PAYROLL FRAUD
Global Problem: Finding a Potential Needle in the Pay Stack!
When it comes to fraud, the recurring headlines undoubtedly draw our attention to this much-covered topic. However, the staggering statistics tell the real story here, as suggested by the following:
Regardless which of the above statistics is considered to be more accurate, what is fair to say is that fraud is a significant and growing problem globally.
Historically, organizations’ approach to dealing with fraud has largely been reactionary and event-driven. That is, many organizations tend to wait for allegations to surface before addressing potential weaknesses in internal controls or recognizing the absence of strong corporate governance; both of which are designed to prevent and detect fraud from occurring.
In recent years, it appears that this philosophy is shifting, with more organizations starting to take a proactive rather than reactive approach to dealing with fraud.
One process within the accounting cycle that tends to draw significant attention from management and boards alike is payroll. This comes as no surprise because of the frequency of payments and the fact that payroll can often represent more than 50% of an organization’s annual expenditures.
Invariably, these factors also contribute to fraudsters frequently targeting payroll. Let’s examine one case study to see just how easy it is for payroll fraud to occur.
- The Royal Canadian Mounted Police (RCMP) Commercial Crime Branch indicated that fraud-related offenses in Canada are thought to be as profitable as drug-related offenses, estimated at between $10 billion and $30 billion annually.
- The Certified General Accountants Association of Canada (CGA Canada) estimates that Canadian businesses lose $3.2 billion annually from occupational fraud alone.
- The Association of Certified Fraud Examiners (ACFE) found that the typical organization loses 5% of revenues each year to fraud. If applied to the 2013 estimated Gross World Product, this translates to a potential projected global fraud loss of nearly $3.7 trillion or $3,700,000,000,000!
Regardless which of the above statistics is considered to be more accurate, what is fair to say is that fraud is a significant and growing problem globally.
Historically, organizations’ approach to dealing with fraud has largely been reactionary and event-driven. That is, many organizations tend to wait for allegations to surface before addressing potential weaknesses in internal controls or recognizing the absence of strong corporate governance; both of which are designed to prevent and detect fraud from occurring.
In recent years, it appears that this philosophy is shifting, with more organizations starting to take a proactive rather than reactive approach to dealing with fraud.
One process within the accounting cycle that tends to draw significant attention from management and boards alike is payroll. This comes as no surprise because of the frequency of payments and the fact that payroll can often represent more than 50% of an organization’s annual expenditures.
Invariably, these factors also contribute to fraudsters frequently targeting payroll. Let’s examine one case study to see just how easy it is for payroll fraud to occur.
Events Giving Rise to ‘Ghost Employee’ Scheme
In one organization, a seasoned Payroll Administrator handled payroll and implemented numerous checks and balances to prevent errors while mitigating the risk of fraud. This proved to be effective, as the payroll administrator’s track record was impeccable. Errors were virtually non-existent, and not a single occurrence of fraud surfaced during her 15-year tenure managing the company’s payroll for more than 500 employees.
The Payroll Administrator reported to the company’s Controller, whose review was normally limited to a cursory examination of the payroll register.
The Payroll Administrator was celebrating a milestone anniversary and decided to take a three-week vacation to Europe. During this absence, responsibility for the company’s weekly payroll was delineated to “Sonia,” a senior, trusted employee and team player by all accounts. After all, Sonia was the company’s Controller and had overall responsibility for the company’s accounting.
Crime of Opportunity
Over the years, Sonia had been progressing well in terms of promotions. During a recent performance review meeting, Sonia’s boss alluded to the fact that there was a “serious” promotion in the making for her. Sonia knew that could only mean a VP role. Recognizing that this would result in a higher salary, bonus, and car allowance, she decided with her spouse to purchase their dream home in advance of being officially promoted.
When it came to promotion time, Sonia was stunned to find out that her long-deserved promotion was being deferred indefinitely as the result of a new VP Finance person being parachuted into the company.
