When you're most at risk of payroll fraud and how to prevent it

March 9, 2022

Payroll fraud is the No. 1 source of accounting fraud and employee theft, which happens in 27% of all businesses. In fact, occupational fraud—or fraud committed by an employee on an employer—causes more financial loss to organizations than those committed by third parties.

Oftentimes, schemes committed by dishonest employees last an extended period of time as they attempt to hide their theft while continuing to work for their employer. According to the Association of Certified Fraud Examiners, payroll fraud schemes tend to last 30 months with occurred losses reaching $63,000. Unfortunately, the losses from payroll fraud have double-impact on businesses—from the initial theft and then again as penalties from the IRS.

Payroll fraud risk of in-house systems

In-house international payroll systems that are harder to police, like those in large organizations with high employee turnover or a dispersed workforce, are an easy target for theft. But, small businesses are also at risk, especially if their payroll system is managed or overseen by one person. Typically, when any company’s payroll function is centrally managed in-house, and there are no internal control measures in place to detect, track and report fraud, a dishonest employee is more likely to take advantage of the opportunity.

There are several ways in which payroll fraud is committed and concealed, so here are some examples of the most prevalent types of in-house payroll fraud:

Payroll “ghosts”

When a non-existent employee (also known as a ghost employee) is getting a paycheck, you have a payroll ghost. Sometimes employees who leave the organization are never removed from payroll and become ghosts—an oversight more likely in multinational companies with no comprehensive offboarding process. But more often, this type of fraud happens when a trusted employee blatantly manipulates payroll, so they can pocket the paycheck of a fake employee. This person is typically a payroll manager with access to the payroll system, who is authorized to add and delete employees from the register.

Exactly how ghost employees are created varies depending on the type of payroll system in place, but they are often achieved by leveraging internal control weaknesses. Large organizations with high employee turnover are generally at greater risk since there is less chance of a fictitious employee being recognized on the system.

Falsified wages

Recently at the Indianapolis Bond Bank, two employees falsified their wages and stole nearly $400,000 in unauthorized pay and benefits over nine years.

Payroll fraud through falsified wages can happen when an employee manipulates their wage rate, tampers with their actual paycheck or increases their sales numbers for more commission pay. Wage rates can be adjusted when a worker finds a way to avoid paying mandated deductions. Or like in the case example, employees can claim inappropriate benefit leave payouts or unauthorized bonuses to enhance their wages.

Employees who have access to your payroll system might also be able to alter check amounts or issue themselves unauthorized checks, since physical paychecks are easier to steal and forge than digital payment methods.

Finally, fraudsters could take advantage of a company with a weak commission policy by claiming commission sales they didn’t earn. When certain employees have increasing commission earnings even as sales across your company are going down, that’s a big red flag for potential payroll fraud.

Timesheet fraud

According to the American Payroll Association, almost 75% of businesses in the U.S. are affected by “time theft”. Timesheet fraud happens when an employee increases their pay by claiming to have worked more hours than they actually did. This type of offense may seem minor in the moment, but can lead to significant costs if it becomes a common occurrence over long periods of time.

Workers are able to steal time in a variety of ways including: recording inaccurate times, soliciting a colleague to clock them in, conducting personal activities while on the clock, or taking frequent breaks. Most of these activities result from blurred lines between professional and personal time rather than blatant theft—making this type of fraud more nebulous to identify.

Unless there is a protocol in place for managers to track and report time theft, it will likely go unreported. And since 43% of hourly workers admit to exaggerating the amount of time they work at least once, tracking these offenses should be top of mind for employers.

Expense and reimbursement fraud

For many employers, fraud could be hiding in plain sight in the form of false expense claims. This commonly overlooked type of payroll scheme occurs when an employee gets paid back for expenses claims that are:

  • Personal
  • Overstated
  • False
  • Replicated

Dishonest reimbursement claims may be authorized by someone in your organization with little experience or knowledge. Or perhaps approving expense claims is a minor “side of the desk” task, which is not given proper attention and consideration. Without procedures in place to verify and control employee expense claims, you are at risk of incurring significant losses.

Each of these employee fraud schemes are a risk to companies who conduct their payroll in-house, but improving internal controls, processes and policy can significantly reduce your risk of damages. Below are a few examples of how to detect and prevent payroll fraud. 

How to prevent payroll fraud: 4 strategies

1. Surprise payroll audits

Surprise audits contribute to the largest reductions in fraud loss and duration and only 32% of fraud cases in the U.S. use them as an anti-fraud control. By leveraging the power of surprise, you are more likely to catch any payroll discrepancies or fraudulent activity before they have the chance to escalate.

At the very least, your payroll processing system should be reconciled quarterly with someone other than the person who runs your payroll.

2. Written policy and procedures

A “Code of Conduct” is the most commonly used anti-fraud control, but employers who go beyond best practices by implementing an anti-fraud policy can better ensure protection.

Most payroll schemes are initially detected through employee “tips”, so ideally your policy will reward and encourage whistleblowing through a fraud hotline. This hotline can help identify suspicious employee behavior, like an overly controlling manager who does not share payroll duties or take paid time off.

An anti-fraud policy is also helpful for informing offboarding procedures and reducing your risk of payroll ghosts. And with regard to expenses and reimbursements, a detailed company policy helps keep employees accountable for the claims they submit.

3. Manager reviews

Even with a reimbursement policy in place, manager reviews and audits are needed to check the authenticity of expense requests. By having a manager routinely review payroll, employees are less likely to overstep ethical boundaries and managers will be able to detect company-wide patterns—potentially identifying when reimbursements are abnormally above average.

You should also require manager review and signature for overtime requests and when changes are made to timesheets in order to avoid time theft.

4. Separation of controls

The payroll staff member responsible for processing should not also be responsible for entering changes or amending employee records, and vice versa. In fact, the segregation of employee duties is the cornerstone of a solid internal control system. Ideally, your payroll system is managed by three separate functions: someone handling payroll authorization, another handling distribution and a third person handling reconciliation.

Enable global payroll fraud prevention with an outsourced solution

As a business owner, outsourcing payroll responsibilities can alleviate a majority of your risk for employee theft—as end-to-end processes are managed by an external party. With clear validation and reporting, a payroll provider can quickly reconcile any discrepancies that might arise between departments—whether HR, Accounting or Payroll. Multinational companies who are struggling to improve their internal controls and standardize their processes across many locations can especially benefit from outsourced payroll services.

Want to learn more about how Payroll 360 can help reduce your risk of employee payroll fraud? Contact us today.

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