CHAPTER 5:

ACCOUNTS PAYABLE, PAYROLL AND OTHER LIABILITIES AUDIT

Learning Objectives: after studying this chapter, you should
1. Describe Nature and source of Account Payable and other liabilities.
2. Discuss Internal Control over Accounts Payable.
3. Describe Audit Program for Accounting Payable.
4. Describe payroll auditing procedures
5. Explain importance of the payroll cycle.
6. Identify special considerations in respect of the payment of salaries
7. Discuss audit of other liabilities
Nature and source of Account Payable and other liabilities
Liabilities are debts owed to outsiders or creditors. There are two categories of liabilities i.e.
current liabilities and long-term liabilities. Current liabilities are those liabilities that will be due
within one year or less which includes account payable, notes payable, salary payable, etc. Long
term liabilities are those liabilities that will be due after long time. When a note is accompanied
by security in the form of mortgage, the obligation referred as mortgage note payable.

The term accounts payable is used to describe short term obligations arising from the purchase of
goods and services in the ordinary course of business. Typical transactions creating accounts
payable include the acquisition on credit of merchandise, raw materials, plant assets and office
supplies. Other sources of accounts payable include the receipt of service such as legal and
accounting services, advertising, repairs and utilities on credit.

Auditor’s Objective in Audit of accounts payable, payroll and other liabilities

1. Consider internal control over accounts payable, payroll and other liabilities.
2. Substantiate the existence of accounts payable, payroll and other liabilities.
3. Establish the completeness of accounts payable, payroll and other liabilities.
4. Establish the clerical accuracy of accounts payable, payroll and other liabilities schedules.
5. Determine that the presentation and disclosure of accounts payable, payroll and other
liabilities are appropriate.

Internal Control over Accounts Payable:

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Internal control applicable to accounts payable may be extended to the purchases or acquisition
cycle.
 Stores or inventory control department: prepare and approve the issuance of a purchase
requisition that will be sent to the purchasing department. A copy of purchase requisition will
be filed and matched with the subsequently prepared purchase order and finally with a copy
of the receiving report.
 Purchasing department: receives the purchase requisition, determines the item that should
be ordered and select the appropriate vendor, quality and price. A serially numbered purchase
order is issued to order the goods. Copies of purchase orders should be sent to stores,
receiving and the accounts payable department.
 Receiving Department: When goods are received, they should be counted and inspected in
receiving department. Receiving reports should be prepared for all goods received and the
copies to be sent to stores, purchasing and accounts payable department.
 Accounts (Vouchers) payable department: all forms should be stamped with the date
received. Vouchers should be numbered serially. Each step in the verification of an invoice
should be evidence by entering a date and signature on the voucher. Comparison of the price
discounts and a term of shipment as on the purchase order and on the vendor’s invoice,
provides a safeguard against the payment of excessive prices.
The official who signs checks should stamp or perforate the voucher and supporting documents
so that they cannot be presented to support payment. The general ledger control accounts,
Vendor’s statements received monthly, should be reconciled promptly with the accounts payable
ledger or list of open vouchers and any discrepancies fully investigated.

Audit Program for Account Payable:

A. Consider internal control for accounts payable.
1. Obtain an understanding of internal control structure for accounts payable.
2. Assess control risk and design additional tests of controls for accounts payable.
3. Perform additional tests of controls for accounts payable: the auditors design and perform
some additional tests of controls such as
a. Verify a sample of postings to the accounts payable control account: The validity of the amount
in the general ledger control account for accounts payable is established by tracing postings to
voucher register and cash disbursements journal. This work is performed before the balance
sheet date as part of general test of postings to all records.

