THE CORPORATE CON:
INTERNAL FRAUD AND THE AUDITOR
(NO. 92-5401)
Cash Schemes
V. Cash Schemes
Introduction
Cash is the focal point of many accounting entries. Cash, both on deposit in banks and petty cash, can
be misappropriated through many different schemes. These schemes can be either on-book or off-book,
depending on the point of occurrence of the fraud scheme. Generally, cash schemes are smaller than
other fraud schemes because companies have a tendency to have comprehensive internal controls over
cash and those internal controls are adhered to. Fraud schemes perpetrated in other areas, such as the
misappropriation of other assets or over-billing schemes are the result of circumvention of the existing
internal control system.
Cash receipts schemes fall into two categories, skimming and larceny. The difference in the two types of
fraud depends completely on when the cash is stolen. Cash larceny is the theft of money that has already
appeared on a victim organization’s books, while skimming is the theft of cash that has not yet been recorded
in the accounting system. The way in which an employee extracts the cash may be exactly the same for a
cash larceny or skimming scheme.
Cash fraud schemes follow general basic patterns, including:
• Skimming
• Voids/Under-rings
• Swapping checks for cash
• Alteration of cash receipt documentation
• Fictitious refunds and discounts
• Journal entries
• Kiting
Skimming
Skimming is the process by which cash is removed from a victim entity before the cash is recorded in
the accounting system. Employees who skim from their companies steal sales or receivables before they
are recorded in the company’s books. This is an off-book scheme; receipt of the cash is never reported
to the entity. This aspect of a skimming scheme means they leave no direct audit trail. Because the stolen
funds are never recorded, the victim organization may not be aware that the cash was ever received.
Consequently, it may be very difficult to detect that the money has been stolen. This is the prime
advantage of a skimming scheme to the fraudster.
Skimming is one of the most common forms of occupational fraud. It can occur at any point where
cash enters a business, so almost anyone who deals with the process of receiving cash may be in a
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position to skim money. This includes salespeople, tellers, waitpersons, and others who receive cash
directly from customers.
In addition, many skimming schemes are perpetrated by employees whose duties include receiving and
logging payments made by customers through the mail. These employees slip checks out of the
incoming mail instead of posting those checks to the proper revenue or receivables accounts. Those
who deal directly with customers or who handle customer payments are obviously the most likely
candidates to skim funds.
EXAMPLE
Employees of a retail business would close out the cash registers early in the day in order to falsify the
cash receipts and keep any cash received in the latter part of the day for themselves. If checks were received
in the afternoon, the employees would merely exchange the checks for the cash collected the next morning.
The cash receipts were not recorded through a system of consecutively numbered receipts nor on a time
sensitive cash register tape. Therefore, it was possible for the employees to close out a cash drawer at any
time during the day.
The fraud was discovered when revenue for the current period was compared to the revenue in similar,
prior periods. There was a substantial decline in the current period’s revenue.
In the video presentation, we heard from Pam just what it feels like after you have been caught in a
skimming scheme. This was her first job and she was proud of her trusted position. She admits that if
she had it to do over again, she would not have stolen the money. In her words, “It’s just not worth it.”
Voids/Under-Rings
There are three basic void/under-ring schemes. The first is to record a sale or cash receipt and then void
the same sale, thereby removing the cash from the register. The second, and more common variation, is
to purchase merchandise at unauthorized discounts. The third scheme, which is a variation of the
unauthorized discount, is to sell merchandise to a friend or co-conspirator utilizing the employee’s
discount. The co-conspirator then returns the merchandise for a full refund, without regard to the
original discount.
EXAMPLE
A manager of a recreational facility directed his staff to alert him anytime a customer came in to pay for
the monthly rental of the facility. The facility was rented to the public at large during the daytime on an
hourly basis, and to civic groups on a per-evening basis. The pricing for the per-evening groups was
somewhat discretionary and the manager preferred to take care of these customers himself. The groups
who rented the facility in the evenings were charged on a monthly basis and the manager maintained the
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receipts log for these charges. Typically these customers would pay on account, each evening they used the
facility.
The manager would charge the customer the full facility rental price, log the charge for less than the full
price, and deposit the difference into an account under his control. The amount represented by the
difference between the full price and the discounted price recorded in the log was not expended for the
benefit of either the facility or returned to the customer.
Although this appears to be a skimming scheme, and in a way it is, in his reports to accounting, the
manager was under-ringing the payments from the evening customers.
The fraud scheme was discovered when a customer called, questioning the endorsement on her canceled
check. She had made a payment on her civic group’s account to the recreational facility and yet the
endorsement on the check was the manager’s own name and not the name of the recreational facility.
Swapping Checks for Cash
One common method in which an employee can misappropriate cash is to exchange their own check
for cash in the cash register or cash drawer. Periodically, a new check is written to replace the old check.
