Why you should conduct an annual payroll audit

No task is more complicated than payroll, because the risk of error is higher than other accounting tasks. However, you can take proactive steps to reduce the risk of error by performing a payroll audit (or payroll compliance audit).

Use the links below to jump to the section that best covers your query, or read end to end for an in-depth overview on the topic.

• What is a payroll audit?
• Why do you need to conduct a payroll audit?
• Payroll audit procedures
• Payroll audit checklist
• Payroll audit best practices

What is a payroll audit?

A payroll audit is similar to a financial statement audit. Generally speaking, audits are performed annually to confirm that dollar amounts are correct and that procedures are completed properly. For example, a financial statement audit confirms the accuracy of the balance sheet and the income statement.

Payroll audits confirm the accuracy of the payroll records. The audit is conducted by comparing these records:

• Employee payroll data (pay rates, hours worked)
• Payroll tax filings (income taxes, FICA taxes)
• Payroll tax dollars withheld from pay and submitted as tax deposits
• Banking activity (payment to workers)
• Accounting records (transactions posted)

Larger businesses often have a compliance officer responsible for payroll compliance. Employees can request a payroll audit of their data if they believe that an error took place. Encourage your workers to contact you if they are uncertain about their payroll information.

Why do you need to conduct a payroll audit?

Conducting an audit can be time consuming, but you should do so at least annually to uncover errors and reduce the following business risks.

Tax reporting and deposits

IRS and state departments of revenue require businesses to file accurate payroll tax returns and submit taxes withheld from pay. You also need to meet filing and tax deposit requirements for Social Security, Medicare, and unemployment compensation programs. If your payroll process works effectively, you can file returns, make deposits on time, and avoid fees and penalties.

Uncovering a fictitious payee

An audit may find a person on your payroll who is no longer employed with your company, and you need to correct the error by removing them.

A payroll audit can also uncover a fictitious payee, or ghost employee, who does not exist. This type of fraud takes place when an employee adds a fake worker to the payroll records and collects the payments for personal use.

Complying with employment laws and other regulations

Audit your payroll to confirm you’re complying with these laws and regulations:

• Correct minimum wage and overtime pay according to the Fair Labor Standards Act (FSLA)
• Keep payroll records on file for a minimum of three years
• For union workers, comply with the pay and overtime rates required in the collective bargaining agreement with the union.
• Follow your state’s employment laws

Providing accurate data to workers

Your workers need to be paid accurately, and they need reliable payroll information to file a personal tax return. You need to confirm that the pay rate, vacation days, and paid time off benefits are accurate.

When you issue 1099s to independent contractors and W-2s to employees, they must be correct. If not, you may create a tax problem for workers who rely on your tax forms.

Understanding payroll audit procedures

You need to consider federal tax withholdings and payments in the audit process. Here are the steps to audit this portion of payroll:

1. Review employee data

Review payroll processed for a specific pay period, and verify this information:

• Worker’s employment: Confirm that you have a completed Form W-4 for the employee so that tax withholdings can be calculated. Both employees and independent contractors must supply a Form W-9 with a Social Security number, or an Employer Identification Number (EIN). These steps confirm the existence of the worker.
• Pay rate: Verify the pay rates for salaried and hourly workers, including the overtime pay rate, if applicable. If the worker took vacation days or paid time off, verify that the human recourse records and pay are correct.
• Gross pay: For salaried workers, gross pay is the annual salary divided by the number of pay periods. For hourly workers, check the hours worked on the employee’s time card. Multiply the hours worked by the hourly rate of pay. Calculate overtime hours based on the FSLA requirements discussed above.

The federal taxes withheld must be posted to a payroll tax report.

2. Check Form 941 and tax deposits

Form 941 reports federal income tax withholdings to the IRS. Businesses submit the form with quarterly tax payments.

• Employment: Confirm that the employee is listed on Form 941 and that the worker was employed for the entire quarter.
• Tax withholdings: Review the worker’s gross pay for the quarter, and confirm that the Form W-4 information was properly used to calculate withholdings.
• Tax deposits: Check the tax deposit detail and verify that the correct dollar amount of withholdings was submitted for the worker.

3. Review bank activity

Confirm that the total tax deposit for the quarter equals the amount posted to the bank statement.

4. Confirm accounting records

Your general ledger lists every accounting transaction. Confirm a journal entry was posted to withhold federal taxes for the quarter. Also, check that cash was paid to deposit the taxes with the IRS.

Perform this audit work for every employee, and the audit should account for the total federal taxes withheld and paid each quarter. A business should perform similar audit work for each of the payroll items listed below.

Complete a payroll audit checklist

Download the payroll audit checklist. 

Payroll audit: Best practices

You’ll get the most benefit out of conducting annual payroll audits by using best practices. These tips will help you conduct a payroll audit accurately and quickly:

• Hire a CPA firm to conduct a payroll audit every few years. When you hire a third party to perform the audit, you eliminate the risk of an employee concealing payroll data to commit fraud.
• Keep the duties of the human resources department and the accounting department separate. A human resource employee should not be able to post accounting entries. In a similar way, no accountant should be able to change the employee payroll records. Accountants refer to this concept as segregation of duties, and implementing this step reduces the risk of payroll fraud.
• Create a formal payroll audit report to get the information in the same format each time. This consistency makes it easier to review the data. If the hours paid don’t match the time and attendance report, you can process retroactive pay for the employee and correct the payroll records.
• Document all of your payroll audit processes in a procedures manual so your team knows how each task is performed and who is responsible.

How automation can help you improve payroll

A payroll audit is much easier to perform if you leverage technology. Payroll processing is complex, and auditing payroll requires a business to audit hundreds (or thousands) of transactions. Use a payroll service or software to process payroll in less time and to minimize the manual work required to perform a payroll audit. You can use accounting software to run payroll software, file tax reports, and manage your bank activity.

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