Payroll Audit: A Step-by-Step Guide on How to Conduct It

A payroll audit is a thorough analysis of a company’s payroll processes and data to ensure accuracy and compliance with laws and regulations. This routine process usually involves verifying employee data, reviewing their taxes, deductions, and benefits, and cross-checking these with the company’s bank records.

If you’re a new business owner and are wondering how to properly conduct a payroll audit, keep reading! In today’s article, we’ll discuss the steps involved in a typical internal audit and share important best practices to keep in mind. We’ll also provide a payroll audit checklist you can follow to make sure you don’t miss any important details.

Let’s dive in!

Key Takeaways

• A payroll audit is a routine examination of a company’s payroll information and processes and can be classified into two main types: internal and external.
• Routine payroll audits are important for complying with laws and regulations, avoiding fraud, and ensuring accurate employee compensation. Audits can also help you catch salary errors and maintain a happier staff.
• To conduct a payroll audit, you start by reviewing the current employee and payroll information and cross-checking them with the company’s bank statements. Then, you need to document your findings for future reference.
• When conducting a payroll audit, remember to double-check employee classification, identify improvement opportunities, and create a formal audit report. We also recommend using online tools to boost efficiency and scheduling an external audit to ensure accuracy.

What is a Payroll Audit?

A payroll audit is the process of reviewing a company’s payroll records to ensure that employees are paid correctly and that all tax deductions and financial reports are accurate. These are often conducted once a year but can be done more frequently when there are major changes to employee structures or payment schemes.

Common errors like miscalculations with employee salaries or withholding tax deductions can lead to serious issues and penalties, so it’s crucial to audit payroll regularly to verify that a company is legally compliant.

Moreover, according to a survey by The Workforce Institute at Kronos Incorporated, 49% of employees will search for a new job after experiencing issues with their paychecks twice. This means that if you want to retain your workforce, it’s vital to invest in routine audits. In fact, ADP’s Global Payroll Survey shows that at least 29% of employers discover payroll errors during an audit.

Internal vs. External Payroll Audit

While payroll audits are usually conducted internally by the company’s payroll or HR department, they can also be done by a third-party organization.

Internal payroll audits are done routinely to discover issues with the company’s payroll processes and identify any areas for improvement. On the other hand, external payroll audits are done to gain an objective review of the company’s payroll system.

Since the latter provides an unbiased assessment, external audits are typically requested by company management during mergers or acquisitions to ensure complete transparency and integrity.

6 Key Reasons Conducting a Payroll Audit is Important

Conducting payroll audits is important for several reasons, from complying with laws and regulations to avoiding potential fraud.

Let’s discuss each of the reasons in more detail:

#1. Catching Errors

Catching and preventing common errors during a payroll audit can help companies avoid significant financial losses. Payroll errors occur due to clerical mistakes, system glitches, or a simple misunderstanding of employee contracts and can lead to incorrect payments and tax deductions.

#2. Complying with Laws and Regulations

Audits also ensure your company’s payroll compliance with laws and regulations, helping you avoid costly penalties. For instance, if a payroll audit reveals that you are not deducting the right income tax from employees, you can immediately rectify the mistake before the IRS is notified of the problem and penalizes the company.

Failing to make timely and accurate tax deductions can result in a penalty of up to 15% of the unpaid amount, so it’s best to prevent this issue in the first place.

#3. Avoiding Overpayment or Underpayment

As we mentioned, catching salary errors is one of the benefits of a payroll audit, meaning you’ll be able to prevent overpaying or underpaying employees on any pay period. Routine audits allow you to stay on top of all employee bonuses, tax adjustments, or overtime hours so you can ensure that they are paid appropriately.

Preventing underpayment can foster trust between the employer and employee and avoid pay disputes while preventing overpayment helps protect the company’s finances.

#4. Preventing Fraud

Regular payroll audits can also help improve payroll security and prevent fraudulent activities, like ghosting employees or unauthorized time adjustments. If you notice any irregularities or patterns in a certain employee’s time logs that don’t correspond to their work output, you may need to investigate the issue further.

#5. Maintaining Happier Employees

Conducting regular audits allows for smoother and more efficient payroll processing, which can help maintain happier employees and high morale in the workplace. Since employees rely on timely paychecks from their employers, failing to provide wages on time can lead to dissatisfaction and potential legal problems.

#6. Ensuring Accurate Compensation and Deductions

One of the main payroll audit objectives is to determine whether an employee is being paid and taxed properly and implement measures to ensure complete legal compliance.

Aside from the mandatory deductions, you can also use a payroll audit to confirm whether an employee’s fringe benefits, such as health insurance or retirement plan packages, are properly compensated. An audit can ensure that employees who opt out of these deductions are not being charged for them, too.

How to Conduct a Payroll Audit: Step-by-Step Guide

If you’re ready to start the payroll audit process, here is a detailed step-by-step guide you can follow:

#1. Decide on Payroll Audit Frequency

Before actually auditing your payroll, you first need to decide how often you’ll be conducting an audit. This helps maintain accuracy in payroll records and avoid any discrepancies with employee wages.

Depending on your company size, you may decide to conduct a payroll audit quarterly or annually. Regardless of the frequency, it’s crucial to stick to the schedule you choose and be consistent with it. We also recommend conducting additional audits at the end of every fiscal year to help with tax preparation.