This process can be continued such that, on any given day, there is a current check for the cash
removed. This is a form of unauthorized borrowing from the company. Obviously, if it is company
policy that cash drawers or registers are reconciled at the conclusion of each day and turned over to a
custodian, then this fraud scheme is less likely to be committed. However, if personnel are allowed to
keep their cash drawers and only remit the day’s receipts, then this method of unauthorized borrowing is
allowed to continue.
EXAMPLE
Christina, a retail sales clerk, has a daughter whose birthday is approaching. Christina does not have the
money to purchase the new Barbie doll her daughter wants, so she writes a check for $20, payable to the
store, places it in the cash register and removes $20 in cash. The next day, Christina replaces the check
for $20 with a new check for $20, which has a current date. This process of replacing old checks with
new checks can go on indefinitely.
Alteration of Cash Receipts Documentation
A lack of segregation of duties can create an opportunity for that employee to misappropriate company
funds. For example, if the same person is responsible for both collecting and depositing the cash
receipts, then this person has the ability to remove funds from the business for their own personal use
and conceal such theft through the deposits. This is often the case in smaller organizations in which
there are few personnel to divide the daily operations between. A variation of this scheme is to mutilate
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or destroy the cash receipt documentation such that any attempt to reconcile the cash deposited with
the cash receipts is thwarted.
EXAMPLE
An employee in food services received daily receipts from sales, along with the cash register tapes from
other cashiers. Allegedly, this employee mutilated the register tapes so that they could not be read. She
prepared the transmittal documentation that was sent to the controller, but kept the difference between the
amount submitted to the controller and the amount submitted by the other cashiers. The mutilated tapes
were sent to the controller with the deposit. The controller’s office did not compare the deposit with the
cash register tapes.
The fraud was detected when one of the cashiers noticed that the transmittal to the controller was small
for a comparatively busy day. When questioned about this difference, the perpetrator could not
substantiate the difference between the amount transmitted and the cash register tapes. The 23-year-old
female, who had been with the company 2 1/2 years, was terminated but not prosecuted.
Fictitious Refunds and Discounts
Fictitious refunds are those in which the employee enters a transaction as if a refund were given;
however, no merchandise is returned, or no discount is approved which substantiates the refund or
discount. The employee misappropriates funds equal to the fictitious refund or discount. This scheme is
most prevalent in the retail and merchandise industry.
EXAMPLE
Roger works in a plumbing supply store as a cashier. There are several cash drawers, one for each
cashier. At the end of each day, Roger and the manager reconcile the cash to the cash register tape. A
deposit is prepared and submitted to accounting, and a security service picks up the cash for daily deposits
to the bank.
Roger knows that some of the contractors in town have discounts on certain items in the store. On
occasion, when a customer other than one of the contractors purchases one of the discount items, Roger
will fill out a discount form as if the customer was a contractor. The customer, unaware of the discount,
pays the full price for the item, and Roger pockets the difference (the amount of the discount).
Journal Entries
Unauthorized journal entries to cash are not as common as the above-mentioned schemes. This type of
scheme may be easier to detect because its method of concealment is more obvious. The typical journal
entry scheme involves fictitious entries to conceal the theft of cash. If the financial statements are not
audited or reviewed, this scheme is relatively easy to employ. However, for larger businesses with limited
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access to journal entries, this concealment method may be more difficult to use. Generally, fraud
schemes which involve journal entries to cash are more likely in financial institutions where there are
numerous, daily entries to the cash account.
Kiting
Kiting is the process whereby cash is recorded in more than one bank account, but in reality, the cash is
either nonexistent or is in transit. Kiting schemes can be perpetrated using one bank and more than one
account or between several banks and several different accounts. Although banks generally have a daily
report which indicates potential kiting schemes, experience has shown that they are somewhat hesitant
to report the scheme until such time as the balance in their customers’ accounts is zero.
There is one important element to check kiting schemes; all kiting schemes require that banks pay on
unfunded deposits. This is not to say that all payments on unfunded deposits are kiting schemes, but
rather, that all kiting schemes require that payments be made on unfunded deposits. In other words, if a
bank allows its customers to withdraw funds on deposits which the bank has not yet collected the cash
to cover, then kiting schemes are possible. In today’s environment whereby customers are utilizing wire
transfers, kiting schemes can be perpetrated very quickly and in very large numbers.
EXAMPLE
The first deposit for $100,000 is placed in account X. A check is then written on account X for
$100,000 to open account Y. The records do not reflect that the check has been written on account X,
and, therefore, the same $100,000 appears in both accounts X and Y. Although this sounds like a
simple scheme to detect, if the amounts are large and the accounts are numerous, it is very difficult to trace
the kiting transactions. Once the kiting cycle has begun, the amounts shown in the various bank accounts
have no relationship to the actual cash on hand.
