5 Ways to Prevent Payroll Fraud

Your credit card payments are encrypted, you back up your data to a secure cloud, and you’ve enabled two-step authentication on your most important software. Congrats, you’re impenetrable.

…just kidding.

Have you looked at your payroll security recently? Payroll fraud is often overlooked, yet a very expensive way that SMBs throw away money. Some payroll fraud may be unintentional, but most of it is done on purpose. What’s more, the median loss from a case of occupational fraud (which includes payroll fraud) is a whopping $150,000. Yeah, Wowza.

The good news is that you can be proactive about preventing payroll fraud. The first step is understanding how it happens, and the next step is stopping it. Like Wonder Woman deflects any incoming threat with the power of her Bracelets of Submission, you too can ward off threats to your payroll funds. Corset and cape optional.

What is payroll fraud?

Payroll fraud is the act of stealing money from a business using the payroll system. This crime manifests itself in a few common ways. If you’re new to payroll accounting, some of them may be unfamiliar to you, so let’s take a few minutes and brush up on our fundamental knowledge of payroll fraud and the way it is most commonly committed.

4 Types of Payroll Fraud

Ghost Employees

A “ghost employee” is created in your payroll system. If you’re a small business with fewer than 50 employees, this one won’t be an immediate threat, but it’s still something to keep an eye on as you grow. In this scenario, someone creates a fake employee in the system and then pockets the money that is distributed to this non-existent worker. Unless you’re paying close attention, an expanding company can easily have an extra “employee” in its system.

Timesheet Fraud

Wages are falsified. Employees can falsify wage records by lying on their timesheets, taking advantage of commission loopholes, or inflating expense reports. More savvy people may even be able to break into a payroll system and assign an unearned bonus to themselves. Common payroll fraud includes:

  • Buddy punching: when one employee puts in a timesheet on behalf of another while they take the day off. 
  • Paycheck diversion: When one employee takes the paycheck of another employee and cashes it.

Fake Compensation Claims

A fake workers’ compensation claim is filed. Workers in nearly any industry can fake a slip and fall or other workplace injuries in order to get paid time off. While you might associate this type of fraud with warehouse work or construction, an employee can just as easily say they slipped on the floor next to a leaking water cooler in your break room.

Employees are Misclassified 

Employees are misclassified. With this type of fraud, the call is coming from inside the house. It can also be unintentional. The IRS requires employers to properly classify employees

When an employee is classified as a contractor (1099-form employees), for instance, but they’re really a full-time employee… the company is guilty of tax fraud.

Some employers classify W-2 employees as 1099 employees to avoid paying taxes or health care insurance. It’s important to learn what a 1099 form is and how to use it to prevent employee misclassification.

How to Prevent Payroll Fraud

Maybe you’re tempted to crawl under your desk about now. But don’t do it. Instead, implement one of these five strategies for stopping payroll fraud before it robs you of your money. While payroll fraud is hard to stop entirely, you can certainly catch it sooner than later if you’re diligent. Here’s how you can stay on top of possible payroll fraud.

1. Set Up a System of Checks and Balances

Even in a small company, the same person who puts a new hire into the system shouldn’t be the same employee who reconciles quarterly reports and balances the payroll books. At the very least, get a second set of eyes on quarterly and/or annual payroll reconciliations. (This is what a bookkeeper actually does for a living.) You could also have executives approve all overtime and commission checks. This may prevent employees from adding a few extra hours or sales here and there, thinking it won’t be detected.

We recommend you implement a system to check the books on a quarterly and annual basis to search for errors that may tip off incidents of payroll padding or ghost employees. Integrate your bookkeepers and payroll personnel into your financial data and set to “view only.” This allows them access to information needed to do their end of the job, but requires executives to approve payroll and ensure there are no signs of fraud.

 2. Switch to a Modern Timesheet System 

Using a sophisticated timesheet system. Rather than having employees self-report hours, consider having a clock-in system that requires a passcode or other two-step authentication. This will prevent misreporting. Ensure that the system relies on a biometric or two-step authentication process in order to prevent buddy punching. 

3. Do an Internal Audit of Payroll Taxes

Doing a regular review of the payroll taxes being paid. This can thwart any accidental fraud on the part of your company. If an employee is accidentally classified as exempt or an independent contractor, a routine review of payroll taxes may allow you to catch the mistake before too much damage is done.

 4. Install CCTV Systems

Having a CCTV system in areas where a workplace injury is likely to take place. Being able to rely on video evidence in the case of an injury report protects you and the employee. Have employees work on certain projects in pairs, including anything that involves a ladder so you can avoid false reports of worker’s comp.

5. Regulate Employee Behavior

Pay attention to employee behavior. Payroll is not a department that often requires working late or taking files home. If you have an employee who works with sensitive payroll data who often prefers to work when no one is around, keep your spidey senses activated. Request they stick to office hours or do a random audit to make sure everything is on the up and up. We also recommend you promote direct deposit within your company when possible. This will minimize the amount of physical checks present that could be potentially stolen or altered.

Payroll fraud doesn’t get talked about a lot, but it can be really costly. It’s especially devastating for startups and small businesses. While you may never be able to create totally fraud-proof systems, there’s no reason you shouldn’t try.

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