How to Prevent Payroll Fraud

Posted by Stephanie Rieselman on Jan 21, 2022

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Payroll is a prime target for fraud on many levels since it is often an employer’s biggest expense. For that reason, payroll fraud is quite common– affecting about 30% of businesses annually, according to the College Investor. If payroll fraud is left unaddressed, it can grow from a minor inconvenience to more significant payroll fraud consequences that can result in financial drain.

A prime example of this happened in 2021 when a small business of about 20 employees fell victim to a spoofed website scam that was mirroring a banking site the company used to issue payroll direct deposits. The business manager logged in to the fraudulent site, effectively handing over the username and password to the online business bank account. The result? A slew of payments made from the account resulting in overdrawn funds – 68 transactions in total and $249,000 lost.

In 2020, the Boston police department uncovered overtime fraud perpetrated years before by nine police officers. The officers were accused of leaving their overtime shifts two or more hours early but continuing to submit fraudulent overtime slips claiming to have worked the entirety of each shift. The falsified timesheets resulted in over $200,000 in pay for fictitious overtime within the department.

These high-profile cases are just two types of payroll fraud that can affect an employer. Understanding the nuances between each type will help you stay vigilant and stop crimes before they cost your company thousands of dollars.

What is payroll fraud?

A simple payroll fraud definition is theft of funds from a business via the payroll system or process. This type of payroll manipulation can be carried out by individual employees as well as criminals outside your organization.

Common payroll frauds and schemes

Payroll scams can be divided into two types depending on who is perpetrating the crime. If an employee or accountant with access to the company payroll system defrauds the company, it can be considered an inside job. As in the case of the Boston Police Department, inside jobs are often difficult to detect due to the trust naturally placed in employees by the employer. 

As in the case of the spoofed website scam, someone external to the company was to blame. While this is less common, it is often orchestrated by career criminals with more advanced technical skills than an average employee. 

Even when unknown actors are targeting your business, often the thief is dependent on an employee making a mistake to gain access to the payroll system. Common mistakes include setting a weak password, clicking on a malicious link in an incoming email, falling for a request for payroll changes from what appears to be a company executive. 

The tactics used by these criminals change over time, so it’s important to keep up to date on the latest activities.

Ghost employee fraud

Ghost employee fraud involves paying employees who don’t actually work for the employer. Most often, this type of payroll embezzlement is perpetuated by a payroll staff member or manager who creates a fake employee profile that is allocated hours and paid during the regular payroll process. The goal is to divert funds to the wayward employee’s bank account or an accomplice’s account.

Payroll padding

Timesheet fraud is relatively common in businesses that pay their workers an hourly rate. Workers can falsify the number of hours worked, often signing in and out of work at incorrect times, or falsely claiming to work certain shifts. This type of wage fraud results in employees being paid for time they haven’t worked.

A frequent type of timesheet fraud is payroll padding, which involves reporting false start and end times via timesheets, often in small amounts, so as not to arouse suspicion. The goal is to be compensated for more time than the employee actually worked. A few common methods of payroll padding are:

  • Rounding up hours (i.e., billing for an hour when the job only took 45 minutes)
  • Logging shorter breaks or lunch than what was actually taken
  • Adding extra time to a pay period, pushing the employee into overtime, which is paid at time and a half for most workers

Payroll fraud example

While most employees of a company are honest, unfortunately, there is a small number who will take advantage for their own personal financial gain. When it comes to payroll fraud, even a bit of padding each workday can start to add up. 

For example, consider a worker who is paid $15 an hour 40 hours a week but fraudulently claims two hours of overtime (that he or she didn’t earn) each week. With overtime at the time-and-a-half rate of $22.50, that’s an extra $45 a week, which could add up to $2,340 a year. Multiply that by a few people, and it will become quite costly.

How to detect payroll fraud

Unfortunately, for many victims of payroll fraud, the offending behavior is not detected until significant sums of money are missing. Sometimes it can be years later when timesheet fraud or ghost employees are detected. By that time, the amount of payroll funds stolen can be in the thousands of dollars or in the hundreds of thousands as in the Boston Police case.

