Conducting a payroll audit helps ensure your payroll process complies with labor and tax laws. Further, regular payroll audits reduce occurrences of fraud, embezzlement, and wage theft. You can strengthen your financial controls and address potential issues using our free customizable payroll audit checklist that covers how to conduct a payroll audit step-by-step.
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Regardless of what software you’re using, here’s how to conduct a payroll audit.
1. Determine the Timeframe & Process for Your Payroll Audit
Set yourself up for success when planning your payroll audit by considering the who, what, and when. We recommend conducting a payroll audit annually, but if this is your first audit and you want to make sure payroll is working, you should consider doing mini audits more frequently—quarterly or even monthly.
Download the Payroll Audit Checklist for free as an editable spreadsheet.
You can use our Payroll Audit Checklist to come up with a plan for what you will be testing, when, and in what order. You may also want to note the names of individuals who can assist. This will help ensure the right team members are present when you need them, so the audit isn’t delayed or completed out of order.
2. Run Reports for Employee & Payroll Data
For the sake of this checklist, we’ll assume you’re using some kind of payroll software or service like QuickBooks Payroll. As such, you’ll typically find they provide reports that make your payroll auditing easier. The first thing to verify is basic employee data and payroll information. Look for correct employee names, pay rates, hours, and overtime.Also, be on the lookout for terminated employees still on the payroll or employees you’ve never heard of. Finding either might indicate there’s a problem.
Here’s what to check for as part of your payroll audit.
Verify Active Employees
In a small company, you can check this yourself easily as you’ll know the names of all your workers. Some companies keep an employee list or census in a spreadsheet. However, in a larger firm, you may need to get help from your managers to ensure all their employees are listed correctly, including terms and new hires, along with their start dates.
Another source for an employee list could be your human resources (HR) software or other systems like your timeclock. Payroll fraud can occur if, for example, the person managing your employee data were to add a fake employee—a relative perhaps—and pay them out of your business account.
“As a former auditor and finance director, one of the most important things I looked at when doing a payroll audit was outlier entries. These were amounts or names—potential ghost employees or employees still being paid after the termination date.
“I have found both on audits. One was an HR assistant who had given herself a raise during a pay raise freeze. The ghost employees were during the same audit and had been entered by the same person, but apparently had been entered for test purposes, and no checks had been cut for them.”
—Jennifer A Harter, Financial Educator, Jennifer Harter Consulting
You’ll want to ensure data matches between the various software programs. Check to make sure that terminated workers or employees on unpaid leave have been inactivated in the payroll software. Also, double-check data for contract workers as their payment information may be stored in your accounting software instead of in your payroll system.
Verify Employee Pay Rates
Your HR or payroll software should have a report that lists employees’ names, jobs, and pay rates. Review it to make sure it’s correct. If you’re using HR software, it often provides dates of pay increases while your payroll software will show overtime pay as well as shift-differential pay. You’re looking to see that this information is correct and that no one isn’t getting paid more or less than they should.
Verify Pay Periods Worked
If you have both a timekeeping and payroll system, you can often compare data for a specific time frame, such as a random pay period. What you’re looking for is that the pay periods line up, and that data from one system—hours worked—matches what the employees got paid in that timeframe.
You also want to make sure that employees are receiving their pay on the designated day, not too early as that affects your cash flow, or too late, which is a potential labor law violation.
3. Develop a Spot Checking Strategy
After you’ve reviewed the reports and data above, it’s a good practice to do some spot checking by looking at payroll data for 5-10% of your total employees randomly vs verifying data for all, unless you only have a handful of employees. And even with just a few employees, it doesn’t make sense to review all of their payroll data. You should find a way to select employees, payroll periods, and payroll transactions randomly.
Once you decide how you’re going to proceed with the audit, you’ll need to take a look at W-4 forms for the employees whose information you’re verifying and compare the withholding rates to what’s set up in your payroll system. Also, look at benefits enrollment forms and plans, and make sure that you are applying the correct deduction amounts to employee paychecks.
Compare Employee Paystubs
Here’s where you may need to pull together data from various sources. For example, your employees may have indicated their benefits enrollment for dental insurance on an open enrollment form, or their 401(k) deduction percentage on a payroll form. If you’re lucky, employees will already have notified you of any issues. However, it’s good to check yourself.
