Payroll fraud and how to prevent it

Payroll fraud costs businesses a lot of money. According to the Association of Certified Fraud Examiners, the median loss in payroll fraud cases amounts to USD 62,000.

Although it might seem that payroll fraud is primarily a problem in large organizations where falsified records and manipulated time sheets can easily go unnoticed, the stats show that the opposite is the case. In fact, small businesses are nearly twice as likely to be affected by payroll fraud than large organizations. One reason for this is that payroll in smaller organizations is usually overseen by one single person, which can be tricky for several reasons.

In this chapter of the Lano Payroll Academy, we’ll take a closer look at some common payroll fraud examples and share some tips and strategies for preventing payroll fraud in an organization. But first of all, let’s define what payroll fraud actually means.

Payroll fraud is when an individual illicitly tampers with an organization’s payroll system to gain a financial benefit. Payroll can either be manipulated by an employee or by the employer, with the latter being less common.

Employees can steal money from the company through schemes like illegitimate expense claims or time sheet manipulation. Employers, on the other hand, can willingly underpay employees to reduce their workforce costs and increase their profits.

There are many different ways to manipulate payroll for personal financial gain. Here are the most common payroll fraud schemes:

• Ghost employees: Paying employees that no longer work for the company is a common payroll error that results from poor employee offboarding management. But paying ghost employees is also a common example of payroll fraud that occurs when personnel records are falsified or when employees are deliberately kept on the business’s payroll after they leave the company. The payroll staff then changes the former employee’s pay details to issue payments to a bank account they can access.

• Time sheet manipulation: There are different ways for employees to manipulate their time sheets. For instance, they can put down more hours than they have actually worked or falsify their attendance status—for instance by getting colleagues to clock in for them while they take a day off. In both cases, they end up getting paid more than they should, which results in higher payroll costs for the business. 

• Overtime manipulation: Similar to regular working hours, overtime entitlements can be falsified. Without strong internal controls, it’s easy for employees to make false claims for overtime they have never actually performed.

• Payroll advance retention: Not paying back payroll advances is yet another payroll fraud example. When employers offer employees an advance on their next pay, it’s common practice to deduct the amount from the employee’s next paycheck. If the accounting department is not vigilant regarding the repayment and recording of granted advances, employees can get out of repaying an advance, which means they cash in twice.

• Pay rate alteration: Altering an employee’s pay rate is a payroll fraud scheme that happens when a member of the payroll department teams up with another employee. The pay rate of the latter is increased and the money is split between the two accomplices.

• Commission pay fraud: Commissions are a popular incentive for employees in the sales department, but they are also frequently subject to fraud. Employees can falsify their sales numbers to cash in higher commissions they didn’t actually earn.

• False expense claims: Another common payroll fraud scheme is tampering with expense claims. While claiming work-related expenses is totally legitimate, adding personal expenses, overstating existing business expenses or claiming fictitious expenses is fraudulent behavior. Unfortunately, dishonest reimbursement claims often go unnoticed.

In all these payroll fraud scenarios, the manipulation of the business’s payroll system leads to financial losses. However, the consequences of payroll fraud can be way more severe. When employees tamper with payroll information, this leads to inaccuracies in the statutory reporting of payroll taxes and social security contributions, which can result in hefty fines for the business.

In addition to the different payroll fraud schemes devised by employees, there is also the possibility of employers manipulating their business’s payroll, the most common example being employee misclassification. Misclassifying employees as independent contractors allows businesses to reduce their employment costs by not paying payroll taxes for their workers. Since the misclassified employees then miss out on important statutory benefits they should rightfully be entitled to, misclassification is a serious case of payroll fraud.

Payroll fraud schemes can go on for quite a while without being detected. In fact, the Association of Certified Fraud Examiners states that the average duration of a payroll fraud case is 24 months. In the case of a ghost employee, this would mean paying a salary to a fictitious employee over a period of two years—benefits, taxes and statutory social security contributions included.

To prevent major financial losses, it’s important for businesses to know how to detect payroll fraud. Here are some red flags to look out for: 

• Irregularities, gaps, or inexplicable changes in payroll records,

• The same bank details or address for more than one employee,

• An excessive amount of overtime paid to an employee,

• Inconsistencies between employee timesheets and absences.

With an average monthly financial loss of USD 2,600 per payroll fraud case, preventing fraud in payroll should be high on any business’s to-do list. Here are a few actionable tips for stopping employees from manipulating the payroll system:

• Implementing a strong checks-and-balances system for payroll: Separation of duties is a key concept when it comes to payroll security and it is also one of the most effective preventative measures against payroll fraud. The idea is that all payroll processes are overseen by at least two people.

• Conducting regular payroll audits: Payroll audits give businesses a chance to review all their processes and records related to payroll. If there are any abnormalities, they will be detected during an audit. Surprise audits are even better than scheduled internal audits to avoid any tampering in preparation of the audit.

• Using biometric time clocks: The safest way to stop time sheet manipulation is to use an employee time tracking system that uses some form of identification verification. Like this, employees won’t be able to clock in on behalf of colleagues who take the day off without permission.

• Monitoring employee time and attendance closely: Businesses that have no time and attendance recording system in place should at least make sure to pay close attention to employee absences so that they can detect time sheet manipulation immediately.

• Recording and tracking all granted payroll advances: The only way to stop payroll advance fraud is to be thorough when it comes to documenting advances that have already been granted. All payroll advances should be recorded along with information on repayment.

• Drafting an anti-fraud policy: A simple yet effective way to prevent payroll fraud schemes is to institute a firm anti-fraud policy that details what consequences employees have to expect in case they get caught. Usually, a detailed fraud-prevention policy is enough to scare off any potential fraudsters.

• Having clear policies regarding commissions and expenses: Drafting a detailed commision and expense policy is an important step towards preventing payroll fraud because these policies clearly outline the steps and procedures that must be followed before a commission is paid out to an employee or before certain expenses are reimbursed.