What Is Lapping in Accounting? How to Detect and Prevent It

Financial fraud poses a threat to the integrity and stability of any organization, leading to monetary losses, reputational damage, and legal consequences. These illicit actions can occur at various levels within a company. Understanding different forms of financial misconduct is crucial for businesses to safeguard assets and maintain a secure operating environment.

Understanding Lapping

Lapping is a deceptive form of accounts receivable fraud where an employee alters accounting records to conceal the theft of cash. This scheme involves misappropriating an incoming payment from one customer and then applying a subsequent payment from a different customer to cover the first customer’s outstanding balance. The core characteristic of lapping is its continuous nature, requiring ongoing manipulation to prevent the discovery of the initial theft.

This method delays the detection of missing funds, making it appear as though customer accounts are being paid. Lapping schemes are prevalent in smaller businesses where a single individual may manage both cash receipts and customer billing. The fraud relies on a steady inflow of payments to maintain the illusion that all accounts are current. If the flow of payments slows down or stops, the scheme becomes increasingly difficult to sustain, often leading to its eventual unraveling.

The Mechanics of Lapping

A lapping scheme begins when an employee intercepts a cash payment intended for the company. For instance, if Customer A pays an invoice, the employee might steal this payment instead of depositing it. To prevent Customer A from complaining about an uncredited account, the employee then takes a payment received from Customer B and applies it to Customer A’s account. This action makes Customer A’s account appear paid, covering the initial theft.

The fraudster must then find a way to credit Customer B’s account, perhaps by using a payment from Customer C. This continuous shuffling of funds from newer payments to older accounts creates a growing “hole” in the company’s receivables. The scheme necessitates meticulous record-keeping by the perpetrator to track which payments have been diverted and which accounts need to be credited.

Detecting Lapping Schemes

Detecting lapping schemes involves identifying specific red flags and unusual patterns in financial records. One common indicator is unexplained delays in depositing cash receipts, as the perpetrator may hold onto payments to facilitate the scheme. Customer complaints about misapplied payments, payments posted late, or uncredited accounts are strong warning signs. Another red flag is an excessive number of adjustments or write-offs to accounts receivable.

Unusual activity in customer accounts, such as multiple payments applied to the same invoice or inconsistent payment patterns, can also signal a lapping scheme. A gradual increase in the aging of accounts receivable might also point to this type of fraud. Businesses should regularly reconcile cash receipts records to trace how payments are applied to customer accounts, looking for instances where funds from one customer are used to credit another. Monitoring employee behavior, particularly an employee who is protective of their work or reluctant to take vacation time, can also be a subtle but important indicator.

Preventing Lapping Fraud

Implementing internal controls is crucial to preventing lapping fraud. Segregation of duties is crucial, ensuring no single employee has complete control over cash handling and record-keeping functions. For example, the individual who receives customer payments should not also be responsible for posting those payments to the accounts receivable ledger or performing bank reconciliations. This separation makes it significantly more difficult for one person to both commit and conceal fraud.

Requiring mandatory vacations for employees involved in cash handling or accounts receivable can also be an effective deterrent. During an employee’s absence, another staff member takes over their duties, which can expose irregularities or discrepancies that the fraudster typically conceals. Regular and independent bank reconciliations, performed by someone not involved in cash receipt or disbursement, provide a check on financial transactions. Furthermore, directly confirming customer account balances periodically and sending customer statements by an independent party can quickly reveal misapplied payments and deter fraudulent activities.