Megaphone

It’s easy to switch. We’ll even set you up for free

Updated: June 3, 2024

Payroll audit primer: How and why employers should run one

Published By:

David Kindness, CPA

More from our experts

A regularly scheduled payroll audit is arguably one of the most important aspects of running a business because paying employees accurately and on time is a must-do. Though it’s unlikely you’ll need to audit payroll processes every day, it can be a good idea to schedule a few throughout the year.

Fast facts about payroll audits

  • Payroll audits help ensure accuracy in calculating wages, benefits, deductions, and tax withholdings
  • Conducting regular payroll audits can lessen the risk of costly penalties or legal disputes and ensure that you’re compliant with payroll laws and regulations
  • Payroll audits can help to detect and prevent fraudulent activities such as ghost employees, unauthorized payments, or timesheet manipulation

Conducting payroll audits can help businesses ensure all regulations are being followed, that workers are receiving their proper wages, and that taxes are being withheld and paid correctly to the proper agencies. But what if this is the first time you’re running an audit and are unsure about where to start?

 

In this business owner’s guide, we’ll review what a payroll audit is, the advantages of conducting one, and what to look for when you audit payroll so that you can add all the key steps  to your organization’s task list.

Payroll audit definition

Simply put, a payroll audit is an in-depth examination of a business’s payroll processes, procedures, and recordkeeping to ensure that they are accurate, efficient, and compliant with legal requirements. A typical audit process involves reviewing past payroll data, such as salaries, wages, benefits, deductions, and tax payments, and keeping an eye out for any potential mistakes, irregularities, or suspicious activity.

 

At a high level, most audits are conducted to determine whether:

  • Payroll processes are being performed efficiently and effectively
  • Workers are being paid the correct wages and on time
  • Taxes are being withheld and paid to the appropriate agencies
  • The organization is compliant with all applicable laws and regulations governing payroll administration.
  • Whether there are any areas in need of improvement

 

Now that we’ve covered the basics, let’s explore some of the benefits of a payroll audit.

Payroll audit advantages

There are plenty of reasons why routine payroll audits can be worthwhile for both your business and its employees.

  • Process optimization: Running a payroll audit reduces the risk of missed payments, which can lead to penalties in some cases. It also keeps your employees happy by ensuring that they get paid in full and on time.
  • Fraud prevention: No business owner wants to experience fraud of any kind, including payroll fraud. Performing regular payroll audits will ensure that managers, HR, accountants, and employees are all performing payroll-related duties with honesty and integrity.
  • Compliance assurance: Auditing your payroll processes will ensure that you’re compliant with all applicable payroll laws and regulations, helping you avoid penalties and fees from Uncle Sam, as well as potential legal disputes with employees.
  • Error detection and prevention: Finally – and arguably most importantly – everyone makes mistakes. Performing payroll audits will help you catch and correct any potential mistakes made by your business or by your employees.

 

We mentioned the potential for penalties if an employee’s wages go unpaid and it’s worth reviewing a few examples. In California, the regulations surrounding payroll errors and unpaid wages are  fairly straightforward and it’s important to note that there can be fees starting at $100 per unpaid wage per employee.

 

Illinois takes a different approach. In that state, payroll errors trigger penalties that start at 5% of an employee’s unpaid wages. As an example, if an employee is owed $2,000, the employer would be liable for $100 right off the bat. But that’s not all. In addition, the state’s Department of Labor imposes an administrative fee of $250, which cannot be waived.

 

The takeaway is that it’s always important to review whether there are any gaps in how you’re paying employees (and correcting errors when they’re identified) in order to prevent what can be a costly mishap.

2024_Q2_SMB_Simplify Growth_Banner_970x250_A

How to audit payroll

Now that we know what a payroll audit is and the advantages of scheduling them throughout the year, let’s discuss preparing for one and who actually performs the tasks that must be completed.

 

How do I prepare for a payroll audit?

Hands down, the better your record-keeping processes are, the more likely you are to be prepared for a payroll audit. The first step is to collect and organize relevant payroll documents, including payroll records, timesheets, employee information, tax filings, and any internal policy documentation.

 

If any errors or discrepancies are found, make note of them so they can be addressed. Finally, you should establish clear objectives and goals for the audit process and outline the scope, methodologies, and specific audit goals.

 

Who performs a payroll audit?

Depending on the scope and complexity of the audit, and the resources that the company has available, the audit can be handled either internally or externally.

  • If the payroll audit is conducted internally, the business’s internal audit team will handle the process and may seek assistance from key employees to collect and process information.
  • If the payroll audit happens externally, an external team of independent auditors will work with the company to collect and process payroll information.

Payroll audit pro tip

Using reputable payroll software can go a long way toward ensuring that you have all the documentation needed for a payroll audit. It may even be helpful with the audit process when the time comes.