How a Simple Kite Works
Start with no money in Bank A and Bank B, and draw $5,000 in checks on each to deposit in the other:
Apparent balances
Actual balances
Bank A
$5,000
-0-
Bank B
$5,000
-0-
Total
$10,000
-0-
Bank A
$13,000
-0-
Bank B
$13,000
-0-
Total
$26,000
-0-
Do it again with $8,000 in checks:
Apparent balances
Actual balances
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Make $6,000 down payment on a Mercedes from Bank A:
Apparent balances
Actual balances
Bank A
$7,000
<$6,000>
Bank B
$13,000
-0-
Total
$20,000
<$6,000>
When the first checks clear, write some more, this time for $9,000 each:
Apparent balances
Actual balances
Bank A
$11,000
<$6,000>
Bank B
$17,000
-0-
Total
$28,000
<$6,000>
Pay the balances to a travel agent and take a long trip:
Apparent balances
Actual balances
Bank A
Bank B
Total
-0-0-0<$17,000> <$17,000> <$34,000>
Remember, not all payments against uncollected funds are check kites, but all check kites require
payments against uncollected funds.
Cash Fraud Detection Methods
There are several basic methods to detect cash fraud which generally are included in most cash audit
programs. The methods, discussed in more detail throughout this section, are as follows:
• Bank reconciliations
• Cut-off statements
• Surprise cash counts
• Customer complaints
• Altered or missing documentation
• Fictitious refunds or discounts
• Journal entry review
• Review and analyses of decreases in gross sales or increases in returns and allowances
• Analytical review
Bank Reconciliations
The preparation of bank reconciliations by a person not responsible for handling cash will frequently
turn up discrepancies. These reconciliations should be prepared on a timely basis. Good reconciliation
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methods include examining endorsements and dates. When examining the bank reconciliations prepared
by company personnel, examine all items that appear to be stale. Obtain satisfactory explanations for the
nature of each of the reconciling items.
EXAMPLE
A fraud was made possible because of a lack of policies and procedures and coordination of cash
collections and transfers of funds between the cashiers and the accounting department.
The misappropriation of funds was detected by comparing the bank deposits with the collection log which
was maintained by the accounting clerk. The review of the collection log took place while the accounting
clerk was absent on sick leave. The accounting clerk was responsible for the preparation of the collection
log, the daily cash report, and the daily deposits. Due to the lack of segregation of duties, this accounting
clerk was able to alter the computerized accounts and misappropriate a total of $23,930. She
accomplished this by preparing daily cash reports reflecting less cash receipts than were actually collected.
The lesser cash amount was deposited into the city’s bank account.
After discovery of the missing funds, the accounting clerk was terminated and prosecuted. She ultimately
pleaded guilty and was sentenced to ten years probation. She was 25 years old and had been with the city
for 3 1/2 years.
Along with the bank reconciliation, one should prepare a schedule of deposits in transit. This schedule
will point out any potential kiting. Deposits in one account should be withdrawals in another account on
the same day. There should be no difference between the dates of deposit and the dates of withdrawal.
EXAMPLE
A cashier was able to misappropriate cash receipts totaling $35,000, and covered the shortage by
subsequent receipts. Mail receipts were listed and forwarded to the cashier who prepared the deposits.
However, the listed receipts were not compared to the deposits by an independent person. This scheme was
discovered as a result of a staff accountant following up on the clearing of deposits in transit listed on the
year-end bank reconciliation.
Cut-Off Statements
Cut-off statements are often used by auditors to ensure that income and expenses are reported in the
proper period. Cut-off statements can also be used to detect unauthorized bank accounts. Additionally,
cut-off statements can be used in cases where there are insufficient personnel within the organization to
assure segregation of duties. If the employees know that, at any time, a cut-off statement will be ordered
and reviewed independently, the employees will be less likely to perpetrate cash fraud.
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A cut-off statement is generally ordered from the bank, delivered unopened to the auditor (or outsider),
and reconciled. A cut-off statement can be ordered at any time during the accounting cycle; it does not
have to be ordered at the end of any accounting period.
Another related method to the cut-off statement is the bank confirmation request. Unlike the cut-off
statement, this detection method is merely a report of the balance in the account as of the date
requested. When ordering cut-off statements or confirmations, be sure to request the information for all
accounts in the company’s name.
EXAMPLE
A $100,000 fraud was uncovered when a bank confirmation was returned indicating that there were
other bank accounts than those detailed in the general ledger. Further investigation revealed that the
corporate executives had been using an unauthorized bank account for a “slush fund.”
Surprise Cash Counts
Sometimes, surprise cash counts can turn up situations of employees “borrowing,” or floating, small
loans (often called “swapping”). It is critical that these cash counts be done on an irregular and
unannounced basis. If employee checks are included in the cash drawer or register, then this may
indicate that the employees are “swapping” checks for cash.
EXAMPLE
Payday was every other Friday at the National Bank of Springsville. Mike, a new teller at the bank,
did not have enough money to make his October house payment, which was due on the fifteenth of the
month, a Thursday. So, on Thursday, Mike placed a check in his cash drawer for the amount of the
shortfall, and withdrew the cash. Mike intended to replace the check with cash the following Monday
morning, after he had cashed his next paycheck. On Friday morning, the internal auditors performed a
surprise cash count, and took note of Mike’s personal check in his cash drawer.
