According to the Association of Certified Fraud Examiners (ACFE), occupational fraud is on the rise: payments, falsifying wages, and payroll tax evasion.¹ If you want to know how to stop payroll fraud, you have to take the proper steps with your accounting, bookkeeping, and administration to protect your business—not from outsiders, but from long-serving employees who know your business well.
This can be an uncomfortable topic, but I want to bring it to your attention.
There are three primary ways payroll fraud occurs.
Payroll fraud takes several forms, each with unique challenges and implications. To stop payroll fraud, we have to know what it is. Here are the top techniques perpetrators use to steal money and the biggest mistakes small businesses make with payroll taxes.
1. Timesheet fraud occurs when employees dishonestly report hours worked or commissions earned, leading to falsified wages.
Employees pull off this simple yet common fraud by either inflating their own hours, falsely claiming commissions or bonuses, or participating in “buddy punching” (clocking in for an absent colleague).
Expense reports are also vulnerable to fraud when employees request reimbursement for false expenses. Employees might claim to have lost receipts to make false claims about the cost of something or report purchases that were never made or miles that were never driven.
2. Paycheck diversion involves the unauthorized rerouting of funds from one employee’s paycheck to another.
It’s common for employees to commit fraud by manipulating the payroll system. One way they do this is by creating “ghost employees,” fake payees with real bank accounts and social security numbers. These fake employees can either be former workers who are no longer with the company or entirely fabricated personas.
Another way employees commit payroll fraud is by inflating a coworker’s hours and diverting the extra funds to their accounts. This type of fraud is particularly dangerous because it’s usually carried out by individuals in managerial or payroll positions, making it easy for them to steal money without getting caught.
3. Misclassifying regular employees as independent contractors can lead to significant financial and legal repercussions.
Employees and contractors have very different relationships² with a business. Misclassifying an employee as an independent contractor can help employers avoid unemployment tax, payroll taxes, and worker’s compensation insurance expenses.
Employees work for your business when, where, and how you tell them to.
A true employee uses your tools, arrives on your schedule, and gets paid an agreed amount regardless of how the business is doing. Your business could not function without them, and you’re responsible for their job security and withholding payroll taxes.
Independent contractors, on the other hand, function as their businesses.
A contractor generally services many different clients, setting their prices and schedules and using their own tools of the trade. Contractors are also responsible for all the expenses associated with employment, from payroll taxes to insurance.
Sometimes, the differences between employees and contractors aren’t obvious.
In this case, you should seek help from a tax professional or business attorney to ensure that you are in compliance. Educate yourself on the distinctions between employees and independent contractors² and if in doubt, seek the help of a business attorney or a CPA who specializes in your industry.
Here are five actions you can take now to prevent fraud.
How do we stop payroll fraud? It requires a proactive and comprehensive approach. Fraud experts recommend the following five strategies.
1. Train your employees about payroll fraud and prevention.
The ACFE’s 2024 Report to the Nations³ highlights that anti-fraud training can reduce the financial impact of fraud by 41% and detect fraud 50% sooner. Training empowers employees to understand the consequences of payroll fraud for all parties and encourages them to participate actively in prevention measures.
A strong work culture emphasizing integrity can discourage unethical behavior and promote employee accountability.
2. Provide an anonymous reporting system.
Tips from other employees constitute 43% of fraud detection cases—three times the next most common detection method. Employees are the key if you want to stop payroll fraud. Establish an anonymous hotline to encourage staff to report suspicious activity without too many complicated steps.
3. Establish and enforce transparent rules for your payroll processing system.
Stringent rules that apply universally can significantly reduce fraud occurrences. Consider the following policies:
- Require periodic audits so problems are recognized quickly.
- Consider the use of monitoring software to confirm employee hours.
- Conduct all financial activities in pairs.
- Use a modern timesheet system to make falsification more difficult.
- Require owner’s verification for key payroll system steps.
- Enforce strict deadlines for the timely submission of employee hours so that details don’t get lost with time.
- Outsource payroll services to a third party.
On the final point—third parties—it’s critical to set permissions appropriately and work with providers to keep the payroll platform secure.⁴
4. Conduct background checks and confirm references when hiring.
Individuals responsible for payroll and account access must have a reputation for professionalism and high integrity. Background checks are a no-brainer, but not all behavior that disqualifies an applicant for one of these roles will be reported to law enforcement.
Always follow up with candidate references and ask specific questions about their experience handling money. A credit check can also give you a heads-up if an employee has an incentive to steal money, such as unpaid debt.
5. Review payroll reports regularly.
Auditing your payroll reports after payroll processing is critical to ensuring accurate employee pay and detecting discrepancies. Cross-check employee addresses, bank account numbers, current hourly rate, commissions claimed, and tax withholdings. Inconsistencies in any of these areas can tip you off to payroll fraud.
Don’t wait for fraud to find you—be proactive.
If you’re ready to refine your payroll process or introduce robust anti-fraud measures, I am here to help. With my financial security and payroll management expertise, I can guide you through setting up efficient systems that deter fraud. Reach out today to explore ways to fortify your payroll operations.
Talk soon,
Jeremy A. Johnson, CPA
References
- ACFE. Association of Certified Fraud Examiners [Internet]. Acfe.com. [cited 2024 May 29]. 2019. Available from: www.acfe.com/
- About Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding [Internet]. irs.gov. [cited 2024 May 28] Available from: irs.gov/pub/irs-pdf/p1779.pdf
- ACFE Report to the Nations | 2024 Global Fraud Study [Internet]. legacy.acfe.com. [cited 2024 May 29]. Available from: legacy.acfe.com/report-to-the-nations/2024/
- Employers should choose their third-party payroll service provider wisely to prevent fraud | Internal Revenue Service [Internet]. www.irs.gov. [cited 2024 May 29]. Available from: irs.gov/newsroom/employers-should-choose-their-third-party-payroll-service-provider-wisely-to-prevent-fraud