7.4 Auditing Employee Benefit Plans
5 min read•august 13, 2024
Employee benefit plans are a crucial part of the payroll and personnel cycle. These plans, including defined contribution and defined benefit plans, provide important benefits to employees but come with complex regulations and risks.
Auditing employee benefit plans involves assessing compliance with laws like ERISA, evaluating internal controls, and testing transactions. Auditors must understand the unique risks and perform specialized procedures to ensure accurate financial reporting and legal compliance.
Types and Characteristics of Employee Benefit Plans
Defined Contribution Plans and Defined Benefit Plans
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- Employee benefit plans are categorized as either defined contribution plans or defined benefit plans, each with distinct characteristics and risks
- Defined contribution plans (401(k) plans) involve employees contributing a portion of their earnings to an individual account, with the employer often matching a percentage of the contribution
- Defined benefit plans (pension plans) provide a specified monthly benefit to employees upon retirement, with the employer bearing the investment risk and responsibility for funding the plan
Other Types of Employee Benefit Plans and Applicable Laws
- Other types of employee benefit plans include health and welfare plans, which provide medical, dental, vision, and other benefits to employees and their dependents
- Employee benefit plans are subject to various laws and regulations, including the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC)
- ERISA establishes minimum standards for employee benefit plans, such as fiduciary responsibilities, reporting and disclosure requirements, and participant rights and protections
- The IRC sets forth tax-qualification requirements for employee benefit plans, including contribution limits, distribution rules, and non-discrimination testing
Risks and Audit Considerations for Employee Benefit Plans
Inherent Risks in Employee Benefit Plans
- Employee benefit plans are exposed to inherent risks, such as investment risk, longevity risk, and compliance risk, which can impact the plan's financial stability and the accuracy of its financial statements
- Investment risk arises from the potential loss of value in the plan's investments due to market fluctuations, economic conditions, or poor investment decisions
- Longevity risk refers to the possibility that plan participants may live longer than expected, requiring the plan to pay benefits for a more extended period than initially anticipated
- Compliance risk involves the potential for the plan to violate applicable laws and regulations (ERISA or IRC), which can result in penalties, fines, or legal action
Audit Planning and Internal Control Assessment
- Auditors must consider these risks when planning and performing the audit, and tailor their procedures to address the specific risks associated with the employee benefit plan being audited
- Auditors should assess the internal control environment of the plan sponsor and the plan administrator to determine the effectiveness of controls in mitigating risks and ensuring accurate financial reporting
- This assessment helps auditors identify areas of higher risk and design appropriate audit procedures to address those risks
- Auditors may test the operating effectiveness of key controls, such as the review and approval of participant transactions or the reconciliation of trust statements to participant records
Compliance of Employee Benefit Plans with Laws and Regulations
Understanding and Evaluating Compliance with ERISA and IRC
- Auditors must have a thorough understanding of the laws and regulations governing employee benefit plans, including ERISA and the IRC, to effectively evaluate the plan's compliance
- Auditors should review the plan document and summary plan description to ensure that the plan's provisions align with the requirements of ERISA and the IRC
- The plan document outlines the specific terms and conditions of the plan, while the summary plan description provides a simplified explanation of the plan's provisions to participants
- Inconsistencies between these documents and the requirements of ERISA and the IRC may indicate non-compliance
Compliance Testing Procedures and Form 5500 Review
- Compliance testing procedures should be performed to verify that the plan adheres to applicable laws and regulations, such as testing for timely remittance of participant contributions, proper calculation of benefits, and adherence to non-discrimination rules
- Auditors should also review the plan's Form 5500 filing, which is an annual report required by ERISA, to ensure that it is complete, accurate, and filed in a timely manner
- Form 5500 provides important information about the plan's financial condition, investments, and operations
- Errors or omissions in the Form 5500 may indicate underlying compliance issues or weaknesses in the plan's financial reporting processes
Audit Procedures for Benefit Plan Transactions
Substantive Testing and Analytical Procedures
- Auditors should develop an audit plan that includes specific procedures to test the accuracy and completeness of benefit plan transactions (contributions, distributions, and investment income)