As luck would have it, Mike got into a fender-bender on Friday night while driving home from work.
His car had to be towed, and the service charge took the last of Mike’s cash reserves.
On the following Monday morning, Mike did not have enough cash to replace his personal check, so he
replaced the old check with a new one which had a current date. Much to Mike’s surprise, the internal
auditors returned on Monday afternoon for a second surprise cash count. They discovered that Mike had
replaced the old check with a new one. Mike was terminated.
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Pam’s fraud, on the video presentation, was detected because the auditors performed a surprise cash
count.
Customer Complaints
Cash thefts are sometimes reported by customers who have either paid money on an account and have
not received credit, or in some cases, when they notice that the credit they have been given does not
agree with the payment they have made.
EXAMPLE
A branch of a large bank received a client complaint that there had been a $9,900 forged savings
withdrawal from her account. The client indicated that she had recently made a $9,900 deposit at the
branch and suspected that the teller who had accepted the deposit could be involved.
The teller was interviewed and admitted to forging and negotiating the savings withdrawal. The teller had
obtained the client’s mother’s maiden name and birth place, had fabricated a duplicate savings receipt
book, and, on an unscheduled work day, went to the domiciling branch, posing as the client. The teller
did not have any identification but was persistent enough to remain in the branch for several hours to
obtain an approval on the savings withdrawal. The teller who forged the withdrawal was only 17 years
old.
Altered or Missing Documents
The cash register tape submitted with the cash receipts should be readable and in good condition at all
times. A common method of detecting potential cash fraud is by examining the cash register tape. If it
has been altered, or is missing, further investigation might be warranted.
EXAMPLE
We have all been in a hurry at the check-out line of retail stores when the cashier has entered the data
into the register incorrectly. The cashier then must call their supervisor to void the erroneous information
and re-enter the correct sale.
In this example, the supervisor is an integral part of the internal control, ensuring that the cashier does
not manipulate the register tape by reversing entries, or by mutilating the tape itself. Although the extra
time may cause frustration, keep in mind that this store may be avoiding mutilated or altered register
tapes.
Fictitious Refunds or Discounts
Fictitious refunds or discounts can often be detected when closely examining the documentation
submitted with the cash receipts. Another related detection method is to evaluate the discounts given by
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the cashier or salesperson. This analysis may point out that a single, or group of employees, have a
higher incidence rate of discounts than other employees. Further examination is then necessary to
determine if the discounts are appropriate and properly documented.
Additionally, if customers are asked to examine their receipts, employees will be prevented from making
inappropriate refunds or discounts. This method employs the customer as part of the internal control
system, to assure that the cashier or salesperson is properly accounting for the sale.
EXAMPLE
Customers can be given a simple incentive for examining their cash register receipts, e.g., receiving their
purchases free if the salesperson fails to give receipts. With this policy in place, both customers and
employees are integral components of the internal control mechanism for assuring that the register tape
and the receipts are equal. In addition, if the register tape must be submitted with the register
reconciliation, the issuance of fictitious refunds or discounts can be substantially reduced.
Journal Entry Review
Cash frauds may be detected by reviewing and analyzing all journal entries made to the cash accounts.
This review and analysis should be performed on a regular basis. If an employee is unable to conceal the
fraud through altering the source documents, such as the cash register tape, then he may resort to
making a journal entry directly to cash. In general, there are very few instances in which a journal entry is
necessary for cash. One of these exceptions is the recording of the bank service charge. However, this is
an easy journal entry to trace to its source documentation, namely the bank statement. Therefore, all
other entries directly to cash are suspect and should be traced to their source documentation or
explanation.
EXAMPLE
A cash fraud of approximately $521,000 was discovered when a computerized review of the journal
entries revealed that several entries had been made to an income account, and that those entries were
unusual in nature.
The employee who perpetrated this fraud had made use of general ledger journal entries to income
accounts. He entered fictitious transactions, which resulted in a cash increase in his own account. He was
caught by means of a computer testing program.
Review and Analysis of Decreases in Gross Sales and/or Increases in Returns and Allowances
Inappropriate refunds and discounts can also be detected by analyzing the relationship between sales,
cost of sales, and the returns and allowances. If a large cash fraud is suspected, a thorough review of
these accounts might enlighten the auditor as to the magnitude of the suspected fraud. An analysis of
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refunds, returns, and allowances with the actual flow of inventory may reveal some fraud schemes. The
refund should cause an entry to inventory, even if it is damaged inventory. Likewise, a return will cause a
corresponding entry to an inventory account. There should be a linear relationship between sales,
returns, and allowances over a relevant range. Any change in this relationship may point to a fraud
scheme unless there is another valid explanation such as a change in the manufacturing process, change
in product line, etc.
In the video presentation, Tony was caught because the auditors, when performing an analytical review,
noticed a marked increase in sales returns and allowances. This unexplained increase concerned them
and so they printed a list of void and refund transactions, sorted by employee number. Tony was the
leading salesperson issuing refunds—he was caught.
