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CHAPTER11
ProductionandPayrollCycle
LEARNINGOBJECTIVES
Review
Checkpoint
s

Exercises
andProblems

Cases

1. Describetheproductioncycle,
includingtypicalsourcedocuments
andcontrols.

1,2,3,
4,5,6,
7,8,9

51

2. Giveexamplesofdetailtestof
controlsproceduresforauditing
thecontrolsoverconversionof
materialsandlaborinaproduction
process.

10,11,
12,13,
14,15

52,53

64

3. Describesomecommonerrors,
irregularities,andfraudsinthe
accountingforproductioncosts,
andrelatedcostofgoodssold,and
designsomeauditandinvestigation
proceduresfordetectingthem.

16,17,
18,19

54

65,66

4. Describethepayrollcycle,
includingtypicalsourcedocuments
andcontrols.

20,21,
22,23,
24,25,
26,27,28

55,59

38,61,62,
68

5. Giveexamplesofdetailtestof
controlsproceduresforauditing
thecontrolsoverpayroll.

29,30,
31,32,33

56,57,60

39,63,69

6. Describesomecommonerrors,
irregularities,andfraudsin
payroll,anddesignsomeauditand
investigationproceduresfor
detectingthem.

34,35,
36,37

56,57,58

39,66,67,
69

POWERPOINTSLIDES
PowerPointslidesareincludedonthewebsite.Pleasetakespecialnoteof:
*
*

ProductionCycle
PayrollCycle

SOLUTIONSFORREVIEWCHECKPOINTS
11.1

Productionplanning
Inventoryplanning
Production
Costaccounting

11
11.2

11.3

Auditorsmustunderstandmanagement'sapproachtotheconversionofresources
andtheuniqueproductionprocesstounderstandtheflowoftransaction
processing.Withoutathoroughunderstandingoftheproductionprocess,the
relateddataprocessingandcostaccountingcannotbefullycomprehendedand
weaknessesininternalcontrolcanbeoverlooked.Ofallthetransaction
cycles,thiswillbethemostlikelytobedifferentforeachclient.
Awalkthroughofaproductiontransactionwillcollectthefollowing
documents:
Productionorder
Billofmaterials
Materialsrequisitions
Inventoryrecord(rawmaterialsissue)
Journalentry(movingrawmaterialstoworkinprocess)
Laborreport(timerecords)
Journalentry(charginglabortoworkinprocess)
Productioncostanalysis
Inventoryrecord(finishedgoodsaddition)
Journalentry(movingworkinprocesstoinventory)
A"walkthrough"involvesfollowingatransactionfrominitiationthroughthe
variousstepsuntilthetransactionisrecordedintheformalaccounting
records.Intheconversioncycle,thefollowingwouldconstituteacomplete
"walkthrough:"PleaserefertothePowerPointslidesincludedonthisCD.
Step

DocumentsCollected

ControlsNoted

Prepareproduction
orders

ProductionOrder
(P.O.)

SupportforP.O.

Preparebillof
materialsand
manpowerneeds

Billofmaterials
(B.M.)Manpower
needs(M.N.)

Separationplanning
fromproduction.

Assignjoborderand
foreman

Noteseparation
production
supervisorfrom
foremanduties.

Jobticketsand
material
requisitions
prepared

Jobtickets(JT)
Material
requisitions(MR)

Productionforeman
dutiesseparated
fromauthorization.

Rawmaterialrecords
updated,issueslips
prepared

Issueslip(IS)

Materialsnotissued
withoutMR.IS
preparedforall
materialsreleased.

Observetimeentered
andforemanapproval
onJT
Directlaborreport
prepared
Observetimekeeping,
comparejobtickets

Approvalbyforeman
ofhours.
Laborreport(LR)

Jobticketssupport
L.R.
Reconciliationhours
perclockcardsto

12
toclockcards
Materialusedreport
prepared

hoursperJ.T.
Materialused
report(MUR)

Observematching
issueslipsand
materialusedreport

Recordsfromsources
reconciled.

Observematchingjob
timetickets(or
labordistribution)
tolaborreport

Recordsfrom
separatesources
reconciled.

Entercostsinjob
costsheets

Jobcostsheets
(JCS)

Supportforall
entriesinJCS.

Summaryentry
prepared.

Summaryentryform

Jobcostsheets
supportsummary
entries.

Tracesummaryentry
toGeneralLedger
posting
Preparationof
completionreport

Separationof
duties;cost
accountingand
generalledger.
Reportofunits
completed(RUC)

Observeunits
comparedtoRUC,
postfinished
records
Productsreceived
reportprepared

Jobsheetsclosed
out,summaryentry
prepared
Tracesummaryentry
toGeneralLedger
posting

Independentreport
ofproduction
completed.
Independentcheckof
RUC.

Productsreceived
report(PRR)

Observecomparison
RUCandPRR

11.4

Issueslipsand
requisitionssupport
MUR.

Independentrecords
ofunitsputinto
finishedgoods
inventory.
Recordsfrom
separatesources
reconciled.

Summaryentryform

Closedjobsheets,
RUCandPRRsupport
summaryentries.
Separationof
duties;cost
accountingand
generalledger.

Theseparationsofdutiesauditorsarelookingforareauthorizationof
transactions,custodyofassets,andrecordingoftransactions,andperiodic
reconciliation.Intheproductioncycle,thesedutiesareseparatedas
follows:Initialauthorizationisaproductionorderpreparedinproduction

13
planningandcontrol,authorizationsoflaborhoursandmaterialtobeused
aregivenbytheforemanwhenjobtimeticketsaregiventoemployeesand
materialrequisitionsaresenttorawmaterialsstores,Rawmaterialsstores
maintainsphysicalcustodyofrawmaterialsandnonearereleasedwithout
authorization(requisition)andrecordofwithdrawal,Foremanmaintains
custodyofworkinprocessinventory,Independentrecordingoflaborand
materialsinproductioncostanalysesbycostaccountingclerksfromrecords
aftercomparingtwosources.
11.5

Omissionofmaterialsandlaborusedshouldbepreventedbyperiodically
examiningdocumentsfromonesourceformissingdocumentfromsecondsource.
Forexample,datedrawmaterialsinventoryissuesnotmatchedtomaterialsin
theproductioncostanalysisindicateapossibleomissionofmaterialusedin
production.Useofprenumbereddocumentsandreportswithaccountingfor
numericalsequenceisalsoaprimarymeansofpreventingomissionof
transactions.
Preventionofdoublecountingofmaterialusedorlaborusedshouldbeissued
bystampingdocumentsas"posted"beforetheyarefiledinjobfolders.

11.6

Someworktoobtainassuranceaboutthereasonablenessoftheclient'ssales
forecastneedstobeperformed.Thisworkisnotanexaminationor
compilationofaforecastascontemplatedbytheattestationservices
standards.Alltheauditorsneedtoaccomplishistolearnaboutthe
assumptionsbuiltintotheforecastforthepurposeofascertainingtheir
reasonableness.Inadditionsomeworkanthemechanicalaccuracyofthe
forecastshouldbeperformedtoavoidembarrassingrelianceonfaulty
calculations.

11.7

Ifhighlevelsofproductionwereplannedandcarriedoutinanticipationof
highsalesthatdidnotoccur,theinventoryshouldshowanincrease.The
potentialproblemisovervaluation(overstatement)ofslowmovingor
obsoleteinventoryandunderstatementofcostofgoodssold.

11.8

Productionreportsrecordthecompletionofproductionquantities.When
coupledwiththerelatedcostaccountingreports,theyarethecompany's
recordofthecostofgoodsplacedintothefinishedgoodsinventory.Inmost
cases,auditorswillauditthecostreportsinconnectionwithdetermining
thecostvaluationofinventoryandcostofgoodssold.