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 b. Vouch to supporting documents a sample of postings in selected accounts of the account
payable subsidiary ledger: Testing the voucher register or the accounts payable by tracing
specific items back through the cash payments journal, purchases journal and other journals to
original document (such as purchase orders, receiving reports, invoices and paid checks.)
4. Reassess control risk and modify substantive tests:
B. Perform substantive tests of accounts payable transactions and balances:
5. Obtain or prepare a trail balance of accounts payable as of the balance sheet date and
reconcile with the general ledger: The auditors will use the list of vouchers or accounts payable
to select a sample for careful examination.
6. Vouch balance payable to selected creditors by inspection of supporting documents: the
vouching of selected creditors’ balances to supporting (vouchers, invoices, purchase orders and
receiving reports) is a substantive test of the existence and valuation of accounts payable. For
companies that use a voucher system, the verification of the individual vouchers will be together in
the unpaid voucher file.
7. Reconcile liabilities with monthly statements from creditors: in some companies, it is a regular
practice each month to reconcile vendors’ statements with the detailed records of payables.
8. Confirm accounts payable by direct correspondence with vendors: accounts payable
confirmation requests should be mailed to vendors from whom substantial purchases have been
made during the year, regardless of the size of their accounts at the balance sheet date. Other
accounts that often are confirmed include those for which monthly statements are not available,
accounts reflecting unusual transactions, accounts with parent or subsidiary corporations and
accounts secured by pledged assets.
9. Perform analytical procedures for accounts payable and related accounts: To gain assurance as
to the overall reasonableness of accounts payable, the auditor may compute some ratios and
compare with ratios for prior years to disclosed trends that warrant/necessitate investigation.
10. Search for unrecorded accounts payable: throughout the audit, the auditors must be alert for any
unrecorded payable. In addition to normal trade payables that may be unrecorded, others include
unrecorded liabilities related to customers’ deposits recorded as credits to accounts receivable,
obligations for securities purchased but not settled at the balance sheet date, unbilled contractor or
architect fees for a building under construction at the audit date and unpaid attorney or insurance
broker fees. A comparison of cash payments occurring after the balance sheet date with the
accounts payable trial balance is generally the most effective means of disclosing unrecorded
accounts payable.
11. Perform procedures to identify accounts payable to related parties
12. Evaluate proper balance sheet presentation and disclosure of accounts payable: proper balance
sheet presentation requires that any material amounts payable to related parties be listed separately

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 from amounts payable to trade creditors. If the client company acts as a consignee of merchandise,
it is possible that sales of consigned goods shortly before the yearend may not have been set up as
a liability to the consignor. An accurate determination of any amounts owing to consignors at the
balance sheet date is one step in proper balance sheet presentation of liabilities.

Payroll Auditing

The concept of payroll is often referred to the total amount paid to employees of a firm as a
compensation for the service rendered to a firm in a given period of time. The payroll and
personnel cycle involves the employment and payment of all employees, regardless of
classification or method of determining compensation.

The following are the steps in the personnel and payroll function:
 Hiring employees
 Authorizing payroll rates, deductions, etc.
 Timekeeping
 Payroll preparation
 Payroll payment
 Paying payroll taxes
 Filing payroll tax returns
Importance of the payroll cycle
Major expense: Employees cost are usually a major expense for all organizations. These costs
include salaries, wages, medical aid contributions, pension, housing etc
Risk of fraud and excessive costs: The payroll is an area, which is particularly vulnerable to
fraud, theft and manipulation:
 Payroll payments often involve large withdrawals of cash.
 Various schemes are used by unscrupulous/dishonest people to insert dummy workmen
onto payroll, or to overstate hours worked or amounts due, for employee services.
 Inefficient management can result in unnecessary employees, benefits and taxes being
paid by the organization.
Table Below Discusses Functions, Documents, Risks And Related Internal Controls Over
Each Activity Related To Payroll Cycle.

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Function Documents Risks Internal Controls

Personnel a) recruiting/retaining a) All recruitments, dismissals and amendments to

1. To assist with all unsatisfactory or payment details of employees should be proposed on a
personnel matters so unnecessary duplicate PAF and appropriately authorized, prior to
as to ensure optimum personnel, acting on proposals.
efficiency from the Payroll b) incorrect dismissals, b) Adequate recruitment and interview procedures should
organization’s work amendment c) Unauthorized ensure That only competent, trustworthy personnel are
force through: form (PAF) amendments to engaged,
- Recruitments payment details of a) A personnel file should be kept for each employee And
- Incentive for employees. should include:
employees - copies of relevant PAF’s
- Dismissals - employment contract
2. To maintain records as a) Discrepancies - qualifications
to all pertinent Personnel file between personnel - performance appraisals
information and payroll records as b) a copy of each PAF should be sent promptly to the
concerning employees. to employee payment payroll department to ensure that they are kept up-to-
detail. date as to all unauthorized employee details such as:
date of employment /dismissal
- rate of pay and
- deductions
Time-keeping & a) Where remuneration is based on hours worked, a clock
Supervision Clock cards a) Overstated card system, or other efficient method of monitoring

To keep a reliable record hours/productivity/ac hours worked, should be implemented.

of the activity of each Job time tivity b) Where remuneration is based on employee activity e.g.

employee, where such tickets b) Unapproved absences commission on sales, a schedule of such activity should

activity will be used to on full pay. be maintained.

calculate the remuneration c) Clock cards/ schedule of activity should be checked by

due to such employee. Other supervisory staff and signed as evidence of approval.