- Substantive testing procedures should be performed to verify the accuracy of participant data, including demographic information, contribution amounts, and benefit calculations
- These procedures may include tracing contributions to payroll records, recalculating benefit payments, and confirming participant data with third-party service providers
- Analytical procedures should be employed to identify unusual trends or fluctuations in plan transactions, such as a significant increase in participant distributions or a decrease in employer contributions
- These procedures help auditors identify areas that may require further investigation or additional testing
Investment Portfolio Review and Reconciliation Testing
- Auditors should review the plan's investment portfolio to ensure that investments are properly valued, classified, and disclosed in the financial statements
- This may involve obtaining independent confirmations of investment balances, testing the valuation methodologies used, and reviewing investment committee minutes for evidence of proper oversight
- The auditor should also test the plan's reconciliation of participant records to the trust statements to ensure the completeness and accuracy of the plan's financial information
- This reconciliation helps identify any discrepancies between the participant records maintained by the plan administrator and the actual assets held in trust
- Auditors may test a sample of reconciling items to ensure they are properly resolved and recorded in the plan's financial statements
Communication of Audit Findings
- Auditors should communicate any identified errors, irregularities, or instances of non-compliance to plan management and those charged with governance, and consider the impact on the audit opinion and financial statements
- This communication should be timely and include a clear description of the issues identified, their potential impact on the plan's financial statements, and any recommendations for corrective action
- In some cases, the auditor may need to modify the audit opinion or include an emphasis-of-matter paragraph in the audit report to highlight significant issues or uncertainties related to the employee benefit plan
Key Terms to Review (18)
Actuarial assumptions: Actuarial assumptions are the estimates and judgments made by actuaries regarding future events affecting the financial outcomes of employee benefit plans, such as mortality rates, retirement ages, and rates of salary increase. These assumptions are essential in calculating the present value of future benefit obligations and play a critical role in the overall financial health of benefit plans, impacting funding requirements and financial reporting.
AICPA Guidelines: AICPA Guidelines refer to the set of standards and recommendations established by the American Institute of Certified Public Accountants for accountants and auditors to follow in their professional practice. These guidelines are designed to ensure quality, consistency, and compliance in auditing processes, including those related to employee benefit plans. They help auditors navigate complex regulations and provide assurance that financial statements are presented fairly.
Confirmations of investments: Confirmations of investments are written communications sent to financial institutions or other third parties to verify the existence, ownership, and terms of investment accounts held by an entity. This process is crucial for ensuring that the reported amounts in financial statements are accurate and correspond with actual holdings, thereby supporting the overall reliability of financial reporting.
Defined Benefit Plan: A defined benefit plan is a type of employee pension plan where an employer guarantees a specific retirement benefit amount for employees based on factors such as salary history and years of service. This plan is essential for employee benefit management, as it provides a predictable and stable income for employees upon retirement, shifting the investment risk from employees to employers.
Defined Contribution Plan: A defined contribution plan is a retirement savings plan where both the employee and employer contribute a fixed amount or percentage of the employee's salary into an individual account. The total retirement benefits depend on the contributions made and the investment performance of the account, making it distinct from defined benefit plans that guarantee a specific payout upon retirement.
Department of Labor: The Department of Labor (DOL) is a federal agency in the United States responsible for promoting and ensuring the welfare of job seekers, wage earners, and retirees. It enforces labor laws regarding workplace safety, wage standards, unemployment benefits, and equal employment opportunity. Its role is critical in the context of employee benefit plans as it oversees regulations that protect workers' rights and ensure that benefit plans comply with legal standards.
Disclosure Obligations: Disclosure obligations refer to the legal requirements for organizations to provide specific information about their financial condition and operations to stakeholders, including employees, investors, and regulators. These obligations ensure transparency and accountability, especially in the context of employee benefit plans, where participants have a right to understand how their benefits are funded and managed.