11.9

Thepointsofdeparture(assertions)inaclient'sfixedassetand
depreciationscheduleinclude:
Assetdescriptions:Helpauditorsidentifyassetstheycaninspect.
Beginningcostbalanceforeachasset:Tracethemtoprioryearworking
papers.
Assetadditions:Auditthemforevidenceofexistence,valuation,ownership,
andpresentationanddisclosure.
Assetsales(dispositions):Auditthemforevidenceofoccurrence,valuation
(includingamountofgainorloss),passageofownership,and
presentationanddisclosure.
Endingcostbalanceforeachasset:Auditthemforevidenceofexistence
(physicalinspection),valuation(otherthantemporaryimpairment),
ownership,andpresentationanddisclosure.Tracetotaltogeneral
ledgerandbalancesheet.
Beginningaccumulateddepreciationforeachasset:Tracethemtoprioryear
workingpapers.
Additions(depreciationexpense)fortheperiod:Auditthecalculationsfor

14
accuracy.Tracetoexpenseaccount(s)andstatementofcashflows.
Dispositionsofaccumulateddepreciation:Combinewithassetcostto
determinebookvalueandamountofgainorlossondisposition.Traceto
gain/lossaccountandtoadjustmentinstatementofcashflows.
Endingaccumulateddepreciationeachasset:Auditthecalculationsfor
accuracy.Tracetotaltogeneralledgerandbalancesheet.
11.10 Theprimaryfunctionsthatshouldbesegregatedintheproductioncycleare:
#
#

Authorization(productionplanningandinventoryplanning)shouldbe
performedbypersonswhodonothavecustody,recording,orcost
accountingandreconciliationduties.
Custodyofinventories(rawmaterials,workinprocess,andfinished
goods)shouldbeinthehandsofpersonswhodonotauthorizetheamount
ortimingofproductionorthepurchaseofmaterialsandlabor,or
performthecostaccountingrecordkeeping,orpreparecostanalyses
(reconciliations)
Costaccounting(arecordingfunction)shouldbeperformedbypersons
whodonotauthorizeproductionorhavecustodyofassetsintheprocess
ofproduction.(However,youwillusuallyfindthatthecostaccountants
preparevariousanalysesandreconciliationsdirectlyrelatedto
productionactivities.)

11.11 Thetwocharacteristicpartsofatestofcontrolsprocedureare:(1)
descriptionofthedatapopulationfromwhichasamplewillbedrawn,and(2)
expressionofanactiontotakeintermsofrecalculating,vouching,tracing,
etc.
11.12 Theproductionorderdocument(orcomputerrecord)providesacontrolover
thequantityofmaterialsusedinproductionbycontaininganapprovedlist
ofmaterialsthatshouldbeused.Thislist(billofmaterials)canbe
comparedtotheactualmaterialsused,ascostedbythecostaccounting
department.
11.13 Improperlydeferredcostsandcostoverrunshavebeenfoundin"unbilled
receivables,"intheinventoryaccount,andin"deferredchargescontract
costs."
11.14 Thepurposeofthisreviewquestionistofosterdiscussiontowardwhat
informationanindependentauditorneedstoknow.Itemsrelevanttothe
quotationmightinclude:
1.
2.
3.
4.
5.

Referencetothefirstgeneralstandardregarding"adequatetechnical
trainingandproficiencyasanauditor".
Referencetothethirdgeneralstandardregarding"dueprofessional
care."
Obviously,theauditormustbeknowledgeableaboutcostaccountingto
auditamanufacturingcompany.
Inamanufacturingcompany,theinventoriesmostlikelywillbeamajor
assetwhichwillrequiresubstantialauditwork.
Aproficientauditormustbeknowledgeableinallphasesofthe
business,includingproduction,marketing,financeaswellasaccounting
dataprocessing.

11.15 Thisisaquestionaboutthedirectionofthetestofcontrols.
Todeterminewhetherallauthorizedproductionwascompletedandplacedin

15
inventoryorwrittenoffasscrap,theauditorsshouldselectasampleof
approvedproductionordersfromtheproductionplanningdepartmentfiles,
thentracethemforwardthroughcostaccountingtoinventoryorwriteoffs.
Todeterminewhetherfinishedgoodsinventorywasactuallyproducedand
properlycosted,theauditorsshouldselectasampleofproductionputinthe
inventoryaccount,thenvouchtheseproductionreportstoapprovedproduction
ordersandcostcalculationsofmaterial,labor,andoverhead.
11.16 Theworkonacompletedproductionorder(productioncostreport)should
include(1)vouchingthecoststosupportingdocumentationofmaterials,
labor,andoverhead,and(2)vouchingtheproductionordertoacustomer
contract,readingitfortermsofsale.
11.17 Theexistenceofthe"unbilledcontractrevenue"assetaccountinthegeneral
ledgershouldraisearedflag.Suchanaccountalwaysmeansthatmanagement
hasmadeanestimateofarevenueamountthathasnotbeendetermined
accordingtocontractandhasnotyetbeenbilledtothecustomerin
accordancewithcontractterms.Eventhoughtherevenueis"unbilled,"the
relatedcostofgoodssoldshouldstillbeinthecostofgoodssoldaccount.
Whileaccountingtheoryandpracticepermitrecognizingunbilledrevenuein
certaincases(e.g.percentageofcompletionforconstructioncontracts),the
accountinghasbeenknowntoharborabusesinsomecases.
11.18 Auditorsshouldalwaysselecttheclient'sadjustingjournalentriesfor
detailauditbecauseexperiencehasshownthatnonstandardadjustingjournal
entriesarethesourceofaccountingerrorsandirregularitiesmoreoften
thanstandardrepetitiveaccountingforsystematictransactions.This
phenomenonmakesthepopulationofadjustingjournalentriesaripefieldfor
controlandsubstantivetesting.
11.19 Yes,indeedthereisplentywrongaboutauditors'helpingclientsobtainbank
loanstopaytheiraccountingfirm'sfees.Obtainingfinancing,especially
throughsecretguarantees,isamanagementfunction.Whereauditorsengagein
suchactivities,theybecomepartofmanagementandimpairtheiraudit
independence.
11.20 Thefunctionsinapersonnelandpayrollcycle:
Personnelandlaborrelationshiringandfiring
Supervisionapprovalofworktime
Timekeepingandcostaccountingpayrollpreparationandcostaccounting
Payrollaccountingcheckpreparationandrelatedpayrollreports
Payrolldistributionactualcustodyofchecksanddistributiontoemployees
11.21 a.

A"walkthrough"ofapersonnelandpayrolltransactionwouldinclude
discussionswitheachpersonhandlingpersonnelandpayrollrecords.The
followingillustratesthestepsanddocumentscollected.
Steps

Document(s)Collected

Hiringpersonneldept.
Deductionspersonneldept.

Authorizationtohireandrateassignment
Personnelforms,employeeauthorization
fordeductions(e.g.,TD1form)
Clockcard
Productiontimeticket
Labordistributionworksheet
Payrollvoucher
Payrollchecks

Timekeeping
Shops
Costdistribution
Accountspayable
Cashdisbursement

16
b.

Ifthepayrollisprocessedbycomputer,theclockcardsandproduction
timeticketswouldbetracedtobatchcontrolinthetimekeepingand
productiondepartments,todatapreparation(keyingtomachinesensible
form),toeditandvalidationerrorreportsandothercomputeroutput
indicatingcontrolandfinallytocomputerpreparedchecks,labor
distributionreportsandsummarygeneralledgerentries.

11.22 Inapayrollsystem,thefunctionalresponsibilitieswhichshouldbe
separatedinclude:
1.
2.
3.
4.
5.
11.23 (a)

PersonnelorLaborRelationsDepartment
Supervision
TimekeepingandCostAccounting
PayrollAccounting
PayrollDistribution
Preventofdetectpaymenttoafictitiousemployee:
#
#
#
#

Paycheckspreparedonlyforpersonswithemploymentauthorization
fromthepersonneldepartment.
Paycheckspreparedonlyforpersonswithapprovedworkattendance,
time.
Paychecksdistributedonlyinpersontopersonsidentifiedas
employees(orbyelectronictransfertovalidatedemployeebank
accounts).
Payrollregisterorlistreapprovedbysupervisorafterpaychecks
arepreparedordistributed.

