What Is Lapping Scheme?
A lapping scheme is a fraudulent practice that involves an employee altering accounts receivable records to hide stolen cash. This sophisticated type of accounting fraud, a subcategory of financial crime, functions by using subsequent payments from one customer to cover up the theft of cash from a previous customer's payment25. The scheme essentially creates a continuous cycle of misapplication of funds, temporarily concealing the misappropriation. Those who perpetrate a lapping scheme often occupy positions where they handle both incoming cash receipts and the recording of those transactions, exploiting weaknesses in internal controls.
History and Origin
The concept of misapplying funds to conceal theft is as old as record-keeping itself. While the specific term "lapping scheme" gained prominence with the development of modern accounting practices and internal audit procedures, the underlying fraudulent act of using new payments to cover old debts has historical parallels in various forms of financial deception. Such schemes are often categorized under broader occupational fraud, a persistent challenge for organizations globally. The Association of Certified Fraud Examiners (ACFE), for instance, has extensively documented occupational fraud types, including asset misappropriation schemes like lapping, in its biennial "Report to the Nations" since 199624.
Early forms of this type of financial manipulation often emerged in environments lacking rigorous bookkeeping and oversight. The continuous nature of a lapping scheme requires constant attention from the perpetrator, a characteristic shared with other long-running fraudulent endeavors. For example, the notorious Ponzi scheme orchestrated by Bernard Madoff, while different in scale and method, relied on a similar principle of using funds from new investors to pay returns to earlier investors, perpetually deferring discovery of the underlying deception23.
Key Takeaways
- A lapping scheme is a type of accounts receivable fraud where an employee diverts customer payments.
- The fraud involves applying money from a later payment to cover an earlier payment that was stolen.
- It requires the perpetrator to continuously manipulate records to avoid detection.
- Weaknesses in segregation of duties are a primary enabler of lapping schemes.
- Red flags include increased aging of accounts receivable and employees unwilling to take vacation.
Interpreting the Lapping Scheme
A lapping scheme is not something to be interpreted in terms of a numerical value or a ratio; rather, its existence is inferred through specific patterns and red flags within an organization's financial data and employee behavior. Detection often relies on identifying irregularities in the application of customer payments to their respective accounts. If cash received from one customer is frequently credited to another customer's account, or if there are unexplained delays in recording cash receipts, these could be strong indicators of a lapping scheme21, 22.
Another significant behavioral indicator is an employee, typically one with control over cash handling and ledger updating, who is overly dedicated to their work and unwilling to take vacation. This unwillingness stems from the need to constantly monitor and manipulate the accounts to prevent the scheme from unraveling in their absence. An increase in the average age of accounts receivable, where customers who have paid their invoices still show outstanding balances, can also signal a lapping scheme. Organizations often employ forensic accounting techniques to trace cash receipts and payment applications, explicitly looking for these discrepancies.
Hypothetical Example
Consider a small manufacturing company, "Widgets Inc.," where Jane handles all incoming customer payments and updates the accounts receivable ledger.
- Initial Theft: On January 5th, Widgets Inc. receives a $1,000 payment from Customer A for an invoice due. Jane intercepts this payment and deposits it into her personal bank account.
- First Cover-Up: A few days later, on January 10th, Widgets Inc. receives a $1,200 payment from Customer B. To prevent Customer A from complaining about their outstanding balance, Jane applies $1,000 of Customer B's payment to Customer A's account. This makes it appear as if Customer A's invoice has been paid. Now, Customer B's account incorrectly shows a $1,000 credit, but they still owe $1,200, so a $200 portion of their payment is unapplied, and the remaining $1,000 balance is now outstanding.
- Continuing the Cycle: On January 15th, Customer C sends a $1,500 payment. Jane takes $1,200 from Customer C's payment and applies it to Customer B's account to clear their balance. This leaves Customer C's account with a $1,200 credit, and their remaining $1,500 balance unapplied. The cycle continues, with each new payment covering a previous theft, creating a growing discrepancy that Jane must constantly manage.
The financial statements initially appear normal, but a detailed examination would reveal misapplied payments and an aging of accounts where customers who have paid are still listed as having outstanding balances.
