15 types of accounts receivable fraud (And how to detect and prevent them)

Businesses, a vast majority being small and midsize, across the U.S. can lose billions of dollars each year to fraud, particularly accounts receivable fraud caused by employees. Fraudsters take advantage of the trust they’ve built and use their professional status to engage in schemes.

If you don’t recognize and address receivables fraud, your business can suffer financially. Even worse, it will tarnish your company’s reputation and damage your relationship with customers. Furthermore, anyone involved in fraudulent activities will face civil and criminal penalties. Plus, you may have to hire an outside PR firm to help weather the storm.

This article will examine the types of accounts receivable fraud, how to detect, prevent and eliminate it, and the best practices for fraud management.

According to PWC’s 25th Annual Global CEO, “CEOs are most concerned about cyber risks (49%). CEOs in the manufacturing and consumer sectors indicated lower levels of concern about cybersecurity (40% and 39%, respectively).” 

The risk of cyber threats can negatively impact companies by damaging bottom lines and reputations, hurting customer satisfaction and trust, stifling innovations and sales and more. Plus, CEOs feel the pressure to constantly produce top-notch results. The threat of fraud and cybersecurity risks adds to the stress of ensuring strong revenues and growth.

Some companies outline what’s needed to ensure security and privacy because of the threat cybersecurity poses. From hiring chief information security officers to including cyber security in major decisions, CEOs can lessen the amount of vulnerabilities within their companies. 

Interestingly, some companies have never assessed their fraud risk, leaving too much room for financial crimes. Bribery, cybercrime and corruption make up most economic crimes, with accounting and procurement frauds behind those. With regulatory challenges increasing, securing and protecting the order-to-cash ecosystem should be a top priority.

According to the 2021 AFP® Payments Fraud and Control Survey:

• 65% of treasury and finance professionals believe that the COVID-19 pandemic is to blame for some of their companies' uptick in payments fraud. 
• In 2020, 74% of companies were the target of payment scams. Checks and wire transfers were the most impacted by fraud activity in 2020. Thankfully, check schemes are decreasing. 
• Business email compromise (BEC) continues to drive attempted or actual payments fraud at 62% of companies.
• Small businesses may experience accounting fraud more than enterprises because of a smaller staff, limited technology and a lack of fraud management best practices.

Let’s explore the most common types of accounts receivable fraud, all of which negatively impact revenue.

AR fraud committed by employees

As your business grows and you hire new employees, you’ll want to become vigilant about detecting and preventing internal fraudulent schemes, especially surrounding fictitious accounts receivable. Below are ways some may try to manipulate AR:

Bogus statements

Statement revisions occur when an employee makes simple changes to your business’ statements to hide the money they’ve stolen. Whoever reviews the statements will not realize funds have been taken from the company because the theft is usually tiny. If you don’t have fraud management best practices in place, you may not know about the thievery.

Check skimming

This is a classic fraud scheme. An AR employee takes an incoming check from an account and cashes and deposits it into their bank account. They cover up their crime by deflecting late notices and account statements.

Customer data phishing

Employees might knowingly or unknowingly breach customer data, which can put your business at risk for fraud and cause customer dissatisfaction and trust.

Fictitious accounts and sales

Management, executives or even officers may create fictitious customer accounts and sales to make your company look very profitable. Why? Because it results in receiving bigger bonuses. If sales staff are paid on volume vs. collections, they may collude with an accounts receivable specialist to ensure fraudulent sales.

Forced balancing

When a customer pays their invoice, an employee may record it as paid, but they don’t make a deposit into your business’ bank account. They either keep the money or split it with a third party. The employee creates a miscalculation to show that a deposit wasn't made.

Fraudulent write-offs

An employee creates fraudulent write-offs by crediting an account for a discount, return or another type of write-off. It’s also used to cover up previous crimes, including lapping and skimming.

Lapping and kiting

What is lapping? It’s one of the most committed frauds in accounting. An accounts receivable specialist or manager fudges AR records to hide the stealing of cash. It occurs by deflecting payment from one customer to another to offset the receivable from the first account. Since there’s a constant turnover of paid older accounts, the lapping scheme doesn’t look that suspicious.