Deflated and demoralized, Sonia returned to her office to start processing the weekly payroll. It occurred to Sonia that with the Payroll Administrator out of town for a few weeks and the new VP Finance getting up to speed, there would be limited controls—particularly segregation of duties—involving the processing of payroll.
The Payroll Administrator reported to the company’s Controller, whose review was normally limited to a cursory examination of the payroll register.
The Payroll Administrator was celebrating a milestone anniversary and decided to take a three-week vacation to Europe. During this absence, responsibility for the company’s weekly payroll was delineated to “Sonia,” a senior, trusted employee and team player by all accounts. After all, Sonia was the company’s Controller and had overall responsibility for the company’s accounting.
Crime of Opportunity
Over the years, Sonia had been progressing well in terms of promotions. During a recent performance review meeting, Sonia’s boss alluded to the fact that there was a “serious” promotion in the making for her. Sonia knew that could only mean a VP role. Recognizing that this would result in a higher salary, bonus, and car allowance, she decided with her spouse to purchase their dream home in advance of being officially promoted.
When it came to promotion time, Sonia was stunned to find out that her long-deserved promotion was being deferred indefinitely as the result of a new VP Finance person being parachuted into the company.
Deflated and demoralized, Sonia returned to her office to start processing the weekly payroll. It occurred to Sonia that with the Payroll Administrator out of town for a few weeks and the new VP Finance getting up to speed, there would be limited controls—particularly segregation of duties—involving the processing of payroll.
The Ghost Employee
Sonia proceeded to add a new fictitious, or “ghost,” employee to the payroll. A ghost employee is a person who is on the books but does not actually work for an organization. In some instances, the fictitious employee worked there previously but either left or died; more commonly, however, the individual never worked there at all.
The ghost employee Sonia added was a relatively junior hire within an existing department that had several recently vacated positions—as this would diminish the likelihood of detection. She used an alias name and her own legitimate bank account to set up the new employee. She also set up an HR file and put in a few “usual” forms (but certainly not the complete file normally found for legitimate employees).
In short, Sonia believed that uncovering one ghost employee among 500 was going to be like finding a needle in haystack—or in this case, pay stack!
After the payroll was processed later that week, Sonia walked the payroll register to the VP Finance to be reviewed, a look through the payroll register and signed off responsibility that was normally assigned to her. The VP Finance took a cursory on it, trusting her employee.
What the new VP Finance apparently failed to consider is that trust is not an internal control. Within weeks of her return from vacation, the Payroll Administrator’s keen eye for details and strong checks and balances uncovered the Controller’s payroll fraud scheme. Sonia was terminated with cause, and the company was able to recover the misappropriated funds through their fidelity insurance (i.e., insurance against employee malfeasance).
The ghost employee Sonia added was a relatively junior hire within an existing department that had several recently vacated positions—as this would diminish the likelihood of detection. She used an alias name and her own legitimate bank account to set up the new employee. She also set up an HR file and put in a few “usual” forms (but certainly not the complete file normally found for legitimate employees).
In short, Sonia believed that uncovering one ghost employee among 500 was going to be like finding a needle in haystack—or in this case, pay stack!
After the payroll was processed later that week, Sonia walked the payroll register to the VP Finance to be reviewed, a look through the payroll register and signed off responsibility that was normally assigned to her. The VP Finance took a cursory on it, trusting her employee.
What the new VP Finance apparently failed to consider is that trust is not an internal control. Within weeks of her return from vacation, the Payroll Administrator’s keen eye for details and strong checks and balances uncovered the Controller’s payroll fraud scheme. Sonia was terminated with cause, and the company was able to recover the misappropriated funds through their fidelity insurance (i.e., insurance against employee malfeasance).