Practical Applications
The understanding and detection of a lapping scheme are crucial for businesses, especially those with less stringent internal controls. These schemes commonly occur in smaller organizations where a single employee may handle multiple accounting functions, such as receiving cash receipts and updating the accounts receivable ledger20. Implementing strict segregation of duties is the most effective preventative measure, ensuring that no single individual has control over an entire transaction from beginning to end19. For example, the person who receives cash should not be the same person who records payments or prepares customer statements.
Beyond prevention, the principles of fraud detection are paramount. Regular, independent reconciliation of bank statements with accounting records, direct confirmation of customer balances, and mandatory employee vacations can help uncover such schemes18. Public companies, in particular, face significant regulatory scrutiny regarding their financial reporting and internal controls. Failures in maintaining effective internal controls can lead to investigations and enforcement actions by bodies like the U.S. Securities and Exchange Commission (SEC), which regularly pursues cases involving financial misstatements and control deficiencies that can facilitate schemes like lapping16, 17. The Association of Certified Fraud Examiners (ACFE) offers comprehensive insights into how occupational fraud, including lapping, impacts businesses and recommends robust anti-fraud programs to mitigate such risks15.
Limitations and Criticisms
A lapping scheme is inherently unsustainable over the long term. Its primary limitation is the continuous effort required by the perpetrator to conceal the fraud. As the amount stolen grows, the number of accounts that need to be manipulated increases, making the scheme increasingly complex and difficult to manage without detection14. Any disruption in the inflow of new payments, or an unexpected audit or inquiry into specific customer accounts, can quickly expose the fraud.
Another criticism is that lapping schemes often indicate a systemic failure in an organization's risk management and control environment, rather than just an isolated act of employee fraud. The existence of a successful lapping scheme highlights critical weaknesses in the design or enforcement of internal controls around cash handling and financial reporting. The median duration of occupational fraud schemes, as reported by the ACFE, is 12 months, with a significant percentage lasting even longer, underscoring the challenge of early detection when controls are weak13. These control deficiencies can lead to severe consequences, including restated financial statements and reputational damage.
Lapping Scheme vs. Embezzlement
While a lapping scheme is often confused with embezzlement, it is more accurately described as a specific method by which embezzlement can be carried out. Embezzlement is the broader act of dishonestly appropriating assets, typically funds, entrusted to one's care for personal gain. It involves the fraudulent conversion of another's property by a person to whom it has been entrusted. A lapping scheme, by contrast, is a specific type of asset misappropriation fraud that focuses on manipulating accounts receivable to hide the theft of cash. The key distinction is that while all lapping schemes involve embezzlement, not all embezzlement involves lapping. Other forms of embezzlement might include skimming cash before it's recorded, creating fictitious vendors, or manipulating payroll, none of which necessarily involve the continuous cross-application of customer payments seen in a lapping scheme.
FAQs
What are the main warning signs of a lapping scheme?
Key warning signs of a lapping scheme include: an increase in the average aging of accounts receivable, customer complaints about incorrect account balances despite having made payments, an employee who consistently works overtime or refuses to take vacation, and delays in depositing or recording cash receipts. Inconsistent or unexplained adjustments to customer accounts may also be a red flag.
How can businesses prevent a lapping scheme?
The most effective way to prevent a lapping scheme is to implement strong internal controls, particularly the segregation of duties. This means that different employees should be responsible for receiving cash receipts, recording those payments, and reconciling bank statements. Regular, independent audits of financial records are also crucial.
Is a lapping scheme a serious crime?
Yes, a lapping scheme is a serious financial crime, typically prosecuted as embezzlement or fraud. The severity of the legal consequences depends on the amount of money stolen and the jurisdiction, but it can lead to significant fines, restitution orders, and lengthy prison sentences. It also results in substantial financial losses and reputational damage for the victimized organization.
Can technology help detect lapping schemes?
Yes, modern accounting software and data analytics tools can significantly aid in fraud detection. Automated transaction matching, continuous monitoring of payment applications, and algorithms that flag unusual patterns in accounts receivable can make it much harder for a lapping scheme to go unnoticed. These technologies help identify discrepancies that manual reviews might miss.
What industries are most vulnerable to lapping schemes?
Industries or businesses that handle a high volume of cash receipts and have less formal internal controls are typically more vulnerable to lapping schemes. This often includes small and medium-sized businesses, non-profit organizations, and any entity where a single individual has significant control over both cash handling and record-keeping functions.1234, 56789, 1011