Compare Employee Timecards to Paystub Data
You may want to go into your payroll system and randomly look at paystubs for different employees and time periods. Consider looking at data for a manager recently promoted, who should have received a pay increase; an hourly employee who often works overtime to make sure their overtime pay data matches; and perhaps a salaried full or part-time employee to make sure their annual pay rate is calculating each pay period correctly.
Compare W-4 Form Changes to Ensure Withholdings Are Correct
Since your W-4 forms are used to collect tax withholding data that you’ll be required to report on at later in W-2s issued to employees and the IRS after year-end, you’ll want to catch and correct any mistakes early. Some states have their own version of a W-4 form, so one employee can choose different withholding allowances for federal vs state taxes. Therefore, check both their state and federal forms as spot-checking can uncover many issues.
“The most important facts to ascertain in a payroll audit are confirmation that the gross payroll figures, either salaried or hourly, are accurate for each employee. Additionally, confirm the accuracy of Social Security numbers as cross-referenced with employee names and addresses, properly allocated deductions for all federal, state, and local withholding taxes based upon rates pursuant to the individual Form W-4, and any predetermined withholding for pensions, health insurance premiums, and other nontax deductions.”
—Shayne Sherman, CEO, TechLoris
4. Verify Hours Worked Against Time Card Data
Once you’ve taken a look at the big picture data—employees, pay rates, pay periods—it’s good to do a deeper dive. For example, you want to make sure employees are being paid correctly for hours worked, including overtime. As the timecard data feeds into payroll, it’s important that time cards aren’t being altered or payments being inflated.
Make Sure Employee Hours Worked Match Amounts Paid
Whether you’re using paper timesheets, punch cards, or a time and attendance app, you can typically look at historical time card data and compare it to payroll data—payroll registers or pay stub copies—for the same time frame. If an employee’s timesheet shows they worked 35 hours from September 2 through September 9, the payroll support should reflect the same information. Be sure you’re comparing data that covers the same pay periods. Note any differences.
If you use QuickBooks Payroll software, you can import timesheets from QuickBooks Time (formerly TSheets). Automating the process of entering employee work hours into your payroll system lowers the risk of error vs doing it manually.Most payroll software will enable you to override time card or payroll data manually, such as when a worker forgets to punch in or out or when a worker is paid a bonus. However, you should always note those changes.
Ensure Overtime Hours Are Calculated & Paid Correctly
A common payroll issue many employers experience is not paying workers overtime correctly. Most states require overtime to be calculated at time and a half, meaning that for every hour an employee works past 40 hours in a pay period, they get paid 1.5 times their regular rate. However, California laws calculate overtime differently.
Check to make sure you’ve calculated and paid overtime correctly per your state requirements. If not, you’ll want to remedy this issue immediately with retro pay. To verify that you’ve paid out the right amount, especially if you process payroll manually, you may need to recalculate some payroll transactions.
To start, find a list of your pay runs and choose a few transactions that include overtime pay. Multiply the 40 regular work hours by the regular pay rate—for example, 40 x $20 regular pay rate = $600. Then, find your overtime pay rate by multiplying it by 1.5 or time and a half. For example, $20 regular pay rate x 1.5 = $30 overtime pay rate.
Finally, you can multiply the hours worked of more than 40 in the pay period, which could differ depending on your state, by the overtime pay rate. For example, 10 overtime hours x $30 overtime pay rate = $300 overtime pay.
In the instance above, the employee’s paycheck should reflect gross earnings of $900—$600 regular pay + $300 overtime pay. If there are differences, you’ll need to backtrack and figure out what the problem is. Incorrectly paying overtime could subject you to fines and penalties. In addition, you may owe more money in taxes.
Verify Tips, Bonuses & Commissions
Some employers running restaurants and service businesses may need to verify that additional payments are being tracked and managed correctly. These include tips to workers in services like hair salons and fine dining establishments or in a sales environment in which staff may earn bonuses or commissions. You should be tracking these amounts as they’re earned and paid and ensure the resulting pay matches on paystubs.
You can view employee tip data, amounts, dates paid, and more on the tip reports. Bonuses should be classified as what they are versus regular pay, so you know that they don’t tie to the employee’s work hours. Also, you should have documentation in your files to support the payout; for instance, it should be clear what the bonus is for (performance, holiday) and who approved for it to be paid.
As for commission payments, don’t just look at the payroll register and stop. Dig deeper to find paperwork that shows how the commission payment was calculated. You should know how many sales the employee made and which products they sold to earn money. You’d be surprised at how many people will inflate the numbers, especially when it affects their pay, and there’s no oversight.