EXAMPLE
The assistant manager in a retail store periodically removed $50 to $100 from the cash register for his
own use. At the home office, the auditors discovered that the relationship between sales returns,
allowances, and sales for this particular location was inconsistent with all other locations. The auditors
monitored the relationship for some time. Rather than improving, the relationship became even worse.
Eventually, it was discovered that the assistant manager was recording the cash thefts as “returns and
allowances.” The auditors noticed the “red flag” because the sales returns and allowances for this location
was a larger percentage of sales than at any other location.
Analytical Review
With the aid of a computer, cash frauds may also be detected through the use of analytical reviews. For
example, searches may be designed to list the following:
• All voided checks
• Missing checks
• Checks payable to employees (except payroll)
• Deposit dates compared with posting dates of customers’ accounts
• Cash advances
• Voids and refunds by employee ID
Voided Checks
Voided checks may indicate that employees have embezzled cash and charged the embezzlement to
expense accounts. When the expense is paid (from accounts payable), the checks are voided and
removed from the mail.
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Missing Checks
If checks are missing, this might indicate that the control over the physical safekeeping of the checks is
somewhat lax. If any checks are found to be missing, this could be a “red flag,” indicating
misappropriation of cash. The fraudster, like Kay Lemon, may have destroyed the “missing checks.”
Checks Payable to Employees
Any checks payable to employees, with the exception of regular payroll, should be examined for
appropriateness. Such an examination might indicate other schemes such as: conflicts of interest,
fictitious vendors, or duplicate expense reimbursements.
Deposit Dates Matched with Posting Dates on Customer’s Accounts
If the dates on the deposits do not match the dates the payments are credited to the corresponding
customer account, then this may be a “red flag” indicative of a lapping scheme (described in more detail
later in this workbook).
Cash Advances
An examination of all cash advances may reveal that not all cash advances are properly documented and,
therefore, inappropriate payments are made to employees. A random, sporadic review of all cash
advances might go a long way to deter employee abuse of an advance system.
Voids and Refunds by Employee Identification
By examining the amounts and occurrence rates of voided sales and refunds, sorted by employee ID,
one might detect a pattern of unrecorded sales or fictitious refunds.
EXAMPLE
A $500,000 fraud was discovered through the use of computer matching. The addresses on refund checks
were compared with the addresses on the disbursement registers. A fictitious refund claim was uncovered.
Tony’s scheme was uncovered when the auditors listed the refunds by employee identification number.
Tony’s name appeared more times than any other salesperson. This discovery eventually led to the
discovery of a $20,000 embezzlement scheme wherein Tony would forge fictitious refund slips and
exchange them for cash in the register.
Cash Fraud Prevention Methods
Segregation of Duties
The primary prevention to cash fraud is the segregation of duties. Whenever one individual has control
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over the entire accounting transaction, the opportunity for cash fraud is present. Each of the following
duties and responsibilities should be segregated:
• Cash receipts
• Bank deposits
• Bank reconciliation
• Cash disbursements
If any one person has the ability to collect the cash, deposit the receipts, record that collection, and
disburse company funds, there is a high risk that fraud can occur.
EXAMPLE
This fraud occurred at one of several campus cashiers’ offices maintained by the university for the
collection and processing of student tuition bills and other related charges.
The perpetrator was employed as a teller for approximately five years before she was promoted to head
cashier. The head cashier was responsible for the reconciliation of the daily cash receipts to the cash
transmittal and bank deposits. The head cashier also prepared the deposits of funds received from outside
departments, such as the bookstore and the dining operations. The deposits from the outside departments
involved substantial amounts of cash. As head cashier, she also prepared the initial documentation that
served as the input for the various general ledger accounts, including accounts receivable.
The perpetrator’s extensive knowledge and experience, coupled with the trust placed in her by the
manager, resulted in a diminishing review of her work, particularly her cash register reconciliations. She
soon was able to manipulate the documentation and the control procedures necessary to conceal the
continued embezzlement of funds. The 29-year-old head cashier stole an estimated $66,000. She was
fired and prosecuted, but the grand jury failed to indict her.
Assignment Rotation and Mandatory Vacations
Mandatory job rotation is an excellent method of detecting cash fraud. In order to sustain a fraud, one
must continually conceal that fraud. By establishing a mandatory job or assignment rotation, the
concealment element is interrupted. If mandatory vacations are within the company’s policies, it is also
important to remember that during the employee’s absence, the normal workload of that employee
should be performed by another individual. The purpose of mandatory vacation is lost if the work is
allowed to remain undone during the employee’s time off.
EXAMPLE
A $1.1 million fraud was uncovered when a new loan officer was routinely transferred. The previous loan
officer had been in collusion with a borrower in a loan-insurance scam. The borrower approached the new
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loan officer, who had the good sense to report the bribery attempt to authorities.
Although it was not called an assignment rotation, Paul Cote, in the video presentation, was very proud
of the fact that he had never taken a sick day. He was able to conceal his fraudulent activities because he
was never reassigned and always available to cover-up his crimes.