Eligibility risk: Eligibility risk refers to the potential for employees to be incorrectly included or excluded from participating in benefit plans, leading to financial or legal implications for the organization. This risk arises when the criteria for eligibility are not clearly defined or properly communicated, which can result in non-compliance with regulations governing employee benefits. Managing eligibility risk is crucial for ensuring that employee benefit plans operate smoothly and fairly.
ERISA Compliance: ERISA Compliance refers to adherence to the Employee Retirement Income Security Act, a federal law that sets minimum standards for pension and health plans in private industry. This law is crucial for protecting employees' benefits and ensuring transparency in the management of employee benefit plans, impacting how these plans are audited and reported.
Funding Status: Funding status refers to the financial health of an employee benefit plan, particularly pension plans, which is assessed by comparing the plan's assets to its liabilities. A positive funding status indicates that the plan has sufficient assets to meet its future obligations, while a negative status suggests potential shortfalls that could affect benefit payments. Understanding funding status is crucial for ensuring compliance with regulations and evaluating the overall sustainability of employee benefit plans.
Pension Benefit Guaranty Corporation: The Pension Benefit Guaranty Corporation (PBGC) is a U.S. government agency that protects the retirement incomes of American workers in private sector defined benefit pension plans. Established by the Employee Retirement Income Security Act (ERISA) of 1974, the PBGC ensures that employees receive their promised pension benefits even if their employer fails to meet its pension obligations.
Reporting requirements: Reporting requirements refer to the specific obligations that organizations must adhere to when presenting financial and operational data, particularly in the context of employee benefit plans. These requirements ensure transparency and compliance with regulations set by governing bodies, such as the Employee Retirement Income Security Act (ERISA) in the U.S. They play a critical role in maintaining the integrity of financial reporting and protecting the interests of plan participants.
Risk Assessment: Risk assessment is the systematic process of identifying, analyzing, and evaluating potential risks that could adversely affect the achievement of objectives. This process is crucial in various contexts, as it enables organizations to prioritize risks and allocate resources effectively to mitigate them, ensuring compliance with standards and regulations.
Segregation of Duties: Segregation of duties is an internal control principle that aims to prevent fraud and errors by dividing responsibilities among different individuals for related activities. This concept ensures that no single person has control over all aspects of a financial transaction, thereby reducing the risk of unauthorized actions and increasing the accuracy of financial reporting.
Statement of changes in net assets available for benefits: The statement of changes in net assets available for benefits is a financial report that details the changes in the assets held by an employee benefit plan over a specific period. This statement is crucial for understanding how contributions, investment income, and benefits paid affect the overall net assets of the plan, offering insights into its financial health and sustainability.
Statement of net assets available for benefits: The statement of net assets available for benefits is a financial statement that summarizes the assets available to pay future benefits to participants in an employee benefit plan. This statement provides crucial information about the financial health of the plan, including details on investments, cash, receivables, and other assets. It helps stakeholders assess whether the plan has sufficient resources to meet its obligations to employees and beneficiaries.
Testing plan provisions: Testing plan provisions refer to the specific guidelines and procedures established during the auditing of employee benefit plans, outlining how various tests will be conducted to assess the compliance and effectiveness of the plan. These provisions ensure that auditors have a structured approach to examining financial statements and other relevant documentation related to employee benefits, ultimately providing assurance about the plan's integrity. They serve as a roadmap for auditors, detailing the necessary steps, timing, and resources needed for thorough evaluation.
Valuation risk: Valuation risk refers to the potential for an asset's value to be misrepresented or inaccurately estimated, which can lead to significant financial discrepancies. This risk is especially crucial in areas where assets are subject to subjective judgments or estimations, affecting both the reported financial position and the overall reliability of financial statements. Understanding valuation risk is essential for ensuring accurate financial reporting and compliance with relevant standards.