A lapping scheme is a type of employee fraud wherein the fraudster pockets the payment of one customer and applies the payment of the next customer to the first customer’s invoice.
What Is a Lapping Scheme? How It Works & Prevention
This article is part of a larger series on Bookkeeping.
A lapping scheme is usually caused by poor segregation of duties, nonexistent or inefficient internal controls, and inadequate supervision. Understanding how it is perpetrated in the business can help you detect it before your losses eat up your profits. We’ll teach you what preventive measures you can take against this fraudulent act, such as rotating employees, implementing strong internal cash controls, and running lifestyle checks.
How Does a Lapping Scheme Work?
A lapping scheme is a continuous fraud because of how it is performed. It requires constant manipulation of customer payments to keep the scheme working.
The lapping scheme is an ongoing fraud because the fraudster always needs the next customer’s cash payment to apply to the previous customer’s invoice. Hence, the latest customer’s invoice will remain outstanding until the next customer pays. A lapping scheme seems like a bottomless pit of fraud but it can end in any of the following circumstances:
- The thief pays back the amount stolen to permanently cover up the fraud.
- The thief writes off an outstanding invoice as bad debt. In our example above, if the employee writes off Customer C’s invoice, there is no need to continue the coverup. The employee in charge of applying payments to invoices should never have the authority to write off an invoice as bad debt.
- The employer uncovers the fraud through spot checks, audits, and job rotations.
- The thief resigns from the company and their replacement uncovers the fraud.
The thieving employee only pockets cash from the first customer and then spends the rest of the time trying to cover their theft. Employees often start the scheme with the intention of paying the employer back and thus being able to end the coverup.
Here’s how an employee commits the lapping scheme fraud by looking at the elements of the fraud triangle:
- Incentive: The employee might be experiencing financial difficulties and need additional funds to pay off debt. However, a financial crisis is not the only plausible reason to perform lapping. It’s also possible that the employee just wants additional cash to support a lavish lifestyle.
- Opportunity: To perform lapping, the employee must have access to customer records and must be the one collecting payments from customers. These two incompatible duties create an opportunity for the employee to manipulate records and pocket cash collections.
- Rationalization: There are many reasons for an employee to rationalize lapping. Poor compensation is a common reason for stealing. If companies aren’t paying employees enough, they’ll be tempted to steal from the business. However, hatred for management can be another. If business managers or owners are too strict, employees may retaliate by committing fraud so that the business suffers.
Opportunities for Lapping
Employees with the rationalization and incentive will likely find the opportunity to commit fraud. Here are some of the opportunities to commit lapping:
Poor Segregation of Duties
Segregation of duties is an important aspect of a good internal control system. Two of the key duties to keep separate are receiving customer payments and recording the payment received in the accounting books.
In a lapping scheme, the recording and custody functions overlap in a single employee.
- The employee can update customer records (i.e., by having access to customer database and subsidiary ledger).
- The employee physically collects the cash from the customer.
When recording and custody functions overlap, employees with the right rationalization and incentive to perform a lapping scheme will use this opportunity to steal money from the business.
For example, let’s assume that Employee A is in charge of receiving cash and Employee B is in charge of updating the records. If Employee A pockets customer payments, Employee B will eventually notice customers aren’t paying, which will trigger further investigation that will uncover Employee A’s lapping scheme.
Very small businesses with only one bookkeeper can find it difficult to segregate duties properly. In this case, the owner of the business should open the mail personally to stay on top of what is happening in the business. They’ll see a customer payment has been made—even if they don’t personally handle the accounting for that payment.
Inefficient or Nonexistent Internal Controls
When internal controls are absent or inefficient, a lot of opportunities for fraud are created, not just specifically a lapping scheme. Think of internal controls as the immune system of the business. If the immune system isn’t doing its job, viruses and bacteria can take over and cause illness.
The same concept applies to a business: internal controls protect the business from fraud. But aside from fraud protection, they ensure that the business properly accounts for all transactions, which could help owners assess business performance.
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Inadequate Supervision
They say that when the cat’s away, the mouse will play. Fraudsters find the lack of supervision an opportunity to commit fraud. In a lapping scheme, there is inadequate supervision when the:
- Employee’s work isn’t approved or reviewed by another person
- Business owner doesn’t make the effort to oversee the financial aspect of the business
As the business owner, being involved in the business’ accounting and financial affairs is part of the responsibility. You must provide oversight and supervision in business areas that lack proper supervision, and if ongoing supervision is needed, consider hiring more people to handle supervisory responsibilities.
How to Prevent Lapping Schemes
Though lapping schemes can cost your business a lot of money if left undetected, you can implement preventive measures to prevent them from happening.
1. Rotate Employees
Rotating employees regularly prevents fraudsters from doing a lapping scheme. Since lapping requires constant manipulation of cash collections, it’s easy to spot lapping whenever another employee takes over the position. That’s why employee rotations will definitely discourage fraudsters in doing a lapping scheme. Rotations can be done monthly, semi-annually, or annually for administrative positions.
When rotating employees, consider how these changes will affect the efficiency of business processes. Employees without experience in their new position might take a while to get them up to speed.
2. Have Strong Internal Cash Controls & Proper Segregation of Duties
Internal cash controls can also deter lapping schemes, especially if incompatible roles are properly segregated. The easiest way to prevent lapping is to encourage customers to pay electronically, such as via credit cards or bank transfers.
Electronic payments eliminate the need to handle physical cash in the business, which removes the incentive for a lapping scheme. Other internal controls over cash that can prevent lapping includes:
- Monthly bank reconciliations
- Owner oversight on bank accounts and transactions
- Strict control over checks
- Spot checks and audits
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3. Run Employee Lifestyle Checks
Since lapping schemes involve the theft of cash, a red flag exists when the employee exhibits changes in their lifestyle that don’t match their current income level. Lifestyle checks examine if the employee is living beyond their means, such as living lavishly.
As the business owner, you should try to observe your employees’ actions and behaviors. Getting to know them on a personal level can also reveal things about their personal life that might raise some red flags.
We don’t encourage you to play detective, which may cause a lack of trust with employees. Be observant, and don’t accuse anyone unless there’s evidence to support your claim.
4. Understand Employee’s Financial State
An employee may have a financial crisis due to several reasons, such as a medical emergency or plenty of personal debts. Employees experiencing financial problems are at greater risk of committing fraud, especially if they have access to cash and customer records.
However, having financial problems doesn’t usually result in fraud. Most employees’ ethics and principles prevent them from committing fraud amid financial turmoil, but sometimes theft happens.
As a business, it’s a wise decision to be careful and consider the possibility of fraud if employees are experiencing a financial crisis. In doing so, you may perform the following:
- Get to know your employees at a personal level
- Offer financial support or assistance to employees (e.g., salary loans)
- Conduct financial literacy workshops or seminars
- Re-assign employee to another position that won’t have direct control over cash
- Enhance support and supervision over the employee if needed, such as conducting weekly one-on-ones or offering to reduce their workloads
Frequently Asked Questions (FAQs)
Skimming occurs when the employee pockets the payment and never records the sale. In lapping, the employee also pockets the payment but covers the theft by applying another customer’s payment to the previous invoice.
Yes, lapping is a form of embezzlement. You can be imprisoned for up to 30 years, depending on the seriousness of the offense and in which state you committed the theft.
Bottom Line
Knowing what a lapping scheme is and how perpetrators do it can help protect your business from this fraud scheme. However, your participation as a business owner is also crucial in preventing the proliferation of fraudulent acts.
