Lapping Scheme

A lapping scheme is a form of accounting fraud typically implemented by an employee with access to both the accounts receivable and the daily cash receipts of a company. This scheme involves the deliberate misallocation of funds meant to cover outstanding receivables, with the goal of concealing an existing shortfall due to theft or error. The scheme’s primary intention is to cover up the theft of cash received from one customer by applying the payment made by another customer to the outstanding receivable balance of the first.

Mechanics of a Lapping Scheme

Initial Setup

An employee responsible for handling accounts receivable or cash receipts begins by stealing a payment intended to settle a customer account. For example, if Customer A sends a payment of $1,000, the employee diverts that amount for personal use.

Covering the Shortfall

To cover up the missing funds from Customer A’s account, the employee then takes a subsequent payment from Customer B and records it as a payment for Customer A’s account. This leaves Customer B’s payment unaccounted for.

Continuing the Cycle

The employee must continue the pattern by taking a payment from Customer C to cover for Customer B, and so forth. This cycle continues indefinitely, as the employee needs to constantly shuffle funds around to prevent detection. This shell game can go on for a considerable time if not detected, especially in organizations with weak internal controls.

Detection Methods

Detecting a lapping scheme can be challenging, but several methods can raise red flags:

Discrepancies in Accounts Receivable

Consistent discrepancies between recorded payments and bank deposits, or unusual delays in the payment application process, can indicate lapping. Accounts receivable aging reports may show accounts being settled irregularly or later than usual.

Analytical Reviews

Regular analytical reviews, such as comparing the total daily deposits to the payments recorded in the accounts receivable ledger, can help identify irregularities. A mismatch could signify that funds are being improperly applied or diverted.

Segregation of Duties

A robust internal control system would segregate various responsibilities among different employees, ensuring that no single employee has control over multiple stages of a financial transaction, such as receiving payments, recording transactions, and reconciling accounts.

Surprise Audits

Frequent and unexpected audits can also help uncover lapping schemes. By reviewing and matching invoices, account statements, and payments unannounced, auditors can detect inconsistencies that may highlight lapping.

Customer Confirmations

Customer confirmations involve directly contacting customers to verify the amounts they have paid and the balances recorded on their accounts. Discrepancies uncovered through these confirmations can help identify lapping.

Example Scenario

Consider a scenario where an employee, Jane, handles both accounts receivable and cash receipts for a small company. Jane accepts a $500 payment from Customer A but uses the money for herself. When Customer B sends a $600 payment, Jane records $500 of it to Customer A’s account and uses the remaining $100 for herself. As a result, Customer B’s balance remains unpaid. Jane must continually redirect funds to cover the shortfall, creating an ongoing cycle.

Implications of Lapping Scheme

The implications of a lapping scheme can be far-reaching and damaging:

Financial Losses

Direct financial losses occur from the theft of cash. Additionally, the company might incur costs related to investigating and resolving the fraud.

Reputational Damage

The company’s reputation can be severely affected, leading to lost customers, business partners, and market trust. Rebuilding trust can be a long and arduous process.

The employee committing the fraud faces legal repercussions, including potential criminal charges and civil liabilities.

Operational Disruption

Detecting and addressing a lapping scheme can divert significant resources and attention from regular business operations.

Preventative Measures

Organizations can implement several measures to prevent lapping schemes:

Robust Internal Controls

Effective internal controls, such as segregating duties, limiting access to financial systems, and requiring regular reconciliations, can prevent opportunities for lapping.

Staff Training

Regular training sessions on ethical behavior and fraud detection can educate employees on the consequences and signs of lapping, promoting a culture of integrity.

Regular Audits

Regular internal and external audits can help identify irregularities early and act as a deterrent.

Use of Technology

Deploying advanced accounting software with built-in fraud detection mechanisms can provide an additional layer of protection.

Real-World Case Studies

ZZZZ Best, Inc.

ZZZZ Best, a historical example of a massive financial fraud, involved a complex lapping scheme. The company’s founder, Barry Minkow, diverted funds meant for various customer accounts, ultimately leading to its collapse and Minkow’s imprisonment.

Washington Inventory Service

Employees at Washington Inventory Service used lapping to cover up cash thefts for years. The fraud was eventually discovered through rigorous audit procedures, highlighting the importance of consistent and thorough verification processes.

Conclusion

A lapping scheme, while deceptively simple, can cause significant financial and reputational damage if not detected and addressed promptly. Organizations must employ robust internal controls, conduct regular audits, and foster a culture of integrity to mitigate the risks associated with such fraudulent activities. By remaining vigilant and transparent, businesses can protect themselves from the potentially devastating effects of a lapping scheme.

For more information on how organizations can prevent and detect fraudulent activities, you can visit professional service firms like Deloitte and PwC which provide specialized forensic accounting and fraud detection services.