When You Suspect Fraud

Who a smart business owner calls to conduct an investigation.

BY JOSEPH T. WELLS
June 1, 2005

he new general manager of a small manufacturing company knew something was amiss. Each time he asked the chief financial officer for critical cost information he got the runaround. “We don’t have a cost accounting system that can produce that information,” the CFO would say. Or, “I’m sure we have those data somewhere. Let me get back to you.” But he never did.

The manager had trouble convincing the company owner there might be a problem. After all, the CFO had been with the owner a long time and he was the company’s second-highest-paid—and most trusted—employee. Moreover, he was successful in his own right: He’d spoken at times of how he had taken the inheritance his wife received, invested it well in the stock market and prospered enormously. His ostentatious lifestyle certainly made that evident.

The CFO had complete control over the company’s finances, and was authorized to sign checks, perform bank reconciliations, post the accounting records and prepare the financial statements. And yes, the owner was aware that all that power could be subject to misuse. Still, he trusted his CFO.

The general manager was uneasy, however. The CFO was very secretive about his activities and always kept his office locked. A lot of his answers didn’t make any sense. Then one day the owner and the general manager were going over the payroll costs for the most recent period. The manager was shocked. “There is absolutely no way that our payroll is anywhere near that high,” he told the owner. “We’ve got to get to the bottom of this.”

OVER THE TOP
Getting to the bottom required the owner to go over the top, literally—he went through the ceiling of the CFO’s office. The owner crawled through the attic, removed some ceiling tiles and dropped into the locked office. In no time at all he found what he was looking for: a number of the company’s cancelled checks made payable to the CFO, signed and endorsed by the CFO and deposited into his personal bank account. The CFO also left a trail of documents: personal tax returns (which, not surprisingly, failed to declare the embezzled funds) and one bank account statement of his wife’s. The tax returns showed the CFO wasn’t such a sophisticated investor after all; he’d deducted significant losses from bad investments.

ENTER THE CPA
The owner contacted his lawyer immediately, who decided to bring in an antifraud expert. “The company was wise enough to avoid conducting its own investigation,” said Rick Britt, CPA, head of litigation support and forensic accounting for Rhodes, Young, Black and Duncan, CPAs ( www.rybd.com ), in Duluth, Ga. “When a situation like this arises, it’s time to call in someone with experience in fraud cases.” Britt had that in spades: Before joining the accounting firm, the CPA and certified fraud examiner had spent nearly three decades with the Internal Revenue Service, rising to chief of Georgia’s criminal investigative division.

Britt was hired to piece together what the CFO had done, to determine how much money actually was involved and to prepare the evidence in the event the case went to trial. “I don’t recommend that clients directly retain a CPA when the possibility of litigation is involved,” he said, “but rather suggest they hire a lawyer, who then can retain the expert. In this way, the CPA’s work can be protected by the work product doctrine of the attorney-client privilege.” (See “ The Attorney-Client Privilege ,” below.)

The Attorney-Client Privilege
I n order for the CPA/CFE’s work product to be protected by the attorney-client privilege, the following four conditions must be met: The client must be the person who retains the attorney, the lawyer must be retained specifically to provide legal advice, and the client thereafter must communicate with the attorney on a confidential basis and the client must not waive the privilege. Business owners should contact their lawyers for details.

“As embezzlement cases go, this one wasn’t very sophisticated,” Britt said. “But gathering the evidence was made more difficult by the mess in the CFO’s office. I spent the first several days just sorting through a stack of files about four feet high that was totally disorganized.”

Then the CPA started seeing a distinct pattern. In reviewing the bank statements, he noticed a number of checks each month were missing. He asked the bank to produce copies and sure enough, those were ones the CFO had written to himself. Britt also said the CFO had recorded the amount of the checks missing for each month on the envelope flap of most of the bank statements. Presumably, they were destroyed so the owner would not notice them.
Britt located all of the missing checks and entered them into a simple Excel spreadsheet that showed the amounts, dates and other information. He documented a whopping $3.7 million in losses to the small manufacturer over an eight-year period. As the embezzlements got larger, so did the company’s line of credit, which was needed to fund the fraud. The thefts were spread among a variety of company expense accounts so that no single account would be suspect.

