited (Big), as well as preparing the audit programmes for the final audit.

Bronze operate several chemical processing factories across the country, it manufactures 24 hours a day, seven days a week and employees work a standard shift of eight hours and are paid for hours worked at an hourly rate. Factory employees are paid weekly, with approximately 80% being paid by bank transfer and 20% in cash; the different payment methods are due to employee preferences and Bronze has no plans to change these methods. The administration and sales teams are paid monthly by bank transfer.

Factory staff are each issued a sequentially numbered clock card which details their employee number and name. Employees swipe their cards at the beginning and end of the eight-hour shift and this process is not supervised. During the shift employees are entitled to a 30-minute paid break and employees do not need to clock out to access the dining area. Clock card data links into the payroll system, which automatically calculates gross and net pay along with any statutory deductions. The payroll supervisor for each payment run checks on a sample basis some of these calculations to ensure the system is operating effectively. Bronze has a human resources department which is responsible for setting up new permanent employees and leavers. Appointments of temporary staff are made by factory production supervisors. Occasionally overtime is required of factory staff, usually to fill gaps caused by staff holidays. Overtime reports which detail the amount of overtime worked are sent out quarterly by the payroll department to production supervisors for their review. To encourage staff to attend work on time for all shifts Bronze pays a discretionary bonus every six months to factory staff; the production supervisors determine the amounts to be paid. This is communicated in writing by the production supervisors to the payroll department and the bonus is input by a clerk into the system. For employees paid by bank transfer, the payroll manager reviews the list of the payments and agrees to the payroll records prior to authorising the bank payment. If any changes are required, the payroll manager amends the records. For employees paid in cash, the pay packets are prepared in the payroll department and a clerk distributes them to employees; as she knows most of these individuals she does not require proof of identity.

(a)  Identify and explain five internal control Strengths in Big’s payroll system. 

(b)  Identify and explain six internal control deficiencies in Big’s payroll system and provide a Recommendation to address each of these deficiencies. (c)  Describe substantive Analytical procedures you should perform to confirm Big’s payroll expense. 

Five internal control strengths in Big’s payroll system

Internal control procedures can be said as practices which are followed for protecting business resources mainly relating to recording, distribution and preparing of payroll (Shah & Nair, 2013). In case the appropriate procedure is placed to ensure that assets of the company are protected from the risk of fraud and eliminating errors. Five internal control strengths in Big’s payroll system, according to the ASA 315, are enumerated as below-

• Electronic Data entry regarding the time of coming and leaving the office: The change of information into a computer-readable form through the use of a mechanical process. Again, most companies have internal controls to assure that data entry is accurate. The application of sequentially number clock is thestrength of the system, as in case manual entry is done chances of fraud and error can increase (Kilgore, Harrison & Radich, 2014). However, thecertainty of same decreases as the data is entered electronically and even the chances of influencing the authority regarding wrong entering of time are also nullified.
• Appropriate reviewing: Internal control gets strengthened if the organization constantly performs reviewing function. The data is automatically entered into clock card to payroll system for calculation of gross and net pay along with statutory deductions. The organisation is not wholly dependent on the system for it as payroll supervisor recheck every payment which is being done for ensuring whether the system is working effectively or not.
• Management’s responsibility: HR department should maintain details regarding employee records to ascertain the rate which is payable to each employee and information relating to statutory benefits (Byrnes,Warren Jr&Vasarhelyi, 2015). In present case appointments of new employees and leaders are managed by Human Resource department as they can do this job with more appropriateness. The manager must not abuse the responsibility task given to them.
• Adequate separation of duties: There are four kinds of major task evolved in payroll: Hiring and advancing, maintaining accurate time sheets, preparing payroll and paying employees and payroll taxes (Ojala, Collis&Pajunen, 2014). These entiretasks are segregated to different departments for ensuring appropriate data has been entered and for reducing the risk of fraud. The same processes are reviewed again for the following aspects-

1. The custody of assets must be segregated from the accounting if assets,
2. authorization of transactions are separate,
3. operational responsibility must be separate from record keeping

• Reasonable Assurance: Rechecking of transfers reduces the chances of fraud as well as chances of wrong transfers. In presentcase, payroll manager reviews the list of payments and review the same before authorising for further bank payments. Assurance also makes certain that the organization acheievs its goals.

b) Deficiency in the records and control system means lack of essential audit evidence. The failure to report weakness of internal control system may lead to huge losses for the company.  

• No supervision while swiping cards at thebeginning and ending of eight shift hour: Although theapplication of electronic cards is thestrength of present payroll system but at the same time as no one present to assess for its supervision that whether the same person is entering the card while coming and leaving the organisation (Chambers&Odar, 2015). As no supervision of same is done, chances of fraud might increase because it might be possible that one employee enters electronic card of more than one person and wages are paid inappropriately.

Recommendation: The above issue can be resolved by maintaining a handbook which clearly states the procedure of clocking in and out and the same will decrease the consequences of falsely entering payroll procedure.

• Payment to employees without assessing their identity cards: In present case, payment is provided in cash without assessing their identity card and having asign after receipt of payment (Christensen, Glover& Wood, 2013). No appropriate system exist in the organisation and only because one person knows most of the employees he is given the obligation of giving salary packets to individuals without any recheck is not an appropriate method of providing salary.
• Recommendation: In order to maintain feasible internal controls it is necessary to have a proper system of distributing salary to the employees.It is because; the risk relating to payment to a wrong person or not paying the person on time might exist. Thus, a system should be developed through which the employees who have received the payment signs on the sheet of record and the same should be rechecked by a senior authority. The person who authorizes payment must be different from the one who keeps records.
• Appointment by factory production supervisors: Appointments of temporary staff is made through production supervisors in present payroll system despite having a Human resource department (Chou, 2015). As they are more capable of searching an appropriate employee they should be provided with the same duty.

