Payroll expense and payroll-related liabilities

• Build a payroll expense expectation from headcount and pay rates
• Reconcile quarterly Forms 941 and annual wage reports to the general ledger
• Test accrued payroll, bonuses and compensated absences at period-end
• Design procedures for the existence of employees on the payroll

Where payroll risk sits

Payroll is high volume and usually well controlled, so substantive work leans on analytics and reconciliations. The risks are fictitious employees, unauthorized pay changes, misclassification between cost of sales and overhead, and period-end liabilities: accrued wages, bonuses, paid time off, payroll taxes and benefit withholdings. AU-C 330.18 applies to payroll expense and the related liabilities as significant accounts.

Analytics as the main substantive test

Payroll expense is predictable, which makes it a good candidate for a substantive analytical procedure under AU-C 520. Build the expectation from data you have tested or can corroborate:

• headcount by month and department from HR records,
• average pay rates and the timing of raises,
• overtime patterns, and
• the employer tax and benefit rates.

Disaggregate by department or location and by month. An annual company-wide comparison will hide offsetting changes. Set a threshold for investigation and document the expectation, the comparison and the follow-up, as AU-C 520.08 requires.

Reconciliations to tax filings

Employers report federal income tax withheld and Social Security and Medicare taxes on Form 941, the Employer's Quarterly Federal Tax Return. Annual wages go on Forms W-2 and W-3. Reconcile:

1. The four quarterly Forms 941 to gross wages in the general ledger.
2. The 941 totals to the W-3 total.
3. Taxes per the returns to payroll tax expense and payments.

Differences point to unrecorded payrolls, misposted bonuses or fringe benefits, or noncash compensation not run through payroll. Look also for deposit timing: IRS Publication 15 sets deposit schedules, and late deposits bring penalties that may need accrual. The 941-to-GL reconciliation template lays it out.

Period-end liabilities

• Accrued wages: days worked but unpaid at period-end, times the daily payroll. Agree to the first payroll after year-end.
• Bonuses: agree to the plan, board approval and the measures used. Check whether the obligation existed at year-end even if the amount was set later.
• Compensated absences: ASC 710 requires accrual of vacation and similar absences when the obligation relates to services already rendered, the rights vest or accumulate, payment is probable and the amount can be reasonably estimated. Test the hours or days, the pay rates and the policy for carryover.
• Withholdings and benefits: agree 401(k) deferrals, health premiums and garnishments withheld but not yet remitted to the subsequent remittance.

Existence of employees

Fictitious employees are the classic payroll fraud. Procedures include matching the payroll register to HR files, comparing bank account numbers and addresses across employees and to vendor files, looking for employees with no tax withholding or no benefit elections, and confirming terminated employees stop being paid. The ghost employee testing guide and the payroll anomaly finder cover the data tests.

Common file findings

• Payroll "analytic" that compares this year with last year with no expectation.
• No reconciliation of Forms 941 to the ledger.
• PTO accrual accepted with no test of the hours or the policy.
• Officer compensation not compared with approvals.

Payroll expectation and accrual at Brookfield Home Health, LLC