(b) Employeesareexpectedtocomplainiftheydonotgetpaid(!).
11.24 Importantinformationinemployee'spersonnelfiles:
#
#
#
#
#
#

Employmentapplication
Backgroundinvestigationreport
Noticeofhiring
Jobclassificationwithpayrateauthorization
Authorizationsfordeductions(e.g.healthinsurance,lifeinsurance,
retirementcontribution,uniondues,TD1formforincometaxexemptions)
Terminationnotice

11.25 Apersonnelfileshouldestablishtherealityofaperson'sexistenceand
employment.Thebackgroundinvestigationreport(prioremployment,
references,socialsecuritynumbervaliditycheck,credentialsinvestigation,
perhapsaprivateinvestigator'sreport)isimportantforemployeesin
sensitiveareassuchasaccounting,finance,andassetcustodypositions.One
oftheprimarysystemcontrolsiscapablepersonnel.Experienceisrichwith
errors,irregularities,andfraudsperpetratedbypeoplewhofalsifytheir
credentials(identification,collegedegrees,priorexperience,criminal
records,andthelike).
11.26 Documentarysupportforvalidityandaccuracyofpayrolltransactions:
#
#
#
#

Personnelfilehiringnotice,rateanddeductionauthorizations
Timekeepingrecordsapprovalofpaybase(time,production)
Payrollregisterjournalsupportforpaycheckproduction(cash
disbursement)
Cancelledchecksactualpaymentdocument

17
#
#
#

Costaccountinglaborcostanalysisreconciliationoflaborcost
distributedtoexpenseandproductiontolaborpaidbypayroll
Wagesclearingaccountshouldbezerobalance
GovernmenttaxreportsshouldreconcilewithYTDearningsrecordsin
detailandintotal

11.27 Federalquarterlyandannualcanbereconciledwiththetotalofthe
employees'YTDearningsrecords.Thesetaxreturnsdonotcontaindetail
schedulesforeachemployee'searnings.
Employees'T4reportscanbecomparedindetailtotheYTDrecords.Thetotal
oftheT4grossearningsshouldmatchthetotalwagesreportedonthe
quarterlywithholdingtaxreturn.
Inprovincesthatrequiredetailschedulesofearningsinstateunemployment
taxreturns,theYTDearningsrecorddetailscanbecomparedtothetax
returns.
11.28 Thepurposeofexaminingendorsementsonthebackofpayrollchecksistotry
todetectspuriousendorsementsbyfictitiousemployeesorbyothercompany
personnelwhomayhavestolenthechecks.Lookforsecondendorsementsand
investigatewhethertheyaresignaturesofothercompanypersonnel.
11.29 Thecommonerrorsforirregularitiesinthepersonnelandpayrollcycleare
(1)recordedemployeetransactionsarenotvalid(fictitiousemployee),(2)
recordedattendancetransactionsarenotvalid(fictitioushours),and(3)
incorrectcostaccountingforlabor.Auditorslookforseparationofduties,
properauthorizationsandgoodreconciliationstopreventorcorrectthese
errorsorirregularities.Auditorsshouldbealerttoaforemanhavingtoo
manyincompatibleresponsibilities(e.g.,hiring,authorizationofhours,
authorizationofpayrate,distributionofpaychecksanddismissalonly
authorizationofhoursisaproperresponsibility).
11.30 Theauditorsneedtobecarefulnottomakethemselvesobvious.Standing
aroundinamanufacturingplantat6:00aminthestandardbluepinstripesuit
uniformisasgoodasprinting"BewareofAuditor"onyourforehead.People
willthenbeontheirbestbehavior,andyouwillobservenothingunusual.
Findanunobtrusiveobservationpost.Useavideocamera.Getaknowledgeable
officeemployeetoaccompanyyoutointerpretvariousactivities.Performan
observationthathasachanceofproducingevidenceofimproperbehavior.
11.31 Anauditorcandeterminewhethertheamountoflaborcostchargedto
productionwasactuallypaidtoemployeesbycomparingthelaborcostin
productionreportstothelaborcostpaidinpayrollreports.
11.32 Thesurpriseobservationenablestheauditortoseehowthedistribution
systemreallyworksandincreaseshischancesofdetectingfraud.Suchan
observationinvolvestakingcontrolofpaychecks,thenaccompanyingaclient
representativeasthedistributiontakesplace.Theauditorcheckstosee
thateachemployeeisidentifiedandthatonlyonecheckisgiventoeach
individual.Unclaimedchecksarecontrolledandexaminedtodetectany
fictitiouspersonsonthepayroll.
11.33 Generalizedauditsoftware(GAS)couldbeusedtomatchthefollowingfiles
andfieldswithalldifferencesprintedout(includingunmatchedemployee
numbers).

18
Personnelmasterfile
employeenumber

matchedto

Payrollmasterfile
employeenumber

matchedto

Personnelmasterfile
withholdingfactors
(convertedtodeduction
codes)

matchedto

Payrollmasteremployee
number
Employeeearningrecord
employeenumber
Employeedeductions
employeenumber
Timecardtransactions
employeenumber
Costdistributionemployee
number
Employeeearningsrecords
employeenumber
compensationclass
Payrollmasterdeduction
codes

GAScouldalsobeusedtoconverttimecardtransactions(withthepayroll
master,compensationanddeductiontables)tocurrentgrossearnings,
deductionsandnetearningsforoneperiod.Thisiscalled"parallel
simulation."
11.34 Controldocumentsandcontrolproceduresthatarenotusedarenogoodatall
forpreventing,detecting,andcorrectingerrors,irregularities,andfrauds.
Theyareapretenseandfacadeforineffectivecontrol.
11.35 Anauditorcanfindoutwhethercontroldocumentsandcontrolproceduresare
followedbyclientpersonnelfirstbyasking(internalcontrol
questionnaire).Iftheanswer(s)is(are)affirmative,thetestsofcontrols
reperformthecontrolprocedurestodeterminewhethertheywereperformed
satisfactorily.
11.36 Failuretoperformcontrolprocedureswhendocumentsforthechecking
comparisonsareavailable.
Noseparationofthesedutiesandresponsibilities:(1)transaction
authorization,(2)recordkeeping,(3)custodyof,oraccessto,assets,and
(4)reconciliationofactualassetstotheaccountingrecords.
Thepayrollemployeewhohasresponsibilityforpreparingpersonnelfilesfor
newhires,approvalofwages,verificationoftimecards,anddistributionof
payrollcheckscan"hire"fictitiousemployees,faketheirrecords,andorder
checksthroughthepayrollsystem.
11.37 Theremaybelittledifferencebetweentestsofcontrolsandtests(audit)of
balancesinthepayrollarea.Payrollisa"classoftransactions,"not
reallyabalance.Ithasnoexternalexistencethatcanbeobserved,touched,
confirmed,counted,orotherwiseauditedwiththeproceduresauditors
generallyregardasdetailsubstantiveprocedures.Somesubstantive
analyticalprocedurescanbeemployedtoproduceevidenceofpayrollamounts,
andthesearenotdetailtestofcontrolprocedures.
SOLUTIONSFORKINGSTONCASEPROBLEMS
11.38 PayrollFlowchart

19
a.

Theflowchartisonthenextpage.

b.

IwishIhadcollected(i.e.Iwishtheproblemhadbeenclearabout):
Informationaboutwhetheremployeessignpayrollformspayrate,
deductions,application,etc.
Informationaboutthefilesmaintainedbythepersonneldepartment.
Informationabouthowmanytakehomesheetsareprepared,becauseit
seemsthateachsupervisorgetsone(forhisownemployeesorforall
employees?).
Informationaboutwheretheoldtimecardsarefiled.
Informationaboutwhetherthereviewandrecalculationdoneinthe
payrolldepartmentreperformsthepayrollregisterpreparationusingthe
ratefilesandtimecardsormerelyrecalculatesthemathonthepayroll
register.Thereperformancewouldbeabetterreview.
Informationabouthowlongthesupervisorsarepermittedtohold
unclaimedchecks.

[seeFigure11.38ONNEXTPAGE
KINGSTONCOMPANY:PAYROLLSYSTEMFLOWCHART]
11.39 PayrollBridgeWorkingPaper
Index

KINGSTONCOMPANY
PayrollControls
December31,2002

Prepared_____Date_____
Reviewed_____Date_____

Item

Strength/Weakness

AuditProcedures

S1

Personnelfunctionsareseparate
frompayrollfunctions.

Scanpersonnelfilesfor
signaturesbypayrollpersonnel.
Scanpayrollrate/deductfiles
forauthorizedsignaturesby
personnelpeople.

S2

Timekeepingiscontrolledbya
mechanicaldeviceinsteadofby
supervisors.

Observehourlyemployeesusing
thetimeclocks.

20

21
S3

Timecardsareapprovedby
supervisorspreventing
unauthorizedpeoplegetting
timecards.

Selectasampleofoldtimecards
andreviewforsupervisors'
authorizedsignature.

S4

Payrollregistersarereviewed
andrecalculated,preventing
clericalerror.

Selectasampleofpayroll
registersandlookforsignature
ofreviewer.Recalculatethese
registers.

W1

Payrolldoesnotkeepacopyof
thepayrollregister,soa
fictitiousemployeecouldbe
addedafterwards(byaccounts
payable,withacheckprepared).

Usingthesampleofpayroll
registers.Scanforanyevidence
(handwriting,etc.)ofadded
namesandamounts.Vouchlast
fewnamestotimecardsandBoard
minutesforevidenceemployee
exists.

S5

Reviewbytreasurerhelps
preventimproperpaymentstothe
extentthetreasureris
knowledgeable.

Scanthesampleofpayroll
registersforsignatureof
treasurerindicatingreview
performed.

S6

Salariedpeoplemustappearin
person,thusinhibiting
fictitiousemployeeploys.

