The Complete Guide to Payroll Audits

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Ensuring accurate payroll is an important, but often overlooked, part of operating a business. Our comprehensive guide will break down the key elements of auditing the payroll process successfully. We’ll provide tips that are immediately ready to implement along with long-term strategies.

Why Payroll Audits Are So Important

The majority of HR departments almost certainly believe they would be able to spot any payroll discrepancies. They may not believe running regular audits will do any good, because they don’t make mistakes. Or, after they run multiple audits with no problems, they may become complacent about running further audits.

However, it just takes one error or one employee trying to commit fraud to create a potential disaster. A regular audit should catch these problems before a significant issue occurs.

Because payroll represents such a large percentage of a company’s budget, any payroll errors or instances of fraud may lead to significant financial issues in a hurry.

Some of the most important reasons to perform a payroll audit include:

  • Deep dive on data: The audit process provides a detailed analysis of the company’s payroll information. Going into such detail isn’t something a company will do under normal circumstances, so the audit is important to perform occasionally.
  • Find areas of weakness: When running an audit, it should identify areas where the company could be vulnerable to fraud or errors in terms of its payroll. This can help the company make changes before fraud occurs.
  • Review tax withholdings: For an organization that sees a lot of turnover in employees, calculating tax withholding can be a huge challenge. Audits ensure all of the numbers line up properly.
  • Catch manual errors: Even for a payroll department that automates much of its data entry, some information may require manual entry. An audit can catch any problems from transposed numbers or similar errors that are possible with manual entries.

Dealing With Payroll Complexity

The complexity of a company’s payroll plays a key factor in determining how the audit will work.

Payroll audits that involve a company with a couple of dozen employees on the payroll in a single office should go quickly. Smaller numbers of employees who all receive a base wage without commission represent a simple type of payroll, leading to a quick audit.

However, for a company that has several hundred employees or more spread across multiple locations, the calculation of payroll is more challenging. Add in the use of contractors or freelancers, and running payroll becomes very complex. Consequently, the payroll audit requires more time.

Always plan for enough time and personnel to handle whatever payroll audit process the company is facing. Audits that will be more complex need extra time and personnel dedicated to the audit versus a more simplistic payroll situation.

Case Study: Payroll Fraud

Certainly, coming up with a plan to commit payroll fraud is nearly impossible for an average employee. When an organization’s HR and accounting departments maintain strict internal controls and policies regarding payroll oversight, it often can prevent fraud. 

However, as the Journal of Accountancy documented in a real-world case, an employee who has the motivation to commit payroll fraud may figure out a way. 

In this case study, an employee for a non-profit organization who was facing mounting personal medical bills committed payroll fraud. He was able to steal the user ID and password for a co-worker who had system management permissions. (Implementing two-factor authentication for the payroll services software could have put an end to this scheme before it started.)

The employee then used these login items to create ghost employees, or fake employees, who would receive a salary. 

Because the employee committing the fraud had an exemplary work record, he was able to con supervisors into signing forms that approved the ghost employees. They didn’t verify the information on the forms, instead simply trusting the employee.

With the ghost employees’ records in the system, the payroll runs generated paychecks for the ghosts. The employee committing fraud was able to have the ghosts’ paychecks deposited into his account. 

Eventually, the organization ran a payroll audit, which quickly identified the ghost employees as fake. Auditors used paper backup copies to track down the exact discrepancies. They then used payroll audit reports to discover the scheme and charge the employee.

Quick Tips to Improve Payroll Audits Today

When making the decision to start running regular payroll audits, taking the first step can seem daunting. We’ve collected some ideas to help with preparing for and starting the process, leading to a better result.

Tip #1 — Treat the Audit As a Necessity

Sometimes, an accounting department may balk at running a payroll audit. If the department personnel have their processes and steps in place for managing payroll, they may not want to run an audit. They may fear having to make changes to how they run payroll and operate the department.

Some personnel may feel like running a payroll audit is the equivalent of an accusation of mistakes or outright fraud in the department. This can cause resistance to running the payroll audit. 

It’s important to explain the reasons for undertaking a payroll audit to all employees. Finding mistakes doesn’t necessarily mean that an employee is in trouble or is committing fraud. It just may mean that some of the payroll processes need tweaking to ensure maximum safety.

Having everyone on board and ready to accept the results is a key first step before running the audit.

Tip #2 — Seek External Help

Even with the best payroll software in place to collect the information, the first time a company goes through a payroll audit, it can be a daunting process. For some companies, it can be helpful to hire an outside accounting firm to guide them through the audit process the first time.

Hiring consultants to help with the payroll audit may not be necessary in every situation. For a small company with a basic payroll process, using only internal people can work successfully. 

However, the right consulting firm can provide valuable information for internal employees who are leery about running the audit. They then likely will feel more comfortable tackling the payroll audit process on their own the next time.

As an added benefit, the consulting firm may be able to provide guidance on how to proceed if the audit unveils problems or discrepancies.

Tip #3 — Establish a Policy for Paying Employees

If the company doesn’t have a policy in writing regarding the classification of employees and the calculation of wages, it should establish one before running the audit.

Some of the items a policy should have include:

  • Wage calculations
  • Starting pay ranges for categories of jobs
  • How the company awards raises
  • How the company awards bonuses
  • When promotions may happen
  • Frequency of pay periods
  • Qualifications for receiving benefits

The policy should be transparent. Employees have a clear understanding of how they receive pay and which items trigger changes in pay. When employees know how the pay system works, they perhaps can help to catch potential errors in the payroll system before the audit event occurs.

