Payroll Audit: How to Audit Payroll Step by Step

Picture this: It’s Friday afternoon, and you’re about to approve payroll when a nagging thought crosses your mind: When was the last time I verified that everything in our payroll system is accurate?

If you can’t remember, you’re not alone.

Many businesses run payroll week after week without taking a step back to ensure everything is running smoothly. That’s where a payroll audit comes in. Trust us, it’s not as intimidating as it sounds!

What is a Payroll Audit?

A payroll audit is a comprehensive review and verification process that examines your organization’s payroll system, procedures, and records to help ensure accuracy, compliance, and efficiency. Think of it as a health check for your payroll. It’s designed to catch errors, identify inefficiencies, and make sure that your employees are being paid correctly while your business stays compliant with regulations.

During a payroll audit, auditors (whether internal or external) systematically examine employee records, wage calculations, tax withholdings, benefit deductions, and payment processes. The goal isn’t to create a gotcha moment, but to create confidence in your payroll processing and protect both your employees and your business from costly mistakes.

Importance of Conducting Payroll Audits

Let’s be honest. Payroll might not be the most exciting part of running a business, but it’s certainly one of the most critical. Here’s why regular payroll audits should be on every business owner’s priority list:

Help Ensure Tax Reporting Accuracy

Nothing keeps business owners awake at night quite like the thought of payroll tax compliance issues. Payroll audits help verify that all tax withholdings, employer contributions, and reporting are accurate and up to date. With tax laws changing frequently and penalties for errors being substantial, this verification process can save you from expensive mistakes and potential legal headaches.

Help Ensure Compliance with Laws

Employment laws are requirements that come with real consequences. A thorough payroll audit helps ensure your business complies with federal, state, and local regulations, including minimum wage requirements, overtime calculations, and record-keeping mandates. Consider it your insurance policy against compliance violations.

Provide Accurate Data

Your payroll data feeds numerous business decisions, from budgeting to performance analysis. When conducting a payroll audit, you’re essentially ensuring that the financial data driving your strategic decisions is reliable and accurate. Clean data leads to better business insights and more informed decisions.

Uncover Potential Errors

Even the most well-intentioned payroll processes can develop errors over time. System glitches, manual entry mistakes, or outdated procedures can creep in without anyone noticing. Regular payroll auditing acts as a safety net, catching these issues before they become bigger problems.

Discover Payroll Errors

From incorrect wage rates to miscalculated overtime, payroll errors can range from minor inconveniences to major financial issues. A comprehensive payroll audit verification process helps identify these errors early, protecting both employee satisfaction and your bottom line.

Types of Payroll Audits

When it comes to audit procedures for payroll, you have two main options, each with its own advantages:

Internal Payroll Audit

An internal payroll audit is conducted by your own team, typically by someone from HR, accounting, or a dedicated internal auditor. The beauty of this approach lies in its accessibility and cost-effectiveness. Your internal team already understands your business operations, company culture, and specific challenges.

Internal audits can be performed more frequently and are perfect for routine checks and ongoing monitoring. They’re also great for identifying process improvements and training opportunities within your team. However, they may lack the objectivity and specialized expertise that external auditors bring to the table.

External Payroll Audit

An external payroll audit involves bringing in outside professionals, such as independent auditors or expert payroll audit firms. These external auditors bring fresh eyes, specialized expertise, and complete objectivity to the process. They’re particularly valuable for comprehensive annual reviews or when you suspect significant issues.

While external audits typically cost more upfront, they often provide deeper insights and carry more weight with stakeholders, regulators, and financial institutions. They’re also essential for publicly traded companies or organizations with specific audit requirements.

Payroll Audit Preparation

Before diving into the actual payroll audit process, proper preparation is the key to success. Think of this phase as laying the groundwork for a thorough and efficient review.

Gather Documentation

First, you’ll need to gather comprehensive documentation, including employee files, payroll registers, tax records, benefit information, and time tracking data. Don’t forget about policy documents, procedure manuals, and any recent changes to compensation structures or benefit plans.

Identify Team Members

Identifying the right team members for the job is also important. You’ll typically need someone from HR who understands employee classifications and policies, an accounting professional familiar with payroll processes and financial controls, and potentially an IT specialist if you’re dealing with complex payroll systems or data integration issues.

Acquire Technology Access

Technology plays an important role in today’s payroll auditing so ensure you have access to all relevant payroll systems, reporting tools, and data analysis software. If you’re conducting an internal audit, make sure your team has the necessary permissions and training to access and analyze payroll data effectively.

Set Objectives and Scope

Finally, establish clear objectives and scope for your audit. Are you focusing on potential compliance issues, accuracy verification, or process improvements? Having clear goals helps ensure your audit efforts are focused and productive.

How to Conduct a Payroll Audit

Now for the main event: the actual payroll cycle audit process. While every organization’s needs are different, the following steps provide a basic framework for conducting effective payroll auditing.

Step 1: Review Employee Master Data

Start with the foundation, your employee records. Verify that all employee information is current and accurate, including personal details, job classifications, pay rates, and employment status. This step catches issues like outdated information for terminated employees or incorrect pay grades that could lead to significant errors down the line.

Step 2: Verify Time and Attendance Records

Examine how time is tracked and recorded in your organization. Review time sheets, punch card data, or digital time tracking records for accuracy. Pay special attention to overtime calculations, break deductions, and any manual adjustments. This step is important for ensuring employees are paid for the time they actually worked.

