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How Small Businesses Can Fight Payroll Fraud Schemes

Organizations worldwide lose an estimated five percent of their annual revenue to workplace fraud, according to a study conducted by the Association of Certified Fraud Examiners. That may not mean much to a business bringing in millions, but those kind of losses can wipe out a small business.

In the 2014 Global Fraud Study, the smallest businesses took a median hit of $154,000, even higher than the median $145,000 for all businesses. Small businesses are also more likely to be affected by payroll fraud than larger businesses. The study found that 16.5% of fraud cases concerned small business payroll, while just 8.2% of larger businesses were victims of payroll fraud schemes.

Fraudulent activity can be difficult to detect. On average, instances of fraud last approximately 36 months, and the longer the fraudulent activity continues, the more financial fallout it causes for the business.

Avoid payroll fraud cases: Set up controls

However, small business owners can help protect their company from payroll fraud and other kinds of small business fraud cases. Secure payroll starts with controlling who has access to certain information and setting up payroll internal controls and processes within the company, said Wendy Bolois, payroll product director for Patriot Software.

Establish checks and balances

“Checks and balances are always a good idea, no matter what size your organization,” Bolois said. These checks and balances should start at the very beginning, with the setup of new hires, she said.

“Usually in a small business, you have one employee running the show. But you definitely don’t want to have the same person setting up a new hire, processing payroll, and handling the quarter-end reconciliation which includes canceled checks,” she added.

Keep a careful watch on your accounting department

According to the study, accounting personnel were the perpetrators in more than 18% of payroll fraud cases studied worldwide (followed by executives and upper management.) Three payroll fraud schemes were found to be most common: fabricating ghost employees, falsifying wages, and falsifying commissions.

Employees of accounting departments may have ready access to account numbers and blank payroll checks, making it all too easy to fabricate a payroll check for a fictional employee and deposit the funds in an account that the fraudster has established. All the more reason to divide up the HR and payroll functions, Bolois said.

“Really the best thing is to have someone other than the payroll processor enter a new employee’s name, address, pay rate and direct deposit information,” she said. “Examine your banking records to make sure all checks clearing the bank have been authorized,” she said. She added that it’s important to also verify that the direct deposit accounts being used actually match the employee receiving the paycheck.

Don’t allow payroll department employees to generate their own paychecks

This measure can help prevent a payroll fraud case like one in Rhode Island, where a longtime employee allegedly embezzled more than $42,000 by adding overtime hours and vacation pay to which she was not entitled and failing to deduct her health insurance premium for six years. Paycheck fraud can be hard to trace, and detrimental to your business over time.

Rotating responsibilities within a department is another good idea, although this may not be feasible for small businesses who only have one person in charge of payroll, Bolois cautioned. In that case, the owner should reconcile the payroll account and look at new hires at least quarterly, she said.

Make sure payroll tax deposits are actually being made

In some small business fraud cases, an employee pockets the payroll tax liabilities due to the government. This can be a double-whammy for the employer, who is ultimately responsible for making sure these liabilities are actually being paid. According to Doug Simmons, payroll tax specialist with Patriot Software, employers can face penalties, interest and even criminal charges if they fail to make the required tax deposits.

“Ultimately, the employer is responsible for making sure their federal tax deposits and tax returns are being filed,” Simmons said.

Employers can keep a separate copy of their PIN and password for the Electronic Federal Tax System and log in to EFTPS.gov periodically to make sure that accurate, timely deposits are being made for the company. Employers can also regularly review the quarterly payroll tax filings for the business to make sure everything adds up, he added.

The same goes for using outside payroll providers to make your federal tax deposits — make sure they are actually making the deposits as promised. EFTPS has started issuing separate Inquiry PIN numbers for business owners who use an outside payroll tax provider. This measure helps business owners to monitor the payroll company’s actions on their behalf, Simmons said.

Encourage employees to share tips about payroll fraud

The ACFE study found that action by whistleblowers is by far the most common and effective way that employers discover fraud in the workplace. At larger companies, 45% of fraud is detected by a tipster, while 34% of small businesses found out about fraud from a tip. However, only 4.6% of small businesses had any rewards system in place to encourage tips from whistleblowers.

Establishing a hotline and a clear procedure for reporting suspected fraud is a good investment in fraud protection. The actions of whistleblowers may mitigate losses more quickly than if the fraud goes on undetected for years and years. Fellow employees also may be in a better position to spot red flags of possible fraudulent behavior.

Train others to look for red flags of payroll fraud cases

While fraud can happen in any business, common red flags occurred in many of the cases studied. The following behavioral red flags were seen related to asset misappropriation in particular:

  • An employee living beyond their means, 45.8%
  • Financial troubles, 35.8%
  • Hesitation to share duties with others, 20.9%
  • An unusually close relationship with vendor or customer, 19.1%
  • Divorce or family problems, 17.3%

Other red flags included a “wheeling-dealing” attitude; irritable, suspicious or defensive behavior; addiction issues; dissatisfaction with pay; past work-related problems; an unwillingness to take vacation time; social isolation; excessive pressure to perform, either inside or outside the organization; past legal issues; instability in the employee’s personal life; and a feeling of a lack of authority. Training other employees to spot these warning signs can contribute to a more effective tip program.

Conduct routine and surprise audits. In nearly 10% of the small business cases studied, the fraud was detected by an internal audit, while an additional 5% of fraudulent cases were discovered an external audit. An independent audit may reveal important red flags, which will be documented.

“If in the course of the audit, the auditor finds indications of fraud, the auditor’s responsibility is to communicate their findings to the audit committee of the Board of Directors (in large companies) or in small companies, to whomever fills the audit oversight,” said Todd Schmitt, controller of Patriot Software, LLC

Establish an ethics code that you expect all employees to follow. While an ethics code will not stop anyone who is already intent on stealing from you, it demonstrates the value of honesty and integrity to the organization and sets the tone for how you expect business to be conducted.

Conduct regular background checks. Establishing a procedure of required background checks may discourage thieves from even applying for a job in the first place. However, be aware that background checks are not a fail-safe, and may not predict future fraudulent behavior in an employee. Only 5% of fraudsters had been convicted of fraud prior to the ACFE study, and many fraudsters work for years before they start stealing from their employer.

Fraud can happen in any company, large or small. But putting these practices in place will send a clear message to employees that fraud will not be tolerated.

Stolen Identity Refund Fraud (SIR F)

There is one more type of fraud that could impact your employees and your payroll: identity theft.

Here’s what is happening. Thieves are taking advantage of the time lapse between when W-2s are issued to employees in January, and when W-2s are submitted to the SSA at the end of March. This means the government cannot cross-check the employee copy of the W-2 with the employer’s W-2 copy that will be submitted later to the SSA. Fraudulent tax returns are filed during the time gap, and the tax refunds are collected by the thieves.

The IRS estimates that $5.2 billion was paid out in fraudulent tax returns in 2013. This significant loss is being addressed in a couple ways. There has been discussion about closing the window of opportunity by changing W-2 deadlines. The employer W-2 filing date could be moved up to match the date that the employees receive their W-2s.

The IRS is taking identity theft seriously and have partnered with the private sector to find solutions. They have already identified 20 elements that could help to detect possible fraud with filed tax documents.

What can you do? As an employer, you can protect your payroll records to deter thieves from stealing the identity of your employees.

Are you using payroll software? Keep your payroll records protected in the cloud. Learn more by using our payroll software for small business for free for the first 30 days.

Originally published 05/30/2014 by author Shalleen Mayes

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