Payroll Audit Checklist 2023

If human resources (HR) or accounting teams notice inconsistencies in payroll processes when reconciling business accounts, it may be time to conduct a payroll audit. A payroll audit analyzes a company’s payroll processes for accuracy and compliance with employment laws. They can also uncover inefficiencies driving needless costs — like outdated payroll software — to more serious issues requiring legal intervention — like fraud.

Although time-consuming, the benefits of a payroll audit are worth the company’s investment. By following the payroll audit steps below, companies ensure not only that they remain financially healthy but that they can identify and rectify faulty processes relating to the payments of their most valuable asset: their employees.

What Should a Payroll Audit Include?

Successful payroll audits analyze the following information in a company’s payroll processes:

• Employee rosters.
• Employee pay, including overtime, variable, and atypical payments.
• Time clock data, such as hours worked and days off.
• Taxes and deductions, including benefit deductions.
• Number of payrolls, including any atypical payrolls.
• General ledger and bank account reconciliations.

When reviewing the data in the payroll audit, HR teams should double-check that their processes adhere to updated federal, state, or local laws and make adjustments or issue corrections as necessary. ‌For example, many states update their minimum wage laws at the beginning of the year. HR leaders should make sure all affected employees’ pay rates are updated appropriately.

Additionally, HR teams should pay attention to errors in the records. Some errors could be as simple as a typo — such as transposing two numbers — while others could point to fraud, embezzlement, wage theft, or time theft. Thus, payroll audits benefit both employees and employers; employees’ pay records are double-checked for accuracy while employers’ accounts are protected from significant financial loss.

How Do You Audit Payroll Records?

To implement an effective payroll audit, companies must determine the parameters of their payroll audit, collect necessary employee pay data, and reconcile them with time records, tax payments, and financial ledgers. At the end of the audit, companies can then take measures to improve their payroll processes to mitigate future errors.

1. Determine the payroll audit timeframe and stakeholders

The first step in a payroll audit is understanding when the payroll audit should take place and who is involved.

When should companies conduct a payroll audit?

Payroll audits can be conducted at any time, but most businesses choose to run annual audits at the end of the fiscal year. Companies conducting their first payroll audit or needing to diagnose problems in their payroll processes should consider semiannual or quarterly payroll audits to resolve payroll inconsistencies sooner.

What is the ‘lookback’ period for a payroll audit?

Typically, the lookback period of a payroll audit is one year, but this could be longer or shorter depending on business preferences. The longer the lookback period, the longer the audit will take. However, the insights a company gains from a payroll audit into their payroll processes generally outweigh any productivity lost by conducting the audit.

Who should conduct the payroll audit?

It depends on the company. On the one hand, smaller companies may benefit from an unbiased outside auditor with no vested interest in employee salaries, benefits, or the business’s overall health. They can also remain objective and provide suggestions for improvement. On the other hand, larger employers with dedicated payroll and HR teams may wish to run the payroll audit themselves since they have the resources and could benefit from the cost savings.

HR, payroll, accounting, executive management, or any combination of the four can conduct internal payroll audits. As each auditor has access to different records, they must work together to complete the audit. Auditors should determine deadlines to complete certain aspects of their portion of the payroll audit to keep teams on track and provide timely results to executives.

Should companies notify their employees of the payroll audit?

Auditors may need to contact or work with employees to fix errors, such as incorrect employee deductions or missing overtime payments during a payroll audit. Therefore, employers should notify employees that they are conducting an audit to avoid catching an employee off-guard about any uncovered paycheck issue.

2. Generate reports and examine the data

Auditors should produce employee rosters, payroll registers, and other payroll reports covering the lookback period. These reports should cover information about employee start and termination dates, job titles, pay rates, deductions, taxes, and so forth. Most companies can produce this information quickly using their payroll or enterprise resource planning (ERP) software; even companies outsourcing their payroll can request such reports from their service providers.

Employee rosters

With their employee roster in hand, employers should examine the data and consider the following:

• Are all employees listed active?
• Are any employees terminated, furloughed, or placed on a leave of absence?
• Are there any employees listed that management does not recognize?

Some errors in the employer roster could simply be the result of a user forgetting to deactivate an employee following termination; others could point to more serious issues. For example, one indication of fraud is the existence of “ghost” employees. These fake employees are listed on the employee roster and are getting paid but do not exist. Employers who carefully examine their employee roster can detect such occurrences and take corrective action, including legal ones.