On the other hand, kiting happens when an employee steals funds and transfers the money from one bank account to another before year-end. The in-transit increase is recorded in the first year, with the decrease recorded in the second year.

Payment diversion

This involves diverting incoming cash from old or slow paying accounts. If your business writes off uncollectible accounts, an employee can keep any funds received because an account receivable for the money isn’t on your books.

Refund skimming

What is skimming in accounting? Fraud involving this is when an employee keeps refunds meant for customers who have overpaid.

AR fraud committed externally

When your business expands, it becomes more vulnerable to external fraudulent activities. Here are some outside schemes to watch out for:

Check fraud

Even though businesses have embraced accounts receivable automation and online payment processing, scammers still create identical, fake checks or forge real ones.

Credit card fraud

Credit card fraud happens in B2B and B2C. Criminals either forge a customer’s signature for purchases and payments or hack into systems to get credit card information.

Email phishing

Businesses are all too familiar with email phishing. It’s a standard fraud scheme where someone makes illegal purchases using a customer’s credit card number without their knowledge.

Fake returns and rebates

Fake returns and rebates occur when someone buys products with the intent of returning them immediately to secure cash. In some instances, the items may be stolen. It’s not uncommon for employees to be involved in this scheme.

Product diversion

Product diversion involves selling products, mostly bulk items, outside or normal distribution channels. It’s common with high-end beauty products. To complete the scam, warehouses may act as illegal storefronts.

Third-party skimming

Third-party receivables happen when a business works with a “third party” to recover old debts. It seems as if customers have disappeared into thin air in most cases. Their emails bounce, calls aren’t returned, etc. Your business name will no longer be used once accounts are placed with a third-party accounts receivable service. This opens the door for theft to occur with enough cash to be taken without arousing suspicion.

How do fraudulent activities affect the order-to-cash cycle?

Because working capital is tied to cash flow reporting, it’s highly susceptible to fraud. You'll want to look for red flags. For instance, working capital management should include scrutinizing the order-to-cash cycle to ensure misappropriation doesn’t occur. If it does, you’ll have to write off the expense. 

If you don’t monitor your accounts receivable consistently, you can miss fraudulent activities. This can lead to an abundance of write-offs which can damage your business’s financial position and character. Being proactive with your order-to-cash cycle allows you to thwart any potential threats. Remember, CEOs are under pressure to show results. If the company’s bottom line takes a hit, it can have a ripple effect throughout the organization.

Noticing accounts receivable fraud may not be easy, but here are some things that should be on your fraud checklist:

• Bank deposits and postings discrepancies.
• Customer complaints about receiving late payment notices.
• Employees who refuse to train new staff, share responsibilities or won’t take PTO.
• Excessive discounts, returns, voids or other sudden activities.
• Increase in employee reimbursements or expense items.
• New activity in a business bank account that’s been dormant for some time.
• Unauthorized sales and higher than normal revenues.

What do auditors look for in accounts receivable?

Keep in mind that an auditor can determine and detect fraud through these objectives:

• Establish that your balance sheet reflects AR properly.
• Inquire about your fraud management practices and ensure proper measures to prevent mishandling of cash and checks.
• Review refund records to determine whether or not returned items were accounted for correctly.

Procedures for auditing AR

Once objectives are set, the audit process will begin. Here are some procedures involved in an AR audit:

Analyze customer orders

Your auditor will compare the invoicing you’ve sent out with customer orders and review whether or not the documents match. If there are discrepancies between the numbers, it indicates that receivables have been recorded incorrectly.

Confirming receivables

An auditor will contact your customers to confirm unpaid accounts receivable at the end of a reporting period and verify the AR you’ve recorded. The process is to review customers with large outstanding balances, then those with past due invoices, and lastly, customers with small receivables.

Reviewing cash receipts

The auditor will look for customer payments, if they can’t confirm receivables with your customers. If customers pay by checks, the auditor will ask for check copies. The next step is to confirm with them by reviewing bank transactions or contacting the bank directly.

