An Internal Control Weakness in Payroll

by Rebecca Demy; Updated September 26, 2017

An important goal of any internal control system is safeguarding assets. Because payroll processes affect both human and financial resources, problems or weaknesses in payroll internal controls can be costly. Recognizing the risks inherent to the payroll process, understanding their potential affects and knowing how to address them can result in significant loss prevention over time.

Risks

Risks in the payroll process include financial reporting problems, such as understatement of payroll and employee benefit-related liabilities or misclassification of labor costs between cost of goods sold (COGS) and selling, general and administrative (SG&A) expenses. Operational efficiency can be compromised by paying phantom or terminated employees (usually the result of collusion) and by using incorrect wage and salary rates. Regulatory compliance is compromised through violation of federal and state wage and hour laws or violation of Internal Revenue Service (IRS) regulations related to employees versus independent contractors.

Impact

The potential financial, reputational and legal impact of payroll problems varies widely depending upon their timing, size and nature. Understanding the impact an event could have is important in knowing how to address it appropriately. Businesses must consider the following: Financial reporting errors may increase external audit fees. Incorrect financial data may result in poor management decisions and may negatively affect investors and other stakeholders, such as creditors. Payments to phantom employees and incorrect pay rates can negatively impact liquidity and increase tax burdens. Violations of wage and hour laws or IRS regulations can result in significant fines, legal fees, higher employee turnover rates and loss of reputation.

Mitigation

You can reduce the likelihood or the impact of a payroll problem if you implement strong payroll controls. However, the benefit of implementing payroll controls should not outweigh the cost. Regular and timely payroll account and data reconciliations to the general ledger and to third party processors' data, file transmissions and other records may prevent or detect financial misstatements. Review of employee labor classifications between direct and indirect costs can help identify classification problems. Segregation of duties between payroll data entry, processing and payment authorization and release personnel is ideal but can be difficult in small companies with limited resources. Higher level management review, approval and communication of pay rates, rate changes, personnel promotions, job changes and terminations may be appropriate where segregation of duties is not cost effective. Appropriate management and supervisor training programs for legal and HR issues may help increase regulatory compliance.

Monitoring

Any internal control system can become ineffective over time as personnel and business processes change through growth or through inappropriate management override of control procedures. Conduct periodic assessments of potential risks, and review the design and effectiveness of payroll controls to ensure that they remain relevant and cost-effective.

About the Author

Rebecca Demy has been writing technical business documents since 1999. Her writing has focused on proprietary memoranda, multimedia training programs, technical SEC and investor-related filings. She graduated maxima cum laude from the University of Portland with a Bachelor of Business Administration in accounting, is a Certified Public Accountant and is pursuing certification as a Certified Senior Adviser.