How to Conduct a Payroll Audit

What is a payroll audit? 

A payroll audit is the process of reviewing your company’s payroll data, documents and processes to ensure everything is correct. During a payroll audit, you verify that you’re paying each employee the correct salary and appropriately managing your company’s payroll withholding. You also check if benefits-related deductions are being properly taken from your staff’s paychecks.

>>Learn More: Payroll Deductions Calculator

Most payroll audits are initiated internally rather than at the request of the Internal Revenue Service (IRS). However, IRS payroll audits do occur. You may be able to avoid external audits by completing regular ones in-house. That way, if your internal auditor identifies errors, you can correct them before more significant problems occur.

Is auditing payroll a requirement?

Auditing payroll isn’t a requirement, but most payroll experts highly recommend internal audits. As discussed above, regular internal audits keep you out of trouble with the IRS. They also help keep your employees satisfied, as they ensure your staff members are receiving accurate wages. These are just two of the many reasons why you should conduct payroll audits — see more benefits below. 

How frequently should you audit your payroll?

You should conduct a payroll audit at least once per year. However, there are advantages 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.

How to conduct a payroll audit

Payroll audits often seem overwhelming at first, but once you start executing them, you’ll likely see they’re actually 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 these questions: Are there any names on there that no longer belong? Is someone missing? Is there a name you don’t recognize? 

Examine your recent payment history for people on your payroll who shouldn’t be there. If you find a former employee is still on your payroll, you most likely forgot to remove them from your payroll system. If you see payments after their final date of employment, you may need to address the issue with the former team member and take measures to reclaim the unearned money.

If you identify a name on your payroll that you don’t recognize, that is a serious problem and requires an in-depth investigation. If you leave this unexamined, 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 being an hourly employee to a salaried one, the information in your system may not have been updated. Adjust the amount to reflect the correct wages, pay the employee any back pay owed, and move on to the next set of numbers.

After you’ve verified pay rates, look at each employee’s number of hours worked per pay period. You’re in the clear if the numbers reflect what the employee’s schedule should be (tracking hours with high-quality time and attendance software can help with this). On the other hand, if you see hours you’re convinced the staffer 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 time sheets.

Next, look at each employee’s total hours and pay. An employee’s total pay should equal the product of their wages and 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, and that has to do with whether employees are classified as exempt or nonexempt. If you have employees who aren’t exempt from the overtime pay provisions of the Fair Labor Standards Act, check that you’ve appropriately compensated them for overtime. If not, adjust your payroll records accordingly and provide the owed back pay. [Read related article: How to Calculate Blended Overtime 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 themselves to tag certain paid hours as PTO days in their self-service portal. This way, your payroll software knows to deduct these vacation days from the employee’s total available hours.

A PTO tracking protocol like this puts the onus on the team member 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 due to the misclassification.

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. If you’re concerned about accuracy, consider having supervisors and managers regularly track PTO.

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 financial 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 automatically and have time-stamped records of these withholdings. However, it is smart 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. [Find out how to use Form 941 to pay quarterly payroll taxes.]

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 of conducting regular payroll audits. 

Fewer compliance errors

Payroll audits may reveal that you’re not deducting as much income tax from employees’ paychecks as required. With this information, you can correct your mistakes before the IRS identifies a lack of compliance. If the IRS discovers this problem before you do, the agency can penalize you. Worse, the IRS could conduct an audit of its own that proves expensive, time-consuming and stressful. You can avoid that risk with your own internal payroll audit.

Benefits accuracy

Like most employers, you probably offer employees a benefits package that requires them to make financial contributions, such as for health insurance or a dental plan. These premiums are usually deducted from the worker’s paycheck. Part of managing employee benefits is ensuring the proper benefit deductions are being taken during the payroll process and that benefits are terminated when a staffer leaves the company. 

A payroll audit allows you to check that everyone enrolled in benefits is having their pay adjusted accordingly. Similarly, it lets you verify that no one who discontinued a benefit is still being charged for it.

Happier employees

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 staffer 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 during the audit that you neglected to add the employee’s raise to your payroll system, and then you’d immediately update the software and issue retroactive payments to your team member.

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 staffer because it demonstrates you’re looking out for them. And we all know getting paid — and getting paid correctly — makes employees happy.

Easier fraud identification

Although trusting your employees fosters a healthier work environment, the occasional co-worker may submit time sheets with hours they didn’t actually complete. Payroll audits help you identify this fraudulent activity. If you know an employee worked a certain number of hours but you see a higher number in your payroll system, you may be uncovering fraud and can investigate the situation.

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 streamline your records. Regular audits identify employees who are still in your system even though you’re no longer paying them.

Consider the tax implications before you delete an ex-employee from your system. If you must issue the former worker tax forms in the future, ensure removing them from your payroll system doesn’t affect your tax form distribution. You should also make sure that all outstanding wages have been paid. This way, when you remove an old employee from your system, you won’t have to restore them in the future because of something you overlooked.

The best payroll software for completing audits 

We recommend using one of the best payroll services on the market to manage payroll and complete your audits. Below are a few options to consider for your business.

OnPay

OnPay, an affordable and comprehensive payroll solution ideal for small businesses, offers features like payroll processing, tax compliance, multiple payment options and integration with popular small business services. With unlimited payroll runs and automated processing, OnPay ensures accuracy and stays up to date on your payroll tax rates. It also provides HR tools, including onboarding, PTO management, document storage and a self-service portal for employees. Learn more in our OnPay review.

ADP

A renowned payroll industry leader, ADP offers plans for businesses big and small. With different platforms tailored to small, midsize and large companies, ADP provides comprehensive payroll solutions. Features include employee self-service portals, direct deposit, onboarding and payroll reporting. ADP’s advanced plans provide additional services like HR support, training and legal assistance. The system leverages AI and machine learning for error detection and can integrate seamlessly with your other business solutions. See a breakdown of the available packages in our review of ADP.

Paychex

Paychex is a comprehensive payroll service that handles payroll processing, tax obligations and other HR-related tasks. With the Paychex Flex platform, which is accessible online or through a mobile app, businesses of all sizes can easily run payroll. This platform provides multiple service plans, various payment methods, features such as Pre-Check for reviewing pay stubs, and labor cost tools for real-time analysis. Paychex also provides human resources tools, time and attendance systems, employee benefits and business insurance. Get all the information in our detailed Paychex review.

Lauren Kubiak contributed to this article.