The Fraud Triangle
Sonia’s ability—albeit temporary—to carry out this fraud scheme can be explained by the “fraud triangle,” which is the generally accepted model for managing fraud risk. It asserts that there are elements of rationalization, opportunity, and motive in every fraudulent act.
In the example case, the rationalization was clear. Sonia believed that she deserved the promotion to VP Finance that was wrongfully taken from her by someone who was parachuted into the company.
Sonia’s opportunity was the fact that she was a long-term, trusted employee reporting to a new boss. Sonia took advantage of the temporary absence of the seasoned Payroll Administrator, coupled with the lack of segregation of duties relating to the processing/review of payroll. However, Sonia failed to consider the Payroll Administrator’s keen attention to detail and ability to identify potential anomalies in the payroll upon her return from vacation.
Finally, Sonia’s motive was to support her lifestyle. Sonia put herself into an adverse financial position by purchasing a larger, more expensive home, but justified it on the basis that she was going to be promoted and therefore was going to earn the additional money she would need to support her mortgage.
In the example case, the rationalization was clear. Sonia believed that she deserved the promotion to VP Finance that was wrongfully taken from her by someone who was parachuted into the company.
Sonia’s opportunity was the fact that she was a long-term, trusted employee reporting to a new boss. Sonia took advantage of the temporary absence of the seasoned Payroll Administrator, coupled with the lack of segregation of duties relating to the processing/review of payroll. However, Sonia failed to consider the Payroll Administrator’s keen attention to detail and ability to identify potential anomalies in the payroll upon her return from vacation.
Finally, Sonia’s motive was to support her lifestyle. Sonia put herself into an adverse financial position by purchasing a larger, more expensive home, but justified it on the basis that she was going to be promoted and therefore was going to earn the additional money she would need to support her mortgage.
What is the Fraud Triangle?
The fraud triangle helps explain the motivation behind why an employee would commit fraud/steal from their workplace. Three components make up the fraud triangle: opportunity, pressure, and rationalization. It is an intentional deception that causes the personal gain of an employee or an entity.
When all these components exist, there is a high likelihood that fraud will be committed. Similarly, this can signal that fraud has already occurred or maybe ongoing. Seldom are frauds committed spur of the moment. Typically, they are deliberately planned and executed.
According to this concept, fraud occurs when conditions for fraud are favorable to the fraud committer, and it is not random. It generates illegal gain or incentive or releases the individual or entity from unwanted pressure. This aggravates the temptation to take such a step and gives a feeling of better control without caring about the consequence.
When all these components exist, there is a high likelihood that fraud will be committed. Similarly, this can signal that fraud has already occurred or maybe ongoing. Seldom are frauds committed spur of the moment. Typically, they are deliberately planned and executed.
According to this concept, fraud occurs when conditions for fraud are favorable to the fraud committer, and it is not random. It generates illegal gain or incentive or releases the individual or entity from unwanted pressure. This aggravates the temptation to take such a step and gives a feeling of better control without caring about the consequence.
Fraud Triangle Explained
The fraud triangle theory explains why and how individuals working in an organization commit fraud. It is the concept that explains the reason behind committing the fraud. The main elements are pressure, opportunity, and rationalization. In addition, there must be strong internal controls, zero tolerance, and a proper code of ethics to prevent fraud, which motivates employees to be ethical.
To prevent and detect fraud, there must be surprise checks and audits, management audits are also encouraged, and there must be strong fraud deterrence policies so that no employee can think of committing fraud.
To prevent and detect fraud, there must be surprise checks and audits, management audits are also encouraged, and there must be strong fraud deterrence policies so that no employee can think of committing fraud.
Elements of Fraud Triangle
Given below are the major elements of Fraud Triangle Model.