5. Run a General Ledger Report
Your general ledger (GL) shows every transaction that occurred within your company, which means it is essential for conducting an effective payroll audit. If there are any amounts in your payroll records that you cannot trace back to the general ledger, you will need to do some research.
For payroll, you’ll typically have expense and payable accounts. The expense accounts show what expenses your business incurred (wage expense), and the payable accounts show the amounts that your business owes others, such as Social Security and Medicare (FICA taxes), consists of both the employer’s and employee’s taxes due.
Primarily, your goal is to verify that amounts in your payroll records jive with what’s on the books—accountant’s term for GL. Note that these records won’t reflect work hours paid but rather amounts paid, so you’ll need to trace the payroll transactions you choose to analyze for the audit throughout the entire process from timekeeping system to payroll records to GL. If you want to mirror real-life auditors, you’ll start by choosing random transactions in the general ledger and work back to verify that they tie with your other records.
Verify Federal & State Tax Payments & Deductions
As an employer, unless you have a full-service payroll solution like QuickBooks Full-service Payroll, it’s on you to pay federal, state, and sometimes even local payroll taxes. As you start reviewing your payroll tax general ledger accounts, you may have to spot check a few employee W-4 forms to ensure you’re withholding the correct tax amounts for those employees. You’ll also need to ensure you’re paying the right amount of taxes. Because you expense some taxes and merely withhold the others from employee paychecks to pay later, this can get tricky.
There are two kinds of payroll taxes you pay as an employer:
- Taxes you pay based on overall payroll like FICA, Supplemental Security Income (SSI), and unemployment insurance (UI), which are employer payroll taxes
- Taxes you withhold from each employee’s paycheck and pay on their behalf to the various agencies on your employees’ behalf
Regardless of whether you remit your payroll taxes quarterly or annually, there will be a delay from the time the expense and liability show up on your books until they are paid. You must trace some of these transactions to ensure they are being handled correctly.
For example, when you pay quarterly taxes, the monies held from January to March shouldn’t still be sitting in the taxes payable account in September. The amounts will enter your taxes payable accounts as credits on each payday and clear as debits when you pay the IRS. If the amounts in your tax payable accounts are steadily increasing throughout the year, even at the end of the quarters after payments should have been made, there’s a problem.
If your payroll tax accounts don’t seem to be clearing properly, and you’re sure you’ve been paying the IRS, start with the cash GL account. The best way to search is by dates. Find all transactions that posted on and around the date you believe you paid the taxes—pull a receipt or some other tax documentation to help you pinpoint.
Look for the amount of the payment in the GL account, and once you find it, you should be able to see the other side of the transaction, especially if you’re using accounting software like Intuit QuickBooks. If the other part of the transaction doesn’t show your tax payable account, that would explain why your accounts aren’t clearing. You’ll need to see where the charges are going and make some corrections to your books. This is essentially payroll accounting, so you may need to solicit help from your bookkeeper or certified public accountant (CPA).
Verify Nontax Deductions are in the Correct Accounts
Most employers deduct monies from an employee’s paycheck for benefits, uniforms, or court-ordered judgments like child support. You should verify your payroll deductions are being booked properly by following a similar process to how we suggested you trace your payroll tax transactions from beginning to end. This will confirm your end-to-end payroll deductions are functioning properly. If not, you’ll need to do some further investigation into the reasons.
Look at the funds withheld on a payday and follow through to ensure those funds were credited to the correct account for holding and then immediately debited in the proper time frame. For example, 401(k) contributions and health insurance premiums can be sent to the provider every payday or at month’s end.
Also, be sure to check that the benefits premiums that your employees are responsible for paying are coming out of their paychecks, so check a few paystubs. If not, and you are paying the full invoice when it comes in, your company is eating the entire expense.
Here are some of the employee deductions you should verify:
- Health insurance: Are employee health insurance deductions being placed in the correct insurance payable account with payments being made to the health insurance carrier on time. Are they being credited to the correct employee?
- Garnishments: Are garnishments being tracked with deductions being made against the employee’s paycheck? Are withheld amounts paid to the requesting agency on time from a garnishments payable account?
- Retirement: Are 401(k) employee and employer contributions being sent to the bank at the end of each pay period? Is the employer contribution amount or percentage correct?
To make payroll auditing easier, you may want to have a separate payables accounts set up for each vendor, if reasonable, or deduction type. For example, some states require employers to provide commuter benefits, so that would be a separate account for payroll accounting purposes.
