Basic Legal Concepts

The expert’s answer provoked a snicker from the judge and jury, and the CPA’s credibility went downhill from there. Before the cross-examination was over, the expert was made to look like an idiot. The truth is, the CPA knew a lot about accounting and he was well-versed in the facts of the case, but he knew little about the legal aspects of fraud—a crucial element for an antifraud witness. As a result, the case was lost. This article will summarize the basic common-law concepts of fraud, beginning with the requisite: The purpose of this article is to familiarize you with the law, not to provide legal advice. For that, check with your attorney.

Appeals courts direct trial judges to closely examine the qualifications of purported experts before allowing them to testify. Failure to answer the basic question above could mean the “expert” might not be allowed to testify. Imagine the implications if the case had been lost because the time for naming new experts had passed.

To qualify as experts, CPAs have to give proof of knowledge, education and/or experience to convince the judge they have reliable and valuable information for the jury. (See “ So You Want to Be an Expert Witness. ”) Qualification is on a case-by-case basis; despite public misinformation by some groups, a blanket qualification—even for CPAs—does not exist in any court system.

Criminal and civil frauds differ in the level of proof required. For civil cases that burden is a “preponderance of evidence.” In criminal fraud the standard is “beyond a reasonable doubt.”

WHAT CONSTITUTES FRAUD
Under common law, three elements are required to prove fraud: a material false statement made with an intent to deceive (scienter), a victim’s reliance on the statement and damages.

A material false statement. Let’s assume an attorney hires you to examine the financial statements of ABC Corp. The attorney represents shareholders who have filed a lawsuit against ABC claiming the financial statements are fraudulent. Your job is to help the attorney determine whether the claim constitutes fraud. You begin by seeking to find out whether the financial statements contain false statements, and if so, whether they are “material.”

For CPAs, materiality is a familiar concept. Generally speaking, a transaction is material if prior knowledge would have changed the outcome of the investor’s decision to part with money. The good news for CPAs is that this element of proof typically involves familiar ground: determining the real numbers. But CPAs inexperienced in fraud cases might stop there. In reality, they should just be getting started; the real work comes when proving intent.

There is no such thing as an accidental fraud. What separates error from fraud is intent , the accidental from the intentional. Assume ABC’s financial statements contain material false statements: Were they caused by error or fraud? The problem with proving intent is that it requires determining a person’s state of mind. As a result, intent usually is proven circumstantially. Some of the ways we can help prove intent by circumstantial evidence include

Motive. The motive for fraud is a strong circumstantial element. In the case of ABC Corp., for example, the CPA could attempt to prove the company was in financial trouble or that earnings per share, if correctly stated, would have fallen below analysts’ expectations. Or, if managements’ compensation is tied largely to earnings performance, documenting that would help establish motive.

Opportunity. Management typically has the opportunity to circumvent or override controls over financial reporting. To prove this element the lawyers would call witnesses from ABC to testify and introduce documents relating to job descriptions. The CPA usually would help identify the specific control weaknesses or overrides that allowed the fraud to occur.

Repetitive acts. Should the financial statements contain a single false journal entry, a fraudster might be able to claim it was an error. Or if an employee steals once, he or she may be able to explain that away. Frauds, whether involving asset misappropriations or fraudulent financial statements, usually are not single acts. For example, assume that someone at ABC Corp. decided to inflate last year’s earnings by falsely debiting accounts receivable and crediting sales. Since one single large entry might draw attention, it is more likely there would be numerous false entries of smaller amounts. This fact makes it more difficult for the ABC fraudster to claim it was an error.

Witness statements. Circumstantial evidence rarely can be sufficient without the statements of witnesses. In a typical financial statement fraud case, management directs underlings to make the fraudulent entries. The CPA typically would identify the potential witnesses, such as bookkeepers or other accounting personnel, who may have made the fraudulent entries.

Concealment. Honest people rarely have the motive to conceal their acts. Therefore, if, for example, the CEO ordered the destruction of key ABC documents prior to an audit, this could be powerful circumstantial evidence of intent.

Victim reliance. Even when there is a material false statement and the intention to deceive can be proved, it does not meet the legal test for fraud unless there is a victim who relied on the false statement. That usually is proven by having the ABC shareholders testify they would not have invested had they known the true financial condition of the company. It may be even more challenging to prove reliance by banks extending loans, especially in cases involving self-employed borrowers who default on an obligation. In many such cases, the bank would have secured the loan with lots of hard collateral, or it may have done its own due diligence, thus making it difficult to prove it actually had been relying on the financial statements when credit was approved.

Damages. The final legal element of fraud concerns damages—usually in terms of money. In some federal criminal cases—for example, bank frauds—an actual loss is not required. But normally, even when there is a material false statement, intent and victim reliance, there is no fraud if the victim is not damaged. For example, the shareholders of ABC hardly would be filing suit if the price of the stock went up as a result of the other elements’ being uncovered.

There are two major types of damages: actual and punitive. The CPA will assist the attorney in determining actual damages; the judge and jury will assess other damages, subject to statutory limitations. In ABC’s alleged fraud, the CPA might be required to restate the shareholders’ equity in light of the fraudulent financial statements. Alternatively, if the stock price has suffered as a result of publicity about the fraud, the CPA typically would determine the amounts involved. The attorney would argue that whichever method produced the largest amount should be allowed as financial damages. The applicable measure of damages—for example, benefit of the bargain, out of pocket—can vary from state to state and case to case. The attorney will determine which measure applies. The CPA can be an invaluable resource in performing the calculation and proving the amounts.

Criminal Prosecution of Fraud
Although federal securities laws address financial statement fraud, prosecutors often also will charge criminal violations under one or more of the below categories, depending on the exact circumstances of the case.
Misrepresentation of material facts. Concealment of material facts. Bribery. Illegal gratuities. Conflicts of interest. Embezzlement. Theft of trade secrets. Mail fraud. Wire fraud. Interstate transportation of stolen property. Racketeer Influenced and Corrupt Organizations (RICO).	False claims and statements. Conspiracy. Foreign Corrupt Practices Act. Bankruptcy fraud. Financial institution fraud. Health care fraud. Identity theft. Telemarketing fraud. Computer fraud. Economic espionage. Money laundering.

The criminal prosecution of fraud (see exhibit , above), as well as civil frauds, share a common thread: They both contain the legal elements of fraud. So if you get into fraud work of any kind, know these elements. And know them well. That way, your definition of fraud and the legal definition are one and the same.

G. Michael Lawrence, JD, CFE, is principal of G. Michael Lawrence, PC, Austin, Texas, and an advisory member of the Association of Certified Fraud Examiners’ Board of Regents. His e-mail address is mike@mikelawrence.net . Joseph T. Wells, CPA, CFE, is founder and chairman of the Association of Certified Fraud Examiners. Mr. Wells has twice won the Lawler Award for the best article in the Journal of Accountancy and has been inducted into the Journal of Accountancy Hall of Fame. His e-mail address is joe@cfenet.com .