One of the first things employers notice after receiving an audit notice from the Washington Department of Labor & Industries (L&I) or the Employment Security Department (ESD) is the extensive list of records the auditor requests. Many business owners are surprised by both the number of documents requested and the variety of records involved.
At first glance, the requests can seem overwhelming. Why does the auditor need bank statements? Why are they asking for your general ledger? What do your federal tax returns have to do with workers’ compensation premiums?
The answer is simple. The records request isn’t just a checklist item. Each document helps the auditor answer a different question about your business, and together they often tell the story the auditor relies on throughout the audit. Essentially, the auditor is trying to answer three basic questions: Who performed work for the business? Were those workers properly classified? And were all required wages, premiums, and taxes properly reported? Every record requested helps the auditor answer one or more of those questions. And understanding why an auditor requests certain records can help employers organize their response, anticipate the issues the auditor is evaluating, and better understand the audit process.
Below are some of the most common records requested in an L&I audit and why the auditor wants to review them.
Pre-Audit Questionnaire
The Pre-Audit Questionnaire is the auditor’s first introduction to your business.
Before reviewing payroll records or financial statements, the auditor wants to understand what your business does, how it operates, how workers are engaged, and how your books and payroll are maintained. The information you provide here often shapes the auditor’s understanding of your business throughout the audit.
Practice Tip: One of the first things we do is review the questionnaire with our client before it is submitted. It often becomes the auditor’s first impression of the business, so we want to make sure it accurately reflects how the company operates and doesn’t unintentionally create confusion that carries through the remainder of the audit.
Employee Information Sheet
The Employee Information Sheet supplements the questionnaire by identifying your workforce and providing additional information about your employees. It helps the auditor to begin reconciling the people who work for your business with your payroll records and tax filings. If your business uses both employees and independent contractors, this information also helps the auditor understand how your workforce is structured and which workers were treated as employees versus independent contractors.
Practice Tip: We compare the Employee Information Sheet against the payroll records and other documents that will be produced during the audit. Even minor inconsistencies can prompt unnecessary questions, so we try to identify those issues before the records are submitted.
Time Sheets
Time records allow the auditor to verify that employee hours were properly reported to L&I.
For businesses with hourly employees, these records are particularly important because workers’ compensation premiums are generally based on hours worked. The auditor will often compare time records against payroll summaries to confirm that the reported hours are consistent. If work was performed by independent contractors who may have been misclassified, the auditor will want records showing how that work was tracked or documented, even if traditional employee time sheets were not maintained.
Practice Tip: We review time records for completeness and compare them against the payroll summaries. If there are missing records or inconsistencies, we’d much rather identify them ourselves than have the auditor discover them during the audit.
Payroll Summaries
Payroll summaries show what each employee was paid during the audit period.
The auditor uses these records to compare your payroll with what was reported to L&I, ESD, and the IRS. The objective is not necessarily to find mistakes. Rather, the auditor wants to determine whether all of your payroll records are consistent with one another. The auditor is also looking to determine whether your payroll records are consistent with your other business records.
When your payroll summaries, quarterly reports, and tax filings all reconcile, the audit generally proceeds much more smoothly.
Practice Tip: We compare the payroll summaries with the quarterly reports and Forms 941 before they’re produced. If there are inconsistencies, we want to understand them before the auditor begins asking questions.
Bank Statements
One of the questions we hear most often is why L&I wants to review a company’s bank statements. The answer is that the auditor reviews bank statements to identify payments made to individuals. If someone received recurring payments but does not appear on payroll, the auditor will naturally want to know who that person is, what services they performed, and whether they should have been reported as an employee.
Bank statements also provide another way for the auditor to compare your financial records with your accounting records and payroll records.
Practice Tip: Before bank statements are produced, we review them carefully for payments that are likely to attract the auditor’s attention, particularly payments made to individuals outside the payroll system. If questions are likely to arise, we work with the client to understand those payments and gather any supporting documentation before the auditor asks about them.
Check Register and General Ledger
If we had to identify one record that auditors frequently spend the most time reviewing, it would probably be the general ledger.
The general ledger and check register provide a detailed picture of where the business spent its money. They often reveal payments to subcontractors, independent contractors, sole proprietors, employees paid outside the normal payroll process, or other individuals who may never appear in the payroll records.
Once the auditor identifies those payments, it is common for them to trace the transactions through your bank statements, Forms 1099, contracts, invoices, and payroll records to determine exactly who was paid and why.