Payroll reports

With their payroll reports, employers should check the following items:

• Are the pay periods correct?
• Do the number of payrolls match the lookback period? For example, an employer with a one-year lookback period and a biweekly pay period should have 26 total payrolls.
• Could any discrepancies be the result of a bonus run or other atypical payroll?
• Are all employees paid timely and at their appropriate rate(s)?
• Were pay rate changes inputted to take place on their effective dates?
• Were any employees misclassified as independent contractors or vice versa?

Although fixing these errors takes time, early identification allows employers to take steps to fix them before they become major labor law violations.

Depending on the amount of payroll data to review, employers should consider implementing a spot-checking strategy. A randomized selection of about 5–10% of the data provides employers with a representative sample size while ensuring the audit remains as unbiased as possible.

3. Confirm payments match hours worked

Auditors should pull time clock data and make sure all employees are being paid appropriately for their actual time worked during each pay period. For example, if an employee works 47 hours in a pay period when they normally work 35, auditors should investigate to understand why.

If the investigation reveals someone else clocking in on the employee’s behalf, this could be grounds for disciplinary action against both the employee and their “buddy” for time theft. HR teams can also modify policies and procedures or take advantage of certain software to make “buddy punching” more difficult. For example, Homebase reduces the likelihood of buddy punching by taking a picture of employees and requiring them to input a unique pin code when they clock in.

Next, auditors should double check overtime hours are being paid correctly. Generally, non-exempt employees must be paid at their time-and-a-half (overtime) rate for any hours worked over 40 hours in a week according to the Fair Labor Standards Act. However, this could differ depending on international, state, or local laws, collective bargaining agreements, or contracts.

For example, in California non-exempt employees must be paid at their overtime rate for any hours worked over 8 in a day and at their double time rate for any hours worked over 12 in a day. Employers should pay employees any owed overtime retro pay as soon as it is discovered.

4. Double-check that variable and atypical payments are correct

Variable payments are payments based on an employee or company’s overall performance and include factors like bonuses, commissions, shift differentials, or tips. Auditors should check that there is documentation in place to support these variable pay structures, such as a handbook policy or employment contract.

Each variable payment should be labeled differently for tracking purposes. Differentiating variable payments from regular or overtime rates demonstrates employers are adhering to tip laws since they differ across U.S. jurisdictions.

Paid time off (PTO) payments should also be labeled and paid correctly. This includes distinguishing payments like vacation, sick, holiday, bereavement, personal time, or jury duty according to company policies.

Auditors should label these payments separately from regular rates to promote accurate paid leave tracking and to effectively diagnose policy procedures in need of improvement. Say, for example, auditors discover the payroll department paid an employee for two weeks of vacation when they had only accrued one. One way HR teams could prevent this from happening again is to update their vacation policy to require signed employee and manager authorization before payment.

Finally, atypical payments include retro-pay, backpay, reimbursements, signing bonuses, relocation, or contractor payments. Auditors should investigate why an employee suddenly makes more or less than they typically make in a pay period. For example, if an employee typically receives $1,000 every paycheck but suddenly starts receiving $2,000, auditors should check if the payment is from a pay rate increase, variable, or atypical payment. If not, this could be a case of payroll fraud.

5. Check the accuracy of tax withholdings and other deductions

Tax withholdings

One of the biggest responsibilities of an employer is properly withholding and remitting taxes to the appropriate government agency. In this step, employers should review the following questions:

• Were federal, Social Security, and Medicare taxes withheld from employee paychecks?
• Were applicable state and local taxes withheld from employee paychecks based on where they lived and worked?
• Were federal and state unemployment taxes remitted to the appropriate agencies?
• Were employee W-4s properly inputted? Are any employee W-4s missing?
• Does the tax information match what was reported on federal forms 940 and 941 and state equivalents?
• For international employees, are their taxes being withheld according to the tax laws of their country?

Businesses are liable for failing to withhold and submit taxes properly. For example, failing to deposit federal income taxes may incur penalties; interest; and in extreme cases, prison time. Therefore, employers who notice and take measures to fix any tax issues from a payroll audit are more likely to save money on future fines and penalties.

Deductions

Employee paycheck deductions range from paycheck deductions for the employee’s portion of health, dental, or vision insurance premiums to garnishments or retirement contributions for a 401(k). They could also encompass deductions following employee and employer contracts, such as company equipment or uniforms. Auditors should review whether these deductions were made timely and accurately and investigate any discrepancies.

