Protecting Your Organization from Employee & Payroll Fraud Schemes

Preventing employee fraud begs the question: Do you know your employees? According to data published by the Association of Certified Fraud Examiners (ACFE), organizations lose an estimated 5% of revenues due to occupational fraud each year. Occupational fraud is defined as an individual using their occupation for personal enrichment via deliberate misuse of their employer’s resources. Victims of employee fraud extend beyond the organization to any other individuals or entities directly or indirectly affected by the profitability of the business. 

What Is Employee Fraud? 

Employee fraud is a type of occupational fraud, whereby the fraud is committed internally by an organization’s employee(s).  Employee fraud can occur in multiple ways, but the most common are asset misappropriation schemes. These schemes involve an employe stealing or misusing the organization’s resources. Employee fraud can look different from case to case through embezzlement, theft, manipulation, and payroll fraud.  

Common Types of Employee Fraud

• Skimming is the theft of cash on hand or of cash receipts, which may occur as theft or via skimming. Skimming schemes may occur related to sales, receivables or refunds. 
• Cash theft via fraudulent distributions may include billing schemes, payroll schemes, expense reimbursement schemes, check and payment tampering, and register disbursements.  
• Asset misappropriation includes theft or misuse of inventory and other organization assets. 

What is Payroll Fraud? 

Payroll fraud is a fraudulent distribution scheme in which an employee causes their employer to issue payment for compensation that is improper. These instances occur when inputs into the payroll system are manipulated.  When internal controls are lacking in the payroll department, it creates an opportunity for multiple fraud schemes to materialize.  

In addition to payroll fraud, expense reimbursement schemes may also be perpetrated via the payroll system.  Payroll fraud is not always perpetrated by someone within the payroll department. Employees from other departments may submit falsified records to the payroll department, resulting in fraudulent payments. 

Common Types of Payroll Fraud 

• Overpayment schemes occur when hours and/or rates are manipulated. Falsified timesheets are often submitted leading to timesheet fraud. An example of timesheet fraud may involve “buddy punching,” which is an arrangement between employees who fraudulently clock-in for one another when one of them is not present. The missing person receives wages without physically being present and performing work duties. 
• Pay rate alteration is a specific example of an overpayment scheme. This occurs when an employee colludes with someone from the payroll department and/or leverages the system to adjust their pay. This is more likely to happen at a small organization due to fewer controls and segregations between work.
• Ghost employee fraud occurs when wages are paid to someone who doesn’t work for the organization. Ghost employees may be real individuals (such as past employees) or fictional identities. These ghost employees can be identified through discrepancies in payroll records. 
• Bonus or commission fraud schemes occur when performance data or commission rates are manipulated. Given that bonus or commission fraud schemes often involve reporting inflated revenues and/or timing differences for revenues, this type of scheme may also include financial statement fraud. 

Examples of Employee and Payroll Fraud 

No-Show Ghost Employee Scheme 

Sam had inherited a family business co-owned and managed by a relative, Tom. Sam became concerned when he asked Tom about the operations and direction of the business and was met with hostility. Sam eventually brought a suit, and an expert was hired to review the organization’s income and determine its value in the context of a shareholder dispute. Besides the numerous personal living costs expensed as operating expenses, a payroll records investigation uncovered numerous ghost employees. Certain employees were flagged due to duplicate addresses, multiple individuals with related last names, and employees with addresses out of the area. In addition to children and grandchildren, Tom had been paying for his father’s nurse and his housekeeper through payroll. 

Terminated Ghost Employee Scheme 

Megan was terminated from her role as an administrative assistant. Instead of updating Megan’s status, Joy, an employee in the payroll department, directed Megan’s paycheck to be printed rather than direct-deposited. Joy then took possession of the physical checks and endorsed them for her own benefit for two pay periods. If there had been no cross-check from human resources, this fraud may have gone undetected due to its short time span. 

Reimbursement Scheme 

In context of a matrimonial dispute, an expert was hired to value a family-owned business for equitable distribution (fairly dividing marital assets). A review of the owners’ expense reports showed multiple reimbursements for the same expense. This expense was submitted one month with a credit card receipt and the next month with a detailed invoice. Both related owners committed this scheme with the other’s knowledge. The victims in this case were the employees with bonuses tied to the company’s profitability and the IRS. 

Steps to Safeguard Your Organization from Employee and Payroll Fraud  

There are several things an organization can do both to prevent occurrences of fraud and mitigate the impact when a fraud is discovered. 

Establish Strong Internal Controls  

Internal controls support reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. Internal controls minimize opportunities for unintentional errors or intentional fraud. For example, preventive controls are designed to discourage errors or fraud, and detective controls identify errors or fraud after it has occurred.  

Implement Segregation of Duties 

Proper internal controls and segregation of duties can prevent many of these schemes. Segregation of duties and controls may involve limiting the number of people who process the payroll, and having different employees record the payroll. While proper segregation of duties can help prevent many fraud schemes, co-conspirators in multiple departments may make discovering employee and payroll fraud schemes more difficult. Therefore, personnel records should be maintained separately from the payroll function to facilitate comparisons between human resources and payroll systems. 

Cross-Check Personnel and Payroll Records  

Payroll fraud schemes, such as ghost employee schemes, may be discovered by cross-checking personnel and payroll records. The employee master file should be reviewed for certain flags such as changes in rates or salary, multiple employees with the same social security number, and multiple employees with the same address. Email addresses should also be verified for duplicates. Changes in the payment method (e.g., a change from direct deposit to physical checks) should also be flagged and reviewed 

Additional Tips to Prevent or Mitigate Employee Fraud 

To prevent employee fraud related to expense reimbursement schemes, companies should implement standard procedures related to the documentation required for reimbursement claims. Expense reports should require original receipts, and reimbursements for prepaid expenses should be revisited after the expense event occurs. 

To prevent or aid in the detection of payroll fraud related to “buddy punching” schemes, organizations should consider the installation of a monitoring device for the time clock, such as a camera, or advanced technology such as fingerprint or retinal scans. 

Any organization may be vulnerable to payroll or employee fraud. An experienced advisor can help you design proper internal controls that address specific risks that your organization faces. If you think fraud may have occurred, consider hiring a certified fraud examiner or forensic accountant to investigate the magnitude of the damage.