Trytobenearbytoobserve
peoplepickinguptheir
paychecks.

W2

Supervisorswhoapprove
timecardsshouldnotalso
distributepaychecksandhold
unclaimedchecks.Supervisors
couldfailtoreporta
terminatedemployee,preparea
timecard,receiveacheck,and
stealit.

Takecontrolofapayrollfora
surpriseobservation.Distribute
thepaychecksinperson,
requiringeachemployeeto
producepersonalidentification.
Thepurposeistopreventa
personfrompickingupmorethan
onecheck.Investigateunclaimed
checks,perhapsbydirect
contactwiththeemployee.

SOLUTIONSFORMULTIPLECHOICEQUESTIONS
11.40 d.

Auditorsneedtodeterminewhetherthecostaccountingsystemassigns
costsproperlytotheinventories.

11.41 b.

Theperpetualinventoryrecordsprobablycontainthemostreliable
recordofthequantitiesactuallyissued.

11.42 d.

Someonewhobothhirespersonnelandhascustodyofpaycheckscould
createafictitiousemployeeandalsogetthepaycheck.

11.43 c.

Actualobservationmeetingthepeopleproducesthebestevidenceof
the"existence"oftheemployees.

11.44 c.

Preparationofgovernmentreportsistheleastobjectionableofthe
choices,andthereportscanbecrosscheckedtootherrecords.

22
11.45 b.

Surprisepayrolldistributionisespeciallyappropriatewhencontrol
riskoffictitiousemployeesishigh.

11.46 a.

RecalculationoftheproperamountofFICAwillrevealerroneous
calculationsbythebookkeeper.(Thequestionofhowthisbookkeeper
actuallygotthemoneyisnotclearinthequestion,however!)

11.47 d.

Vouchingpayrolltotimecardsproducesevidenceofvaliditypersons
paidfortheactualhoursworked.

11.48 c.

Aspecialbankaccountforunclaimedwagesistypical.(Asafedeposit
boxchoice(a)isaboutthesame.Neitherofthesechoicestell
anythingaboutwhohasaccesstothesafedepositboxorthebank
account.)

11.49 b.

Correct.Thereconciliationoftimechargedtojobsandtimepaidby
payrollgivestheopportunitytodetectlackofagreementbetweenthe
twosourcesoflabortimeinformation.

11.50 b.

Correct.Alltheotherdata(employeenumbers,jobnumbers,
reconciliationofhours)canbecalculatedwithcomputeroperationson
computerfiledata.Supervisors'signaturesarenot"visible"tothe
computer.(However,somesystemsmayhavesupervisoryaccessthat
involvesan"approval"implicitintheentryofpayrolldata.)

SOLUTIONSFOREXERCISESANDPROBLEMS
11.51 ICQItems:PossibleErrororIrregularityDuetoWeakness
Question
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

PossibleErrororIrregularity
Unauthorizedproductionforpersonalproducts.
Workinprocessomittedfromjobcostaccounting.
Materialswithdrawnfrominventoryorhoursworkedfor
unauthorizedprojects.
Foremanincorrectlyrequestsmaterialorassignsjobskills.
Notallmaterialorlaboraccountedforcorrectly.Foremancould
alsoconcealunauthorizedmaterialorlaborinauthorized
job.
Productionorderslostandaccountingincomplete.
Laborormaterialusedbutnotrecorded.
Validmaterialsortimenotaccountedfor,orinvalidmaterials
ortimeallowed.
Materialusageomittedfromchargestojobs.
Productionmaybestartedforuneconomicjobsorpersonal
projects.
Materialsandlabormaybeusedforuneconomicjobsorpersonal
projects.
Issueslipsnotcomparedtomaterialusedreports.Material
withdrawnfrominventorynotaccountedfor.
Differencesnotinvestigated.Laborusednotaccountedforby
assigningtoajob.
Obsoletecostsused,inventoryimproperlyvalued.
Comparisonnotmadeordifferencenotinvestigated.Production
completednotputintoinventory.
Accountingentriesmaygetputinthewrongaccount.

23
17

Errorsinsummaryentriesnotdetectedandcorrected.

11.52 TestofControlsAuditProcedures
Procedure

(b)ControlObjective

(a)Strength

(1)

Validworkinprocessinventory
transactionsarerecordedand
noneomitted.

Preparationofsummary
materialandlabor
entries.

(2)

(4)

Validfinishedgoodsinventory
transactionsarerecordedand
noneomitted.
Recordedlaborandmaterial
transactionsarevalid
Allmaterialissuesareauthorized.

(5)

Recordedtransactionsarevalid.

(6a)

Materialusedrecordedinproper
period.
Jobaccountingcomplete.
Materialusedauthorized.
Jobcostaccountingaccurate.
Materialreleaserecorded.
Authorizedissueofmaterialandin
properperiod.
Inventoryrecordedinproperperiod.

(3)

(6b)
(6c)
(6d)
(6e)
(6f)
(7)
11.53 a.

Standardcontrolnumber.
Materialreceived,custody.
Propermaterialreceived.
Properreleaseofmaterials.
Materialreleaseauthorized
andtimely.
Timelyrecording.

Compareaspectsofcontrolwithwhichthelaborcostreportproposal
compliesandexamplesfromthecasetosupporteachoftheaspects
cited:
1.
2.
3.
4.
5.
6.
7.
8.
9.

b.

Preparationofsummary
finishedgoodsinventory
entries.
Independentcheckonmaterials
andlaborused.
Issueformssecureandusedby
authorizedpersonnel.
Separationofrecordingfrom
custodyofassets.
Recordingofmaterialsused.

Proposalisflexibleandwidelyapplicable.Exampleitcanbeused
foralltypesofjobs.
Proposalshouldbeeconomical.Exampledatarequiredaregenerally
availableandmostcalculationsaremadecurrently.
Proposalfocusesattentionattheproperorganizationallevel.
Examplethedepartmentisthebasisforthereport.
Proposalemphasizesasignificantcostelement.Examplelaborisa
majorelementofcost.
Proposalprovidesforquantitativeevaluation.Examplejob
estimatesactasstandards.
Proposalprovidesforacomparisonofactualresultstostandardto
ascertaindeviations.Exampleactuallaborcostsincurredbythe
departmentarecomparedtoestimates.
Proposalprovidesforanindependentpartytomakethecomparison.
Exampleanaccountingclerkmakesthecomparison.
Proposalemphasizesexceptionreporting.Exampleonlysignificant
variancesaresenttotheproductionmanager.
Proposalrecommendscorrectiveactionstogotosomeonewhocan
takeactions.Exampletherecommendationsaresenttothe
productionmanager.

Commonaspectsofcontrolwithwhichthedepartmentallaborcostcontrol
methoddoesnotcomplyandexamplesfromthecasetosupporteachofthe
aspectscited:

24
1.
2.
3.
4.
5.
6.
7.

Proposalfailstoreflectthenatureandneedsoftheactivity.
Exampletheappropriatecomparisonshouldbebyjob,not
department'stotal.
Proposalfailstoconsideronthespotaction.Examplenomention
ismadeofpossibleresponseswithindepartmentswhenvariances
arise.Mostjobsarecompletedwithinthetwoweekpayrollperiod.
Proposalfailstoprovidespecificcriteriaforidentifying
problems.Exampletheaccountingclerkisgivenlittleguidancein
determiningwhetherasignificantvarianceexists.
Proposalfailstoreflectorganizationalpatternemphasizingwhere
responsibilityforactionlies.Exampledepartmentforemendonot
receiveacopyofthereportwhensignificantdeviationsoccur.
Proposalfailstoprovideforpromptinvestigation.Example
investigationdependsontheassistantcontroller'savailabletime.
Proposalfailstoconsiderchangedconditions.Examplenomention
ismadeofanyconsiderationsgiventotheestimationprocessor
revisions.
Proposalfailstoconsiderallpossiblecauses.Exampleno
indicationisgiventhatcostsotherthanlaborwereconsidered.