Federal, state, and local laws place limits on employee paycheck deductions. Therefore, employers should seek legal counsel before withdrawing any missing funds from any employee’s paycheck due to a deduction inaccuracy, especially if it was the employer’s mistake.

6. Compare payroll records with the General Ledger and bank accounts

Auditors should pull the General Ledger (GL) from the lookback period and reconcile it with payroll records from the same time. Each payroll expense in the GL should match the auditors’ findings from the payroll audit. If they do not, auditors must investigate further. For instance, if an auditor notices an employee’s paycheck listed twice in the GL, it could either be a clerical error or an indication an employee was accidentally double paid.

To know for sure, auditors should repeat the same process as above, this time by comparing the payroll transactions in the GL with their payroll bank accounts. Does the bank account confirm the employee was actually paid twice? Are there any other transactions that were missed? What about uncashed payroll checks? Companies can use this time to correct internal documentation, void and reissue any stale checks, and update procedures to prevent double payments or fraudulent activity.

7. Take advantage of payroll software

Companies can speed up the payroll audit process by leveraging payroll software. Instead of compiling reports for the payroll audit lookback period by hand, payroll software can instantly assemble:

• Employee rosters.
• Payroll ledgers.
• Tax reports.
• Deduction reports.
• Employee pay stubs.

Moreover, payroll software automatically calculates complicated employee pay rates, from overtime rates for shift differentials to fluctuating workweeks. Many of these solutions also include code to prevent errors, reducing the risk that a payroll audit will uncover glaring issues.

ADP, for example, has safeguards in place to notify employers of critical issues, such as missing employee data, duplicate Social Security numbers, or unbalanced transactions. Employers can then fix these errors before they finalize payroll.

Meanwhile, companies looking to save time inputting or transferring payroll information into their accounting programs can benefit from an integrated solution. QuickBooks, for instance, allows companies to easily reconcile payroll reports with transactions in the GL with their combined account and payroll software.

Additionally, payroll software assists employers with labor law compliance, reducing the risk of uncovering major payroll law violations during a payroll audit. For instance, Paycor automatically updates federal, state, and local tax rates and withholding limits whenever they are enacted. Because they no longer have to research and make the new calculations themselves, employers can increase efficiency while ensuring employees’ tax withholdings remain accurate.

8. Address payroll processes in need of optimization

In addition to uncovering errors in need of correction, payroll audits can give businesses concrete action items that will help improve their processes, such as:

• Requiring managers to review timecards for accuracy.
• Adding extra steps to the payroll approval process.
• Implementing measures to flag uncashed checks.
• Limiting payroll data access to mitigate the risk of fraud.
• Evaluating if the payroll software needs to be switched or upgraded.

Failing to address and update payroll processes following the insights of a payroll audit will guarantee companies continue to make the same mistakes over and over again, costing companies future time and money.

9. Put a process in place for future payroll audits

Companies should make sure systems are in place for future audits and write a policy outlining a regular payroll audit timeline. Employers should consider the following questions when outlining their policy:

• What worked and what didn’t during the payroll audit?
• How long did the payroll audit take? Were there areas that required more time and why?
• Did everyone involved in the audit need to be involved, or were more people necessary?
• Was every area of the payroll audit addressed in a timely manner?
• Should the scope of future payroll audits expand or shrink?

In addition to addressing the questions above, employers should prepare a payroll audit checklist to improve the efficiency of future audits.

Why Companies Need Payroll Audit Procedures

Because payroll is one of the core functions of any business, inefficient or inaccurate payroll processes can cost companies significant time and money to correct major payroll mistakes or mount defenses for payroll-related labor law violations. However, companies that implement a regular payroll audit process can address inefficiencies or fraudulent activity before they become serious problems.

Not only do payroll audits prevent the likelihood of future payroll mistakes or compliance issues, but they also ensure the integrity of payroll. Even companies with no computational or transactional errors in their payroll audits can utilize payroll audit data to correct any employee miscategorizations, unfair or discriminatory pay practices, or poor record-keeping procedures. Ultimately, failing to conduct a payroll audit costs companies in the long run, as they miss out on valuable insights to improve archaic payroll procedures.

If you’re ready to search for payroll software that will support a successful audit, check out our Payroll Software Guide for solutions.