Recommendation: For maintaining appropriate internal control, it is necessary that duty is allocated to appropriate person so that the organisation gets the best result. For existing weakness, appointments of thenew employee whether permanent or temporary all should be made by Human Resource department.

• Division of payroll processing: If the personnel forpayroll accounting have the capability to modifying items in the file of payroll master, there is a weakness in internal control. In present case inefficiency has been observed in the process of division of payroll processing as no appropriate procedure for the same exists in the organisation

Recommendation: Human resources are usually responsible for setting up new employees in thepayroll system, processing the data and distributing paychecks. In case the duties are not segregated, thepossibility of creating a false employee exists as all the functions are performed by one and the same person (Cohen&Simnett, 2014). Thus, appropriate segregation and practice of rechecking the same at reasonable interval should be adopted for resolving the same issue.

• Lack of systematic internal audit

No practice of systematic internal audit is followed by the organisation as per the ASA 610. Thus, due to the same issue, the internal control is weak, and auditors are not able to rely on information provided by the management with ease (Ihendinihu& Robert, 2014). It is one of the reason due to which most employees who successfully embezzles a large amount of moneydo such overtime.

Recommendation: Periodic publicised audit of payroll and accounting functions could assist in resolving the issue relating through assisting in searching the dishonest person. Through same procedures, financial losses due to fraud can be reduced (Chou, 2015). The practice of internal audit will also provide a base through which strength of internal control can be increased, and the same will also provide an ease to auditor while auditing.

• Data security: No practice or procedure is being followed by the company regardingthesecurity of data. Thus the chances of manipulating data or deleting the data are very more in the organisation. No practice of entering apassword is present in the present system, and due to same, it is very easy for them to violate the privacy laws and the same might be paid as a cost in form financial terms or in terms of reputation.

Recommendation: Security controls are meant to ensure employees personally, and payroll data or information remains private. In thecase of aweak internal control system in which no measure regarding security is present, hard copy information, ablank check or check stamping can lead to theft of information. Thus the issue can be resolved by providing apassword on the system so that only the needed employee is able to access the data (Knechel&Salterio, 2016). It should also be verified that he could access to the extent he is required to accomplish its obligation; else the issue of manipulating data will not be resolved. The unauthorized person must not be allowed for accessing the important documents. Proper password system must be developed for the same.

ASA 520 deals with Analytical procedures and design of tests for internal control according to which sustainability analytical procedure are applied for given assertions, taking account of the assessed risk of material misstatement and test of details for assessing any of the above assertions. The same are also performed for evaluating the reliability of data which is used by the auditor for the purpose of calculating expected amount as well as ratios (William jr, Glover&Prawitt, 2016). The analytical procedure can also be performed when theoverall conclusion is to be made at the end of theperiod to determine whether the financial report is in accordance with the auditor’s understanding of entity. These procedures assist in ascertaining the potential problems and determining the important areas of audit.

The following analytical procedures can be followed for confirming payroll expenses:

• Comparison of expenses with the comparable prior period for ascertaining the changes; through this auditor would be able to know whether theappropriate amount of expense have been charged or not.
• Analysis of anticipated results: such as budgets, interim or annual data for obtaining evidential matter about particular assertions relating to classes of transactions.
• Comparison of recorded amounts or analysis of ratios developed through expected amount with theexpected amount in accordance with the auditor (Luo, 2015). The same detail assists in identifying plausible relationships which are reasonably expected to exist in accordance with auditor’s understanding of client as well as the industry in which it operates.
• The gross margin of thecompany is compared with gross margin of industry in which it operates for assessing whether additional wages have not been incurred in order to reduce the gross margin.
• Flow Charts are used for analysingof the relationship of financial information with non-financial information such as assessment of registers or salary sheets and verifying the amount with the amount of expense charged during that period (Cohen&Simnett, 2014).
• Internal control questionnaire- The main analysis is done by application of analytical procedures at the end of the period, the test of details and detection of material misstatements have been done,and internal control seems to be more efficient than it should be in accordance with circumstances available. At that point, analytical procedures are applied by theauditor for taking appropriate further steps.

References

Books and journals

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Chambers, A. D., &Odar, M. (2015). A new vision for internal audit. Managerial Auditing Journal, 30(1), 34-55.

Chou, D. C. (2015). Cloud computing risk and audit issues. Computer Standards & Interfaces, 42, 137-142.

Christensen, B. E., Glover, S. M., & Wood, D. A. (2013). Extreme estimation uncertainty and audit assurance. Current Issues in Auditing, 7(1), P36-P42.

Cohen, J. R., &Simnett, R. (2014). CSR and assurance services: A research agenda. Auditing: A Journal of Practice & Theory, 34(1), 59-74.

Ihendinihu, J. U., & Robert, S. N. (2014). Role of Audit Education in Minimizing Audit Expectation Gap (AEG). International Journal of Business and Management, 9(2), 203.

Kilgore, A., Harrison, G., &Radich, R. (2014). Audit quality: what’s important to users of audit services.Managerial Auditing Journal, 29(9), 776-799.

Knechel, W. R., &Salterio, S. E. (2016). Auditing: assurance and risk. Routledge.

Luo, Y. (2015). Acctg 626 Audit and Assurance Services.SAGE.

Ojala, H., Collis, J., &Pajunen, K. (2014). Audit quality and decision-making in small companies. Managerial Auditing Journal, 29(9), 800-817.

Shah, M., & Nair, C. S. (Eds.). (2013). External Quality Audit. Elsevier.

William Jr, M., Glover, S., &Prawitt, D. (2016). Auditing and assurance services: A systematic approach. McGraw-Hill Education.