How to Conduct a Payroll Audit

What is a payroll audit? 

A payroll audit is the process of reviewing your company’s payroll data, documents and systems to ensure everything is correct. During a payroll audit, you verify that you’re paying each employee the correct salary and appropriately managing your company’s payroll withholdings. You also check whether benefits-related deductions are being properly taken from your staff’s paychecks. Although this might sound like a lot of work, the best online payroll services make it a cakewalk.

“The main goal of a payroll audit is to ensure that payroll processes are followed appropriately and comply with regulations,” said Jim Pendergast, senior vice president and general manager at altLINE by The Southern Bank.

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Most payroll audits are initiated internally rather than at the request of the Internal Revenue Service (IRS). However, IRS payroll audits do occur. You may be able to avoid external audits by completing regular ones in-house. That way, if your internal auditor identifies errors, you can correct them before more significant problems arise.

“A payroll audit helps identify inefficiencies or discrepancies in payroll processes,” said Nancy Sanchez, director of payroll at Flex HR. “It’s a proactive way to ensure accurate employee classifications, tax calculations and deductions.”

Is auditing payroll a requirement?

Auditing payroll isn’t a requirement, but most payroll experts highly recommend internal audits to keep businesses out of trouble with the IRS, minimize compliance errors, and ensure accurate wages are being paid.

How frequently should you audit your payroll?

Many experts advise conducting payroll audits at least once per year. However, there are advantages to auditing your payroll more frequently. Twice a year is good, but quarterly is even better. The sooner you catch errors, the less time and money you’ll spend correcting them.

“Depending on business requirements and legal changes, audits can be regular or on an as-needed basis,” Sanchez said.

How to conduct a payroll audit

Payroll audits may seem overwhelming at first, but once you start doing them, you’ll likely see they’re actually straightforward. Here’s how to conduct a payroll audit.

1. Review all employees and independent contractors on your payroll.

Look at the complete list of employees on your payroll. Address these questions: 

• Are there any names that no longer belong? If a former employee is still on your payroll, you most likely forgot to remove them from your payroll system. If you see payments after their final date of employment, you may need to address the issue with the former team member and take measures to reclaim the unearned money.
• Is someone missing? If an active employee isn’t on the list, you’ll need to investigate immediately. Their information may have been entered incorrectly, or worse, they may not be receiving their paychecks as expected. An immediate resolution is necessary to maintain employee trust and compliance.
• Is there a name you don’t recognize? Identifying a name on your payroll that you don’t recognize is a serious problem and requires an in-depth investigation. If you leave this unexamined, you could wind up losing money you owe to no one. 

Pendergast noted that independent contractors should be considered alongside employees in this step. “Even though they’re not full-time employees, they are still considered part of the workforce, and their pay will need to be included in the audit process,” Pendergast explained. “Just ensure they’re classified as independent contractors; categorization issues can create complications with the U.S. Department of Labor.”

Sanchez noted that it’s important for accounting departments to work with HR and benefits teams to minimize payroll issues and discrepancies. “[Collaborate to] confirm [that] employee data, benefits and deductions match payroll records,” Sanchez advised. “It’s also important to cross-check time sheets with pay data and document any audit findings for follow-up action.”

2. Check your numbers.

Checking your numbers involves the following steps: 

• Check pay rates. Check every employee’s pay rate to verify you’ve recorded the correct wages. If you’ve recently given a staff member a raise or changed them from an hourly employee to a salaried one, the information in your system may not have been updated. Adjust the amount to reflect the correct wages, pay the employee any back pay or retro pay owed, and move on to the next set of numbers.
• Check hours worked. Examine each employee’s number of hours worked per pay period. Tracking hours with the best time and attendance software can help with this. If the numbers reflect the employee’s schedule, you’re in the clear. On the other hand, if you see hours you’re convinced the staffer didn’t work, there might be a problem. 
• Check total hours and pay. Next, look at each employee’s total hours and pay. An employee’s total pay should equal the product of their wages and hours. Their complete hours should also be the sum of all hours worked per paycheck. If both conditions are met, your numbers are likely correct.
• Ensure overtime obligations have been met. There’s one more area where your numbers could be wrong, and it has to do with whether employees are classified as exempt or nonexempt. If you have employees who aren’t exempt from the overtime pay provisions of the Fair Labor Standards Act, check that you’ve compensated them appropriately for overtime. If not, adjust your payroll records accordingly and provide the owed back pay. 

[Read related article: How to Calculate Blended Overtime Pay]

3. Account for vacation time.

An employee’s paid time off (PTO) may appear as days worked in your payroll system. In some cases, you can easily distinguish between vacation time and actual hours worked. That’s because some payroll software allows employees to tag certain paid hours as PTO in their self-service portal. This way, your payroll software knows to deduct these vacation days from the employee’s total available hours.

A PTO tracking protocol like this requires team members to operate within an honor system. The employee controls whether they log their vacation days as such, but they could choose to mark them as regular paid days instead. This would mean they’d never run out of vacation days, and your business would suffer due to the misclassification.

After you review PTO, look at all of your employees’ days off to ensure they’re labeled properly. They should be separated for paid vacation, unpaid vacation, personal days, sick days, parental leave or bereavement leave. These latter categories may be paid or unpaid. If you’re concerned about accuracy, consider having supervisors and managers track PTO regularly.

