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Ten Tips to Help Businesses Avoid Payroll-Related Fraud

July 21, 2015

Christopher S. Ernest, CPA, MSM
Principal

Payroll is one of the largest, if not the largest, expense on a corporate income statement. Accordingly, companies should design, implement and maintain a system of controls over payroll in order to ensure that transactions are properly authorized and recorded. Payroll-related fraud is not industry specific and can be difficult to detect. It is also one of the most common. According to a 2014 report by the Association of Certified Fraud Examiners (ACFE), payroll fraud is the top source of accounting fraud and employee theft. The ACFE estimates that payroll fraud occurs in 27% of businesses. Finally, they note that the average payroll fraud lasts approximately 24 months. Payroll fraud, like many other frauds, often starts out small and grows over time as the perpetrator finds success. Some common examples are as follows:

  • Ghost Employees ― Fake or fraudulent employees created by an individual who processes payroll. Checks are then deposited into an account in which the individual can access the funds.
     
  • Inflated time records ― Time cards (or equivalent records) that include hours that were not worked. The most obvious example would be an hourly employee attempting to gain additional compensation by inflating the hours worked on his/her time card. However, salaried employees whose compensation has a bonus component tied to a goal involving hours worked would also have motivation to inflate time records.
     
  • Unauthorized payroll or bonus checks ― Fraudulent payroll disbursements made to an individual without proper approval.
     
  • Manipulation of leave time ― A payroll claim and disbursement for fictitious or inflated leave time.
     
  • Manipulation of withholdings ― Failure (by an individual with payroll processing authority) to withhold items such as 401(k) or health insurance deferrals from an employee’s paycheck, while funding the items from company cash when initiating transfers to benefit administrators.
     
  • Expense report fraud― A claim and reimbursement for fictitious, inflated or personal expenses.

The following are simple, cost effective controls that can be put into place to prevent and detect fraud in this important area:

  1. Maintain a timekeeping system with the appropriate authorizations and reviews. Particularly, overtime (for hourly employees), sick, vacation and other leave time should require review and approval.
     
  2. The owner or chief executive officer of the organization should review each payroll, focusing particularly on those employees involved in the payroll function and spot checking several others on each report. This review should include a review of pay rate, withholdings, etc.
     
  3. The owner or chief executive officer should note the total of each payroll before and after processing to ensure that no manipulation has taken place after the initial review.
     
  4. The owner or chief executive officer should review the entire payroll report for duplicate and/or fictitious employees.
     
  5. The owner or chief executive officer should approve all changes to salaries, and someone independent of the payroll processing and accounting function should be designated to set up new employees in the payroll system.
     
  6. The owner or chief executive office should review a “payroll change report”, which lists any and all changes made to payroll for that particular period. Those changes would include new employees, pay rate changes, changes to withholdings, etc. This serves as a control to ensure that all changes are properly approved.
     
  7. There should be a segregation of duties so that the individual who prepares bank reconciliations for the payroll account does not have the ability to record payroll transactions to the general ledger. Ideally, the person preparing bank reconciliations should not have access to the general ledger or check-signing authority.
     
  8. Reconcile payroll registers to the general ledger payroll accounts on a quarterly basis. This exercise will assist in detecting if payroll has been misposted to another area of the general ledger, or if other fraudulent transactions (e.g. cash-related fraud or fraudulent financial reporting) have been posted to payroll accounts.
     
  9. Require approval of all expense reports by a person outside of the accounting function with the appropriate level of authority.
     
  10. There should be segregation of duties so that the individual signing the expense reimbursement check is not the one approving the reimbursement.

Many of the controls listed above can be implemented without significant financial costs; however, they do require some time investment. While it is important for organizations to create an efficient environment, it is equally critical to ensure that there are processes in place safeguard a company’s assets.

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