Synopsis
Bernie Madoff’s primary goal was to accumulate wealth, leading him to establish his own brokerage firm named Madoff Securities. Having been raised in New York City, he understood that Wall Street was the gateway to worldwide fortunes. In 1960, right after graduating from college, he set out on a mission to join the influential group of individuals who controlled Wall Street.
Madoff played a crucial part in transforming Wall Street through the promotion of computer technology. In the 1970s, he made important contributions to the establishment of NASDAQ, which later became the largest electronic stock market worldwide. Eventually, even NYSE had to embrace electronic securities trading.
The lower transaction costs of electronic securities trading, which were largely thanks to Bernie Madoff, have benefited millions of investors. However, Madoff’s legacy as a pioneer in electronic securities trading is overshadowed by his association with the Ponzi scheme. Despite the success of his stock brokerage firm, Madoff ventured into investment advisory services as well.
Over a period of several decades, Madoff gained a reputation as the Wizard of Wall Street for consistently and impressively earning returns on the billions of dollars investors entrusted to him. However, these returns were fraudulent, along with Madoff’s secretive investment strategy that generated them. This case examines the Madoff fraud, with a specific emphasis on its impact on the nation’s financial reporting system. Numerous critics argue that the SEC’s ineffectiveness played a significant role in enabling Madoff to perpetuate his fraud for an extended period.
Likewise, critics argue that Madoff’s independent auditor played a crucial role in allowing the fraud to continue undetected for many years. Madoff Securities was audited by a small accounting firm, primarily by David Friehling, a professional accountant. Friehling became the second individual arrested in relation to the investigation of Madoff’s massive fraud. He was charged with violating auditor independence rules and conducting false audits for Madoff Securities. (Source: Case 1.2 Madoff Securities)
Here are key facts about Madoff Securities:
- Bernie Madoff’s primary motivation was his aspiration to amass wealth.
- Madoff founded Madoff Securities, an early adopter of computer technology for cost reduction in securities transactions. He is also credited as one of the founders of NASDAQ, the world’s largest electronic stock exchange.
- The investment advisory division of Madoff Securities experienced significant growth throughout the firm’s existence due to consistently impressive returns for investors.
In December 2008, Bernie Madoff confessed to his family about the fraudulent nature of his investment results. This revelation exposed a massive Ponzi scheme that had been operated by Madoff for several decades. As a result, public outrage ensued and questions were raised regarding the failure of the capital market’s watchdog, specifically in regards to the independent audit function. The auditing firm responsible for overseeing Madoff’s company, Friehling & Horowitz, consisted of only one accountant named David Friehling. Experts viewed this as absurd given the size of Madoff Securities. In March 2009, Friehling was arrested and charged with securities fraud and aiding an investment fraud due to allegations of conducting fake audits for Madoff Securities. It was also discovered that Friehling and his firm had invested a significant amount of funds with Madoff Securities. The SEC received severe criticism when it became evident that a financial analyst named Harry Markopolos had repeatedly alerted them about Madoff’s extensive Ponzi scheme while providing evidence to substantiate his claims.
Madoff admitted to committing multiple crimes, including fraud, money laundering, perjury, and theft in March 2009. As a result, he was given a 150-year prison term in June of the same year. David Friehling is currently being investigated for fraud and could face a prison sentence exceeding 100 years if found guilty. KPMG, one of the four major accounting firms, is facing legal action for allegedly failing to properly examine Friehling & Horowitz during their audit of the financial records of an important feeder company where the plaintiff had invested.
The SEC has proposed a series of reforms aimed at preventing or detecting future frauds like the Madoff scandal. One of the proposed reforms is to implement annual surprise audits for investment advisers, ensuring the proper safeguarding of customer funds. Case 1. 12 Madoff Securities 88 Instructional Objectives: 1. Identify the main precursors of financial fraud. 2. Identify red flags or risk factors indicating fraud. 3. Highlight the crucial role of an independent audit function in a free market economy. 4. Examine the regulatory responsibilities of the Securities and Exchange Commission. 5. Understand the nature and purpose of peer reviews.
