What’s the highest expense on your income statement? Let me guess. It’s payroll.
Payroll is the leading expense for most small businesses, and it’s also one of the most complex. That’s why small business owners can only benefit from spending extra time inside their payroll account to root out errors.
Overview: What is a payroll audit?
A payroll audit verifies that your business is paying employees accurately, timely, and in compliance with the law.
Payroll audits are two-pronged. The first step is making sure your payroll records are accurate, timely, and complete. After making any corrections to any errors uncovered in the first part, it’s time to identify faults in procedures — called internal controls — that have led or could lead to inaccuracies.
Business owners should conduct payroll audits at least once a year to identify and remedy problems in their payroll systems. You can do it yourself or delegate the task to a trusted employee. If your small business budget allows, an outside accounting firm will complete a payroll audit for you.
Businesses of all sizes should complete payroll audits, but it’s particularly crucial for small businesses. The Association of Certified Fraud Examiners found in its that payroll fraud is twice as likely to exist in small businesses than large businesses.
3 benefits of conducting an internal payroll audit
Auditing payroll can take a couple of weeks if you’re juggling running a business simultaneously, but they are hours well spent. Here’s why you should conduct an internal payroll audit at least once a year, and preferably twice.
It deters payroll fraud
Payroll fraud disproportionately plagues small businesses. Making it known that you do a sweep in your payroll accounts every six or 12 months could dissuade employees from trying to get one over on you.
It uncovers errors
You’re more likely to find payroll errors than flat-out fraud during a payroll audit. And for every mistake you catch, that’s another one prevented for the future.
Regularly checking for payroll errors reduces the likelihood of run-ins with the IRS, too. Noticing employment tax underpayments early can save you money and hassle. Penalties pile up monthly.
It improves legal compliance
An integral part of the payroll audit process is comparing your payroll policies with federal, state, and local mandates. Overtime and state minimum wage laws can change from time to time, so studying compliance laws should always make it on your payroll audit checklist.
How you can perform a payroll audit for your business
Let’s dive head-first into your payroll spreadsheets to see what’s going on. Here are the main payroll audit procedures you should complete once or twice a year. You might want to work with an accountant to devise an internal payroll audit checklist tailored to your company.
1. Scan your employee list, pay rates, and hours worked
Check that everyone on the payroll is a bona fide employee and is taking home the correct pay rate.
Many payroll fraud schemes involve ghost employees. Rather than haunting your house or your dreams, ghost employees spook your business bank account. Unscrupulous payroll administrators will sometimes add fake employees to payroll and funnel the earnings into their own pockets. Ghost employees are set up using fake names or by repurposing a former employee’s payroll accounts.
This step shouldn’t take long for payroll software users. Most payroll solutions have a section that lists every worker on your payroll.
2. Confirm pay rates and hours worked
Those in charge of payroll might have changed employee pay rates or hours worked to help themselves or a friend take home more than you agreed to pay. They may just as easily adjust the number of hours an employee worked to bump up their total compensation.
Your business should have pay stubs and timesheets for every pay period and every employee. While it might take you some time, it’s worth making sure there were no transposition errors or fraudulent alterations.
3. Verify variable payments
Take some time to review all variable payments for proof of authorization. Your payroll journal should break out variable pay separately from regular wages and salaries.
Holes in internal controls could give payroll clerks the ability to award bonuses unbeknownst to those in charge.
Examples of variable pay include:
- Shift differentials
4. Scrutinize off-cycle payroll
Let’s put the “counting” in “accounting.” Count the number of payroll runs in the period you’re auditing. Compare the number of payroll runs to how many should have occurred.
For example, a business that follows a semi-monthly pay period should count 24 payroll runs in a year. If the business had 25 payroll runs, investigate what happened.
There might be nothing wrong. Some businesses process variable payments, like bonuses, separately from regular payroll, which would create an additional payroll run. Atypical payroll runs are called “off-cycle payroll.”
However, it’s taking a look at all off-cycle payroll runs for nefarious activity. A payroll administrator might have accidentally run payroll twice for one pay period, for instance.
5. Do a payroll reconciliation
The payroll reconciliation marks the most time-consuming — and most vital — piece of the payroll audit. A payroll reconciliation compares your payroll records to the general ledger.
Many modern small businesses have two separate but integrated software solutions for payroll and accounting. Payroll software will run payroll, pay employees and taxes, and send the data to the accounting software.
The data is transmitted in the form of journal entries, which is how accountants record transactions. The payroll reconciliation process confirms that nothing got lost in translation and that taxable wages and deductions were calculated correctly.
It’s best practice to complete a payroll reconciliation before every payroll run to prevent errors from happening.
6. Reconcile internal payroll records with tax forms
Now that you can vouch for your payroll records' accuracy, make sure they match what’s reported on employment tax forms 940 and 941.
Businesses report Federal Unemployment Tax Act (FUTA) tax on Form 940, which is filed annually. Federal Insurance Contributions Act (FICA) taxes and federal income tax withholding get reported on Form 941, a quarterly return.
Pull a payroll tax report for the period under audit and verify that your payments to FUTA, FICA, and federal tax withholding match what’s reported on 940 and 941.
States have their own versions of forms 940 and 941 for reporting state-level taxes and income tax withholding. Follow the same process using those forms.
7. Search for outstanding tax liabilities
Most payroll software create outstanding tax liability reports that detail tax payments that it couldn’t make on your behalf. It’s ultimately your responsibility to make timely tax payments.
Payroll software can miss tax payments for any number of reasons. For example, every time you start paying an employee who lives in a new state, you might need to get a unique state-specific tax identification number. The onus turns to you to make payroll tax payments in the interim. Talk to an accountant before running payroll with employees living in a new state.
If there are outstanding payroll liabilities that you missed, send in the payment promptly.
8. Identify areas for improvement in the payroll process
No more numbers from here until the end.
Payroll audits should get more comfortable each year. As you implement new internal controls, you should find it easier to gather the necessary documentation and make fewer errors during the year.
Before the payroll audit winds down, think about updating your policies for:
- Approving timesheets: Timesheets should be submitted by a specific time every week, and a direct supervisor should approve them before payroll is run.
- Authorizing bonuses: Businesses should communicate variable pay in writing to the employees receiving it. Include the amount and the date of payment.
- Access to payroll records: Limit access to payroll records to those who need them to do their jobs.
9. Ensure compliance with labor and recordkeeping laws
I’m putting this last, but this step can happen at any point in your payroll audit program. Get cozy with the federal Department of Labor and state labor department websites. That’s where you’ll get the most trustworthy updates on minimum wage changes, overtime laws, and payroll recordkeeping policies.
It’s important to stay apprised of changes to labor laws. Falling out of compliance with labor laws is not only unfair to your employees, but it’s also going to cost your business money.
Find a mistake? Ask for help
Not every payroll error leads to the IRS knocking on your door, but it’s a good idea to bring them up to an accountant to ensure your corrective action doesn’t cause more of a blunder. If you suspect fraud, don’t hesitate to bring in a legal professional to help you navigate your next steps.