Payroll Audit: Checklist & How To Run It [Free Template]
A former Virgin Media payroll administrator stole €870,000 from the company over a 10-year period. This is not the only costly payroll mistake a business can make, highlighting the importance of conducting effective payroll audits. Is it time to review your payroll processes?
Maintaining accurate payroll records is a key HR responsibility. However, one in four employees have received a paycheck with errors, and 29% of employers say they only uncover these mistakes when running a payroll audit.
Organizations must make sure they’re paying their employees correctly and on time, and comply with ever-changing employment laws and payroll regulations. Although Payroll is sometimes a separate department from Human Resources, they must both work together on payroll audits to ensure accuracy and compliance.
In this article, we’ll explore what a payroll audit is, different types of payroll audits, their purpose, and how to conduct one. We’ve also included a handy downloadable payroll audit checklist.
Contents
What is a payroll audit?
What are the main payroll audit objectives?
How to conduct an effective payroll audit
Payroll audit checklist
What is a payroll audit?
A payroll audit is a regular review of all payroll records to ensure all employees are paid correctly, all deductions and reports are accurate, all information is up to date, and the organization is compliant with tax laws. Sometimes, mistakes can continue for months or even years without discovery, which can result in legal issues or incorrect financial statements. The good news is you can catch mistakes early with a payroll audit, which should be an indispensable part of your company’s compensation and benefits strategy.
While audits may sound intimidating, most payroll audits are simple internal checks on the accuracy of the organization’s data. Payroll audit procedures can take a few minutes to a few weeks, depending on the size of your organization and the extent of the audit. For faster responses, Payroll and HR can automate some audit checks.
Although the Payroll department is typically responsible for running payroll audits in larger organizations, HR must also be involved. Why? Because HR communicates pay to employees, and there can be errors between what HR or a manager tells an employee and what ends up in the payroll system. For instance, a hiring manager may negotiate a higher salary for a candidate than stated in the initial offer letter but fail to notify HR. Pay is also a sensitive subject, so HR must be involved in resolving employee concerns and ensuring all necessary communications take place.
Types of payroll audits
There are different types of payroll audits, each with different purposes. The two main types are:
Internal payroll audits
An organization’s staff conducts an internal payroll audit to assess and improve payroll processes. This lets the business know where it stands, and helps it to identify and rectify problems as early as possible.
External payroll audits
In this case, an organization hires third-party auditors to conduct an external payroll audit to provide an independent assessment of the its payroll practices. Having fresh eyes can be beneficial for spotting errors internal employees may have overlooked. Typically, the company’s management, board of directors, or audit committee hires these external auditors to ensure compliance, accuracy, and integrity in payroll processing.
Another type of payroll audit is an audit by a government agency or another regulatory body. In the U.S., the following organizations are examples of authorities conducting payroll audits:
- Internal Revenue Service (IRS): Conducts audits to ensure compliance with federal tax regulations.
- Department of Labor (DOL): Ensures compliance with wage and hour laws, such as the Fair Labor Standards Act (FLSA).
- State Labor Departments: Each state may have its own labor department responsible for enforcing state-specific payroll regulations.
What are the main payroll audit objectives?
Everyone wants accurate pay, properly withheld taxes, correctly calculated health insurance, and legal, accurate deductions. Let’s dive deeper into the main objectives of conducting a payroll audit.
Ensure accurate tax reporting and deposits
- In the U.S., for instance, each employee has to fill out a W-4 tax form, which allows payroll to apply the proper tax deductions. You can check this during a payroll audit.
- The system must match employee requests. Each state has different tax laws, and in some states, each town has different deductions for payroll taxes.
- One important part of the payroll audit is working location. If employees work from home permanently, their state and local tax deductions may differ from those applicable to employees who work at a designated office or place of business. That’s why you need to know not only an employee’s salary but also their working location.
Ensure compliance with employment laws and other regulations
- A payroll audit helps you determine the following: Did everyone who was entitled to overtime pay receive it? What about employees who work piece-rate? Do you have both their productivity data and their hours?
