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How to Ensure Accurate Paychecks through a Payroll Audit

Payroll AuditPayroll Audit
min read
August 21, 2023

If you own a small business with full-time employees, hourly workers, and independent contractors, you might be manually calculating their pay and transferring it into their bank accounts at the end of each payment cycle

But such manual calculations aren't always accurate. After a while, you might start noticing some irregularities in paychecks, which can mean you're not paying the right amount of payroll taxes too.

That's where a payroll audit comes in. A payroll audit can help you correct those payroll errors so you can avoid penalties from the IRS, ensure employees are getting their due pay and catch any fraud happening in your system—so let's dive in!

What Is a Payroll Audit?

A payroll audit is when you review the information in your payroll system to verify its accuracy. It ensures you pay the correct salaries to your employees and payroll taxes to the Internal Revenue Service (IRS), and follow pay-related labor laws. It's also sometimes referred to as a payroll compliance audit.

What Are the Objectives of a Payroll Audit?

The main objective of a payroll audit is to uncover the errors in your payroll records. During the audit, you'll look at each employee's payroll data to ensure their personal information and pay rates are accurate. You'll also verify that you withheld the correct taxes from your team's paychecks.

Based on your findings, you can correct your payroll entries and adjust the payroll management system so those errors don't happen again.

How Long Does a Payroll Audit Take?

The time you need for a payroll audit depends on the size and nature of your business. 

If you have a small business with only a few full-time employees, it might only take a few hours to verify your payroll. However, the payroll audit could take a few days if you have different types of workers, like salaried and hourly employees, and independent contractors.

How Often Should You Audit Payroll?

The payroll audit isn't a one-and-done process. It's a good idea to audit your payroll entries quarterly or at least every six months.

What Triggers a Payroll Audit?

One of the biggest triggers of a payroll audit is when a business goes through a significant change, like taking over another business and/or hiring a ton of new employees.

These changes might introduce a payment or tax withholding error into your payroll. And a payroll audit can help you catch those errors. 

What Are the Benefits of a Payroll Audit?

Does auditing your payroll sound like a time-consuming process? It can be, but it's time well spent.

Let's look at the benefits of routine payroll audits. 

Avoid Payroll Errors

Small business owners often process payroll manually. 

The business owner or an accountant adds or removes employees from the payroll, enters time and salary into the system, issues payroll checks, and reconciles payroll with the bank. Often, no second person reviews these details or approves the payroll. 

This could lead to the following payroll errors:

Regular payroll audits will help you detect and correct these errors. 

Ensure Compliance

While running a business, you need to adhere to state and federal regulations. 

In particular, you must withhold income taxes from your employees' salaries and pay the correct payroll taxes to the IRS. Plus, the Department of Labor (DOL) has fixed overtime pay rates for hourly workers. 

The IRS charges a Failure to Deposit Penalty for businesses that don't pay payroll taxes on time or fail to pay the right amount. The penalties vary from 2-15% of the underpaid amount. If the IRS considers the failure to pay taxes tax evasion, it may even lead to a fine of up to $500,000 or jail time of up to five years, or both. 

What's more, the DOL can charge a penalty of up to $1,000 for each instance of overtime pay violation

A payroll audit ensures you comply with these labor laws since you verify overtime wages and tax liabilities regularly. 

Sound complicated? Instead, you can use Hourly—a payroll platform that automatically generates payroll data, pays your state and federal payroll taxes, and helps you comply with overtime laws

Stay Safe from Payroll Fraud

If your payroll records aren't in order, people could tamper with them and steal from you. Adding employees who don't exist (ghost employees) or exaggerating billable hours are examples of payroll fraud. A payroll audit ensures you don't lose money that way. 

Now that we have explored the "what" and "why" of a payroll audit, we'll get into the "how." Let's explore the basic steps of a payroll audit procedure.

How Do You Conduct a Payroll Audit?

The top two challenges to payroll accuracy are:

So, your payroll audit checklist should include steps to combat these things. With that in mind, let's look at the audit steps. 

Step 1: Classify Your Workforce Accurately 

Your workforce might include exempt and non-exempt employees, and independent contractors. The DOL treats each of these groups differently—let's go through those differences below. 

Exempt vs. Non-exempt Employees

According to the Fair Labor Standards Act (FLSA), there are two kinds of employees—exempt and non-exempt. You need to pay non-exempt employees overtime pay if they have worked for more than 40 hours in a week. 

Typically, hourly employees come under the non-exempt category. On the other hand, salaried employees can be exempt or non-exempt, depending on their salary and job duties. As a rule of thumb, if they're white-collar workers earning more than $684 per week, they're exempt, and vice versa.

For more information, you can check out DOL's fact sheet regarding FLSA exemptions

Employees vs. Independent Contractors

You may also have independent contractors or freelancers you regularly do business with and whose fees become linked with your payroll. 

For example, say you routinely pay a freelancer whenever you run payroll. Over time, the freelancer's payment may become a part of your payroll. 