Verify Payroll Account Data Matches Bank Account Data
By looking at bank account statements and comparing them to your payroll cash GL account, you’ll notice if amounts are being paid out of the cash account that doesn’t belong. You may also find that some employees haven’t cashed their final checks or that a payroll amount was paid twice to the same worker. Those are issues you’ll want to address. You may need to void and reissue the check if you can contact the terminated employee; we recommend reaching out a reasonable number of times. If you’re unable to reach the employee, you’ll need to send the check to the state as unclaimed funds.
6. Look for and Document Any Atypical Transactions
This is where you’re doing a gut check and looking for anything that’s out of the norm. If you see an employee is paid $2,600 every pay period for 3 months and, all of a sudden, they receive a $5,000 paycheck, you should research it. If you notice a garnishment payment that seemingly starts all of a sudden, and you have no knowledge of it, dig deeper. You’ll want to verify it and make sure you’re abiding by the court document.
Other transactions to look out for are prior-period payments coded as retro pay. Is the reason for the payment documented? And if you hire freelancers, are they being paid through payroll or accounts payable? Either way, you’ll need to process a year-end 1099, so you may as well audit your W-9 forms.
Examples of atypical transactions to look for and monitor are retro pay, back pay, garnishments, and freelancer pay.
Retro pay is typically a line item that’s added to an employee’s paycheck when you’re paying them after a payroll mistake has been made in a prior pay period. Maybe they got a raise, but it wasn’t processed on time, or perhaps they forgot to tell you they worked 6 hours on a Saturday. Those retro amounts are added to their current paycheck and should be infrequent.
Back pay is due when you’re ordered by a government agency to pay a person for prior pay periods due to, for example—miscalculating overtime pay, paying a worker below minimum wage, or docking their pay illegally. In cases of wrongful termination, back pay may be ordered by the court as part of the judgment. Being ordered to pay back pay often indicates that you have an HR or payroll compliance problem in your business that you’ll want to fix going forward.
Garnishments, like child-support, are managed differently in different states. The IRS may also garnish a person’s wages for back taxes. Ensure your garnishment documentation is on file for payroll record-keeping purposes as well as that the correct amounts are being deducted and paid.
Some businesses use their accounts payable software to manage payments to freelancers while others add those workers to their payroll system using an indicator that shows they’re not an employee and that they pay their own taxes. Be sure your business is not expensing payroll taxes on the amounts paid to freelancers. Also, to avoid tax violations, make sure that your freelancers are classified correctly.
“Verify that employees are being paid the correct amounts with accurate contributions. When employees take PTO [paid time off], sick days, or leave from work, a great deal of paperwork and updates need to be made to keep everything accurate and in check. Conducting a payroll audit after a season of promotions, raises, and bonuses is vital to catch any errors. This is when most updates are made and when the highest errors are possible. Make sure all zeroes and decimals are in the right place. Could you imagine if you gave someone an extra zero next to their monthly salary?”
—Jared Weitz, CEO & Founder, United Capital Source Inc.
7. Reconcile Payroll Accounts With Bank Account
In addition to looking at what’s in the general ledger, it’s not a bad idea to take a look at the specific bank accounts you have set up to manage payroll payments—employee payroll checks and direct deposits—as well as payroll tax accounts.
Make Sure the Numbers Match
Banks sometimes make mistakes. Perhaps they’re issuing paper checks when you have all your employees signed up on direct deposit, or maybe there are some reversals or fees on your bank statement that don’t look right. Compare what’s in your general ledger accounts to balances and transactions in your bank accounts used for payroll processing and make sure they line up.
Look for Any Uncashed Checks
Checks that have gone uncashed for a year or more need to be managed according to your state’s escheat laws, commonly known as unclaimed property laws. The check amount belongs to the employee, but how you handle it varies by state. For example, in some states, you must turn over unclaimed funds to a state agency.
Confirm Tax Payments Are Made Correctly & Timely
By looking at your bank statement and comparing it to the tax agency due dates, you can determine whether tax payments are being made on time. Even if you’re working with third-party payroll software that manages your tax payments, mistakes can happen. In those cases, you—not the payroll processor—are typically liable for late tax payment penalties.
Payroll Rules Vary by State
Rules for processing payroll, such as pay period limits, minimum wage, and pay stub requirements vary by state. Some states let you mandate direct deposit, but others don’t. Some states require you to give an employee their final paycheck the same day you fire them. Others don’t allow semi-monthly pay. As you’re auditing your payroll, it’s not a bad idea to confirm that your company’s payroll process, timelines, and rules are in sync with what’s required by businesses in your location and industry.