11.54 AudittheFixedAssetandDepreciationSchedule
(a) TheComputerBsystemisdepreciatedforafullyear($583,000),but
depreciationshouldbecalculatedforonly8months.Correctamountis
$389,000.
ThedepreciationonthePressshouldbe$75,000insteadof$150,000.
Somebodydoubledthedepreciationexpenseforthisyear.
AccumulatedDepreciation
CostofGoodsSold
Inventory
GeneralandAdminExpense
(b)

269,000
67,500
7,500
194,000

Listtwoauditproceduresforauditingthefixedassetadditions.
Thebestwaytoapproachthisrequirementistowriteaprocedurefor
eachassertion.
Building2:
Existence:Inspectthebuildingtodeterminedthatitis"inproductive
use"(evidenceofexistence).
Rights(Ownership):Vouchthelegaltitlepapersandrecordeddeedfor
evidenceofownership.
Valuation:Vouchthecontractor'sbillingsandthepaymentsforevidence
ofappropriatecostvaluation.
PresentationandDisclosure:Studyanyrelatedloanagreementsfor
pledgeassecurityforloansinrelationtonecessarydisclosure.
Inspectinsurancepoliciesforevidenceofadequateinsurance
(inadequateinsurancemayrequiredisclosure).
Completeness:InspectBuilding1andmakeinquiriesaboutwhetherany
partofithasbeensoldorleasedsincethenewbuildingwas
occupied(evidenceofcompletenessofrecordingofdispositions,if
any).
ComputerBsystem.
Existence:Inspectthecomputerandobserveitinoperation(existence)
Rights(Ownership)andValuation:Vouchpurchaseandtitledocuments

25
(ownershipandcostvaluation).
PresentationandDisclosure:Studyanyrelatedloanagreementsfor
pledgeassecurityforloansinrelationtonecessarydisclosure.
Inspectinsurancepoliciesforevidenceofadequateinsurance
(inadequateinsurancemayrequiredisclosure).
Completeness:Vouchexpensesintherepairsandmaintenanceaccounts(or
similaraccounts)forinstallationandtestingcoststhatshouldbe
capitalized(evidenceofcompletenessofrecordingassetcost).
Auto2
Existence:Inspecttheautoandobserveitinoperation(existence).
Rights(Ownership)andValuation:Vouchpurchaseandtitledocuments
(ownershipandcostvaluation).
PresentationandDisclosure:Studyanyrelatedloanagreementsfor
pledgeassecurityforloansinrelationtonecessarydisclosure.
Inspectinsurancepoliciesforevidenceofadequateinsurance
(inadequateinsurancemayrequiredisclosure).Insurancemaybe
requiredforlawfuloperation.Inquireaboutitsuse;ifby
executiveofficers,itmayneedtobereportedascompensationin
theproxystatement(publiccompanies).
Completeness:Vouchexpensesintherepairsandmaintenanceaccounts(or
similaraccounts)fortypicaladditionalcosts(e.g.tax,title,
license)thatshouldbecapitalized(evidenceofcompletenessof
recordingassetcost).
(c)

ThelossonthesaleoftheComputerAsystemshouldbe$542,000($5,000
$3,958$500).ThegainonthesaleofAuto1(fullydepreciated)
shouldbe$1,000.
Thecashflowfrominvestingactivitiesshouldshowcashinflowfrom
saleofassetsintheamountof$501,000.Thereshouldbecashoutflow
forpurchaseofassetsintheamountof$$45,522,000.

11.55
Question(abbreviated)
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

Employeespaidbycheck?
Specialpayrollbankaccount
used?hoursorfictitious
employee.
Independentpayrollcheck
signers?
Independentbankstatement
reconciliation?
Payrollemployeesrotated,take
vacationsandbonded?
Timekeepingindependentof
payroll?
Personneldepartmentreports
employeesterminatedtopayroll
department?
Payrollcomparedtopersonnel
files?
Independentcheckdistribution?
Unclaimedwagescontrolled?
Occasionalsurprisepayoffby
internalauditors?
Personneldepartmentreports

PossibleErrororIrregularity
1.
2.

Errorsinwithholding,rate.
Bankreconciliationerrors.

3.

5.

Fictitiousemployees.
Unauthorizedpayments.
Fictitiousemployees,
incompleteaccounting.
Fictitiousemployees.

6.

Fictitiousemployeesorhours.

7.
8.

Terminatedemployeespaidand
anothercasheschecks
Fictitiousemployee)
Fictitiousemployees.

9.
10.
11.

Fictitiousemployees.
Impropercashingofchecks.
Fictitiousemployees.

12.

Unauthorizedemployeepaid.

4.

26

13.
14.
15.

employeeshiredtopayroll
department?
Payrollchecksprenumbered?
Sequencechecked?
Wageratesapproved.

Fictitiousemployee)
13.

Checksissuedandnotrecorded.

14.

Unauthorizedrates,improper
rates.
Incorrectdeductions.

Deductionauthorizationssigned
byemployees?
Hoursandcostdistribution
approvedbysupervisor?
Timeclockused.

15.

Payrollsheetsignedand
approved?
Costrecordsreconciledto
payroll?
Periodicauditofpayrollby
internalauditors?

18.

19.

21.

Classificationinstructions?

21.

22.
23.

Reconciliationwithtaxreports?
Reviewbyacctgofficer?

22.
23.

16.
17.
18.
19.
20.

11.56 1.

a.
b.

c.
2.

3.

a.
b.
c.
a.
b.
c.

4.

a.
b.
c.

16.
17.

20.

Hoursovercharged(fictitious
hours).
Incorrecthoursclaimedand
paid
Unauthorizedemployees,hours,
orrate.
Incompleteaccountingusually
costrecordsnotcomplete.
Undetectederrorsand
irregularities(allofthe
above).
Misclassifieddebitsin
accounts.
Over/underreporting.
Accountingandclassification
errors.

Recordedpayrolltransactionsarevalid(nofictitiousemployees).
Selectasampleofpersonnelfilesfornewhiresandterminations
andtracetoreportssubmittedtothepersonneldepartment.Trace
alsotofirstorlastpaycheckissuedandtocumulativepayroll
records.
Paychecksmightbedelayedandterminatedworkersmightcontinueto
be"paid"(withtheftofcheckbysomeoneelse)ifpayrollisnot
promptlynotifiedofnewhiresandterminations.
Recordedpayrolldeductionsarevalid.
Selectasampleofpayrolldeductionsandvouchthemtosigned
authorizations.
Incorrectamountsmightbedeductedfrompay.
Recordedpayrolltransactionsarevalidandauthorized.
Observethetimekeepingoperationstodeterminewhethertheyare
performedseparately.
Ifpayrolldepartmentpersonnelwerealsoresponsiblefortime
records,theywouldhaveeffectivecontrolovertransaction
authorization(i.e.,hoursworkedapproval)andcouldoverpay
themselvesorfriends.
Payrollandlaborcosttransactionsarecomplete.
Obtainreconciliationworksheetsorcheckoffreportsandseeif
thereconciliationisdone.
Costaccountingrecordsmightcontainmoreorfewerdollarsthan
actuallypaid(perpayrolldata).Simpleerrorsincostanalyses
mightoccur.

11.57
a.

Inadditiontotheusualpayrollauditprocedures,theauditprogram
shouldincludespecialproceduresdirectedtotheareasofinternal
controlweaknesses.
1.
Determinebyinquiry,scanningofpayrollsheetsandminutesofthe

27

b.

salarycommitteewhichofficeshadhighturnoverinpersonnel.
Scanningofpayrollsheetsmightrevealalterationsofsalariesand
deductions.
2.
Forselectedoffices,footarepresentativenumberofpayrolls.
3.
Checkcomputationofsalariesanddeductions.
4.
Tracepayrolldeductionstothebranchoffice'saccounting
statements.
5.
Traceearningsanddeductionstoindividualpayrollrecords.
6.
ComparesignaturesonpayrollsheetswithsignaturesonTD1forms
orotherpersonnelforms.
7.
Comparequestionablesignatureswithhandwritingsamplesofthe
branchmanager.
8.
Comparepayrollsheetsandminutesofthesalarycommitteefor
agreementastostartingdates,terminations,promotions,salary
adjustmentsandtransfers.
9.
ComparedatesonTD1formsandotherpersonnelformswithpayroll
sheetsasfurtherindicationofcorrectstartingdate.
10. Asafurthertestoftheauthenticityofemploymentandtermination
dates,comparenamesanddatesappearingonstatereportsof
unemploymentcompensationpaidtoformeremployees.
11. Reviewreportssubmittedbytheareasupervisorsforreferencesto
personnel.
12. Considertherelationshipofthenumberofpersonnelandsalary
costsincomparisontothebusinessvolume.
13. PreparenegativeconfirmationstobemailedwithTD1forms.
InvestigateanyunclaimedTD1forms.
14. Observeasalarydistribution,orifnotpossible,includeinyour
fieldworkingpaperinstructionstherequirementthatthefield
auditorshouldlistpersonnelworkingintheofficeforsubsequent
comparisontothepayrollrecords.
Internalcontrolhasmanyweaknessesbecauseoftherelianceonone
person,thebranchmanager.
1.
Fictitiousnewemployeesmightbe"hiredandreleased"withina
shorttime.
2.
Fictitiousparttimeortemporarypersonnelmightbeplacedonthe
payroll.
3.
Aterminatedemployeemightbecontinuedonthepayrollforsome
timebeforeaterminationnoticeisforwarded.
4.
Unclaimedwagesmightbediverted.
5.
Thebranchmanagermightoverpayhimselfbynotdeductingfor
unauthorizedabsences.
6.
Legitimatesalaryincreasesorpromotionsmightbediverted.
7.
Deductionsforwithholdingtaxandnetpaymightbechanged.
8.
Hoursmightbeincreasedandsalaryrecomputed.