Practice Tip: The general ledger often tells us where the audit is headed. We identify payments to subcontractors, sole proprietors, and others who performed labor so we can evaluate those relationships before the auditor begins asking questions.
Cash Payment Records
If your business pays workers in cash, you should expect the auditor to request those records as well.
Cash payments receive additional scrutiny because they may not appear in your normal payroll records. The auditor wants to determine who received the payments, what work they performed, and whether those payments were properly reported.
Practice Tip: When cash payments are involved, we take the time to understand who received the payments, why they were made, and what documentation exists to support those transactions. Cash payments are not necessarily a problem, but they almost always receive additional attention during an audit.
Federal Tax Returns
Many employers are surprised to see federal tax returns included in the records request.
Federal tax returns provide another source of information the auditor can use to compare your payroll and financial records. They also help the auditor understand the overall structure and financial operations of your business. For businesses that engage independent contractors, the returns also provide another point of comparison between payroll expenses and amounts paid to nonemployees.
Practice Tip: We compare the federal tax returns with the payroll and accounting records being produced to make sure the various records are generally consistent. If amended returns have been filed or adjustments have been made, we identify those early in the process so we’re prepared to explain them if necessary.
Forms 941
Forms 941 report the wages and payroll taxes submitted to the IRS. Auditors routinely compare these forms with payroll summaries and the quarterly reports filed with Washington agencies. Again, the objective is to determine whether all of the payroll records are consistent.
Practice Tip: Before Forms 941 are produced, we reconcile them with the payroll summaries and other payroll records. If differences exist, we want to understand the reason before the auditor begins making those comparisons.
Forms 1099
Too many employers assume that issuing someone a Form 1099 establishes that they are an independent contractor. As many of you know, it’s nowhere near that simple.
From the auditor’s perspective, Forms 1099 identify individuals whose classifications may warrant further review. They tell the auditor who was treated as an independent contractor, not whether that classification was legally correct.
If your business relies heavily on independent contractors, you should expect the auditor to ask questions about many, if not all, of those relationships.
Practice Tip: We identify each contractor who received one and evaluate whether the supporting documentation adequately explains why that individual was treated as an independent contractor. If additional records should be gathered before the audit, we’d much rather do that before the questions begin.
Forms W-2
Forms W-2 generally do not generate much discussion because they simply provide another way for the auditor to verify employee wages. The auditor will compare the Forms W-2 against payroll summaries, Forms 941, and quarterly payroll reports to confirm that all of the payroll records reconcile.
The Forms W-2 are also commonly reviewed alongside the Forms 1099 to better understand how the business classified its workforce between employees and independent contractors.
Practice Tip: We verify that the Forms W-2 reconcile with the payroll summaries and Forms 941 before they’re produced.
Independent Contractor Agreements and Supporting Documentation
The audit will usually request independent contractor agreements along with supporting documentation such as business licenses, invoices, and similar records.
While independent contractor agreements are certainly important, they are only one piece of the analysis. The auditor is not simply asking whether you have a contract. The auditor is asking whether the contract accurately reflects how the relationship actually operated. In other words, the paperwork matters, but so do the underlying facts.
Practice Tip: We rarely review the independent contractor agreement by itself. Instead, we look at the agreement together with invoices, business licenses, certificates of insurance, websites, advertising, and other records that help paint a complete picture of the relationship. After all, that’s how the auditor will evaluate it.
Records Tell the Story of Your Business Better Than You Can
One of the biggest misconceptions about an L&I or ESD audit is that the auditor reviews each document independently.
That’s not how it works. Instead, the auditor is constantly comparing records. Payroll summaries are compared with Forms 941. Forms 941 are compared with Forms W-2. Bank statements are compared with the general ledger. The general ledger is compared with Forms 1099. The Forms 1099 are compared with contracts and invoices. Throughout the audit, the auditor is asking one fundamental question: Do all of these records consistently tell the same story?
Understanding that process helps explain why the records request can seem so extensive. Each document provides another opportunity for the auditor to verify, or question, the information reflected in the other records. Hence the reason to approach this process with care.
By understanding the auditor’s perspective, identifying potential questions in advance, and ensuring that your records present a consistent picture of your business, employers are often able to make the audit process considerably smoother and more efficient. Finally, if you don’t have all of the records the auditor has requested, preparing for the audit will require an even more thoughtful approach. Missing records often change the strategy for responding to the audit and may require using alternative records or other evidence to address the auditor’s concerns. In our next article, we’ll discuss how employers can prepare for an audit when records are missing or incomplete.