4. Examine other payment records.

Your payroll system isn’t the only place you’ve recorded employee payments; payroll disbursements are also reflected in your ledger and business checking account. The numbers in all three areas should match. If you find discrepancies, you’ll need to do a deep dive into your financial records.

Once you identify the source of the discrepancy, correct the error. This step should resolve any mistakes in your employee pay system. 

5. Analyze your tax reports.

When you pay employees, you must withhold income, Medicare and Social Security taxes. Your payroll software should handle this task automatically and have time-stamped records of these withholdings. However, it’s wise to also verify mathematically — by hand — that you’ve withheld the correct amount for each tax type. Do the same for any state or local taxes you and your employees pay. 

[Read related article: Using Form 941 to Pay Quarterly Payroll Taxes]

6. Back up your data, and ensure ongoing data backups.

After every payroll audit, contact your payroll service provider to confirm that it’s storing copies of all your data in the cloud across multiple servers. This way, if there is any damage to your equipment or that of your service provider, your data will remain intact. 

“In the case of a malfunction, you’ll want to have your payroll data backup created regularly,” Pendergast said.

After you complete a payroll audit, download the relevant data in a spreadsheet and upload it to one of the best document management software platforms. In doing so, you create a second backup source for your data. You also set the expectation that, after every audit, all of your information gets saved in a secure digital location that all relevant team members can access anytime. You’re all but guaranteed never to lose track of your data.

Benefits of conducting a payroll audit

Regular payroll audits provide a wealth of benefits for your small business, including the following. 

Fewer compliance errors

Payroll audits may reveal that you’re not deducting as much income tax from employees’ paychecks as required. With this information, you can correct your mistakes before the IRS identifies a lack of compliance. If the IRS discovers this problem before you do, the agency can penalize you. Worse, the IRS could conduct an audit of its own that proves to be expensive, time-consuming and stressful. You can avoid that risk with your own internal payroll audit.

“Regular audits can help prevent costly errors, such as missed tax filings or overpayments, and ensure compliance with changing payroll laws,” Sanchez noted.

Benefits accuracy

Like most employers, you probably offer employee benefits that require employee financial contributions. Premiums for these benefits, such as health insurance or a dental plan, are usually deducted from the worker’s paycheck. Part of employee benefits management is ensuring that the correct benefit deductions are taken during the payroll process and that benefits are terminated when a staffer leaves the company. 

A payroll audit allows you to check that everyone enrolled in benefits has the appropriate deductions made from their pay. Similarly, it lets you verify that no one who has opted out of a benefit is still being charged for it.

Happier employees

Let’s say you give an employee a raise but forget to add it to your payroll software. This employee will be underpaid until someone discovers the misstep. Chances are, the staffer will notice the error and approach you. Even if you fix the mistake immediately, you’ve caused your employee unnecessary concern.

A payroll audit could have prevented this situation. During the audit, you’d likely discover that you neglected to add the employee’s raise to your payroll system. Then, you’d immediately update the software and issue retroactive payments to your team members.

You’d be able to approach the employee, explain the error, apologize and assure them that their back pay is on the way. This proactive approach reassures your staff because it demonstrates that you’re looking out for them. And we all know getting paid — and getting paid correctly — makes employees happy.

Easier fraud identification

Although trusting your employees fosters a healthy work environment, a worker occasionally may submit time sheets with hours they didn’t actually complete. Payroll audits help you identify this fraudulent activity. If you know an employee worked a certain number of hours but notice a higher number in your payroll system, you may be uncovering fraud and can investigate the situation.

Earlier removal of former employees

Data on former employees can take up unnecessary storage space in your payroll software, but payroll audits can help you streamline your records. Regular audits identify employees who are still in your system even though you’re no longer paying them.

However, consider the tax implications before you delete an ex-employee from your system. If you must issue the former worker tax forms in the future, ensure that removing them from your payroll system doesn’t affect the distribution of these payroll forms. Additionally, before you delete them, confirm that all of their outstanding wages have been paid. This way, when you remove a former employee from your system, you won’t have to restore them in the future because of something you overlooked.

Payroll process improvements

Pendergast noted that each error encountered in an audit offers a potential opportunity to improve existing payroll processes. 

“For example, you might have completed an audit, but you were left feeling that it was too time-consuming and felt extra tedious to complete,” Pendergast explained. “This might encourage you to explore investing in new accounting software with better payroll audit capabilities, further streamlining your process moving forward. Or, it might be something as simple as realizing you need to be more diligent and organized moving forward when it comes to adding, removing or adjusting employee information from your list of payroll.”

Treat each payroll audit as a chance to identify challenges and brainstorm improvements with your accounting, HR and benefits teams. Invest in new infrastructure, and deploy it gradually — well before your next payroll audit — to streamline employee payments, tax filing, benefits withholding and everything in between.

Payroll audits keep everything in order

Though not legally required, payroll audits are a highly valuable exercise for your business. They uncover costly errors, prevent similar future mistakes, help keep your team happy, and uncover areas for potential process improvement. Plus, with payroll software, all the data you need is within reach. Leverage this software, and collaborate with your accounting, HR and benefits teams to refine your payroll processes — and then do it again in due time.