11.58 MajorRisksinPayrollCycle
PayrollCycleRisk

ControlObjective

Assertion

Payingfictitious
"employees"

Validity,onlyvalid
transactionsrecorded

Existence,employees
exist

Overpayingfortimeor
production

Accuracy,payaccurate
amountsearned

Valuationofpayroll
amounts,proper
inventory,costofgoods
sold,andexpenseamounts

28
Incorrectaccounting
forcostsandexpenses

Classification,correct
classificationofcosts
andexpenses

Presentationand
disclosure,consistent,
and

11.59 Thepurposeofthisquestionistogeneratediscussionabouthowdifficultit
istodeterminewhereauthorizationtakesplacewhenacomputerisinvolved.
However,sinceauthorizationisanimportantcontrolprocedure,thepoint(s)
ofauthorizationshouldbedetermined.Authorizationofpayrolltransactions
cannotbedeterminedwithoutunderstandingthecompleteflowoftransaction
processing(manualandcomputer).
Thefollowingcouldbepointsintheflowwhereauthorizationtakesplace:
*

*
*

Whenthecomputerapplicationprogramiswritten(andapproved)to
acceptcertainemployeecodesandtocomputethegrosspayrolland
thenetamount.
Whentheforemaninitialsthetimecard.(Alternatively,thetime
maybeautomaticallyenteredfromatimeclockintothecomputer
fileswithoutforemaninitialsthentheemployeeclockinginand
outistheauthorization.)
Whenpayrollbatchesoftimecardsaretotaledandsubmittedto
dataconversion.
Whenthetimecardsarekeypunchedoropticallyscanned.
Whenthepayrollprogramsarerunusingthetimeclocktransactions
andthepayrollmasterfile.
Whenthesignatureplateisinstalledontheprinterandchecksare
printed.
Whenthepayrateisenteredintotheemployeemasterfile.

11.60 Thisdiscussionquestionbringsuptheauditors'responsibilitywhenpayroll
isprocessedbyaservicebureau,acommonoccurrenceinmanysmaller
businesses.Themainpointisthattheauditcontrolconcernsarethesame
whereverthedataisprocessed.Followingaresomeofthediscussionpoints
thathavecomeupinthepastuseofthisquestion.
*
Auditplanningwillrequiredeterminationofwhetherareportis
availablefromtheservicebureau,preparedbyindependentauditors
(serviceauditors).Ofparticularinterestiswhethertheservice
auditor'sreportcovers"designonly"orcoversboth"designand
certaintestsofcontrols."
*
Whenaservicebureauisused,clientpersonnelareresponsiblefor
userinputandoutputcontrol,e.g.,authorization,completeness
(batching),reconciliationofinputcontrolstooutput.
*
Specificcontractualagreementsofcontrolresponsibilitiesbetween
theclientandtheservicebureauneedtobeexaminedand
evaluated.
*
Generalcontrolsaretheresponsibilityoftheservicebureau,
e.g.,systemandprogramdocumentation;backupforcomputer
processing,datafiles,documentationandstaff;andrestrictions
overaccesstocomputerequipment,datafilesandprograms.
*
Servicebureauprocessingrequiresincreasedemphasisonclient
proceduresforverifyingcontinuingauthority,completenessand
accuracyofmasterfile.
*
Servicebureauprocessingrequiresincreasedemphasisonerror
correctionandresubmissionprocedures.
SOLUTIONSFORDISCUSSIONCASES

29
11.61 CroydenFactory,Inc.,EvaluationofFlowchartforPayrollControlWeakness
(problemflowchartisatransparencymasterattheendoftheinstructors'
manual)
a.

Weaknessesinthesystemofinternalcontrolarethefollowing:
1.
Lackofapprovaloftheforeman'sclockcardbyanappropriate
supervisorisanunsoundpractice.Employeesshouldnotbe
permittedtomaintaintheirowntimerecordsandsubmitthem
withoutapproval.
2.
Thecomputationofregularandovertimehourspreparedbypayroll
clerkno.2thatisusedinthepreparationofthepayrollregister
isnotcomparedwiththesummaryofregularandovertimehours
preparedbytheforeman.
3.
Arithmeticcomputationsandratesofpayusedinthepreparationof
thepayrollregisterarenotcheckedbyapersonwhoisindependent
oftheirpreparationandpayrollregistercolumnsarenotverified
(readded)byapersonotherthanthepreparerofthepayroll
register.
4.
Payrollchecksarenotreconciledtothepayrollregisterinorder
topreventimproperdisbursements.
5.
Asignaturestampmachineshouldnotbeinthecustodyofany
payrollclerkwhohasaccesstounsignedchecks.
6.
Payrollisnotapprovedbyanofficerofthecompany.
7.
Sincethepaymastershouldbeindependentofthepayrollprocess,
signedpayrollchecksshouldnotbedistributedbytheforeman.
8.
Unclaimedpayrollchecksshouldbeinthecustodyofanemployee
whoisindependentofthepayrollprocess.
9.
Thecomparisonof(regularandovertime)hoursindicatedonpayroll
check(orattachments)with(regularandovertime)hoursindicated
onclockcardsshouldnotbeperformedbytheclerkwhois
responsiblefortheoriginalcomputationof(regularandovertime)
hoursindicatedonclockcards.
10. Thecomparisonofgrossandnetpayrollindicatedonpayrollcheck
(orattachments)withgrossandnetpayrollindicatedinthe
payrollregistershouldnotbeperformedbytheclerkwhois
responsibleforpreparingthepayrollregister.

b.

Oneshouldinquirewhether
1.
Payrollclerkno.2checksclockcardsfortheforeman'swritten
approval.
2.
Payrollovertimeisindicatedonclockcards.
3.
Employment,wage,andrelateddatainpayrollfilesare
periodicallycrosscheckedwithpersonnelfilesforagreement.
4.
Thepunchingofclockcardsisobservedbyatimekeeper.
5.
Othermitigatinginternalcontrolmeasures(forexample,bonding,
requiredvacations,andsoforth)areinexistence.

11.62 VaneCorporationsControlWeaknessinComputerizedPayrollSystem
ControlWeakness:
PayrollProcedure
1. Timecardisnotadequate.
2. Timekeepingfunctionis

Recommendations
1. Timecardsshouldbepreprinted
and/orprepunchedand
prenumbered.
2. Companyshouldemployatimeclock

30
inadequate.
3. Inadequatecontrolin
completionoftime.
4. Inadequatecontrolinthe
collectionoftimecards
anddistributionof
paychecks.

3.

5. Inadequatejobcost
reporting.

5.

6. Weaknessinhandlingnon
routinechangessuchas
newemployees,
terminations,payrate
changes,etc.
7. Inadequatelaborreportsfor
foremen.

6.

8. Payrollchecksarewrittenon
regularbankaccount.

4.

andtimekeepingshouldbea
separatedepartment.
Foremanshouldapprove(sign)all
timecardsandjobtickets.
a. Timekeepingshouldcontrolthe
issuingandcollectingof
timecards.
b. Paychecksshouldnotbe
distributedbyforeman.
Theyshouldbemailed
directlytotheemployee,
distributedbytheinternal
auditstafforsomeoneelse
independentoftheplant.
Jobcostingshouldbeintegrated
withpayrollsystem;timecards
andjobticketsshouldbe
reconcileddaily.
Personneldepartmentshouldbethe
onlyoneauthorizedtomake
changes.

7. Improvedtimekeepingfunctionand
integrationofpayrollandjob
costingsystemcouldprovide
foremenwiththedesired
reports.
8. Aseparateimprestpayrollbank
accountshouldbeestablished
tolimitpossiblelosses
throughfraudulent
disbursementsandtofacilitate
easierreconciliationof
accounts.

(Itemnumbersforthissectionarekeyedtothesevenerrorslistedinthe
problem.)
ControlWeakness:
ComputerProcessing
1. Checknotprocesseddueto
transpositionerror.

