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Payroll Fraud Within Your Business: Detecting and Preventing

Payroll fraud can strike businesses across the U.S., large and small. Learn about how you can identify the warning signs and prevent it from crippling your business.
payroll fraud

Employee payroll fraud is a challenging issue for U.S. small business owners. The process of detecting and preventing this starts with a thorough understanding of the different types of payroll fraud that exist, and mechanisms to implement to keep damage to a minimum.

What is payroll fraud?

Payroll fraud is when employees or employers wrongfully manipulate the payroll system to either receive payment they haven't earned or, in the case of employers, withhold payment of rightfully earned wages or taxes due on those wages. Fraud takes many forms and is sometimes difficult to detect. If businesses aren't diligent, the toll of this deception and theft can be considerable.

Common types of payroll fraud

Some of the common types of payroll fraud include:

1. Timesheet fraud

If employees falsify their timesheet submissions and get paid for hours they don't work, businesses lose money. In some cases, employees arrange for coworkers to clock in and out for them when they're not working. Another common timesheet fraud scheme is when a payroll clerk manually overrides an employee timesheet, adding hours to increase payment.

2. Worker misclassification

Someone who works for your business must be classified either as an employee (Form W-2 recipient) or an independent contractor (who receives a Form 1099-MISC if they earn more than $600 in a calendar year). Employers sometimes misclassify workers by accident, but others may do so intentionally in an attempt to avoid paying unemployment tax, payroll taxes, or workers' compensation insurance. This is employer payroll fraud and can be punishable by law.

3. Pay rate alterations

In this scheme, employees collaborate with a payroll department employee to boost the amount of their hourly pay within the payroll system. Sometimes the deception takes place days before payday and is then changed back to the legitimate rate to evade detection.

4. Padding work hours

Padding hours to timesheets is among the most frequently occurring form of employee fraud. It's often perpetrated in small amounts so as to not to make a supervisor suspicious. This practice can flourish in workplace settings where managers neglect to closely monitor timesheets.

5. Outstanding advances

When an employee asks for an advance payment and doesn't pay it back, the employee has committed payroll fraud. If the accounting department charges this advance to "expenses," nonpayment of the advance often goes unnoticed.

These forms of payroll fraud depend upon lax accounting and oversight procedures. Businesses should maintain and strictly adhere to thorough accounting and anti-fraud policies at all times.

Addressing fraud

Experts contend that one of the most effective solutions to help prevent fraudulent behavior is separation of duties. An individual who is responsible for processing payroll should never also be responsible for entering changes or amending employee records.

How can you detect payroll fraud within your business?

Common situations may include:

  1. Employees who share an address or bank account. This sometimes occurs when different family members work for the same company. But if they are not related, it can be a sign of fraud.
  2. An employee living beyond their means. When an employee makes a big purchase (new car, upscale house, international travel) without a prior history of such activity, it could be another potential sign of fraud.
  3. Flaws in payroll records. Any gap in the way payroll records are managed and monitored leaves open the possibility for deceptive practices.
  4. An employee who never takes PTO. As Accounting Today notes, a potential red flag of fraud "is an employee who hoards her work duties and never takes PTO," indicating "an unwillingness to leave for fear the fraud will be discovered by someone covering for her."

How to report payroll fraud

Whether through an illegitimate payroll service provider or employees intentionally falsifying their hours to collect wages on time they did not work, payroll fraud can be especially devastating to small and medium businesses. One solution is to outsource your payroll functions to a reputable service provider that can separate functions of tracking hours and payment. It's critical to report fraud as soon as possible. You should have a record of individuals involved, nature of the fraud, duration, amount of money involved, and how it came to your attention. Certainly, having accurate data records can make information gathering easier. Share your information with a trusted manager, who is not associated with your suspicions. You can also contact your state attorney general's office, or alternatively, the FBI, which often investigates payroll fraud and embezzlement for criminal activity.

Protect your business against payroll fraud

Clearly, payroll fraud represents a significant threat to any business. Here are ways to prevent fraud occurring in your company:

  • Monitor payroll reports. Managers and employees should never blindly sign off on payroll reports before a comprehensive review. The same due diligence applies to employee requests for time off. It's only in an atmosphere of lax controls that fraud will flourish.
  • Separate specific duties. Cases of fraud can be significantly reduced when different employees are responsible for different parts of the payroll process. As previously noted, never assign the same individual to process payroll and make changes in reporting or amendments to payroll reports.
  • Stay aware of canceled checks. As part of the monitoring process, review all canceled checks to ensure they really are canceled. Also, never sign your name on a blank check.
  • Audit payroll. In terms of fraud prevention, auditing is probably the wisest step an employer can take. Arrange for ongoing audits designed to reconcile payroll at least once a quarter, and have the process overseen by an individual other than the person who regularly processes payroll.
  • Work with a reputable payroll provider. As small businesses grow, the complexities of managing payroll and other HR services can become overwhelming, and they may want to consider seeking professional help. An increasing number of small businesses are opting to work with a payroll service provider that offers them the flexibility to report payroll information over the phone or email or to enter payroll information themselves.

Employee payroll fraud is a serious threat, but adopting these safeguards can dramatically reduce the risk your company faces in this area.

How to find a payroll services provider to help fight fraud

Many small businesses choose to collaborate with a payroll service provider when it comes to addressing fraud. By outsourcing this critical process to a reputable third-party provider, you can benefit from their technology and flexible service options.

A word of warning: Payroll providers handle sensitive documents such as company funds, analyze employee information, and process tax forms. Therefore, it's vital that these companies keep data safe and deliver a high level of accuracy. Ask to see payroll provider's financial information, such as investor presentations, Securities and Exchange Commission (SEC) filings, and annual reports. You need to know that the payroll firm you're working with is financially secure.

Key vetting questions to ask a payroll company include:

  • Are you a nationally recognized company?
  • Do you have a proven track record of implementing high ethical standards?
  • Are you required to adhere to SEC regulations?
  • Do you have a certificate of liability insurance?

Don't rush to sign up with the first payroll service provider you come across. Follow these helpful tips to find the right payroll service for your business.

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