How to identify and prevent payroll fraud

When you think about employee theft in your company, you likely consider acts such as employees stealing inventory or company or customer information through cyber fraud. But, there’s another way that they can siphon off cold, hard cash, and that’s through payroll fraud.

Here are the most common types of payroll fraud and the red flags to watch for, along with fraud prevention tips:

1. Ghost employees

You shouldn’t be paying them because they’re not really there. In this common type of payroll fraud, the payroll staff creates a fake employee in the system and then sends the direct deposit or payroll checks to themselves instead.

To prevent ghost employee fraud:

This is more common in a larger organization where you might not know everyone, making it easier to create a ghost employee than it would be in a small business. But, a system of internal controls should make it clear who actually works for you and who’s in your payroll records.

It’s smart to review payroll regularly, as well as look for addresses, Social Security numbers, bank account numbers and other identifying factors that might be duplicates. You also can verify Social Security numbers with the Social Security Administration. And, when an employee leaves, make sure their information is wiped clean to avoid having them become an easy ghost employee.

2. Timesheet fraud

Did your employee work an extra hour or two last week—or an extra week last month? In timesheet fraud, an employee will doctor their timesheet to look as though they were working when they weren’t. Timesheets can also be manipulated by independent contractors, as well as a fraudster in the human resources department, particularly if you use paper timesheets.

If you have a system where employees or independent contractors bill specific clients or projects for their time, it could result in those clients being overcharged, which can cause an even bigger headache than just you losing out on payroll—it could cost you a client.

To prevent timesheet fraud:

Electronic timesheets remove much of the potential for abuse, as they can’t be changed along the way—not by a nefarious supervisor or someone in human resources. And, sometimes timesheet “fraud” is inadvertent, as employees try to recreate their time from a week or so ago when they realize they forgot to submit their time record and don’t have an accurate memory.

That can be mitigated by implementing a real-time system where employees enter their time online every day. (That can make payroll easier, too, when the time tracking function integrates with your payroll system.) Finally, make an effort to be familiar with employees’ schedules and take the time to spot check timesheets periodically.

3. Timecard fraud

The time clock that monitors your employees’ moves? Yes, it doesn’t work if a co-worker is clocking them in and out—either keeping them from getting busted for being tardy in the morning or after lunch, or helping them take the day off—with pay.

To prevent timecard fraud:

One of the best ways to combat this is to be present by talking to your team and being visible. They’ll be a lot less hesitant to try to dupe you if they think they’re going to get caught. You also can make it a requirement that you sign off on timecards and pay close attention to the hours that have been recorded.

If you’re particularly concerned about this type of fraud, you could install a special time clock that reacts to the employee’s face or fingerprint, or position a camera near the timecards so you can review footage, if needed.

4. Pay rate alteration

Does one of your team members, or even a new employee, believe they deserve a little raise? Sometimes, they take it upon themselves to provide an hourly or monthly bump through the payroll department, either by taking control of the systems themselves or having another employee help them out. Sometimes, they’ll just do it for a brief period to avoid detection.

To prevent pay rate alteration fraud:

This can be detected by taking the payroll register and conducting an audit that matches pay rate to each figure.

5. Paycheck diversion

This happens when someone just boldly cashes another employees’ paycheck.

To prevent paycheck diversion fraud:

Wait. What’s a check? That’s ok if you weren’t sure—most companies use automatic deposit today, eliminating the need for paper checks. And, with it, that eradicates a common type of payroll fraud. If you do still cut checks, take a cue from the word itself and “check” ID to ensure that whomever is picking up the paycheck is the employee in question.

6. Commission fraud

This can take a variety of forms, most typically involving falsified sales records to bump up numbers. A salesperson might manipulate the CRM system to front-load sales to a certain month to hit a quantity target, or enter sales and then cancel them once the commission has been paid.

To prevent commission fraud:

It starts with an airtight commission policy that takes into account these common potential fraud arrangements and expressly forbids earning commissions on any sales that skirt the policy. And, keep an eye on the books to see if commission outlays are rising in a way that doesn’t seem commensurate with sales. Finally, take a look at the compensation of top performers, who might find it easiest to game the system, to make sure that they aren’t indulging in any commission schemes.

7. Workers’ compensation fraud

Workers faking injuries can cost your company—in the form of rising premiums or direct payouts, not to mention lost time—as well as the insurance company. Sometimes, employees work together to create a situation that resulted in an “accident,” while other times an employee might have been legitimately injured, but it was off the job and they prefer the more lucrative payout that comes from workers’ compensation insurance.

To prevent workers’ compensation fraud:

First, insist that accidents be reported immediately, which makes it far more challenging for an off-site event to be claimed as a workers’ compensation incident. Onsite cameras can also make it possible to pinpoint if fraud has occurred. And, finally, insist on medical corroboration consistent with the injury. The good news is that you likely have an ally in your insurance company, which might even monitor your employee’s activities while they are recovering.

Overall tips for preventing payroll fraud

According to the Association of Certified Fraud Examiners (ACFE), nearly half of all fraud involved internal control weakness. In 30% of the cases, companies lacked the controls they needed, and in nearly 20% of the cases, employees were able to override the controls. So, tight controls are the No. 1 way you can prevent payroll fraud.

Here are some other tips that can help you detect payroll red flags and deter common types of payroll fraud:

• Develop internal controls that include random checks of the books, bank account and all timekeeping back-up to detect any sort of anomalies.
• Reduce the ability for one person to have total control. Cross train your team and rotate jobs to create a system of checks and balances that can help prevent or reveal fraud during random pay periods. Insist on mandatory vacation for anyone who regularly handles payroll to see if red flags arise while that person is gone.
• Create a payroll account that is separate from your regular business account, which can make it easier to keep accurate records and notice inconsistencies in that specific part of the business. Review payroll reports each payroll period, after it is processed.
• Develop a culture of honesty. Perhaps surprisingly—but certainly reassuring—is that a company code of conduct was one of the most effective ways to reduce fraud loss, according to the Association of Certified Fraud Examiners.

Finally, remember that payroll fraud schemes are incredibly common. Don’t ever assume it couldn’t be you, or turn a blind eye to the fact that it could be occurring in your business. Vigilance and awareness can be business owners’ best defense.