2. Nolimittestonpayroll
processingofgrosswages.

Recommendations
1. Prepunchedtimecards(sameas1.a.
underPayrollProcedures)and
employ
aneditruntocheckvalidityof
employeenumber,e.g.,checkdigit.
2. Alimittestshouldbeincorporated
intotheprogramtohaltthe
processingofanyemployee'srecord
wheneverthegrosswagesexceed
$300
perweek;alistingofall
exceptionswouldbepreparedfor
reviewtodetermineiftheamounts
wereaccurateorneededtobe
corrected.

31
3. Nocontrolstoassurethat
all
itemssubmittedwere
processed
(poorbatchingmethods).
4. a. Noprotectionagainst
inadvertentdestructionof
mastertapes.
b. Possiblelimitedfile
reconstructionability.
5. a. Nolimittestof
processingoflaborhours.

b. Lackofinput
verification.
6. Recordsinmasterfileare
skipped,indicatingmaster
filesarenotproved
properly.
7. Impropermodificationsof
data
bycomputeroperator.

11.63

3. Implementprogrammedbatch
controls,
e.g.,atotalofemployeenumber,
recordcounts.
4. a. Employfileprotectionring.
b. Atleasttwopreviousmaster
tapesshouldbemaintaineduntil
themastertapeisprovedby
subsequentrun(sonfather
grandfatherconcept).
5. a. Alimittestshouldbe
incorporatedintotheprogramto
halttheprocessingofany
employeerecordwhoselabor
hoursexceed60;alistingof
allexceptionswouldbeprepared
forreviewtodetermineifthe
hourswererightorneededtobe
corrected.
b. Errorscanbeeliminatedbykey
verificationoruseofatime
clock.
6. Employtapelabelwhichwouldhave
recordcounts.
7. Operatorsshouldnotbeallowedto
makedatachangesattheconsole,
theconsolelogshouldbereviewed
regularlyforoperator
interruptions,andtheprogramming
andoperatorfunctionsshouldbe
separated.

PayrollTestofControls

[SEEFIGUREONNEXTPAGE]
Procedure

Evidence

SampleofClockCards:
B2
Notesupervisors'approval.
Tracetoperiodicpayroll
registers.

Missingapprovaldeviation
Wronghoursdeviation.
Wrongemployeedeviation.

SampleofPayrollRegisterEntries:
B1b Vouchhourspaidtoclockcards
andsupervisors'approval.

Wronghoursdeviation.
Missingapprovaldeviation.

32

11.63PayrollTestofControls

33
B1c

Recalculategrosspay,
deductions,netpay.
Recalculatepayrollregisters.

Inaccuratepaycalculation
deviation.
Inaccuratepayrollsummary
deviation.

B1e

Examinecanceledpayrollchecks
andemployeeendorsements.

Inaccuratecheckamt.dev.
Invalidendorsementdeviation.

B3

Vouchperiodicpayrolltotalsto
payrollbankaccounttransfer
vouchersanddeposit.

Inaccuratepayrolltransfer
deviation.
Missingpayrolltransfer
deviation

B1d

B4

TracepayrollentriestoYTD
records.
ReconcileYTDrecordswithtotal
payrolls.

Incompleteupdatedeviation
Inaccuratepayroll(taxreturn)
deviation.

B6

Accountingincompletedev.
Accountingincompletedev.

Tracepayrolltomanagement
reportsandtogeneralledger
postings.

11.64 CostAccountingTestofControls
[SEEFIGUREONNEXTPAGE]
Procedure
SampleofCostAccountingPayroll
Analyses:
C1a Reconcileperiodictotalswith
payrollregisterrecordof
payments.

Evidence
Incompletecostingdev.

C1b

Vouchcoststotimerecords.

Invalidtimeanalyzeddev.

C2

Tracecostaccountinglabor
distributionstomanagement
reportsandpostingsingeneral
ledgerandsubsidiaryaccount(s).

Inaccuratereportingdev.
Incompleteaccountingdev.
Wrongclassificationdev.

SampleofRecordedLaborCostItems:
C3
Vouchlaborcostentriesto
supportinglaborcostanalyses.

Invalidentriesdeviation.

34

35

11.64CostAccountingTestofControls

36
11.65
The case involves a processing error for currency exchange on a purchased inventory
cost component. An understanding of inventory costing has to be applied to analyse
the problems in the case. An approach to analyzing the case is as follows. Other
approaches are possible.
a) Assuming Thermox will ultimately pay the exchange difference to the supplier, one
impact is that accounts payable is understated by the amount of exchange that was
underpaid. A further error exists in the standard costing formula, since the
Canadian dollar price is significantly higher than the US dollar amount used in the
formula. This will result in inventory and cost of sales, which are measured at
standard cost, being understated. Because these errors tend to offset each other,
there may not be large variances and the problem would not be evident through
controls that involve monitoring cost variances.
b) Records and analyses include the standard costing formula and materials listing
for items that Thermox produces, the supporting documentation for material prices
and other costs included in standard costs, the usage of the component that is
incorrectly priced in work in process and finished goods inventory and goods sold
during the period. The auditor would need to assess the extent to which the pricing
error is reflected in production costs during the year (for costs of sales
valuation) and in the year end inventory on hand ( for WIP and finished goods
valuation). For accounts payable, records include the total purchases of the item in
question in US dollars, the amount paid and recorded in Canadian dollars, and
managements intent regarding payment of the difference.
c) A control procedure of periodic comparison of standards cost components to actual
suppliers being used and prices of components would detect changes of this kind. The
procedures should also provide for revisions to be made to standards costs when
appropriate, and these changes should be independently reviewed and approved.
11.66
The question requires one to consider what different errors discovered in control
testing may indicate about control conditions and what action by the auditor would
be appropriate to address the findings. Various interpretations are valid, depending
on assumptions made. One possible set of analysis and conclusions is set out below.
a) Labour cost recording is incomplete. Comparisons to budget (assuming budgets are
realistic and designed for control purposes) are not being followed up. Alternately,
labour costs efficiencies have been realized and budgets have not been updated to
reflect this, or budgeting is not being done on a realistic basis. The auditor
should make enquiries to determine what is actually occurring
b) Validity of labour costs is in question. High frequency of discrepancies suggests
either daily labour reports are incomplete (e.g. not regularly kept up to date for
new employees, exacerbated if employee turnover is high), or false claims of hours
worked are being entered. Follow up should be enquiry and examination of procedures
for authorizing employee pay, to determine if the unidentified employees can, and
did, receive pay.
c) Accuracy (i.e. validity or completeness) of labour costs is in question. The
control of comparison of labour cost entries to actual pay potentially is not being
used effectively if these kinds of discrepancies are occurring but not being
followed up. Further enquiries and examination to indicate frequency and whether the

37
control is being applied effectively throughout the audited period.
d) Validity and authorization of inventory costs is in question. The control of dual
accumulation of costs (WIP listing and material usage report based on materials
issued slips) indicates discrepancies. Enquiry whether both systems are being
implemented (seems a costly system considering the risk involved, unless materials
are very valuable and easy to steal) and whether comparison of actual material use
to materials issued is followed up to resolve discrepancies, if not the control is
not very effective.
11.67
The question requires one to consider the audit independent issues. The cost
deferrals manipulations in the case are similar to the techniques used by WorldCom
to overstate its results, a case currently in the news. This is also of ongoing
relevance in Canada as cost deferral is generally accepted in practice and used more
widely than in the US.
One issue of auditor independence is the arrangements around fees, that appear to
give the auditors an interest in the successful outcome of the IPO that they may put
ahead of their duty of care, i.e. their duty to be objective about the financial
statement information in the interests of potential users (investors in this case).
This self interest of the auditors led to inadequate verification and even
complicity with misstatements in the financial statements.
Given recent incidents of corporate malfeasance and audit failure (e.g., WorldCom,
Enron, Andersens) the SEC penalties seem inadequate to send the message that self
interested behaviour by auditor is not tolerable, and in the case of public
companies this can be very detrimental to the interests of investors and can destroy
their confidence in the stock market. One can speculate that under current
conditions, the penalties imposed on the auditors would be far more severe.

11.68 PayrollFlowchartControlPoints
NoteforInstructors:Usethesolutionfor8.56.
11.69 TestDataTransactionsinaPayrollProcessingSystem
NoteforInstructors:Usethesolutionfor17.50.
a.

b.

