What is a payroll audit

Payroll audit is to the process of reviewing a company’s payroll system and records. This is done to ensure employees are being paid correctly and the company is complying with relevant laws and regulations.

Comprehensive payroll audits include reviewing payroll tax filings, employee classification, overtime calculations, benefits administration, and other payroll-related processes. Whether you own a big or small business, the human resources team should insist on a regular payroll audit within scheduled time frames.

Why conduct a payroll audit?

A payroll audit ensures a company follows best practices and legal requirements. It identifies areas for improvements to increase efficiency, and reduces the risk of errors. It also guards against non-compliance in record-keeping, tax reporting, employee pay rates, and payroll.

An auditor may examine payroll records, employment contracts, tax returns, and other documentation during a payroll audit. By doing so the auditor seeks to identify discrepancies or potential issues. Whether you hold external audits conducted by a registered CPA or run internal payroll audits, an audit offers many insights.

Benefits of a payroll audit

Conducting an effective payroll audit can provide a company with a range of benefits, including the following.

• Ensuring compliance with legal and regulatory requirements.
• Identifying potential errors or discrepancies in payroll calculations.
• Reducing the risk of legal or financial penalties.
• Improving the overall accuracy and efficiency of payroll processes.
• Identifying areas of over and underspending, providing strategic insight.
• Creating opportunities for process and procedural improvements.
• Allowing staff to offer feedback on any payroll-related concerns.

In short, such audits give you a broad overview of your payroll process, and any weaknesses in your procedures. Let’s look a little more closely at each of those benefits:

Ensure compliance with legal and regulatory requirements

A payroll audit ensures compliance with legal and regulatory requirements. It does so by reviewing a company’s payroll system to identify areas of noncompliance. The audit examines intentional payroll practices and procedures to make sure they comply with employment laws and regulations. These include requirements for minimum wage, overtime, tax laws, and benefits administration.

Identify potential errors or discrepancies in payroll calculations

A payroll audit identifies potential errors in payroll calculations by examining a company’s payroll system and records in detail. Close analysis helps to improve the accuracy and reliability of a company’s payroll system.

Reducing the risk of legal or financial penalties

By detecting and correcting inaccuracies, a payroll audit helps to mitigate the risk of legal or financial penalties, such as fines or legal action, which can be costly for the company and add to payroll expenses. A payroll audit also improves the accuracy and reliability of the payroll system, reduces the risk of fraud or other irregularities, and assures stakeholders that the company is operating ethically and transparently.

Improving overall accuracy and efficiency of payroll processes

The audit may identify opportunities to automate certain processes, streamline workflows, or implement new payroll software that helps reduce the risk of errors and make regular payroll audits less time-consuming. 

Identifying areas of over and underspending

Doing such an audit can help you identify where you are paying unusually large sums, or where you’re light, which may indicate understaffing. You can pass these insights on to finance managers, and help improve your allocation of financial resources.

Creating opportunities to make process and procedure improvements

An audit might identify shortfalls in your processes, such as the paying of invoices, the allocation of overtime, or the time taken to process expense claims. These insights can lead to further efficiency gains.

Providing a chance for staff to offer feedback

Surveying staff concerns should always be a part of your payroll audit. While accountancy practices are paramount, employee perception is also important. When staff feel their payroll concerns are not addressed, they can become unhappy, which can increase employee turnover.

Common challenges in payroll audits

Conducting a payroll audit is essential, but it also comes with challenges. Being aware of these challenges can help companies prepare for a smoother process.

Handling Inconsistent Records

One common challenge is dealing with inconsistent or incomplete records. For example, missing timesheets, outdated employee data, or unrecorded overtime can complicate the audit process. Keeping detailed records and ensuring they are updated regularly can prevent this issue.

Misclassification of Employees

Another challenge involves misclassifying employees, such as treating independent contractors as full-time employees or vice versa. This can lead to tax errors and penalties. A payroll audit helps identify and correct such misclassifications.

Outdated Payroll Technology

Many companies rely on outdated systems for payroll processing. These systems may lack the automation and precision needed to meet modern compliance standards. Updating to newer software with advanced features can save time and reduce errors.

How technology simplifies payroll audits

Technology has become an essential tool in making payroll audits more efficient and accurate. Here are some recent technological advances that have helped optimize the process:

Benefits of Automated Payroll Systems

Automated payroll systems can reduce the burden of manual calculations and minimize errors. Features such as tax compliance tools, real-time reporting, and automated record-keeping streamline the audit process.

Cloud-Based Solutions

Cloud-based payroll software allows businesses to access data from anywhere, making audits more flexible. Additionally, these systems often come with built-in security measures to protect sensitive payroll information.

Artificial Intelligence in Payroll

AI tools can analyze large volumes of data to identify patterns or errors in payroll records. For instance, an AI-powered system can flag unusual overtime patterns or detect potential fraud more quickly than manual methods.

Payroll audit checklist

Several steps are required to conduct a payroll audit and ensure a company’s payroll system is accurate, reliable, and compliant with applicable laws and regulations.

