Before the dawn of payroll software, calculating your employees' wages and tax withholding was a tedious affair. It meant painstaking calculations for every employee – calculations that had to be error-free to avoid issues down the road. Payroll software has streamlined this process, but payroll audits remain necessary to plan for human error.
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What is a payroll audit?
A payroll audit is the process of reviewing your company's payroll software and processes to ensure they are correct. During a payroll audit, you will verify that you're paying your employees their proper salaries and appropriately managing your company's payroll withholding. You'll also check if benefits-related deductions are being properly taken from your employees' paychecks.
Most payroll audits are internal rather than at the request of the IRS. However, IRS audits do occur. You may be able to avoid external audits by completing regular internal ones. That way, if an internal auditor identifies errors, you can retroactively correct them via additional wage or tax payments.
How to conduct a payroll audit
Payroll audits often seem overwhelming, but once you start executing them, you'll likely see that they're straightforward. Here's how to conduct them:
1. Review all employees on your payroll.
Look at the complete list of employees on your payroll. Address the questions: Does anyone there no longer belong? Is someone missing? Is there a name you don't recognize?
Examine the payment history for any employees currently on your payroll who shouldn't be there. You most likely forgot to remove the employee from the payroll software. If you see payments after their final date, you may need to address the issue with the former employee by taking measures to retrieve the money.
It is a serious problem if you identify a name on your payroll that you don't recognize. This occurrence will require an in-depth investigation. However, if you leave this stone unturned, you could wind up losing money that you owe to no one.
2. Check all your numbers.
Check every employee's pay rate to verify you've recorded the correct wages. If you've recently given a staff member a raise, or moved them from an hourly employee to salary, the information may not have been updated. Adjust the amount to reflect the correct wages, pay the employee any back pay owed, and then move on to the next set of numbers.
After you've verified wages, look at each employee's number of hours worked per pay period. You're in the clear if the numbers reflect what you remember to be the employee's schedule. On the other hand, if you see hours you're convinced the employee didn't work, there might be a problem. It's one thing if you offer paid time off – vacation days may be listed as paid days – but it's another if the employee is providing inaccurate timesheets.
Next, look at each employee's total hours and pay. An employee's total pay should equal the product of their wages and entire hours. Their complete hours should also be the sum of all hours worked per paycheck. If both these conditions are met, chances are your numbers are correct.
However, there's one more area in which your numbers could be wrong: employees classified as exempt vs. nonexempt. If you have employees who aren't exempt from the overtime pay provisions of the Fair Labor Standards Act (FLSA), check that you've appropriately compensated them for overtime. If not, adjust your payroll records accordingly and provide the back pay.
3. Account for vacation time.
Paid time off (PTO) can appear as days worked in your payroll system. In some cases, you can easily distinguish between vacation time and actual hours worked. That's because some payroll software allows employees to tag certain paid hours as PTO days. This way, your payroll software knows to deduct these vacation days from the employee's total available hours.
A PTO tracking system puts the onus on the employee to operate within an honor system. Only the employee controls whether they log their vacation days as such – they can always choose to mark them as regular paid days. This way, they theoretically never run out of vacation days, and your business suffers.
Once you review PTO, look at all of your employees' days off to ensure they're labeled properly. They should be separated for paid vacation, unpaid vacation, personal days, sick leave, parental leave, or bereavement leave. The latter three categories may be paid or unpaid.
4. Examine other payment records.
Your payroll system isn't the only place where you've recorded your employee payments. Payroll disbursement is also reflected in your ledger and bank account. The numbers in all three areas should match. If you find discrepancies, you'll need to do a deep dive into your records.
Once you identify the source of the discrepancy, rectify the error. This step should resolve any mistakes in how you pay your employees. However, it leaves one last area of payroll open for analysis.
5. Analyze your tax reports.
When you pay employees, you must withhold income, Medicare and Social Security taxes. Your payroll software should handle this task and have timestamped records of these withholdings. It is good practice to also verify mathematically – by hand – that you've withheld the right amount for each tax type. Do the same for any state or local taxes that both you and your employees pay.
Is auditing payroll a requirement?
No, auditing payroll isn't a requirement, but most payroll experts highly recommend internal audits. As discussed above, internal audits keep you out of trouble. They also help keep your employees happy to receive accurate wages. These are just two of the many reasons why you should conduct payroll audits.
Benefits of conducting a payroll audit
Regular payroll audits provide a wealth of benefits for your small business. These are some of the top advantages for conducting regular payroll audits.
Fewer compliance errors
Payroll audits may reveal that you're not deducting as much income tax from employees' paychecks as is required. With this information, you can correct your mistakes before the IRS identifies a lack of compliance. If the IRS discovers this problem, it can penalize you. Worse, the IRS could conduct an audit of its own that proves expensive, time-consuming and stressful.
Let's say you give an employee a raise but forget to add it to your payroll software. This employee will be underpaid until someone discovers the misstep. Chances are, the employee will notice the error and approach you. While you'll immediately fix the mistake, you've caused your employee unnecessary concern.
A payroll audit could have prevented this situation. You'd likely discover that you neglected to add the employee's raise to your payroll software, and then immediately update the software and issue retroactive payments to your employee.
You'll be able to approach your employee, explain the error, make your apologies, and assure them that their back pay is coming. This proactive approach reassures your employee, because it demonstrates you're looking out for them.
Easier fraud identification
Although trusting your employees creates a healthier work environment, the occasional co-worker may submit timesheets with hours they didn't actually complete. Payroll audits help you identify this fraudulent activity. If you know that an employee worked a certain number of hours, but you see a higher number in your payroll system, you may be noticing fraud.
Earlier removal of former employees
Data on former employees can take up needless storage space in your payroll software, but payroll audits can help you retrieve this space. These regular audits identify employees who are still in your system even though you're no longer paying them.
Consider the tax implications before deleting an ex-employee from your system. If you must issue the employee tax forms in the future, make sure that deleting them from your payroll system doesn't block your tax form distribution. You should also check that all outstanding wages have been paid. This way, when you remove an old employee from your system, you don't have to restore them in the future.
How frequently should you audit your payroll?
You should conduct a payroll audit at least once per year. However, there are benefits to auditing your payroll more frequently. Twice a year is good, but quarterly is even better. The sooner you catch errors, the less time and money you'll spend correcting them.
Use one of the best payroll services on the market to complete your audits. Our review of ADP reveals it is designed for complex payroll needs, while our Paychex review shows this program is ideal for a growing company.