#2. Review All Employees Listed on the Payroll

Once you’ve decided on a schedule, the first step in your payroll audit is to review all the employees on the company payroll. This is done to ensure that you are only paying active employees, such as full-time, part-time, and contractual workers.

If there are any names you don’t recognize or some employees you have fired recently, then be sure to remove them from the list. Then, you can cross-reference the latest employee records with the remaining employees to confirm that they are currently employed in the company. Doing so will help you avoid unnecessary payments to terminated workers.

#3. Analyze Payments and Hours Worked

Next, you’ll need to check each employee’s timesheets and salaries to confirm that they are properly paid. You can do this by reviewing their paycheck or pay stub and comparing the amount stated there with their pay rate and total hours worked.

You should also check their attendance logs and overtime hours to confirm the accuracy of their timesheet and keep an eye out for any payroll discrepancies, such as unapproved overtime or missed entries. If you have an automated time entry system, carefully review any manual entries to ensure that the employee actually worked during those hours.

#4. Check Variable Payments

After the standard salaries, you then have to review any variable payments made for commissions, shift differentials, or bonuses, as these are often prone to fraud and overpayment.

To avoid significant financial losses, we advise double-checking that these payments are distributed to the correct employees and that each variable payment made aligns with company policies.

#5. Review Tax Withholdings

Proper tax compliance is a critical part of payroll audits, so it’s important to thoroughly review each employee’s tax withholdings to ensure that you are deducting the appropriate amount. Remember, the amount of taxes due can change depending on work locations or employee tax brackets, so it’s best to verify them individually.

#6. Reconcile Payroll Records

Once you’ve finished verifying all the necessary employee information, the next step is payroll reconciliation or comparing this data with the company’s financial records. Do your bank statements match the amounts stated on the payroll ledger? Are all variable payments properly documented and accounted for?

While double-checking all these numbers can be time-consuming, this is a crucial step in ensuring that there are no salary discrepancies, such as mismatched totals or unrecorded transactions, that can indicate underpayment, overpayment, or fraud.

#7. Document Findings and Develop an Improvement Strategy

Finally, you need to document all your findings, including any errors and unusual employee patterns, into a comprehensive report and use this to develop a strategy to improve your payroll process.

There are several payroll audit templates you can use to help you draft this document, but essentially, the report should include information about the discrepancies you found, how you resolved them, and what your plans are to prevent them from occurring in the future.

Audit Payroll Checklist

You can refer to our simple payroll audit checklist to make sure you don’t forget an essential step during your audit:

5 Best Practices and Tips for Payroll Audit

Whether you are auditing for the first time or are simply looking for ways to boost efficiency, consider following these best practices to ensure a successful payroll audit:

#1. Use Online Tools

Leveraging online tools like Paystub.org’s invoice generator can go a long way toward improving your payroll auditing speed. Our handy tool allows you to create templated financial documents that are easy to read and even easier to organize. With all your employee information presented in the same standardized format, it’ll be much quicker to find the data you need.

#2. Double Check How Employees are Classified

When verifying your employee details, be sure to confirm their employee classification to help speed up your auditing process. This refers to their being exempt or non-exempt from minimum wage and overtime pay.

Being exempt means that they do not qualify for any overtime pay and, as such, will be unpaid for extra hours worked. Knowing this classification is important, as misclassifying a non-exempt employee can lead to hours of unpaid overtime and legal fines.

#3. Identify Improvement Opportunities

Payroll audits aren’t just a way to identify errors but also to determine how to improve your overall payroll process. For instance, if you notice recurring errors in employee time tracking that lead to pay miscalculations, consider investing in automated time-management software to address the problem.

#4. Create a Formal Audit Report

After every payroll audit procedure, make sure you create a formal audit report explaining the exact steps you took during the audit. Regardless of whether you find any errors or not, keeping a detailed record of your audits can help track your progress and avoid repeat improvement suggestions.

#5. Schedule an External Audit

Even if you have already conducted an internal payroll audit, consider scheduling an external audit with a professional firm to add another layer of assurance. Since these companies specialize in finance, they are more likely to identify vulnerabilities in your payroll system that you may have overlooked.

Final Thoughts

A payroll audit ensures that your company provides accurate employee compensation while complying with labor and tax laws. However, regular auditing payroll processes can be quite time-consuming, especially in larger organizations with hundreds or thousands of employees.

To make your audits more efficient, consider using a reliable paystub generator like Paystub.org for your employee paychecks. Our professional tool allows you to automatically calculate pay, subtract deductions, and keep an organized record of all employee financial documents so you can easily access and review them during the audit.

Payroll Audit FAQ

#1. Is auditing payroll mandatory?

No, auditing payroll is not mandatory, but it is necessary to prevent payroll fraud, avoid overpaying or underpaying employees, and ensure that your business is paying taxes correctly.

#2. How long does a payroll audit take?

A payroll audit can usually take a few days to a month, depending on the size of the company. Bigger organizations with more employees will take longer to audit simply because it will require more time to review every employee’s data.

#3. Can you fail a payroll audit?

Yes, you can fail a payroll audit. This is usually more often when conducted by a government agency. When this happens, your business may be subject to legal fines, interest, and penalties that can damage the company's reputation and trust between employer and employee.

#4. What are the different types of payroll audits?

The different types of payroll audits are internal and external. As the name suggests, internal audits are done by staff within the company, while external audits are carried out by third-party organizations. Another payroll audit example is a government audit that is done by government agencies at random to ensure that businesses comply with local tax regulations.