How to Conduct a Payroll Audit Step-by-Step

A payroll audit thoroughly examines a business’s payroll processes, data, and records. It ensures accurate employee payments, correct payroll tax calculation and remittance, and adherence to relevant laws and regulations. Businesses conduct these audits to identify errors, prevent fraud, and maintain compliance, proactively addressing issues before they lead to significant financial penalties or legal complications. Audits verify payroll processes are compliant and up-to-date, minimizing risks from inaccurate calculations or missed deadlines. This internal review supports financial record integrity and ensures correct, timely employee payments, which is also a federal and state legal requirement. Regular payroll audits help businesses avoid external reviews and significantly reduce the risk of costly discrepancies.

Key Elements of Payroll

Payroll encompasses various components that determine an employee’s total compensation and employer obligations. Gross wages are total earnings before deductions, including salaries, hourly pay, overtime (typically 1.5 times the regular rate for non-exempt employees working over 40 hours weekly), commissions, and bonuses.

Deductions are amounts subtracted from gross pay. Pre-tax deductions (e.g., 401(k), health insurance) reduce taxable income. Post-tax deductions (e.g., Roth 401(k), wage garnishments) are taken after taxes. Deductions can be voluntary (union dues) or involuntary (court-ordered garnishments).

Payroll taxes involve contributions from both employees and employers. Federal income tax withholding, based on Form W-4, is remitted to the IRS. Federal Insurance Contributions Act (FICA) taxes, comprising Social Security and Medicare taxes, are shared between the employee and employer. For Social Security, the employee and employer each pay 6.2% on earnings up to an annual limit, while for Medicare, each pays 1.45% on all earnings.

Employers also pay Federal Unemployment Tax Act (FUTA) taxes, funding unemployment benefits. State Unemployment Tax Act (SUTA) taxes are similar, paid to states with varying rates. Many states and local jurisdictions also impose income taxes, which must be accurately calculated and remitted.

Information Needed for a Payroll Audit

Gathering specific documents, records, and data is a preliminary step for a payroll audit. Employee records are foundational, encompassing new hire paperwork, such as the Form W-4 for federal tax withholding allowances and the Form I-9 to verify employment eligibility. Employment agreements, which outline pay rates and terms, along with termination records, are also necessary to confirm employment status and pay accuracy.

Timekeeping records (timesheets, electronic data) provide evidence of hours worked, vital for verifying regular and overtime pay. Payroll registers and summary reports detail gross pay, deductions, and net pay, serving as comprehensive compensation records.

Payroll tax filings confirm compliance with federal, state, and local tax obligations. These include quarterly federal tax returns (Form 941), annual federal unemployment tax forms (Form 940), and annual wage and tax statements (Form W-2). Equivalent state tax returns and reporting forms are also required.

Financial records like bank statements and reconciliation reports trace payroll disbursements. Benefit plan documentation (health insurance, 401(k) agreements) verifies deduction calculation and remittance. General ledger entries for payroll expenses allow reconciliation with payroll reports, ensuring data consistency.

Conducting the Payroll Audit

The actual process of conducting a payroll audit involves a systematic review of various data points and processes to confirm accuracy and compliance. A primary step is the verification of employee data, which includes checking new hires against submitted Forms W-4 and I-9 to ensure proper setup and authorization. Employee terminations and any changes in employee status, such as promotions or job title changes, should be cross-referenced with payroll records to confirm that pay adjustments were correctly implemented and that only active employees receive compensation.

Verifying hours worked and wage calculations is another area. Auditors compare timekeeping records, like timesheets or clock-in data, with payroll reports to confirm that all hours, including regular and overtime hours, were accurately recorded and paid. For non-exempt employees, overtime calculations must adhere to federal Fair Labor Standards Act (FLSA) requirements (typically 1.5 times the regular rate for over 40 hours weekly), ensuring correct pay rates are applied.

Validation of deductions ensures proper amounts are withheld and remitted. This includes reviewing pre-tax deductions like health insurance premiums and 401(k) contributions against employee authorizations and benefit plan documents. Post-tax deductions, such as wage garnishments, must also be verified against court orders or other legal mandates to confirm correct calculation and timely remittance.

Payroll tax compliance requires verifying accurate calculation and timely remittance of federal, state, and local payroll taxes. Auditors cross-reference payroll registers with filed tax forms (e.g., Form 941) to ensure reported liabilities match calculated amounts. The timing of tax deposits is also scrutinized, as federal tax deposits follow specific schedules based on employer tax liability.

Reconciliation of payroll accounts compares general ledger payroll expense accounts with payroll registers and bank statements. This confirms that total wages, taxes, and deductions in the accounting system match amounts processed and paid. Discrepancies are investigated to identify their root cause.

A review of internal controls surrounding the payroll process assesses existing procedures. This includes segregation of duties, authorization requirements for pay changes, and audit trails within payroll systems. Examining these controls helps identify weaknesses that could lead to errors or fraud, ensuring payroll system integrity.

Reviewing Payroll Audit Outcomes

Upon completing the procedural steps of a payroll audit, the next phase involves consolidating observations and interpreting the findings. This process begins with identifying and categorizing discrepancies discovered during the audit. Errors might include calculation mistakes in wages or taxes, data entry inaccuracies in employee records, or compliance issues related to specific regulations such as minimum wage laws or tax withholding rules.

Assessing the impact of identified issues quantifies financial implications (e.g., underpayments, overpayments) and evaluates compliance risks (e.g., penalties from IRS or Department of Labor). Understanding these impacts helps prioritize corrective actions and remediation urgency.

Thorough documentation of all findings is paramount for a comprehensive audit. This involves detailing each observation, citing specific records or calculations with discrepancies, and providing supporting evidence. Well-documented findings ensure transparency and provide a clear basis for adjustments or corrective measures.

The final stage involves preparing for discussion with stakeholders, typically management or department heads. This often includes compiling a summary report outlining the audit’s scope, methodology, key findings, and their potential implications. Presenting these findings allows for informed decision-making on process improvements, corrective actions, and prevention strategies.