Surprise Cash Counts
Surprise cash counts are a useful fraud prevention method if properly used. It is important the
employees know that the cash will be counted on a sporadic and unscheduled basis. For example,
remember Pam in the video? Pam was not aware that the company regularly reconciled her cash drawer.
She admits that had she known, she would not have taken the money at all. Although it is recommended
that employees know that cash counts are periodically conducted, employees should not be advised in
advance of an impending cash count.
EXAMPLE
A hoard of cash was discovered in a fast food retail outlet when the external auditors included a surprise
cash count as one of their audit steps.
When the auditors couldn’t reconcile the cash in the registers with the register tapes, they discovered that
the employees had hidden cash throughout the store. They found caches in the ceiling, taped to the bottom
of the portable ovens, and even inside toilet tanks. Apparently, cash receipts were deposited directly to the
bank and the register tapes were mailed to centralized accounting. There was no reconciliation of the
deposits with the register tapes.
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Accounts Receivable Schemes
VI. Accounts Receivable Schemes
Introduction
There are four basic schemes in accounts receivable:
• Lapping
• Fictitious sales with corresponding accounts receivable
• Diversion of payments on old written off accounts
• Borrowing against accounts receivable
The two most prevalent types of internal fraud schemes in accounts receivable are lapping and fictitious
accounts receivable. Lapping is the recording of payment on a customer’s account sometime after the
payment has been received. Fictitious accounts receivable are a by-product of fictitious sales. This
scheme is often utilized to make the financial statements appear better than they are.
Lapping
Lapping customer payments is one of the most common methods of concealing receivables skimming.
The term lapping is used to describe a method of concealing a defalcation, wherein cash received from a
customer is originally misappropriated by the employee, and, at a later date, cash received from another
customer is credited to the first customer’s account. The second customer’s account is credited still later
by cash received from a third customer. This delay of payment applications (credits) continues until it is
detected, the cash is restored, or it is covered up by credit to the proper customer and a fictitious charge
to operating accounts. Lapping is the fraudster’s version of “robbing Peter to pay Paul.”
The basic lapping scheme operates as follows: the employee has misappropriated company funds
through customer A’s account. (For example, by diverting a cash payment or issuing a refund payable to
the employee.) In order to conceal the misappropriation, the employee must now record payments to
customer A’s account. When customer B makes a payment, the employee posts the payment to
customer A’s account. When customer C makes a payment, the employee posts it to customer B’s
account, and so on.
EXAMPLE
A highly trusted Division Accounting Manager for a company was involved in a lapping scheme which
diverted approximately $251,000 from the company. This employee would record an adjustment to a
customer’s account, and divert the funds for his own personal use. The employee also created a fictitious
customer account to house the fictitious debit and credit entries used to conceal the lapping scheme.
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The fraud was uncovered when two customers complained about invoices on their accounts which were not
theirs.
Lapping schemes do not require the employee to divert funds for their personal use. The funds can be
diverted for other business expenses.
EXAMPLE
An agent for an insurance company collected the insurance premiums in his territory. He used the funds
to pay for other operating expenses rather than remitting the payments as received. As more payments
were received, the agent merely recorded the second batch of payments on the accounts of customers
included in the first batch, and so on.
An examination of the bank accounts revealed that the deposits made by the agent did not correspond
with the reporting to the home office. In fact, the bank account was short nearly $1.2 million.
Often the employee will falsify documents to conceal the misappropriation of the funds in a lapping
scheme.
EXAMPLE
This perpetrator removed cash from a customer’s account for his own use. To conceal the
misappropriation of the cash, the employee intercepted the customer’s regular statement before it was
mailed to the customer. Blank statement forms were readily available, so the employee merely created a
new statement for the customer; one that reflected what the account balance should have been.
The fraud was uncovered when the new staff accountant traced the withdrawal to the customer. The new
staff accountant’s reaction to his discovery was that he was new, and had “over-audited” the account.
Because lapping schemes can become very intricate, fraudsters sometimes keep a second set of books
on hand detailing the true nature of the payments received. In many skimming cases, a search of the
fraudster’s work area will reveal a set of records tracking the actual payments and how they have been
misapplied to conceal the theft. It may seem odd that people would keep records of their illegal activity
on hand, but many lapping schemes become extremely complicated as more and more payments are
misapplied. The second set of records helps the perpetrator keep track of the funds that were stolen and
which accounts need to be credited to conceal the fraud. Uncovering these records, if they exist, will
greatly facilitate the investigation of a lapping scheme.
While lapping is more commonly used to conceal receivables skimming, it can also be used to disguise
the skimming of sales. Employees sometimes steal all or part of one day’s receipts and replace them with
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the receipts from the following day. This type of concealment requires the employee to delay making the
company deposit until enough money can be collected to recoup the stolen funds. If an organization
rigidly adheres to a deposit schedule, it is unlikely that lapping will be effective in concealing this type of
fraud.
