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Payroll accounting – What you don’t account for can hurt you

Payroll accounting is an essential function of an organization and involves a variety of duties. This includes developing and overseeing processes to record labour costs, comprised of wages, benefits, taxes and other related expenses that appear on a company’s financial statements. These expenses are generally budgeted each year. When strong accounting procedures are in place, the variance between budgeted versus actual expenses are identified and explained on a monthly basis during the reconciliation process.

The accounting function within payroll requires the preparation of payroll journal entries, accounts payable cheque requisitions and payroll bank reconciliations. Cash management analysts need current and accurate knowledge of all payroll transactions to ensure proper management of the company’s cash flow. In order to provide this information, every organization is required to keep records of their financial transactions along with supporting documentation, which includes approvals and proper sign-offs of such transactions.

Depending on the size of the organization, many payroll practitioners may also wear the hat of accountant. Whether these functions are handled by one employee or more, the financial transactions must be entered into the General Ledger, and at some point, that information must be reviewed and approved to ensure its accuracy and integrity. Anyone overseeing the analysis of payroll or company transactions must have the ability to assess account transactions, prepare regular account reconciliations and recognize any “red flags” of potential payroll fraud.

Checks and balances to reduce fraud

In any financial process, having adequate segregation of duties is essential. Segregation of duties ensures that no one person is responsible for all critical tasks, such as authorizing new hires, establishing rates of pay, authorizing inputted hours, sending bank transmissions or signing off on the bank reconciliations. Segregation of duties reduces the risk of erroneous or fraudulent transactions.

Fraud may be committed within the payroll department, from an outside source, or in collusion with one or more persons. Unreconciled accounts expose the organization to fraud, reporting errors and costly mistakes. The best way to prevent payroll fraud is to reconcile all balance sheet accounts and payroll records monthly or, at the very least, quarterly. You need to analyze accounts for any discrepancies. All discrepancies must be investigated until you have a clear answer, and then corrected if needed.

If organizations do not have solid internal controls and documentation in place, they run the risk of paying fictitious or terminated employees, and losing money to overpayment errors, theft of hours from dishonest employees and administrative costs associated with correcting errors.

Overpayments, in particular, may result in litigation, collection charges and write-offs if they cannot be collected.

Reducing errors with payroll controls

Here are some examples of how your payroll department can develop and maintain payroll controls to reduce errors.

Audit trails
The process of hiring employees and setting them up on payroll requires clear and established auditing trail procedures. A best practice is to ensure that documentation can be traced back to an original source and authorized entry. A signed and dated new-hire request from an individual with hiring authority should be provided. It should include the following information about the employee:

  • name
  • address
  • social insurance number
  • date of birth
  • work location
  • start date
  • pay rate and hours
  • status (which may determine under which RP number to pay employee, such as under a reduced Employment Insurance rate, if applicable); and
  • other company-required information, such as department and cost centre

Authorization to hire and terminate an employee should be given to individuals who do not have the ability to change information in the payroll system. If they are able to make changes, an internal auditing process must be established to validate the information. Often this is handled by Human Resources with final sign-off from the hiring manager.

Time sheets
All time sheet entries for hourly paid employees, including temporary employees hired through an employment agency, must be matched to authorized time sheets. It is most effective to have the department manager whose budget will pay for the employee’s hours sign off on the time sheet. After the payroll is processed, some organizations may also require the manager to sign off on the actual payroll register for integrity and auditing purposes.

Hours should be authorized by a supervisor or department manager, sent to payroll and payroll should balance the hours to the time entry sheets or uploaded data to ensure the proper hours are being paid. This may be in the form of time sheets or an automated timekeeping system.

Payroll data entries must be reviewed and audited by someone independent of the process pre- and post-completion. Audit trail reports should be included with payroll, which include total number of hours; total employees; new hires and terminations; and any employee changes to pay rates, positions and personal data. The latter must have authorized sign-off by the appropriate manager.

Note: Payroll is generally more accurate if changes, hours and employee data are automated or imported from your time and attendance system or human resources system. Manual entries increase the risk of errors and should be validated against source documents to ensure you are not paying terminated employees or overpaying employees.

Segregation of duties
Even in smaller companies, no one person should be able to process a new hire form, set up the employee on payroll, and authorize the payment of that employee via bank transfer or manual cheque. Appropriate access levels must be established within your organization.

Internal audit
Organizations with medium to large payroll departments, specifically where the payroll is handled in-house, should set up internal audit practices to test and maintain their payroll controls. With changing employees at all levels within the system, periodic testing will determine if established controls are still being met.

Remember, even if you outsource your payroll, you should still conduct audits on a regular basis to ensure there are no overpayments or errors.
A critical element of payroll control involves having internal audit reports produced and signed off each pay period. Audit reports include:

  • reconciliation of total head count to previous pay, showing new hires and terminations
  • analysis of total payroll compared to previous pay and explanation for any increases or decreases
  • review of net pay over the set tolerance dollar amount

Reconciliation
Frequent reconciliation can also help uncover possible errors and ensure that manual and cancelled payments are processed on a timely basis. Monthly reconciliations of bank accounts should be completed by an independent person outside the payroll department. Labour costs should be analysed by the individual department heads and compared to budgets for variances.

Other considerations
Here are a few more examples of payroll controls your organization should consider putting in place:

  • Ensure the bank file for direct deposits is authorized and released by someone outside of payroll.
  • Rotate responsibilities for different tasks on a regular basis among the employees of a department or organization.
  • Clearly document processes and procedures to ensure compliance with company policies, employment contracts, collective agreements, and applicable federal and provincial legislations, including employment standards and the Income Tax Act.

Payroll practitioners must comply with over 190 federal and provincial regulatory requirements while keeping up to date on constantly evolving payroll-related legislation. Improper accounting procedures or record keeping can mean poor control, which impedes compliance. When effective internal controls are in place and all transactions can be validated by an internal and/or external auditor, the likelihood of payroll fraud and its associated costs declines dramatically.

By Laura Angelo

Laura Angelo holds the Certified Payroll Manager certification from the Canadian Payroll Association (CPA) and has been a proud member of the CPA since 1991. She is one of 11 subject matter experts in payroll legislation, research and training with the CPA’s Compliance Services and Programs team. When Laura is not busy assisting members with their payroll inquiries through InfoLine, she is reviewing and updating materials for the CPA Professional Development (PD) seminars and reviewing employer guides for the federal and provincial governments. Laura also facilitates PD seminars and webinars for the CPA.

Occasional Contributors

In addition to our regular guest bloggers, Inside Internal Controls blog published by First Reference, provides occasional guest post opportunities from various subject matter experts on the topics of risk management and best practices in finance and accounting, information technology, environmental issues, corporate governance, sales/marketing and operations, not-for-profits and business related issues in Canada. If you are a subject matter expert and would like to become an occasional blogger, please contact Yosie Saint-Cyr at editor@firstreference.com. If you liked this post and would like to subscribe to Inside Internal Controls blog click here.

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