A payroll audit reviews and analyzes an organization’s payroll process for accuracy.
The audit covers payroll elements like wages, salaries, pay rates, active employees, tax withholdings, and more. Payroll audits should occur at least once per year to ensure the process is up-to-date and compliant.
The term “audit” tends to scare people, as it’s commonly associated with the IRS. But generally speaking, payroll audits are conducted internally—performed by someone within the business or from a third party hired by the company.
All businesses can benefit from running payroll audits. But it’s always a good idea to learn more about this subject after you’ve made a change in this department. Switching payroll providers, getting new HR software, or changing payroll procedures are all examples of recent events that should trigger a payroll audit.
Once you have a firm grasp of how these audits work, it will be much easier to run your first payroll audit. This guide will steer you in the right direction.
Why Do Payroll Audits Matter?
Payroll accuracy is arguably the most important responsibility of any employer. Mistakes like underpaying employees, forgetting to remove someone from the payroll, or miscalculating withholdings are all too common–and really mess with company budgets and compliance when they happen.
But running payroll audits can help you catch errors quickly and avoid big problems like payroll fraud, IRS penalties, tax corrections, and unhappy employees.
What Does Success Look Like?
Running payroll can be a complex task for any business. To make sure the audit goes smoothly, there are certain things you need to look for to verify the audit’s effectiveness.
The very first thing you need to do is ensure the payroll process itself is streamlined and consistent. A successful payroll audit will help you uncover any gaps or problems that can create errors or inconsistencies.
For example, all new hires need to fill out tax forms, payroll forms, and potential elections for purchasing benefits like health insurance. If the new hire fills out these forms by hand, then submits them to HR where a staff member manually inputs the info into your payroll system, there’s just too much room for error.
Payroll audits can open your eyes to this type of problem and ultimately help you improve the process. As a result, you might decide to use payroll software with an employee self-service portal so they can fill out these forms electronically directly with your payroll provider.
Not only does this eliminate time-consuming steps in the process, but it also reduces the chances for errors.
Compliance is another significant component of running payroll. A successful audit verifies correct wages, employee classifications, accurate tax filings, and employment laws.
For example, you might learn that you’ve misclassified a non-exempt employee as an exempt employee. In this scenario, you could face fines and lawsuits if you fail to pay that person proper overtime rates based on federal, state, or local laws.
Underpaying and overpaying employees are equally bad for your business. More than half of all employees in the US have had errors on their paycheck.
Not to mention that there are steep fines for payroll non-compliance. The IRS fines over 40% of small businesses for issues related to payroll tax.
Successful payroll audits identify errors, rectify them, and implement a new process to prevent them from occurring again in the future.
Other common benefits and goals of payroll audits include:
- Verify the accuracy of paid and unpaid time off
- Compare time cards to actual hours paid
- Identify calculation mistakes for payroll conducted by hand
- Remove former employees from your payroll
- Eliminate payroll fraud via mismarked time cards or “ghost” employees
- Verify the accuracy of raises and bonuses
- Eliminate as many manual steps as possible
- Automate as much as possible
- Use modern payroll software and HR solutions to improve your payroll process
If you don’t have the time or internal resources to conduct an internal payroll audit on your own, your accountant or a third-party CPA firm should be able to provide assistance. Later on in this guide, we’ll show you our secret weapon for payroll audits that will make your life much easier—especially if you don’t want to hire someone for help.
Not all payroll audits will find significant errors. In many cases, conducting an audit will help your business prevent issues from occurring in the first place. Let’s take a closer look at a case study to illustrate this point.
CDE Lightband, an electricity provider in Tennessee, spends over $7 million in payroll per year. They ran an internal audit with the following goals:
- Review payroll activity for a 15-month period
- Verify compliance with federal, state, and local laws
- Verify compliance with CDE company policies
- Evaluate HR policy compliance with FLSA (Fair Labor Standards Act)
- Determine the effectiveness of internal controls for payroll processing
Based on the audit, they were 95% confident that 97% of all payroll transactions within the months checked were accurately calculated and compliant.
However, the audit uncovered some potential holes in the payroll process that could lead to problems in the future.
The audit team discovered that payroll access was not restricted to employees with HR and payroll roles. Essentially, employees who weren’t associated with payroll could make changes to the payroll system.
After the audit, CDE Lightband determined it was in their best interest to restrict access to certain payroll functions in their system. Even for some payroll and HR roles, they’re only offering read-only access to data and limiting who can actually make changes to payroll.
The audit also found that CDE Lightband was in violation of a local city code within Clarksville, Tennessee. According to the code, all full-time employees must have at least one formal performance evaluation per year, which the company was not currently doing.
Both of these findings allowed CDE Lightband to change its processes to avoid payroll mistakes and penalties in the future.
One Secret Weapon For Payroll Audits
Gusto is an all-in-one solution for payroll and HR. It comes with employee self-service features to ensure accuracy and improve your payroll process. You’ll also benefit from features like automatic tax filings and integrated time tracking.