— David Kindness, CPA

Internal audits

So how does this work and should you keep this task in-house? Internal audits are generally performed by a combination of employees from the accounting, HR, and even the management team, who all work together to collect and analyze documentation about your payroll processes. If they discover discrepancies or suspicious activity, then they should document the issues and create reports detailing strategies for improvement. Management can then determine how to implement any needed changes moving forward.

 

External audits

But what happens if you outsource this task? The assessment will be handled almost exclusively by the external firm you choose to work with. There’s no “one-size-fits-all” when selecting help from outside of your organization, as companies you work with can include accounting firms, payroll providers, or consulting firms. You should expect them to collect data and documentation, analyze it, and come to conclusions about your current setup. If there are opportunities for improvement,  then they will make suggestions and provide action items you can follow.

 

Now that we’re ready to put our auditing hat on, let’s get into the specific type of information that should be included in your review.

What to check when auditing payroll?

A comprehensive payroll audit should cover various aspects of your payroll software, calculations, and recordkeeping. Below is a comprehensive list of items to review:

  • Gather employment documentation: Collect all relevant documentation, such as employee records, timesheets, employee and contractor agreements, tax tables, payment records, and tax forms.
  • Define the scope of the audit: Will you be reviewing a specific timeframe, such as a quarter or a year, or will you instead be focusing on specific payroll areas, such as employee classifications or tax withholdings?
  • Verify employee information: Ensure that employee data, such as names, addresses, Social Security numbers, and employment statuses, are accurate and up-to-date. Additionally, review employee records, employment contracts, contractor records, and payroll registers to ensure that employees and contractors are classified correctly.
  • Test your internal controls: Evaluate the internal controls utilized by your payroll system. This may include:
  • Reviewing access to controls:  Consider who has access to modify payroll data, and whether there are any review or approval procedures in place.
  • Examining data backup procedures:  Is your payroll data backed up regularly, and if so, how often are backups created?
  • Separating payroll responsibilities: Ensure that payroll processing tasks are separated from functions such as approving timesheets and authorizing payments.
  • Analyze and reconcile information: Compare official payroll data with supporting documentation such as bank statements, accounting records, tax filings such as Forms 940 and 941, Forms 1099-NEC and 1099-MISC, and Form W-3. Analyze payroll calculations, wages, salaries, tips, contractor fees, overtime, bonuses, payroll taxes, and deductions.
  • Identify and address discrepancies: If any discrepancies or unusual patterns are found, investigate the root cause by reviewing individual employee records or contacting relevant departments or personnel. Document the discrepancies and develop a plan to correct issues moving forward.
  • Document and report findings: Prepare a comprehensive payroll audit report to summarize your findings. Include information such as the payroll areas you audited, the audit’s time frame, procedures performed, any discrepancies and their root causes, and corrective actions you plan to implement moving forward.

 

What to avoid with a payroll audit

It’s important to conduct your payroll audit purposefully, efficiently, and with a specific goal in mind. Here are some things you should avoid when conducting a payroll audit:

  • Not having a plan: Ensure you have both a specific plan and specific goals before beginning the payroll audit process.
  • Lack of documentation: It’s a good idea to maintain proper documentation of your payroll processes, employee information, and audit processes. This applies to both the audit process and to your payroll processes in general.
  • Not auditing payroll regularly: Consider making payroll audits a regular part of your business. It can go a long way to help you stay on top of payroll responsibilities and catch issues before they get too big.

 

Audit payroll regularly for improved operations

Keeping track of your payroll processes can help ensure you are paying employees the correct amount and paying taxes to state and federal agencies on time, giving you one less thing to worry about as a business owner. Periodic audits can also reveal ways to improve your company’s overall financial health. We hope this article helps you take the best first step when incorporating a payroll audit into your company’s operations and provides guidance you can use as your company grows.

Take a tour to see how easy payroll can be.

David Kindness is a CPA, experienced financial writer and editor, and a tax and accounting expert with 7+ years of experience. David lives and works in San Diego, California.

Frequently asked questions employers have about payroll audits

  • How frequently should you audit your payroll?

    Payroll audit frequency depends on a number of factors, including company size and risk, industry regulations, and risk tolerance. There is no one-size-fits-all answer, but performing audits annually is a good starting point for most businesses.

     

  • Are payroll audits mandatory?

    Payroll audits are not mandatory by law, but they may become mandatory if your business is involved in a tax or financial audit. However, payroll fraud is illegal (obviously), and paying your employees properly is required by law, and payroll audits provide visibility into both of these potential issues.

  • How much does a payroll audit cost?

    The cost of a payroll audit varies and can depend on several factors, including the scope of the audit, the auditor’s expertise, and whether the audit is conducted internally or externally. Internal audits will generally be less expensive than external audits and may cost from a few hundred to a few thousand dollars, depending on the staff and time required. External audits can cost from a few thousand dollars to $10,000 or more for complex audits by specialized firms.