THE LEGAL PROCESS
Once the losses were tallied, the company’s lawyers successfully sought an injunction to prohibit the CFO from disposing of any assets he might have purchased with the stolen funds. Britt, who was qualified by the judge to be an expert in fraud matters, used the spreadsheets and copies of the checks to support his testimony at the hearing. (See “ Qualifying As a Courtroom Expert ,” below.)

Qualifying As a Courtroom Expert
U nder rule 702 of the Federal Rules of Evidence, a witness qualified as an expert by “knowledge, skill, experience, training or education” may testify to an opinion based upon “scientific, technical or other special knowledge” if such testimony will “assist the trier of fact to understand the evidence or to determine the fact in issue.”

Although CPAs generally are regarded as specialists in accounting matters, there is no such thing as an automatic qualification as an expert witness. That determination is made by the presiding judge on a case-by-case basis.

“Fraud cases almost always involve volumes of documents,” Britt said, “and cases are won or lost on the strength of the evidence. It must be carefully preserved.” (See “ Evidence Preservation Rules ,”below.) Many frauds may seem outwardly complex, but they rarely are. Because CPAs are detail-oriented, there is a natural temptation to include too much information in exhibits, making them difficult and tedious for judges and juries to absorb. Good litigation experts like Britt remember three words: simplify, simplify, simplify. Another natural temptation for CPAs is to express opinions—especially opinions on guilt or innocence—when they should not (see “ Opinions on Guilt or Innocence, ” below).

Evidence Preservation Rules
F or courtroom purposes, documents and other evidence must be carefully preserved in original condition until the time of trial. Here’s what should be done:

Log each piece of evidence and fully describe it.
Mark each document with your initials and the date it was obtained.
Make copies of the original documents to use as workpapers.
Lock the originals away in a safe place so you can truthfully testify others have not had access to them.
When you turn the original documents over to the court, obtain a signed receipt.

After obtaining a civil injunction against the CFO, Britt’s legal team turned over the evidence to the district attorney’s office. “Some people believe the victim must choose between a criminal prosecution or a civil lawsuit, but that’s not true,” Britt says. “Parallel proceedings allow you to pursue both avenues simultaneously, and that’s what we did in this case.”

Opinions on Guilt or Innocence
T he court alone makes the determination of guilt or innocence. In a courtroom, no good attorney would ask a CPA to express such an opinion, and no alert judge would allow it. CPAs also should refrain from expressing such opinions outside the courtroom. If, for example, you opine that a defendant was guilty and he or she is subsequently acquitted, you could find yourself being accused of defamation.

Even if you are not a certified fraud examiner, you can find guidance in the CFE Code of Professional Ethics, which states: “A CFE will obtain evidence or documentation to establish a reasonable basis for any opinion rendered. No opinion shall be expressed regarding the guilt or innocence of any person or party.”

The DA’s office issued subpoenas for the CFO’s personal bank accounts. The evidence was revealing: He wasn’t a sophisticated investor at all; he’d lost millions playing the stock market. He also had acquired two lake houses, two boats, a condo, expensive automobiles, jewelry for his wife and prepaid college tuition for his two children.

Because of Britt’s efforts, the employer was able to secure both a criminal and a civil victory and recover about $1.5 million from the defendant, insurance companies and other parties. The CFO, who pleaded guilty, was sentenced to prison and ordered to pay restitution.

Rick Britt has seen thousands of cases of fraud. He believes that CPAs who act as litigation experts must have a thorough understanding of their roles and be able to present testimony in a clear, concise and understandable manner. Or, as he succinctly puts it, “If it takes you more than a few sentences to sum up your case, you’re going to have trouble in the courtroom.”

JOSEPH T. WELLS, CPA, CFE, is a contributing editor to the Journal of Accountancy . He is founder and chairman of the Association of Certified Fraud Examiners in Austin, Texas; a two-time Lawler Award winner for the best article in the Journal ; and a member of both the Journal of Accountancy Hall of Fame and the AICPA Hall of Fame. His e-mail address is joe@cfenet.com .

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