The good news is that there are ways to detect payroll fraud within your organization. One of the best ways is to schedule regular payroll audits.

What to look for in a payroll audit

A payroll audit can help you identify and correct payroll errors related to fraud, such as fictitious timesheet data or payments to ghost employees, but it can also detect unintentional errors. An annual audit is a good start to ensuring payroll accuracy, but creating a process to perform a quarterly or monthly audit is even better. 

Audits can be executed by internal staff, such as an accounting professional who doesn’t directly work in payroll or a company director or owner. Or you could turn to external resources such as your CPA or a consultant to inspect payroll data on a recurring basis.

Here are standard activities you should include in your internal payroll audit or expect from an outside service:

  • Verify payroll procedures you’ve established are actually being followed each pay period. If you have one employee processing payroll and another approving payroll, ensure those steps are being followed.
  • Review your list of payroll software administrative users and ensure only active employees processing payroll have those specific system rights. Sometimes terminated employees are not promptly terminated as users in systems.
  • Review a list of all active employees against your payroll register. Look for employees on one list but not the other.
  • Review lists of terminated employees and ensure there are no payments made for periods that occurred after the termination date.
  • Analyze pay rates for any unusual pay rate alterations, especially with no change in job or other obvious reason for the change.
  • Examine hours worked for unexpected overtime or a higher number of hours than expected for part-time employees. Spot-check hours paid against timekeeping system records.
  • Review commissions and bonus pay as well as any off-cycle payroll checks.
  • Compare total payroll expenses across pay periods within your general ledger and look into any unexplained fluctuations. 

How to verify a ghost employee

A simple audit strategy for detecting ghost employees is to look for anyone who has few or no deductions from their pay. Some other notable things to look for include:

  • An employee record with information missing.
  • Using the same bank account for the deposit of wages for more than one employee.
  • An unexplained or regular turnover of staff, particularly in employees from one area of the business and especially if that area is remote.
  • An employee name on the payroll list that lacks a clearly defined job description or that no one recognizes.

Top 4 ways to prevent payroll fraud

There are many steps you can take as an employer to protect your organization and payroll department from fraud attempts. Here are four top recommendations.

  1. Conduct background checks for anyone responsible for payroll or who will have access to company bank accounts.
  2. Limit access to payroll data and share only with those who absolutely need to obtain it to do their jobs properly.
  3. Segregate payroll duties by processing payroll using a checks-and-balances procedure where one person prepares the payroll and a different individual reviews the payroll.
  4. For each pay period, review standard employee and payroll reports to quickly spot errors in payroll.

Frequently Asked Questions

Is payroll fraud a felony?

One of the charges related to payroll fraud is wire fraud, which is a felony punishable under criminal law that comes with a maximum penalty of 20 years in prison for each count. Because payroll fraud can involve stolen funds, stolen identities, and false tax reporting and payments, the FBI, IRS, and Justice Department can become involved in payroll fraud cases.

How can I recover from payroll fraud if it happens to me? 

What happens if you’ve already fallen victim to payroll fraud? The sooner you take action, the better chance you’ll have at regaining any stolen money. Your first step should be to ensure you prevent further losses by securing the payroll system and process that was compromised. If money was moved electronically, through direct deposit, for example, call your bank right away. You should also report the crime as soon as possible to local authorities. Develop a timeline and collect all relevant documents and facts to help in the investigation.

Check your insurance coverage and consult with a financial advisor or lawyer when recovering losses. Lastly, make sure your payroll data and process are secure in the future. There are steps you can take to keep your payroll data secure.

Can you sue for payroll fraud?

It is possible to sue for damages resulting from payroll fraud through civil court action, however, it is unlikely because many incidents of payroll fraud are reported to local authorities and worked through to resolution in criminal court. Because they have broken state or federal law, payroll fraud perpetrators who are caught are often ordered to pay restitution to victims as well as sentenced to prison time.

Topics: Payroll, Scams

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