Pressure
The pressure is the motivation behind fraud committing, and that can be either personal financial pressure or pressure from superiors. Both the pressures give the motivation and fraud triangle opportunity. Very few people steal for the high it gives them. There is typically a reason behind the action If the pressure remains unsolved by rational and legal means, then individuals might go for irrational ways. The individual can feel cornered and feel that there is no other way out. Reasons for Pressure to occur:
Opportunity When pressure is present, the employee looks for an opportunity to commit fraud. For example, if there is no internal control over the inventory room, then the employee finds the chance to pilferage it and sell it in the market. It can be done by abusing the position, for example, pressure by superior to subordinate to show accounts by window dressing. The opportunity provides an individual a way to remove funds or assets from a company or individual. As well as be able to cover up the fraud that has occurred. Cash is the main target, but assets that can be turned into cash are also valuable, as well as assets that can be used to supplement the fraudsters expenses. This is the only component of the fraud triangle that the business has control over. The business can control the assets, people, information, and computer systems to limit an employee’s opportunity to commit fraud. Reasons for an Opportunity to occur:
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Rationalization
It is the last stage in the fraud triangle theory. This stage requires fraudsters to justify fraud acceptably. Most fraud committers do not see themselves as criminals; instead, they explain the situation of committing fraud. Similarly, fraud by management gives reason for performance and pressure from shareholders for dividends and all. Significantly, rationalization is a necessary component of the crime before it takes place; in fact, it is the part of the motivation for the crime. Because an embezzler does not view himself as criminal, he must justify his misdeeds before he ever commits them. The rationalization is necessary so that the perpetrator, can make his illegal behavior intelligible to himself and maintain his concept of himself as a trusted person. In other words, rationalization is the justification that individuals use to rationalize their actions. This could be because they believe that their actions would not hurt anyone or that they are entitled to the proceeds of their crimes. It could also be because they believe that their victims deserve it or that they would not be caught. People who commit fraud rationalize their actions. They explain the situation that made them commit fraud and not how their actions were criminal. This is because they had rationalized to themselves that the misdeed was OK. This rationalization makes it okay for them to commit fraud and as a result, shows how they are deserving of what they unfairly took. Reasons for Rationalization:
Fraud Combination In short, when two or three of these exist simultaneously, you have a situation that is ripe for fraud. Sometimes the fraud is just a one-time deal. Other times the fraud is perpetuated over months or even years. However, the longer the fraud goes on, the bolder the individual becomes, and the more they can siphon out of the company. |
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‘Red Flags’ of Payroll Fraud
Regardless of the country in which payroll is processed, many potential indicators, or “red flags,” may help uncover errors in payroll or potential fraud schemes (such as that committed by the Controller), including the following:
Arguably, even those companies with the most robust corporate governance models, detailed policies, and procedures governing every process performed on a day-to-day basis can be victimized by fraud.
This can often be explained simply as complacency. Employees need to be reminded that fraud is a real and ongoing risk and that they should be on the lookout for any suspicious transactions or potential discrepancies. Employees also need a mechanism, such as a whistleblower hotline, to report such issues, particularly if they are not comfortable coming forward to their supervisors.
- Employees with duplicate addresses and/or bank account information
- Invalid social security or social insurance numbers
- Employees without source deductions and/or employee files
- Fluctuations in payroll expense as compared to prior periods, including inconsistencies between the level of payroll as compared to department productivity.
- Timesheets with notations in different handwriting or color
- Extra pay stubs left over after distribution to employees.
- Changes to payroll from one pay period to the next that are unsupported or unauthorized.
- Expense reports with photocopied/altered receipts, calculation errors, and supporting documentation lacking details of expenses incurred.
Arguably, even those companies with the most robust corporate governance models, detailed policies, and procedures governing every process performed on a day-to-day basis can be victimized by fraud.
This can often be explained simply as complacency. Employees need to be reminded that fraud is a real and ongoing risk and that they should be on the lookout for any suspicious transactions or potential discrepancies. Employees also need a mechanism, such as a whistleblower hotline, to report such issues, particularly if they are not comfortable coming forward to their supervisors.
