Keys to a Successful Payroll Audit

The Purposes
There are three main reasons why a company may conduct a payroll audit: statutory and regulatory compliance, compliance with internal policy, and due diligence prior to a merger or acquisition.

First, every company needs to comply with the Fair Labor Standards Act (FLSA) as well as laws for the states and municipalities in which they operate. A payroll audit should be conducted with those federal, state, and local laws in mind to confirm compliance or identify gaps under current or anticipated laws and regulations.

Second, companies often have internal policies and procedures that may be more stringent than statutory or regulatory requirements. A payroll audit can help confirm compliance with these internal policies and procedures.

Third, a payroll audit can be critical to determining existing liability before acquiring a company. This evaluation can be embedded into the merger and acquisition due diligence process, and should be completed before the transaction is finalized so that reserves can be made accordingly.

The Players
There are three groups of people that should have a stake in the audit: outside counsel, external consultants, and company representatives.

Special care should be taken during the payroll audit because any work product from the audit could be made available during discovery in a future lawsuit. As such, all audits should be conducted under privilege at the direction of outside counsel. Furthermore, counsel can work with the company on specific issues or remediation and coordinate with outside consultants on deeper, more thorough analyses.

For payroll audit to be truly successful, thorough data analysis will be required. External consultants skilled in data analysis and labor regulations are indispensable during this process to perform in-depth analysis of the data and detailed, complex calculations to determine risk areas and potential remediation. They also allow for independent, third-party review of the data. Consultants should be engaged by outside counsel and work under their direction.

Finally, key stakeholders know the company’s data and the internal policies with which employees should be complying. A series of interviews with the person most knowledgeable (PMK) of the data will identify the available key data sources and the format and structure of that data. An interview with the PMK in the company’s human resources group will assist in identifying potential risk areas for exploration; and an interview with the PMK in the payroll department will assist with understanding historical payroll processes and procedures, including how regular rate and overtime payments were calculated during the normal course of business.

Other Key Considerations
Two other key considerations include the scope of data requests and the location of the company.

Data requests should be proper and sufficient, but not burdensome. A payroll audit does not need to be conducted on all available data. It can be based on a sample of available information that should be sufficient to cover any potential issues that may arise. For example, if the company has an annual bonus and the purpose of the audit is to determine whether the regular rate of pay is being properly calculated, then at least one year of data is required to audit the calculation. However, if the purpose of the audit is to evaluate meal and rest break compliance, the data from several pay periods for all employees may be sufficient. The scope of the data request should fit the purpose of the audit and typically includes timekeeping and payroll data, pay stubs, and payroll check images.

Federal regulations are different than state and local regulations. To do a proper payroll audit, attention must be paid to the geographical area in which the company is operating or will be operating. For example, the FLSA requires overtime payments for time worked over 40 hours per week, but states including California, Colorado, and Nevada also have daily overtime requirements. The FLSA also requires that additional compensation (e.g., shift differentials and nondiscretionary bonus payments) be included in an employee’s overtime pay rate. We discussed these issues in a previous article.

There is no federal requirement for meal and rest breaks, although these breaks may be required under state or local law or industry regulations. For example, California requires a meal period of no less than 30 minutes by the fifth hour of work for employees that work more than six hours, and Illinois requires a 20-minute period by the fifth hour of work for employees that work more than 7.5 hours in a shift.

Finally, there are other issues, such as minimum wage, that also differ by state and at the federal level. While there are states without a minimum wage separate from the federal minimum wage, other states, such as California and New York, have set their own, higher minimum wage. There are also further considerations at the local level. For example, Seattle has a $15 minimum wage, which is higher than the Washington state minimum wage of $11.

Conclusion
Although the idea of a payroll audit may be perceived as an unnecessary cost, the audit provides a tremendous upside by determining potential liability before any litigation has started. Companies can use this process to identify risk areas, minimize financial exposure during the acquisition of another company, and/or minimize the potential risk of a future lawsuit and associated penalties or findings of willfulness.

Jeremy Guinta is an associate director and Angela Sabbe is a director in the Global Disputes and Economics Practice at Navigant in Los Angeles, California.

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