Step 3: Analyze Wage Calculations

Dig into the math behind the paychecks. Verify that regular wages, overtime pay, bonuses, and commissions are calculated correctly according to your policies and legal requirements. Don’t forget to check that minimum wage requirements are met and that exempt vs. non-exempt classifications are appropriate.

Step 4: Examine Deductions and Withholdings

Review all deductions from employee paychecks, including tax withholdings, benefit contributions, garnishments, and voluntary deductions. Ensure that all deductions are properly authorized, calculated correctly, and remitted to the appropriate parties on time.

Step 5: Review Tax Compliance

Verify that all payroll taxes are calculated, withheld, and deposited correctly. This includes federal, state, and local income taxes, as well as FICA, unemployment taxes, and any other applicable taxes. Check that tax forms and reports are filed accurately and on time.

Step 6: Assess Internal Controls

Evaluate the internal control procedures for payroll to identify potential vulnerabilities or areas for improvement. Look at approval processes, segregation of duties, access controls, and documentation requirements. Strong internal controls are your first line of defense against errors and fraud.

Step 7: Test Payroll System Accuracy

Conduct sample testing to verify that your payroll system is calculating and processing payments correctly. This might involve recalculating a handful of paychecks manually or using alternate methods to verify system accuracy.

Step 8: Document Findings and Recommendations

Thoroughly document all findings, both positive and negative. Provide clear recommendations for addressing any issues identified and establish timelines for implementing improvements. Good documentation is essential for tracking progress and ensuring accountability.

Primary Risks for Payroll Audits

Even with the best intentions, certain risks commonly surface during payroll audits. Being aware of these potential pitfalls can help you focus your audit efforts:

• Misclassification of employees as contractors or incorrect exempt/non-exempt status, leading to compliance violations and potential legal issues.
• Calculation errors in overtime, bonuses, or commission payments that can result in underpayment or overpayment of employees.
• Unauthorized changes to employee data, pay rates, or deductions without proper approval or documentation.
• Ghost employees or terminated employees who continue to receive paychecks, often exposing weak internal controls.
• Tax compliance failures, including incorrect withholdings, missed deposits, or late filings that can trigger penalties.
• Benefits administration errors such as incorrect deductions or coverage that doesn’t match employee elections.
• Time tracking irregularities including buddy punching, unauthorized overtime, or missing time records.
• Data security vulnerabilities that could expose sensitive employee information or allow unauthorized access to payroll systems.

Payroll Audit Best Practices

Want to make your payroll audit program as effective as possible? These best practices can help ensure thorough, efficient, and valuable audits:

• Schedule Audits: Establish a regular audit schedule rather than waiting for problems to surface. Quarterly or semi-annual reviews work well for most organizations.
• Use Analytics: Analytics help identify patterns, anomalies, and trends that might not be obvious through manual review.
• Use Effective Documentation: Document everything thoroughly including procedures, findings, and corrective actions to create an audit trail and support future reviews.
• Conduct Trainings: Train your payroll team regularly on new regulations, system updates, and best practices to prevent errors before they occur.
• Segregate Duties: Implementstrong segregation of duties ensuring that no single person has complete control over the entire payroll process.
• Stay Up to Date: Stay current with regulatory changes by subscribing to updates from relevant agencies and participating in professional development.
• Use Standards: Create and use standardized checklists and procedures to help ensure consistency and completeness in your audit approach.
• Be Prompt: Follow up on recommendations promptly to ensure identified issues are addressed and don’t recur in future audits.

Paycor Helps with Payroll Audits

When it comes to streamlining your payroll audit verification process, having the right technology partner makes all the difference. Paycor’s comprehensive payroll software is designed with audit capabilities in mind, offering robust reporting tools, detailed audit trails, and automated compliance features that make conducting thorough payroll compliance audits more efficient and effective.

Comprehensive Audit Trail & Reporting

• Maintains detailed records of all payroll transactions, changes, and approvals
• Creates a comprehensive audit trail that auditors appreciate
• Generates detailed reports on wages, deductions, tax withholdings, and more
• Makes it easy to analyze payroll data and find potential issues

Built-in Compliance Features

• Helps ensure payroll processes meet federal, state, and local requirements
• Reduces the risk of compliance violations during audits
• Integrates time and attendance tracking for accurate data flow between time collection and payroll processing

Expert Support Services

• Provides payroll audit assistance
• Offers compliance guidance and best practice recommendations
• Team of payroll professionals available to help prepare for audits
• Assists with interpreting findings and implementing process improvements

Conduct Payroll Audits with Paycor

Ready to take your payroll audit program to the next level? Don’t let payroll compliance and accuracy concerns keep you up at night. Paycor’s comprehensive payroll solution and expert support team are here to help you conduct thorough, efficient payroll audits that protect your business and give you peace of mind.

Whether you’re looking to streamline your current payroll audit processes, improve compliance, or simply gain better visibility into your payroll operations, Paycor has the tools and expertise to help. Contact Paycor today to learn how our payroll solutions can transform your audit capabilities and ensure your payroll processes are accurate, compliant, and efficient.

Take the first step toward payroll confidence—take our guided tour and discover how the right technology partner can make payroll auditing simpler, more thorough, and far less stressful.

Payroll Audit FAQs

Payroll audits help ensure compliance, accuracy, and financial transparency by finding errors, preventing fraud, and staying aligned with employment laws and tax requirements. Below are answers to the most common questions about payroll audits.