The service comes with direct access to HR experts as well to help ensure compliance. This will help you avoid fines and other costly penalties.
4 Essentially Strategies For Payroll Audits
Now that you understand the importance of payroll audits and how they work, we’ll dive deep into some real strategies that will lead to success.
Strategy #1: Eliminate Manual Calculations From Your Payroll Process
One of the first things you need to do is identify any steps within your current payroll procedure that involve a manual calculation. Those are the first numbers that should be checked for accuracy before ultimately removing this from your process altogether.
Humans make mistakes—it happens. But payroll is the one department where mistakes are unacceptable.
If you have a bookkeeper that’s manually adding up time cards on a calculator before submitting those numbers to payroll, there’s just too much room for error.
The easiest way to implement this strategy is by using a modern payroll platform. Gusto makes this easy by automating the vast majority of your payroll, including payroll tax calculations and filings.
Right away, this strategy saves you time, eliminates inaccuracies, and sets you up for long-term success. You won’t have to worry as much about errors related to overpaying or underpaying employees either. Payroll mistakes leading to tax filing issues, compliance violations, and penalties can be reduced as well.
Strategy #2: Verify the Employees Listed On Your Payroll
Employee turnover happens at businesses of all sizes. People quit, get fired, have long absences—this is all normal.
A crucial aspect of any payroll audit is confirming that your employment records match your payroll list.
Remove any employees that aren’t working for the company anymore. If you find inaccuracies here, you may need to do some further investigating to find out why those employees are still on your payroll in the first place.
In many cases, this could just be an administrative error. But sometimes, employees commit payroll fraud by keeping someone on the payroll or adding a fake employee to your payroll. Both of these instances would obviously be a serious violation for anyone involved.
You should also confirm that only employees who worked during periods analyzed are receiving checks. If someone is sick or on vacation and not entitled to PTO, those people shouldn’t be getting paid.
Alternatively, if someone is entitled to PTO but isn’t being paid, that’s another problem that needs to be addressed.
This strategy can also clean up access control issues or other negligent payroll security processes within your HR department.
Refer back to the case study on CDE Lightband that we discussed earlier. While they didn’t find any payroll fraud, their system had some holes that could have made it possible. Running a payroll audit allowed them to make adjustments to prevent this from happening in the future.
Strategy #3: Verify Time Worked, Time Paid, and Time Categories
Payroll is more than just the number listed on a check or the amount deposited in an employee’s bank account.
You need to compare employee attendance records against the actual pay rates. Determine whether or not the hours were classified correctly as well.
The rates will vary for categories like regular pay, overtime, sick leave, vacation time, bereavement leave, etc.
While the actual paycheck itself for 40 hours worked might be the same for five days of paid vacation, accurate time categories are crucial. If the vacation pay gets run as regular pay, employees could take advantage of the system and request more paid vacation time than they’re entitled to.
These types of errors could easily be overlooked, as the recordkeeping would show that they still have unused vacation time.
Not only could this lead to overpaying or underpaying employees, but it could also create compliance issues as well. For example, employers can face fines for failing to accurately pay overtime wages to qualifying employees.
Variable payments should be analyzed here too. This includes things like commissions, bonuses, or profit-sharing. These all need to be labeled accordingly, as opposed to just adding an extra 15 hours to a time card and calling it a bonus.
What’s stopping an HR rep or someone in the payroll department from issuing unauthorized bonuses? An audit will uncover these types of scenarios.
Strategy #4: Run a Payroll Reconciliation
Payroll reconciliations can be the most time-consuming part of a payroll audit if you’re not using the right tools. This process compares a company’s payroll records to its general ledger.
Lots of smaller businesses have two separate solutions for payroll and accounting. So the reconciliation process would require a line-by-line comparison between each system.
Using an integrated system is an easier solution. Time tracking and payroll occurring within a single platform essentially eliminate the need to run a manual reconciliation.
Payroll software like Gusto integrates with other popular systems for accounting and time tracking, like QuickBooks, Xero, and TSheets.
In addition to reconciling payroll with your general ledger, you should also compare payroll runs to your bank statements. Verify that the amounts listed for each pay cycle have been properly withdrawn from your account.
To make this process easier, consider opening a separate bank account that’s strictly for payroll. This will make the bank reconciliation process go much faster.
Most Common Mistakes Associated With Payroll Audits
To make sure your payroll audits go smoothly, make sure you avoid these common mistakes that can derail the operation.
- Running an audit with a biased employee: Don’t run an audit with someone who is currently part of the payroll process. This person is less likely to find their own mistakes and could potentially cover up fraud or inappropriate actions.
- Not defining audit goals: Falling to identify your goals before an audit starts makes it difficult for the audit committee to find problems. They need to have some direction.
- Not acting quickly after finding a mistake: Payroll problems are too important to be taken lightly. Any issues or holes found in the audit warrant immediate action.
All businesses should be running a payroll audit at least once per year. This helps save time, money and avoid compliance-related penalties. Use the tips and best practices in this guide to get started with your next payroll audit.