Other Common Fraud Schemes
In addition to “ghost” employee schemes, payroll practitioners should be aware of other common fraud schemes so that they can help to minimize the likelihood of fraud in their own organizations. These fraud schemes can victimize organizations, regardless of their location, and can include the following:
- Falsified wage schemes—include any scheme whereby employees make a claim for compensation for hours not worked or by falsifying their timesheets/timecards.
- Fraudulent commission schemes—such schemes are typically carried out by salespeople and normally involve the manipulation of commission policies and structures as well as the use of side agreements to record sales or revenue prematurely or without basis.
- Workers’ compensation schemes—include schemes whereby employee’s fake injuries, such as neck, back, bone, or joint problems, for the purpose of bilking their employer and insurance company (also injuries sustained out of the workplace but represented to have occurred in connection with the person’s employment)
- False expense claims—include schemes whereby employees claim personal expenses and represent them to be business-related, overstated expense claims, claims involving altered or fictitious receipts, and expenses claimed on behalf of other employees in duplicate.
- Failure to remit schemes—include schemes whereby individuals responsible for withholding taxes and other deductions withhold the funds from employee pay but fail to remit such funds to the applicable government authority.
Prevention the Best Deterrent
With the passage of time, it is human nature for complacency to kick in, which may include processing transactions without considering how such transactions may be fraudulent. By providing employees with regular anti-fraud training, you not only increase the chances of catching errors and fraud sooner, but you also deter would-be fraudsters from engaging in illicit activity in the first place, as they know that everyone around the payroll is now trained in fraud prevention.
With technology playing a greater role in our day-to-day lives, we have seen the advent of automating the review of payroll registers. The purpose of such reviews is to identify potential changes to payroll or anomalies that may be errors or, worse, could indicate an ongoing fraud scheme.
Although the risk of fraud can never be completely eliminated, having effective payroll checks and balances and internal controls can certainly reduce it significantly. Regular testing of the effectiveness of such controls is required.
In short, no one, no matter how senior, should ever be exempt from any of the organization’s internal controls. Moreover, the messaging or “tone from the top” must be clear: There is simply no room for fraud and other illicit activity in your organization.
Fraud awareness needs to be top of mind in order to keep the crooks off the books!
With technology playing a greater role in our day-to-day lives, we have seen the advent of automating the review of payroll registers. The purpose of such reviews is to identify potential changes to payroll or anomalies that may be errors or, worse, could indicate an ongoing fraud scheme.
Although the risk of fraud can never be completely eliminated, having effective payroll checks and balances and internal controls can certainly reduce it significantly. Regular testing of the effectiveness of such controls is required.
In short, no one, no matter how senior, should ever be exempt from any of the organization’s internal controls. Moreover, the messaging or “tone from the top” must be clear: There is simply no room for fraud and other illicit activity in your organization.
Fraud awareness needs to be top of mind in order to keep the crooks off the books!
Halifax Business Owner Sentenced To Three Years In Jail And He & His Companies Fined Over $600,000 For Fraud & Tax Evasion
The Canada Revenue Agency (CRA) announced today that Mr. Ralston MacDonnell, of Halifax, Nova Scotia, was sentenced to 3 years in jail, and fined a total of $301,511.25. MacDonnell’s three related corporations were fined a total of $301,516.25. On May 18, 2021, a Halifax Provincial Court judge found MacDonnell and three of his related companies guilty of seven counts of fraud and four counts of tax evasion. In addition to the court imposed fine, MacDonnell will also have to pay the full amount of tax owing, plus related interest and any penalties assessed by the CRA.
A CRA investigation revealed that MacDonnell operated an engineering firm in Halifax, Nova Scotia, that splintered into three related companies: MacDonnell Security Risk Management Ltd., MacDonnell Group of Canada Ltd., and the numbered company 3182552 Nova Scotia Limited. From 2009 to 2014, MacDonnell and his three companies collected Goods and Services Tax/Harmonized Sales Tax (GST/HST) and Payroll Source Deductions and systematically failed to remit them to the CRA.