The above list is a sample of what an auditor looks for when auditing accounts receivable. If  “red flags” appear, your business may become under investigation. Those involved in illegal activities can face legal charges.

How can accounts receivable fraud be prevented? By creating fraud management best practices, including identifying any weaknesses in your accounting practices. For example, if you’re a small business owner and have only one person responsible for account receivables, it leaves the door open for potential fraud to occur. It pays to budget for additional bookkeeping and AR staff in the long run. Even some enterprises can use more accounting personnel. Like everything in finance, you need to ensure checks and balances.

Here are some ways to prevent accounts receivable fraud:

Assess hiring practices

Your hiring practice can include background checks to uncover potential secrets candidates may try to hide. Also, ask for at least three references, preferably former bosses or colleagues.

Be aware of what is happening in the work environment

If you want to detect lapping schemes and other accounting frauds, you and your management team must pay attention to your AR team. Some employees commit financial crimes and fraud schemes because they’re desperate. If someone appears distraught or speaks openly about their struggles, be supportive and ask how you can help. Working overtime, getting extra time off to address their issue or receiving an advance on their paycheck may alleviate their financial pressure. If your company offers a wellness benefits package, you may consider adding “financial counseling” to it.

Define responsibilities

Outline user roles and access rights, approval processes and other policies. Consider having process owners who may perform tasks, ensure operations integrity and question anything out of the ordinary. You may also consider splitting accounting functions among multiple employees, including the following:

• Collections
• Customer service
• Deposits
• Invoicing

Notice behavioral changes

How well do you know your employees? If you or your accounts receivable manager don’t pay attention, you can miss cues such as a change in attitude or a vehicle upgrade. If an employee refuses to take PTO, won’t share or train another employee or has become too close with customers, investigate what is going on.

Obtain insurance to cover potential fraud

Even with the best fraud management practices, fraud may happen. Consider getting insurance because it may reduce the expense to cover illicit employee activity. Ask an insurance representative about criminal insurance to safeguard company assets from potential employee misconduct. Do whatever you can to reduce the risk to your company, customers and ethical employees.

Provide ongoing education and training

How does one commit accounts receivable fraud? It’s easy without mandatory education and training, especially for management. Companies require cybersecurity training, so it makes sense to include accounts receivable fraud. The more educated employees are about scams and how to spot them, the better they’ll feel about reporting suspicious activity. Set up a system (whistleblower hotline) so that employees can anonymously report potential fraud.

Stamp checks “for deposit only

Checks should be marked with “for deposit only and cash-based customers should submit their payments directly to a secure lockbox. Reconcile cash receipts and send customers account statements regularly. Create and implement other procedures to make it difficult for fraud to occur.

Use technology to minimize scams

If your business accepts digital payments, you need to have security to protect your customers’ information. You can use encryption and tokens to secure payment data and data analytics to detect anomalies and avoid potential AR fraud. Ask your bank representative or merchant processor about their anti-fraud policies and procedures and tools that are included with their cash management services. You may use these to prevent theft, such as stolen credit card information and other nefarious activities.

Work with an outside auditor

Enterprise and mid-sized businesses work with outside auditors and so should small businesses. Not only can an auditor audit your company’s financials, but they can answer questions you may have about fraud detection and prevention. You may uncover unintentional mistakes, inefficiencies, and willful fraud through your conversation and audit.

Accounting fraud can cost your business time and money. It can also hurt your O2C process and damage your reputation, which is why prevention and security must become a top priority across the order-to-cash cycle. Fortunately, accounts receivable (AR) automation software can help mitigate some risks. However, leadership must embrace investing time and money on technologies and educating and training staff because it can help prevent fraud during the AR process. 

Finally, remember that fraudulent schemes can impact customers on many levels, from stolen information to payments. Once you lose their trust, they might start doing business with your competitors. You don’t want that, do you? Ensure that your business’s accounts receivable are secure by implementing fraud management best practices today.