ThePAmusttestthecutoffofsalesandaccountsreceivableatthe
balancesheetdate.Iftheitemsaretobeexcludedfrominventory,the
PAmustensurethatsalesinvoicesarepreparedandrevenues(and
relatedaccountsreceivable)arerecordedinthecurrentyear.But
excludingtheitemsfrominventoryandrecordingsalesinthecurrent
yearisprobablyinappropriatesincetheproductshavenotyetbeen
shippedtocustomers.Thefactthatthetruckswereparkedatthe
shippingducksuggeststhattheybelongtothecompany,notan
independentcommoncarrier.Asaresult,titletothegoodswouldnot
passuntildeliveryatthecustomersplacesofbusiness,andrevenue
shouldnotberecognizedjustbecausethetruckswereloadedpriorto
yearend.
ThePAneedstoperformadditionaltestsofobsolescence.Heshould
examinetheperpetualrecordstodeterminethedatesofproductionof

38

c.

d.

thequestionableitemsandthepatternofrecentsales.Also,heshould
verifythattheitemsaresoldinthecompanyscurrentproductlineby
examinationofcatalogues,pricelists,etc.Inaddition,heshould
verifysalesoftheseitemssubsequenttoyearend.Finally,thePA
mustensurethatthegoodsarevaluedatthelowerofcostormarketby
comparingthecarryingcosttothenetrealizablevaluesofthe
inventory.Indoingso,thePAshoulddiscusswithappropriate
personnelthesizeofthepricediscountswhichwilllikelyberequired
inordertomovethisstock.
ThePAshoulddiscussthisapparentchangeinthemethodofcalculating
costs(reclassificationofperiodcoststoproductcosts)with
managementtodeterminethereasonforthechange.Presumablythere
musthavebeenamajorchangeinthenatureofworkdonebyelectrical
engineeringtojustifythechangeinaccountingpolicy.ThePAshould
verifythroughdiscussionswithengineeringpersonnelandexaminationof
availabletimerecords,thatthecostschargedtooverheadactually
relatetocurrentproduction,andnotnewproductdevelopment,etc.
Finally,thePAshouldcalculatetheeffectofthechangeincost
calculationuponinventoriesandnetincomeandconsiderwhether
disclosureofthepolicychangeinthefinalstatementsisnecessary.
ThePAshouldthoroughlydiscussthesituation,anditspossible
implications,withmanagement.Thelackofagreementbetweentheactual
goodsonhandandtheperpetualrecordsmayindicateproblemsinthe
physicalcontroloverinventoryitems,problemwiththeperpetual
inventorysystem,orboth.ThePAneedstoconsidertheimpactofthese
systemproblemsonhisassessmentofcontrolrisk.Heshouldalso
discussanyspecificcontrolproblemsinhismanagementletterissuedat
theconclusionoftheaudit.However,sincethecompanytookacomplete
physicalinventoryatyearend,thiscontrolproblemswillnotdirectly
resultinmisstatementsofbalancesheetinventoryamountsorrecorded
costsofsales.

11.70 AuditApproach:InventoryandDeferredCostOverstatement
TOYINGAROUNDWITHTHENUMBERS
AuditObjective:Obtainevidencetodeterminethevaluationofmanufactured
inventoryatlowerofcostormarket
Control:Thesalesforecastshouldbebasedonrealisticassumptionsand
expectations.Thecompanyshouldhavedocumentationorplausibleexplanations
fortheassumptionsunderlyingtheforecast.
Detailrecordsoftoolingcostbalancesbytoylineshouldcarryforwardfrom
theendoftheprioryeartothebeginningofthecurrentyearinthesame
amountandforthesametoylines,justlikethecostoffixedassets.
TestofControls:Thereisnothingroutineaboutreviewingasalesforecastfor
reasonableness.Thecompany'sdocumentation,ifany,shouldbestudied.Persons
responsibleforitspreparationshouldbeinterviewed.Onetypicalprocedureisto
tracktherecordofmanagement'spastsalesforecastswithsubsequentactualsales
experience.Responsestoinquiriesshouldbeanalyzedforreasonablenesson
whateverbasesareavailable(excludingwildoptimism).
TestofBalances:Muchofthebalanceauditworkoninventoryobsolescenceflows

39
directlyfromthecontroltesting.Inthiscase,thevalidityoftheforecastwas
thecrucialstepbecauseinventorywasnotevenflaggedforLCMcalculationunless
itexceededtheforecast.(Notmuchcouldbedeterminedfromthephysical
observationbecausetoysdon'tshowsignsofmoldorrust.Whenoversupplied,they
aresoldatcloseoutprices.However,afewkindsofpartsandrawmaterialsmight
be"observed"asquestionablyobsolete.)
Reviewtheforecastforcuriousdiscrepancies.Inthiscasezerodifferences
betweeninventoryquantityonhandandforecastsalesoftoysandusageofparts
shouldbringsuspicionthattheforecastwas"plugged."Furtherinquiryintothe
forecastprocessiswarranted.
Beginningbalancesofunamortizedtoolingcostsshouldbetracedtoprioryear
workingpapersortheclient'sprioryearrecords.Thisshouldhaveshowedthe
movementofprioryearamountstodifferenttoylines.
Amortizationratesshouldbetestedagainsttheforecasts,andtheforecast
experienceshouldbereviewed.
DiscoverySummary(Adapted:ASR292):Theauditorsdidnotnoticeanythingcurious
aboutinventoryquantitiesandforecastquantitiesbeingequalin19of128lines
sampledfordetailedaudit.Theydidnotnoticetheinterchangeablepartnumbers'
referencetothepartitselfinsteadoftoanewtoy.Inoneoftheyears,theydid
notcomparepriorforecasttosubsequentactualsalesexperience;intheother
year,theauditorsmadethecomparison,butacceptedmanagement'sexplanationof
howsaleswouldincrease.
Theauditorsapparentlydidnottracethebeginningtoolingbalancestoprioryear
endbalancesandfailedtonoticethemovementoftheamountstoothertoylines.
However,theydidnoticethepoorforecastexperiencefortoolingamortizationand
recommendedanadditional$2millionamortizationoftheprepaidexpense.After
discussionwithmanagement,anadjustmenttoamortizeanother$1.4milliontooling
costwasrecorded.Thatstillleftthebalanceoverstatedbecausetheauditors
recommendedanadjustmentonlyforthesampleofitemstheytestedanddidnot
projectthemisstatementtotheentiredeferredcostpopulation.
11.71 AuditApproach:InadequatePayrollTimeRecords
PAYROLLINTHEBLUESKY
Objective:Obtainevidenceofthevalidityoflaborcostsdeferredastooling
andtheamountclaimedascostoverrunreimbursementondefensecontracts.
Obtainevidenceofthe"existence"ofthelaborcostreimbursementclaimin
termsofitsbeingsupportedbysufficientdocumentationtojustifycarrying
asanasset.
Control:Themajorcontrolliesintheproceduresfordocumentingthe
validityoflaborcostassignmentsidentifyingthetimeandcostspecifically
tothecategoriesclaimed.Forthereimbursementclaim,thecircumstances
alsoneedtomeetthetermsofthecontractrespectingcostoverrun
reimbursement.
TestofControls:Thetestofcontrolprocedureistoselectasampleof
journalentriesthatcreatedtheassetsdeferredtoolingcostandcost
reimbursementclaim.Vouchthemtosupportingdocumentation.Thetransactions
canbeauditedforcontrolovervalidityandaccuracy.However,these
procedureswillalsosatisfythedualpurposeofauditingtheassetbalances

40
thatarisedirectlyfromthetransactions.
TestofBalances:Theaccountbalancescreatedbythedeferraljournal
entriesareaudited("dualpurposeprocedure")byauditingthesupporting
documentation.Thesebalanceswerecreatedentirelybythejournalentries
andtheir"existence"aslegitimateassetscostdeferralandreimbursement
claimdependsonthebelievabilityofthesupportingexplanations.In
connectionwiththedefensecontractclaim,auditorscanreviewitwith
knowledgeofthecontractandtheextentofdocumentationrequiredby
governmentcontractauditors.
DiscoverySummary:Byperformingtheproceduresoutlinedabove,themanager,
senior,andstaffaccountantsontheengagementdiscoveredallthe
questionableandimproperaccounting.Theynoticedthatthetoolingcost
deferrallaborcostwas"supported"byworkordersofrecentdateand
numericalsequence,butthelaborchargeticketswerecreatedseveralmonths
prior.Thisfindingtippedthemoffthatthelaterjournalentryestablishing
thedeferredchargewasinventedforincomemanipulationpurposeslaterin
thefiscalyear.
Thegovernmentcontractcostoverrunclaimhadsimilardeficient
documentation.Thelaborcosthadnoassociatedworkordersconnectedwith
thegovernmentcontractsinprogress.Collectiblewasverydoubtful.The
accountwasadjustedto"writeoff"theclaim.
11.72 EmployeeEmbezzlementviaPaddedPayroll
(DuplicatedinChapter19,case19.53)
NoteforInstructors:Usethesolutionfor19.53(GhostRidersonthe
Payroll).