But you need to differentiate between your employees and freelancers since you must withhold income and payroll taxes from the paychecks of your salaried and hourly employees. On the other hand, freelancers pay their own taxes. 

Note: Even though you don't withhold taxes from independent contractors, you need to ask them to fill out IRS Form W-9 to collect taxpayer information, like their Social Security number (SSN) or employer identification number (EIN). Sometimes, the IRS might think you're falsely claiming your employees as freelancers. So, make sure to sign contracts with freelancers and ensure you can justify their classification. 

The first step of your payroll audit should be classifying your workforce into the correct category:

Step 2: Ensure Your Payroll Only Has Active Employees

Be it full-time employees, hourly workers, or independent contractors, ensure you only pay for the active workforce. Go over your payroll records and remove terminated employees and those who quit their positions.

As freelancers are not on your payroll, check your transaction records to ensure you aren't paying any freelancer who is no longer working for you.

When your workforce grows, so does the chance of payroll fraud. For example, an employee with access to your payroll system could add a ghost employee and draw salary on their behalf. 

So, during the payroll audit, check the following information for each person in your workforce to ensure they currently work for you. 

Step 3: Verify Employee Pay Rates

Not all your employees are paid at the same rate—and an employee's pay rate can change, like when they get a promotion. So, you should verify that the payroll entries show the correct rate for every employee. 

Verifying the pay rate will also help you comply with the overtime pay mandated by the FLSA—since you pay wage workers at the standard rate for the first 40 hours of the week and the overtime rate for any additional hours.

Step 4: Compare Actual Payments Against Attendance Records

The next step in a payroll audit is cross-checking the time cards submitted by your employees and wage workers. Human resource (HR) teams often handle time cards, but your payroll entries should show the same data. 

Cross-check your payroll records with the HR team's records to verify that you're only paying active employees and employees on paid time off, not unpaid vacations

Tracking vacation schedules is also important. Let's say an employee comes back three days before or after their scheduled return. The payroll audit will ensure you pay them accurately and find system discrepancies.

Verifying attendance records is a crucial part of auditing your payroll. It makes sure you pay the correct amount according to the time each employee worked. 

Step 5: Payroll Reconciliation 

You also should ensure payroll expenses match your financial records during the payroll audit. Review your monthly bank statement and ensure you have a corresponding bank transaction for each payroll expense. The date and amount of the bank transactions should match your payroll journal entries

If you have a general ledger, your payroll expenses should match the general ledger entries. Also, look for any unusually high amounts in your ledger and see if they come from payroll expenses.

Step 6: Verify Employment Tax Withholding and Remittance

The IRS mandates that you withhold the following taxes from your employees: 

When you audit your payroll, ensure the tax withholding for each employee is accurate. The amount of tax you withhold should match what you submitted on their W-2 forms and your Form W-3.  

You should also look at your bank statements and general ledger to ensure you're making timely tax payments and cross-check them with your Form 941 submissions.  

Step 7: Report Findings and Create Best Practices

In the final step of the payroll audit, you'll create an audit report and share it with relevant departments. For example, you may want your finance and accounting department to look into the discrepancies you found. 

You may also want your HR department to look at the audit results. They could look for differences in employees' job roles, pay rates, vacations, or time cards. 

After the audit, you should correct the errors immediately to avoid penalties by the IRS and DOL. 

What Are Some Payroll Best Practices?

Once you complete the audit, it's a great idea to follow some best practices to avoid payroll errors in the future. They include:

Same Data Everywhere 

The finance, accounting, and HR departments might store employee data independently, leading to inconsistencies. Instead, it's best to use the same software to track data like job roles, pay rates, work hours, and vacations. It will ensure that every department uses the same data.

Control Access to Payroll System and Include Multiple Approvals

Review who has access to your payroll system and ensure that only authorized people can modify entries. 

Moreover, when you run the payroll, make sure multiple people approve it, such as the accounting head and business owner. 

Accurate Documentation

You should have all the necessary documentation, like employee and independent contractor tax forms. Also, encourage your employees to submit their timesheets every week. Or use Hourly, which lets every employee clock in and out on their phone—and shows you your labor costs in real-time.

Routine Payroll Audits

Conduct an internal audit of payroll at least once every six months. Document your audit process so it's easier next time. 

Consider hiring an external auditor for your payroll audit if you can afford it. An external auditor will ensure there's no internal tampering. 

Stay Up to Date with Regulations 

Review federal and state labor laws and payroll taxes to identify changes and adjust your payroll processing. 

Use Payroll Processing Software

The chances of errors are high if you process your payroll manually. 

Payroll software, like Hourly, can help you:

Payroll Auditing is Essential to Ensure Accuracy

Running payroll is a crucial part of managing your small business. Even minor mistakes in the payroll record could result in a loss of money and penalties. To avoid such errors, routinely audit your payroll.

Now that you know all about payroll audits, what's next? It's time to gather up your records and get started!

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