When the audit runs, it will be able to compare the payroll results to what’s in the policy. Without specific guidelines about how employees receive pay in place, the audit may return unusual results. It may mark items as errors that actually represent normal company policy, but that need to be part of a written policy.

Tip #4 — Start Using Payroll Software

For companies that want immediate help with running a payroll audit, beginning to use online payroll software is a smart starting point.

Our favorite selection for payroll software is Gusto. It delivers the best set of services for the majority of businesses and organizations. Smaller companies will be able to access features normally limited to larger companies with Gusto. Large companies will have a wide range of features they need to handle complex situations.

Gusto offers a variety of features where employees are able to monitor their own payroll records. This helps with reducing errors and discrepancies in terms of overtime pay, vacation pay, hours worked, and other items. When employees monitor their own pay information, they can spot errors faster than someone in the accounting department can.

The Gusto software also has built-in features for things like calculating tax withholdings for employees. This creates a greater likelihood of accurate information versus trying to make manual calculations.

Additionally, compliance becomes easier when using software like Gusto.

Long-Term Strategies for Payroll Audits

After implementing some of the quick tips we mentioned earlier, an accounting department then can focus on some longer-term ideas to reduce errors and to have more successful audits.

#1 — Reduce Manual Entries

The most common reason errors show up in a payroll audit has nothing to do with fraud. Far more often, it involves someone making an error while entering data manually.

Should payroll department employees have to perform calculations manually before entering the data, the chances of errors increase even more. This may occur if someone is trying to add up hours on a time card by hand before entering the number into the payroll software, for example.

Typographical errors are more common than you may think too, especially when someone is entering numbers for hours at a time. When trying to hurry to enter the numbers, the chances of mistakes increase.

Review any processes the payroll department uses that require manual calculations or data entry. Try to automate those processes wherever possible. One of the best online payroll services, such as Gusto, can help with the automation process. 

#2 — Eliminate Unnecessary Payroll Runs

Companies may attempt to avoid running payroll outside of the normal designated time, such as every two weeks. However, employees sometimes may ask for special payroll runs to handle bonuses or quarterly commission payments faster. 

In the most extreme circumstances, these off-cycle payroll runs could be a sign of fraud. A payroll department employee may trigger an off-cycle payroll run to try to collect extra paychecks. The more payroll runs that occur outside of the typical time, the more chances that exist for someone to try to commit fraud. 

For a company that frequently runs off-cycle payroll, adopting a policy to greatly limit or stop these runs is a good idea.

Should a company have some payroll security issues, it’s important to fix them. But until the company can take all of the steps required to overcome these issues, reducing the number of payroll runs will help. Having fewer payroll runs reduces the chances of security problems popping up.

#3 — Verify Compliance With Regulations

Companies must remain in compliance with federal, state, and local employment laws. When it comes to paying overtime, for example, employers can receive penalties when they don’t calculate the payments for overtime correctly.

Other types of non-traditional compensation require proper labeling within payroll. Bonus payments or commissions must have the proper labels. Accounting departments can’t just count commission as extra hours worked, or it could end up with a violation of overtime regulations.

Regular audits can catch any discrepancies in overtime pay and in other regulations, allowing the company to self-correct the issues before receiving fines.

Using online payroll service software can help with keeping the company in line with all regulations. 

#4 — Verify All Payroll Records

When running a payroll audit, the company has a chance to make certain that all of its employment records and payroll records match up properly. 

As businesses grow, they will have turnover in the employee ranks. Frequent turnover can greatly complicate maintaining accurate employee records. Some record changes may slip through the cracks inadvertently. Regular audits catch these problems before they become bigger.

Should an administrator who adjusts the employment records purposefully leave someone on the rolls who quit weeks ago, this could be an attempt at fraud. Audits will catch these problems.

Additionally, payroll audits should catch other problems, including:

  • Incorrect calculation of vacation pay
  • Incorrect calculation of paid time off
  • Incorrect calculation of federal and state income tax withholdings
  • Incorrect calculation of Social Security and Medicare tax withholdings
  • Incorrect assigning of employee job classifications
  • Inconsistencies between payroll, employment, and accounting records

When making use of online payroll software, it can maintain integration between payroll, employment, and accounting records. This simplifies the process of achieving accuracy throughout the system.

#5 — Set Up a Policy for Running Audits

It’s important to have policies in place for the company’s plans for payroll audits. With rules in place about things like who will run the audit and the frequency of the audit, the process will go smoother.

Enacting policies ensures that audits will occur on a regular basis. Employees must stick to the policy for the payroll audit, rather than putting off running the audit because the company is going through a busy time.

A company’s payroll audit policy may include:

  • Frequency of audits: Depending on the complexity of the company’s payroll needs, some companies may want to run audits three to six times per year. If a small company’s payroll is without complexity, running a payroll audit once or twice per year may be enough.
  • Checks and balances: Companies need to make sure that those running the payroll audit are trustworthy. It helps to have a few people involved in the audit process for checks and balances, guarding against the possibility of fraud. Having one person control the audit can cause potential fraud issues.

Next Steps

With plans in place for running a payroll audit, think about how the company will react if it finds issues. Being prepared for any eventuality allows for a faster response time. 

The company should not take discrepancies lightly. Dealing with any problems quickly gives the company the best chance of avoiding a major violation.

The idea of running a payroll audit is to help the company find problems before fraud occurs. So don’t ignore any identified problems. Have the team ready to respond to fix the issue as quickly as possible. 

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