When horses start riding your payroll: The trials and tribulations of payroll fraud and errors

A study shows that payroll fraud is the number one source of accounting fraud and employee theft, occurring in 27 per cent of all businesses.

Happy summer (or should I say construction season)! I hope you are enjoying the warm weather and will get a chance to take in whatever Mother Nature decides to offer us during these next few, short months!

I have been asked many-a-time by senior management and boards what kinds of frauds should be keeping them up at night, when it comes to misappropriation? Logically, I think about the cases that I have been brought in to investigate for almost two decades, and my mind keeps gravitating towards payroll fraud.  I also consider accounts payable and procurement as two other key areas targeted by fraudsters.

But don’t just take my word for it.  

A study  shows that payroll fraud is the number one source of accounting fraud and employee theft, occurring in 27 per cent of all businesses. The study also found that payroll fraud occurs nearly twice as often (14.2 per cent) in small organizations with less than 100 employees than in large ones (7.6 per cent).

With payroll accounting for as much as two-thirds of some organizations expenditures, these statistics should be setting off alarm bells.

When it comes to payroll errors, I have worked with several organizations to proactively sniff out weaknesses in their payroll process.  Such engagements have suggested that errors invariably occur in 100 per cent of organizations.  A variety of factors lead to this result, including human error, lack of supervisory oversight and complacency, just to name a few.

In one case, a manager responsible for payroll took copies of the department timesheets to their supervisor for filing, while the original timesheets were taken to payroll for processing.  Once the copies were safely in the hands of the supervisor, the manager found an arithmetic ‘error’ in their own timesheet and changed it on the original before submitting it to payroll.

The manager inadvertently forgot to advise the supervisor about this correction.  When the payroll came back processed with the revision made by the manager, it became crystal clear that nobody was reconciling the copies to the originals submitted to payroll.  The ‘opportunity’ to commit fraud just introduced itself.

Two years and $150,000 of corporate funds misappropriated later, this somewhat innocuous payroll-error-turned-fraud became the CFO’s nightmare!

While fraud may cause an organization adverse reputational damage and costs to investigate and prosecute the fraudster, errors also create considerable additional work (and costs) for the organization and can result in efficiencies in what is otherwise supposed to be a routine process.

Consider the employee who took maternity leave, only to return the following year to find out that their salary status had never been adjusted in payroll.  As a result, they were overpaid by $30,000 and were required to return that money to the company. No one envies the person who has to share the bad news with the recently returning employee!

Many organizations also find it challenging to keep track of their employees.  When you have over a thousand employees and a decentralized operation with multiple locations, it’s next to impossible to know exactly who are legitimate vs. illegitimate employees.

Now compound the problem by having an organization that constantly hires short-term contractors as well as seasonal and part-time workers to fill-in during peak season or high production periods.

Mandating supporting documentation to be signed by the appropriate supervisor relating to any changes to payroll — including the addition of new employees — would be considered internal control best practices.  However, consider the case where the employee created ‘new’ overtime approval forms by taking forms previously authorized by their manager and simply substituting the dates, in order to support unauthorized overtime that was never worked.

This scheme reminds us that fraud is only limited by the creativity of the fraudster!

Here’s another thought: Assuming your payroll is complete and accurate, in order for a ghost employee to be added or unauthorized revisions to occur, something must change on your payroll. Therefore, if someone outside of payroll continuously monitors the appropriateness of such changes, you should theoretically be able to catch most intentional or unintentional errors, no?

While I believe that even the most robust internal controls can enable payroll fraud (and errors) to occur with the right circumstances and opportunity, I am confident that most payroll frauds and errors can be caught!

Do you have any thoughts or stories on payroll fraud or errors that you’d like to share? Please comment below.

Until next time, I bid all of our accounting colleagues and other faithful readers farewell, but not adieu. Have a fabulous summer!

About the Author

Edward Nagel, CPA, CA•IFA, CBV

Forensic accountant