Review payroll processes and procedures

One of the essential steps in a payroll audit is to review the company’s payroll processes and procedures. This step involves examining the policies and procedures governing payroll activities, such as how pay rates are determined, how overtime is calculated, and how employee benefits are administered. 

Reviewing payroll processes and procedures aims to identify discrepancies or inconsistencies that may lead to inaccuracies or non-compliance with relevant laws and regulations.

Examination of payroll records

When examining payroll records, auditors review employee files, timesheets, pay stubs, bank statements, and tax filings to ensure all information is accurate and up-to-date for the current pay period. Tax forms and tax payments are examined alongside the number of active employees to ensure payroll compliance.

Identifying payroll errors or discrepancies enables the auditor to recommend corrective actions that ensure employees are paid accurately and in compliance with legal requirements.

Verification of employment data and payments

Verifying employment data and payments involves confirming the employee’s name, social security number, and employment status, as well as other details such as eligibility for overtime pay, the correct amount of tax withholdings, and income tax.

The auditor will also verify that all payments, including salaries, wages, bonuses, and benefits, are accurately calculated and appropriately authorized. This step is key to identifying discrepancies or irregularities, such as fraudulent activities or unauthorized payments, and recommending precautionary measures to prevent similar issues from occurring in the future.

Identification of errors and discrepancies

At this stage, payroll reports are cross-checked with the general ledger. Common errors include incorrect pay rates, overtime calculations, and benefit deductions. By identifying errors, auditors can suggest alternative actions. 

Being proactive about identifying errors helps to reduce the risk of legal and financial consequences for the company.

Recommendations for improvements

All of the above steps help an auditor make recommendations for future payroll audit procedures. Suggestions may include improving policies and procedures, implementing new software or technology, or providing additional training to employees responsible for payroll processing.

By recommending improvements, auditors can help the company to increase efficiency, reduce the risk of errors and noncompliance, and enhance the accuracy and reliability of the payroll system.

The role of external vs. internal audits

Payroll audits can be conducted internally or externally. Each approach has its own advantages.

Internal Payroll Audits

Internal audits are conducted by the company’s HR or payroll team. These audits are often less expensive and can be scheduled more frequently. However, they may lack the objectivity of an external audit.

External Payroll Audits

External audits are performed by independent professionals, such as certified public accountants (CPAs). These audits are more objective and can provide a deeper level of scrutiny, but they can also be more costly.

Legal implications of payroll errors

Payroll errors can have serious legal consequences. Some of the most common issues include:

• Wage and Hour Violations: Failure to pay employees the correct amount for overtime or minimum wage can result in lawsuits.
• Tax Noncompliance: Incorrect tax filings can lead to fines and penalties from the IRS. Payroll tax audits focus specifically on this aspect.
• Breach of Contract: Miscalculations in pay can violate employment contracts, leading to legal disputes.

A payroll audit helps businesses stay ahead of these issues by ensuring compliance with laws and regulations.

US legislation for payroll and payroll auditing

There are several statutes which must be followed to ensure payroll compliance. These include key federal laws and regulations designed to protect workers' rights and ensure fair labor practices. The main five Acts that apply are:

• Fair Labor Standards Act (FLSA): The FLSA sets minimum wage, overtime pay, recordkeeping, and child labor standards for full-time and part-time workers in the private and public sectors. Employers must comply to avoid legal penalties.
• Federal Insurance Contributions Act (FICA): FICA requires employers to withhold Social Security and Medicare taxes from employees' wages and contribute matching amounts. Accurate calculation and prompt payment of these taxes are essential.
• Federal Unemployment Tax Act (FUTA): FUTA requires employers to pay a federal tax to fund state workforce agencies. This tax funds unemployment compensation programs for jobless workers.
• Employee Retirement Income Security Act (ERISA): ERISA sets standards for pension and health plans in private industry to protect covered individuals. Employers must follow ERISA's reporting and disclosure requirements.
• Family and Medical Leave Act (FMLA): The FMLA allows eligible employees to take unpaid, job-protected leave for specific family and medical reasons, while remaining covered for group employment insurance. Employers must maintain accurate records of such leave.

Compliance with these laws requires meticulous recordkeeping and regular payroll audits to identify and rectify discrepancies. Employers should stay informed about updates to these regulations to maintain payroll compliance and avoid potential legal issues.

Making payroll audits a priority

Payroll audits are more than just a routine task—they are a vital part of running a successful business. By identifying errors, improving processes, and ensuring payroll compliance, audits can save businesses time and money while protecting employees' rights.

To make payroll audits effective, companies should invest in proper preparation, leverage technology, and conduct them regularly. With a well-organized approach, any business can streamline its payroll system and avoid costly mistakes.

Deel’s payroll expertise can save you time and money

By using an HR and payroll platform like Deel, you can optimize all your global payroll operations, reduce errors, improve efficiency and ensure a painless audit process. Check out our step-by-step payroll guide, or request a demo.