- If employees are subject to a tip credit, you should ensure their combined tips and hourly pay add up to at least the state minimum wage.
- If a company provides employees with health insurance, Health Savings Accounts, or retirement plans, you must make sure the deductions are correct. You also need to ensure the money goes where it is supposed to — is the health insurance company receiving the proper payments? Is the retirement money placed directly in each employee’s 401k account?
- If an employee has a court-ordered garnishment, you must ensure it’s correct. Garnishments can be for anything (from an unpaid debt to child support) and can change with court orders. You must make sure you’ve accurately applied all court-ordered garnishments
Provide workers with accurate data
- Employees need accurate pay records. Each paycheck should come with a paystub (either on paper or electronically) that covers all details of their pay, including hours worked, overtime paid, and explanations of all deductions.
- At year-end, Payroll needs to provide tax documents with this information. Employees should conduct a self-audit and notify payroll if anything is amiss, but this doesn’t always happen. Periodic payroll audits throughout the year can prevent many of these problems.
Uncover potential errors and inaccuracies
- A thorough audit can help you uncover payroll fraud. Is everyone receiving a paycheck an actual employee? People have embezzled from companies through ghost employees. Are any terminated employees still on your payroll?
- Is everyone working precisely 40 hours a week? It’s unusual for everyone paid by the hour to work precise hours every week. This can indicate they are not receiving earned overtime or are being paid more than is due to them.
- Was an extra zero added to someone’s paycheck? Typos happen!
Uncover common payroll issues
- Have you classified your workers accurately? Within an organization, employees often have different types of contracts that include different compensation conditions.
- Employees are either nonexempt or exempt from minimum wage and overtime pay. Those who are nonexempt must receive at least minimum wage for every hour worked and overtime when working more than 40 hours in a week. in the U.S., improper employee classification can leave the employer liable to pay affected employees all unpaid overtime for up to three years before the date of their claims.
- It’s easy to make miscalculations when it comes to hours worked, overtime rate, and differential pay, especially if these rates change (for example, a higher rate for Sundays or public holidays).
- Are all your employees in the correct tax bracket for their earnings? Promotions can move an employee into a new tax bracket.
- Late payroll reporting or non-reporting can lead to a delay in salary payout, as well as government penalties.
Preparing for a successful payroll audit
Here are some steps to help you prepare for a payroll audit.
Create your timeline
Although you can conduct a payroll audit at any time, most companies complete this at the end of their financial year. The “lookback” period is typically one year, though this varies from one business to another. The longer the audited period, the longer the payroll audit will take to complete.
If you are about to conduct your first payroll audit or experiencing issues with your current payroll processes, you could benefit from conducting an audit quarterly or semi-annually so you can diagnose and resolve problems sooner.
Assemble your team
The next step is to decide who will conduct your payroll audit. Businesses with a dedicated payroll, HR, accounting and executive management team will likely complete the audit themselves. Smaller businesses may enlist help from an external auditor.
If you have a combination of people from different departments involved in the auditing process, make sure deadlines are set for everyone’s separate tasks to keep the process on track.
Identify key areas of focus for the audit
If you have some problems in your current payroll processes, you should focus on key areas like your payroll systems, tax contributions, financial ledgers, and time and attendance records.
Gather necessary documentation and information
Here are some documents and types of information you should gather for your payroll audit:
- Employee rosters
- Payroll registers (including employee pay, overtime, deductions, taxes, etc.)
- Timesheet data (hours worked and days off)
- Financial ledger and bank account reconciliations
You should be able to get most of this information from your payroll or ERP software.
How to conduct an effective payroll audit
Follow these steps in order to run a comprehensive payroll audit in your organization:
1. Review employee data
This step requires communication between HR and Payroll to ensure the data payroll matches the information the employee receives. Unlike sending spreadsheets back and forth, connected systems minimize the chances of error and make this step more efficient.
If your Applicant Tracking System (ATS) is not integrated with your HR and Payroll systems, you should verify the relevant information against employee offer letters. Check whether everyone on the payroll is an active employee and whether they are classified correctly (exempt vs. nonexempt, full-time vs. part-time, etc.). Ensure people who are on leaves of absence receive the correct pay as well, especially if this differs from their regular paycheck.