Fictitious Accounts Receivable
Generally, the motive for adding fictitious accounts receivable to the records is to disguise fictitious
sales. There are two primary motives for fictitious accounts receivable, including:
• Meeting sales quotas, or “window-dressing,” the company.
• Receiving sales-based compensation.
Meeting Sales Quotas
If unobtainable sales quotas are established which employees think are arbitrary, this will increase the
pressure to establish performance levels fictitiously. If the pressure becomes unsharable, the employee
may resort to adding fictitious sales and accounts receivable to meet the sales quotas.
EXAMPLE
The SEC filed a civil action against Coated Sales, Inc., alleging that some of the officers of the company
were engaged in a scheme to inflate accounts receivable and inventory.
The officers allegedly created phony sales invoices and recorded the corresponding accounts receivable. The
purpose of the scheme was to make Coated appear to have more sales then it really did. Proceeds from the
sale of common stock were used to reduce the accounts receivable such that it appeared that the fictitious
accounts receivable were being paid in a timely manner.
Receiving Sales-Based Compensations
If a salesperson’s primary compensation is based on sales, without regard to collection, then there is an
incentive to produce quantity rather than quality sales. It is natural for companies to desire higher sales
levels in order to sustain growth. However, if the salespersons’ compensation is based solely on quantity
and not on a combination of quantity and quality, then the compensation incentive is misplaced. This
may create an atmosphere which, if coupled with opportunity, will produce inflated or fictitious sales.
EXAMPLE
Martin, the top salesman for Thortan, Inc., was on a base salary plus commission compensation plan.
The base salary was determined at the beginning of each year as a function of the prior year’s sales plus
cost of living increases. Commissions, which represented over half of Martin’s total compensation, were
based on a formula. Commissions were equal to: current year’s sales, less last year’s sales, times 20%.
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The formula did not take into account the collectability of any of the sales.
Martin quickly learned that his compensation was not a function of the ultimate collection of the accounts
receivable. Therefore, he engaged in a scheme to falsify sales. He would submit false sales invoices with
fictitious customers in the fourth quarter of each year. Oddly enough, the fictitious sales each year would
exactly equal the total sales of the prior year. In the second quarter of the following year, Martin would
issue credit advices to all the fictitious customers. After three years of submitting these fictitious sales,
Martin was finally discovered when an internal auditor analyzed the sales trends on Martin’s customers.
She noticed that in the second quarter each year, Martin’s sales would be substantially below the other
quarters (due to the credits), and that the fourth quarter sales were always equal to the prior years’ sales.
Old or Written Off Accounts Receivable
Another internal fraud scheme in accounts receivable is the diversion of payments on old or slow-paying
accounts. In this scheme, once an account has been written off, the employee has the opportunity to
collect the receivable and divert the funds to themself, because companies typically do not keep track of
old, written off accounts receivable.
Often old accounts receivable are assigned to a collection agency for collecting. These agencies typically
are paid on a percentage of the collected amounts. Fraud schemes can be perpetrated by these collection
agencies if the company does not monitor the method by which the agency receives old accounts and
the collection process itself. The assignor company needs to assure itself that the collection agency is
being assigned only truly old accounts and not good accounts which can be reasonably expected to pay
within the normal course of business. Additionally, the company needs to be sure that the collection
agency cannot compromise the indebtedness such that collections are not reported to the company.
This would allow the collection agency to compromise indebtedness for its own collection and not remit
amounts owed the company.
EXAMPLE
A CFO hired an outside agency to assist the billing department collect old accounts receivable. Any
payments received on these accounts went first to the CFO, and then to accounting for posting. No one
reconciled or reviewed the list of accounts which had been turned over to the agency for collection.
Additionally, no one reviewed the percentage billing the agency submitted for payment.
As it turns out, the CFO was receiving kickbacks for assigning new or healthy accounts receivable to the
agency for collection. Because the agency was collecting recent accounts with a high probability for
repayment, their collections were higher, as was their billing. The total estimated fraud was $250,000.
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Borrowing Against Accounts Receivable
Infrequently, employees will use the company’s accounts receivables as collateral for their own personal
loans. This is similar to schemes in which employees use the company’s investments for the same
purpose. This scheme is described in more detail in another chapter of this workbook.
For example, in the video presentation, John Faulkner accidentally discovered how to make loans using
insurance customers’ policies. He merely called the home office, requested that the loan checks be sent
to his own post office box, forged the customers’ checks, and deposited the proceeds in his own bank
account. Faulkner didn’t just use the insurance company’s receivables for collateral; he actually made
“loans” against the insured’s policies and deposited the cash.
Accounts Receivable Fraud Detection
There are five basic detection methods for accounts receivable fraud schemes. They include: matching
deposit dates, confirmations, accounting cut-off analysis, trend analysis on written off accounts, and a
tracking system for written off accounts.
Matching Deposit Dates
Lapping can usually be detected by comparing the dates of the customer’s payments with the dates the
customer’s accounts are posted. This will necessitate the examination of the source documents, such as
the detail of bank deposits.