Payroll preparation & a) Payroll details should only be changed in terms of

accounting a) Fictitious workers authorized PAF’s, received from the personnel

To calculate amounts Payroll b) Unauthorized department i.e. new employees, dismissals, and

payable in respect of deductions amendments to deductions and pay.

remuneration and Payroll ledger c) Unauthorized pay b) Management should review the payroll to ensure that it

deductions. accounts rate changes reconciles with the details in the personnel files.
d) Misallocations c) The payroll should be split and distributed to the
Costing e) Calculation errors departmental heads, for approval of payments to their
records employees (evidenced by signature).
analyzing d) Reconciliations should be performed as follows:
labor costs

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  Payroll to direct labor costing,
 Payroll to tax records.
e) Someone independent of payroll preparation should
check payroll computations.
f) Clear instructions should be given to ensure correct
allocation of labor in cost accounting records.
g) Above allocation should be checked by an independent
person.
Payroll payments & Payroll a) Isolate responsibility for signing of cheques to two
recording cheques a) Errors of theft of cash independent senior officials.
during: b) These officials should review the payroll and perform

To prepare salary cheques Pay slips  Drawing of cash, random checks prior to signing the payroll cheque for

and pay packets and  Making of total net salaries or total net wages.

distribute these to Unclaimed paychecks,

employees. wage register.  Payment of

employees.
Defalcation of
unclaimed wages or
incomplete electronic
transfers.

Special considerations in respect of the payment of salaries

1. The check for the total net salaries should be drawn on the main bank account and deposited
into a separate “Salaries Bank Account”.
2. Checks for individual employees should then be drawn on the “Salaries Bank Account”.
3. Check signatories should match checks amounts to net salaries per the payroll, prior to
signing checks.
4. The “Salaries Bank Account” should be reconciled to the relevant bank statements on a
monthly basis.
5. Regular management reviews should be performed to ensure that:
 The “ Salaries Bank Account” is reduced to nil soon after each month end,
 There are no unusual endorsements on the returned paid checks, and
 Bank reconciliations are satisfactorily performed and there are no unusual reconciling
items.

Special Considerations In Respect of the Payment of Wages

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1. Payment Procedures
a) The check for total net wages should be drawn should be cashed from the main bank
account, by someone independent of payroll preparation or recording.
b) Pay packets for individual employees should be prepared by two staff, independent of the
payroll preparation.
c) The wage payout should be controlled by an independent paymaster, accompanied by the
foremen who are able to identify employees.
d) Employees should be required to produce ID, check the contents of their wage packets
and sign the payroll as evidence of acceptance.
2. Unclaimed Wages
a) The paymaster and a foreman should reconcile pay packets still on hand at the end of the
payout (i.e. unclaimed wages) to amounts on the payroll which have not been signed for.
b) Both parties to the reconciliations should sign the payroll as evidence of their check.
c) All unclaimed wages should be entered in an “Unclaimed wage register”.
d) Unclaimed wages should remain in the paymaster’s custody and should be locked in a
safe. They should keep for no longer than two weeks.
e) Employees who wish to collect unclaimed wages during this two-week period must
produce ID and sign in person in the unclaimed wage register.
f) Wages still unclaimed after two weeks should be re-deposited in the main bank account.
g) Incomplete EFT transfers should be investigated by management and followed up to
ensure satisfactorily resolved e.g. employee’s bank account details confirmed and
corrected where necessary.

Auditing the payroll Cycle

Controls related the payroll Cycle discussed earlier may be tested in a number of ways:
 Inspection of documents supporting transactions e.g. For signatures evidencing that a
supervisory check has been carried out,
 Enquiry as to whether controls have been performed or not,
 Observation as to whether intended controls have been performed,
 Re-performance of internal controls e.g. sequence of document numbers.
1. Key control activities
The key control activities on which the auditor should focus when carrying out test of
controls for this cycle are:

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  Segregation of duties.
 Authorization of payroll amendments.
 Adequate personnel records and documentation.
 Clocking procedures/maintenance of activity schedules.
 Wage payout procedures.
 Unclaimed wages procedures.
 Reconciliation procedures.
 Supervisory procedures.
 Supervisory and management checks.
2. Key control objectives
The key objectives in carrying out tests of control in respect of this cycle may be described as
follows:
a) Validity: Test of control should be performed tom identify whether:
 Employees on the payroll are valid or fictitious,
 Hours worked per the payroll are valid or overstated,
 Rates of pay per the payroll are authorized, and
 Deductions per the payroll are valid and/or authorized.
Testing of all control activities will yield evidence as to the validity of payroll details.
However, key controls to test will be:
 Clocking procedures and wage payout procedures. It is important to test these
controls by surprise observation,
 Management reconciliations of payroll details to personnel records,
 Management reviews of reconciliation between salaries bank account and the relevant
bank accounts.
b) Accuracy: Test of controls on the following key control activities should be performed to
identify whether errors are adequately detected and corrected:
 Performance and review of the reconciliations would assist with ensuring accuracy, as
well as validity,
 Independent checks of payroll calculations,
 Any supervisory checks carried out on a regular basis to ensure that employees are
performing their functions and control activities accurately and conscientiously.
3. Audit of Salaries and Related Accounts

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Existence of salary earners: For a sample of employees extracted from the salaries payroll,
establish the validity of the employees listed as follows:
 Inspect the documentation in the employee’s personnel file,
 Perform a positive identification of salary earners’
 By discussion with the staff in the personnel section and examination of the employment
and dismissal documentation, check that;
 Staff are introduced to and removed from the salaries register at the correct time,
employment and dismissal documentation is properly authorized by the designated
staff.
 Confirmation of the above can be obtained from the managers from whom the
employee works/worked.
Measurement/Completeness:
 By re-performance verify that postings from the payroll to the relevant accounts in the
general ledger have been correctly performed.
 By re-performance, verify that clearing accounts, in respect of all deductions, are cleared
by paying over amounts deducted to the relevant authorities timorously.
General/Analytical Review
 Compare salaries on a month to month basis in total and by cost centre, department or
division and investigate any large fluctuations.
 Review payroll ledger accounts for any strange or out of the ordinary amounts or entries
which may require further investigation.
 Obtain or extract exception reports of the following:
- duplicate or missing records and employee numbers
- duplicate bank account numbers
- duplicate employee names and details

Auditing of other liabilities

Amounts withheld from employees’ pay: payroll deductions are numerous: among the more
important are individual income taxes. Income taxes withheld from employees’ pay and not
remitted as of the balance sheet date constitute a liability to be verified by the auditors. This
verification usually consists of tracing the amounts withheld to the payroll summary sheets,
testing computations of taxes withheld and accrued, determining that taxes have been deposited
or paid in accordance with federal and state laws and regulations and reviewing quarterly tax

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returns. Payroll deductions also are often made for union dues, charitable contributions,
retirement plans, insurance and other purposes.
Sales taxes payable: in most of the countries, businesses concerns are required to collect sales
taxes imposed by the governments on retail sales. These taxes do not represent an expense to the
business, the retailer merely acts as a collecting agent .Until the amounts collected from
customers are remitted to the taxing authority they constitute current liabilities of the business.
The auditor’s verification of this liability includes a review of the client’s periodic tax returns.
The reasonableness of the liability is tested by a computation applying the tax rate to total
taxable sales.
Unclaimed wages: A list of unpaid wages should be prepared after each payroll distribution. The
payroll checks should not be left for more than a few days in the payroll department. Prompt
deposit in special bank account provides much improved control. The auditor will analyze the
unclaimed wages to determine that the credit represents all unclaimed wages after each payroll
distribution and the debit represent authorized payment to employees.
Customers Deposits: many companies require that customers make deposits on returnable
containers. The verification should include obtaining a list of the individual deposits and
compare with general ledger control account.
Chapter Review Questions
1. Discuss Nature and source of Account Payable and other liabilities.
2. Discuss Internal Control over notes and Accounts Payable.
3. Describe Audit Program for Accounting Payable.
4. What is payroll, payroll register; identify and discuss components and importance of payroll.
5. Identify & discuss functions of payroll cycle, related internal control activities & objectives.
6. Describe payroll auditing procedures.
7. Identify special considerations in respect of the payment of salaries and wages
8. Discuss audit of salaries and other liabilities
9. At one American university, an employee in the payroll department was able to steal
thousands of dollars by manipulating the payroll records of student workers. When students
quit their jobs, she would delay in putting their termination dates in her computer, continue to
submit time cards in their behalf, and cash the subsequent payroll checks generated by the
system.
Instruction:
I. Identify the internal control weaknesses of the University.

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II. Indicate the audit procedure that most likely would have led to the discovery of the error.

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