Using online self-service payroll software like QuickBooks Payroll that links to your QuickBooks accounting software is a great way to ensure state labor law compliance for your business. QuickBooks Payroll has built-in programming rules that will flag errors if, for example, you attempt to set up payroll in a way that violates state law. It also makes payroll auditing easier by having accounting and payroll synced within the same application.
How a Payroll Audit Works
Payroll audits work by verifying data across the various accounts and software systems that manage your employee data, such as employee job classification like exempt vs nonexempt, pay type like salary vs hourly, pay rate, and overtime rules. They work as a risk-avoidance tactic to prevent you from making mistakes that may end up being costly to your business or reputation.
Further, by auditing payroll, you’ll be able to uncover both innocent mistakes and fraudulent activity. Perhaps your admin switched to part-time but is still being paid a full-time salary. On the more nefarious side, a staffer with access to payroll and bank accounts can deduct money from one account to pay herself extra. Your payroll audit will likely catch that.
One of the best practices is to have separate individuals manage employee data vs time worked data vs payroll data. For example, if HR can add a new hire, they shouldn’t also be allowed to make payroll changes. Instead, you need segregation of duties to eliminate any temptation for staffers to steal from you. Payroll audits then verify that your processes are being followed.
“Verify proper controls are in place and verify the controls are not defeated. For example, you don’t want to have one person in charge of the entire process. One person could set up a new ghost employee, issue a new check to that employee, intercept the check or payment and steal money. Ideally, one person would initiate the payroll process, a second person would review and approve the checks, and then the owner or check-signer would sign the checks. These controls provide a system of checks and balances over the payroll processing cycle.”
—Ken Stalcup, CPA/ABV, CFE, CFF, Senior Director, Houlihan Valuation Advisors
Frequently Asked Questions (FAQs) About Doing a Payroll Audit
You may have questions when conducting your first payroll audit.
Who should conduct the payroll audit?
In a small firm, if you have time, you can do it yourself by using our payroll audit checklist. What you don’t want is the person doing payroll to audit their own work as it’s too tempting for them not to report issues. Instead, consider hiring a temporary worker to audit your payroll, using an accounting firm, or having a finance manager audit your payroll files. Give them the payroll audit template and have them report their findings back to you.
Can software make payroll auditing easier?
These days, there are software programs to manage employee data, scheduling, timekeeping, and payroll. Many of these interface with each other, meaning you can input data in one system, and then it passes to the next. Shared data may include hire dates, pay rates, weekly hours worked, benefits enrollment, and more. You can then run reports to simplify payroll auditing.
What do professional payroll auditors look for?
Professional payroll auditors are looking for data discrepancies across all employee payroll data, from time worked data to bank accounts used to pay employee withholding taxes. What’s different is that they may not have access to your software as you do and, instead, will rely on data—employee files, payroll registers, timecards, and bank account statements—that you provide them. Then, using a checklist similar to our payroll audit checklist, they’ll confirm both the accuracy of your payroll processing as well as report any issues they find.
How does a payroll audit verify salary?
Often, a salary is documented on an offer letter for a new hire, or a promotion form for an existing employee. It’s best if you keep track of the date and dollar amount when you give someone a raise. That way, when you do a payroll audit, you can confirm that the person is being paid the correct annual salary.
To determine that the hourly, daily, weekly, or pay period equivalent is correct in your payroll system for the salary you’ve promised, you’ll need to take the annual pay and divide it by the unit of measure. For example, if you pay $25,000 a year to your sales reps who are paid weekly, you’ll want to make sure the weekly pay times 52 weeks equals the annual rate.
You don’t have to wait until year-end to do a payroll audit. Listen to your gut. If something looks or feels off in your accounting system or payroll bank account, it’s time to investigate. After all, it’s your money at risk, and it’s your business reputation at stake if payroll violations crop up that you aren’t aware of, you get fined for late taxes or sued for unfair pay practices.
Using online payroll software like QuickBooks Payroll makes payroll compliance and your payroll auditing practices easier. That’s because it integrates with QuickBooks accounting software so that transactions are captured accurately, and you can view payroll and accounting data on simple reports. Plus, your payroll calculations are more likely to be correct in the first place. Take advantage of QuickBooks Payroll’s discounts today.