Confirmations
Confirmation of customers’ accounts is another method that may detect lapping. Confirmations are
especially effective on large accounts where the time value of money is an issue. However, customers
who pay on invoice rather than on balance may not know the exact balance of their account. If this is
the case, it may be more effective to confirm by invoice and reconstruct the account balance using the
source documents in the files and the results of the confirmation. If a scheme is suspected, ask the
customer to return a copy of both the front and the back of the check(s) used to pay specific invoices.
Match the data on the check copies with the posting dates in the customer’s account.
In the video, John Faulkner’s fraud scheme was discovered when the insurance company sent out
routine confirmations to policyholders who had taken out loans on their policies. The policyholder
whose policy John had fraudulently borrowed against responded to the confirmation. John was caught.
Accounting Cut-Off Analysis
Typically, when a fictitious sale has been recorded with a corresponding fictitious account receivable, the
sale will be reversed shortly into the next accounting period. An examination of all sales returns
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(reversals) shortly after an accounting period ends will help identify whether a scheme to inflate sales
and accounts receivable exists. Do not, however, stop with the accounting period immediately following
the sales cut-off. Examine the second or third consecutive accounting period as well.
Trend Analysis on Written Off Accounts Receivable
Stratify the written off accounts receivable data. Examine this data for possible trends and patterns. For
example, do any of the following trends appear?
• Same salesperson
• Same accounting period (unless only an annual review of accounts receivable is performed)
• Same collector
• Same vendor
• Collection rates by agency or collector
Any of these trends might indicate fictitious accounts receivable, or that only new or good accounts are
being assigned to collectors or collection agencies.
Tracking System
The detection of old written off accounts receivable is best accomplished by maintaining some cost
effective method of tracking the old accounts receivable. Any delinquent account is worth tracking to
the extent that the expected return is equal to or greater than the cost of maintaining the system.
Accounts Receivable Fraud Prevention
Fraud in accounts receivable can be minimized through strong internal controls and other company
policies. Internal controls can be designed such that the opportunity to commit accounts receivable
fraud is minimized and, at the very least, if fraud is committed, it will be detected through normal
auditing procedures. Additionally, management can institute company policies which lessen or minimize
the motive to commit accounts receivable fraud.
The primary internal control for accounts receivable is the segregation of duties and lock-box
arrangements for cash receipts on customers’ accounts. The primary management policy which
specifically addresses the issue of accounts receivable frauds is an objective sales-based compensation
plan. A checklist of internal control measures is included in appendix B of this workbook
Segregation of Duties
As with cash, the best method of preventing fraud in accounts receivable is the segregation of duties. As
long as any single employee has both the responsibility of collecting the cash and recording the payment,
there exists an opportunity for accounts receivable fraud.
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The following duties should be segregated:
• Collection of cash
• Posting of accounts receivable
• Writing off old, uncollectible accounts receivable
If the person responsible for collecting cash (for example, opening the mail and depositing the receipts)
is also responsible for posting accounts receivable, then a lapping scheme can be perpetrated
indefinitely.
If, on the other hand, different personnel are assigned the functions of cash receipt and accounts
receivable, respectively, then the opportunity to commit accounts receivable fraud has been substantially
reduced.
This preventative method also holds true for old written off accounts receivable. If the person assigned
the collection function is also responsible for posting the payment, then the opportunity to divert the
cash received for one’s own use exists. The possibility of diverting payments on old accounts receivable
will occur if the collection of those accounts is not segregated from the posting of receipts, or from
having the authority for writing off accounts.
EXAMPLE
A female employee of a wholesale distributor was responsible for opening the mail, which contained
accounts receivable payments, and reconciling the accounts receivable. In addition, this employee reconciled
the bank statements. Because of this simple lack of segregation of duties, she was able to divert accounts
receivable payments for her own personal use resulting in the theft of about $427,000.
Lock-Box Arrangements
If customer receipts are payable to a lock-box rather than through the normal company mailing address,
then the issue of lack of segregation of duties discussed above has been eliminated. In today’s
environment, it may be more cost effective to eliminate the extra personnel required to adequately
segregate the cash receipts function from the posting function by employing the use of a lock-box
arrangement with the company’s bank. This will allow the customer to make payments directly to the
bank and, therefore, also eliminate the time delay which occurs when the receipts are mailed to the
business’ address and then deposited into the bank.
Objective Sales-Based Compensation Plans
In order to minimize the pressure of sales performance, objective sales-based compensation plans
should be established. If properly designed, these plans should incorporate all facets of the sales
function in order to eliminate potential fictitious accounts receivables. The compensation plan should be
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designed to encompass both the quantity of sales desired and also the quality of the customer. For
example, if a compensation plan encompasses sales quantity, collection quality on current and old
accounts, returns and allowances within established norms, and some pre-established sales credit
memos, then the plan will be more likely to produce a lower ratio of old or written off accounts and
higher quality sales. Lower sales volume levels may be more profitable to the enterprise than lower
quality (but higher volume) customers are.
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