| CPA was hired to be an expert witness
in a civil fraud case. On cross-examination the
opposing attorney asked the expert a seemingly
simple question: “Would you please define ‘fraud’
for the jury?” The CPA replied, “Do you want to know
the legal definition or my
definition?” The attorney countered, “You mean
there is a difference?” |
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.
Definition of Fraud
All multifarious means which human
ingenuity can devise, and which are
resorted to by one individual to get
an advantage over another by false
suggestions or suppression of the
truth. It includes all surprises,
tricks, cunning or dissembling, and
any unfair way which another is
Black’s Law Dictionary, 5th
ed., by Henry Campbell Black, West
Publishing Co., St. Paul, Minnesota,
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.
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
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
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
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
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’
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.
|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
Concealment of material
Conflicts of interest.
Theft of trade secrets.
Interstate transportation of
Racketeer Influenced and
Corrupt Organizations (RICO).
| False claims and statements. |
Foreign Corrupt Practices
Financial institution fraud.
Health care fraud.
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
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
email@example.com . 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 firstname.lastname@example.org