Case 7: Designing Substantive Audit Tests: Compensation Plan

Case 7: Designing Substantive Audit Tests: Compensation Plans- Discussion Questions

1) A company profit-sharing arrangement is a matter of auditor concern because it provides an incentive for employees to generate artificially high income figures. These individuals can receive direct financial benefits from the manipulation of reported earnings. This potential problem is even more of a concern in the Lakeside engagement because controls are weak and each store is geographically isolated from the oversight provided by the administrative offices.

2) A sample of tests of controls that Mitchell might have performed in evaluating Lakeside’s payroll system include the following:
• Compare the payroll records produced by Sarah Sweet to time tickets

By setting aside sufficient cash for payroll, the company guards against spending money required for that purpose.
• Allows for additional control over unclaimed checks, uncashed checks, etc.
• Facilitates the audit function in that the payroll balances are easier to verify.
• Limits the amount of money that would be subject to theft in a payroll system.
• Facilitates reconciliation of the bank account. Some organizations even use 12 bank accounts – one for each month – to limit the problems associated with the bank reconciliation process.

6) Some of the more critical potential problems involving payroll include:
• Checks are issued to fictitious employees or to former employees who have left Lakeside, with the checks being diverted and fraudulently cashed.
Substantive tests that may disclose this problem: o Observe distribution of payroll checks. o Review personnel files for a sample of employees to verify current status is maintained. o Compare names in files to time tickets and verify authorization of time tickets. o Review company 's system for removing names of employees who no longer work for the company. o Compare current number of employees to previous years for unusual