2. Review hours worked and paid
Verify hours worked using timesheets and ensure they’re in line with the amounts paid. This is especially important for employees earning hourly wages. Too many employees with identical time cards can mean someone is editing the time cards, in which case, HR should investigate potential time theft. Watch out for indications of buddy punching, too.
3. Check variable payment and different types of compensation
You must thoroughly check overtime pay, bonuses, commissions, and piece-rate information. If the organization hires tipped employees, make sure they report their actual earnings for more accurate data. If your company does vacation pay or shift differentials, be sure to check this as well.
Remember, overpaying can be just as stressful as underpaying. No employee wants to have to repay money they may have already spent or saved because of mistakes on Payroll’s part six months ago that led to employees being overpaid.
4. Examine and document atypical payroll transactions
This is another area with high fraud potential, and usually invovles signing bonuses, relocation pay, back pay, and previous corrections. If you process reimbursements through the company’s payroll, double-check that this is accurate. It may require liaising with the finance department or whoever handles reimbursements.
5. Check tax withholdings and deposits
Are you withholding the correct amount for your employees? Are you paying the right amount of income taxes? These numbers can change, especially if people move or the rules change. Keep in mind that due to differences in work locations, an employee who is classified as working at the office may have completely different tax withholdings from an employee who is classified as working from home.
6. Reconcile payroll
Review your organization’s bank activity. Do its bank statements match its payroll records? Do you have proper documentation for all direct deposit change requests? Double-check all your documentation and make sure everything adds up.
7. Consider payroll rules
Payroll rules are especially critical if the government audits your company. These rules vary by state and country, so make sure your organization is compliant with the regulations where it operates. Of course, these rules are even more complex for multinational organizations. Failure to adhere to these regulations can result in significant fines and legal repercussions.
8. Report the findings
Create a payroll audit report and share it with key members of staff, including the heads of HR and Finance. Keeping documentation of audits can be useful in case problems, such as a lawsuit, arise later.
9. Identify improvement opportunities
Think about how you can improve your payroll processes going forward. What has your payroll audit taught you? What are you doing well, and what can be improved? Automation is becoming increasingly popular in payroll management as it helps minimize inaccuracies and errors. An all-in-one HRIS (Human Resources Information System), payroll system, or accounting software can substantially reduce data errors.
10. Create a plan for implementing improvements
Once you know which improvements must take place, create a plan of action for making those improvements. Consider timelines, budget, and key stakeholders who need to sign off on proposed changes. Implement improvements based on order of priority, beginning with the most pressing changes that will make the biggest impact.
Payroll audit checklist
Based on the payroll audit process outlined above, we’ve created a payroll audit checklist template in Excel to follow so you can stay on track and ensure you conduct a thorough, effective audit for your organization:
Here’s the full payroll audit checklist, which you can adapt to suit your organization’s needs:
Over to you
A fundamental understanding of payroll audit allows HR professionals to identify opportunities for improvement and ultimately, ensure compliance and boost employee experience.
Payroll and HR need to maintain a good working relationship to ensure that everyone is paid fairly and on time. Your employees deserve it.
Use our downloadable payroll audit checklist to stay on track, ensure your payroll audit procedures are effective, and remain compliant.
FAQ
A payroll audit is a review of all payroll records to ensure your data is accurate, employees are paid correctly and on time, and your company is compliant with tax laws.
If you fail a payroll audit by a government agency, it can result in financial penalties, interest, and forced payment of any employment taxes your company didn’y pay due to worker misclassification. This can have a negative impact on your reputation and employer brand, and damage the trust among employees, customers, and key stakeholders.
The three main types of audits are:
Internal audit: Carried out by in-house staff to assess current payroll processes, identify problems, and make improvements.
External audit: An assessment of payroll processes carried out by third-party auditors.
Government audit: Checks carried out at random by government agencies to ensure every business is paying the correct amount of tax.
Learn more
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