MacDonnell made several false and deceptive statements in dealings with the CRA, which included the evasion of requirements to pay and the withholding of information. MacDonnell also used cheques knowing that they were drawn from an account that had insufficient funds. During the same period, MacDonnell diverted corporate funds into personal bank accounts unknown to the CRA, to cover personal expenses, including three mortgages, a car lease and other personal spending.
During the period from January 1, 2009, to December 31, 2014, MacDonnell and his three companies defrauded the Government of Canada by collecting and failing to remit GST/HST and payroll source deductions totaling $961,700.55.
All case-specific information above was obtained from the court records. Tax evasion is a crime. Falsifying records and claims, willfully not reporting income, or inflating expenses can lead to criminal charges, prosecution, jail time, and a criminal record. From April 1, 2020, to March 31, 2021, there were 36 convictions, with 15 taxpayers sent to jail for a total of 26.2 years. These individuals were sentenced for willfully evading payment amounts totaling $10,902,950 in tax.
The CRA remains dedicated to maintaining the integrity of Canada’s tax system, as well as the social and economic well-being of Canadians during these unprecedented times. The CRA continues to aggressively pursue tax evasion and false claims with all tools available to them.
The CRA is continuously working towards making sure that individuals and businesses report income earned and eligible losses, and claim benefits to which they are entitled, so that important benefit programs can be administered to those who need them. As a result of COVID-19, we are seeing the increased importance of these benefits, and are working to make sure that they continue to be available to Canadians. Any individual or business who underreports income, or claims losses or benefits to which they are not entitled, including ineligible claims for COVID-19 benefits, may have to repay the benefit amounts and may be subject to other possible action.
A CRA investigation revealed that MacDonnell operated an engineering firm in Halifax, Nova Scotia, that splintered into three related companies: MacDonnell Security Risk Management Ltd., MacDonnell Group of Canada Ltd., and the numbered company 3182552 Nova Scotia Limited. From 2009 to 2014, MacDonnell and his three companies collected Goods and Services Tax/Harmonized Sales Tax (GST/HST) and Payroll Source Deductions and systematically failed to remit them to the CRA.
MacDonnell made several false and deceptive statements in dealings with the CRA, which included the evasion of requirements to pay and the withholding of information. MacDonnell also used cheques knowing that they were drawn from an account that had insufficient funds. During the same period, MacDonnell diverted corporate funds into personal bank accounts unknown to the CRA, to cover personal expenses, including three mortgages, a car lease and other personal spending.
During the period from January 1, 2009, to December 31, 2014, MacDonnell and his three companies defrauded the Government of Canada by collecting and failing to remit GST/HST and payroll source deductions totaling $961,700.55.
All case-specific information above was obtained from the court records. Tax evasion is a crime. Falsifying records and claims, willfully not reporting income, or inflating expenses can lead to criminal charges, prosecution, jail time, and a criminal record. From April 1, 2020, to March 31, 2021, there were 36 convictions, with 15 taxpayers sent to jail for a total of 26.2 years. These individuals were sentenced for willfully evading payment amounts totaling $10,902,950 in tax.
The CRA remains dedicated to maintaining the integrity of Canada’s tax system, as well as the social and economic well-being of Canadians during these unprecedented times. The CRA continues to aggressively pursue tax evasion and false claims with all tools available to them.
The CRA is continuously working towards making sure that individuals and businesses report income earned and eligible losses, and claim benefits to which they are entitled, so that important benefit programs can be administered to those who need them. As a result of COVID-19, we are seeing the increased importance of these benefits, and are working to make sure that they continue to be available to Canadians. Any individual or business who underreports income, or claims losses or benefits to which they are not entitled, including ineligible claims for COVID-19 benefits, may have to repay the benefit amounts and may be subject to other possible action.