Suggestions for Use: This case is ideal for starting an auditing course, especially at the undergraduate level. It involves a high-profile case, is concise, not overly technical, and importantly emphasizes the significance of independent audits in our economy. After studying this case, students should have a clear understanding of why it is necessary for all large companies, both public and private, to undergo a thorough and independent financial statement audit every year.
If the allegations against Mr. Friehling are proven, it is certain that almost every business in the United States was affected directly or indirectly by Bernie Madoff’s massive fraud. The substandard audits he conducted played a pivotal role in enabling Madoff to sustain his fraud for an extended period. Utilizing this case in your auditing course can serve as a valuable addition to your coverage of various crucial topics such as internal controls, auditor independence, and fraud.
This case offers an opportunity to discuss two technical topics that are rarely addressed in other audit failures. One topic is the audit procedures that should be used for a client’s major stock market investments. The other topic is peer reviews. Just like with the other cases in this text, it is recommended to have students research recent developments in this case and consider the initial case question. It is expected that there will be interesting revelations and new developments in this case for years to come.
Suggested solutions to the case questions include having individual students or groups provide updates on various aspects of the case, such as additional criminal charges filed, developments regarding Friehling and his audits of Madoff Securities, litigation involving auditors of Madoff’s feeder firms, and regulatory reforms resulting from the Madoff fraud.
The main authoritative source for investment auditing is Statement on Auditing Standards No. 2, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities (AU Section 332). The AICPA has also issued an accounting and audit guide specifically for investment companies. The increasing complexity of securities investments in recent years has significantly complicated the auditing process, especially for investments.The alleged investment strategy of Bernie Madoff prominently featured the buying and selling of put and call options, as stated in the case of 12 Madoff Securities involving options and other exotic transactions.
Below are examples of suggested audit procedures for material investments, as outlined in AU Section 332:
- Confirmation of settled transactions with the broker-dealer or counterparty
- Confirmation of unsettled transactions with the broker-dealer or counterparty
- Inspecting underlying agreements and other forms of supporting documentation, in paper or electronic form
- Inspecting supporting documentation for subsequent realization or settlement after the end of the reporting period
- Performing analytical procedures
- Inspecting financial instruments and other agreements
Inspecting documentation in paper or electronic form for activity following the reporting period, confirming significant terms of the given investment with the third party investee, reviewing minutes of board meetings, reading contracts and agreements to gain further insight into the nature of the investments, assessing the reasonableness and appropriateness of the fair value model used to determine the reported value of the security, calculating the fair value of the investment, and comparing it with subsequent or recent transactions.
The auditors of Madoff’s feeder firms have not publicly disclosed the specific audit procedures they performed on their clients’ Madoff-held investments. Therefore, it is unclear if they assessed whether the accounting principles used had general acceptance, if those principles were appropriate for the circumstances, and if the financial statements provided informative information for their use, understanding, and interpretation.
There has been no public disclosure of the specific details of the audits conducted by Friehling & Horowitzs of Madoff Securities financial data. It is hoped that the pending lawsuits in this case, as well as future lawsuits, will shed light on the nature and extent of the feeder firm audits and the audits conducted by Friehling & Horowitzs of Madoff Securities. Consider assigning student groups to research and present an in-class report on SAS No. 92 or the accounting and audit guide for investment companies.
You can expand this project by having certain students or student groups provide reports on prior alleged audit failures involving investment companies. (Note: Cases appearing in past editions of this casebook examined the audits of the large and ultimately doomed brokerage company E. F. Hutton and ESM Government Securities, an investment firm that specialized in securities issued by the federal government.) 3. A peer review is an examination of an accounting firm’s quality control system and its compliance with the requirements of that system by one or more accounting professionals. You may want to point out to your students that the PCAOB has established its own inspection program to ensure that auditors of public companies have established and are applying appropriate quality control policies and procedures. Of course, the PCAOB inspection program is technically not a peer review program but it serves the same general purpose. Assuming that Friehling & Horowitz’s audits of Madoff Securities were, in fact, sham audits as alleged by federal prosecutors, then it seems reasonable to conclude that a thorough peer review would have revealed that those audits were substandard.
The peer review report filed with the relevant regulatory or oversight body would most likely have led to Friehling & Horowitz being disqualified as Madoff’s audit firm. The case discusses New York’s adoption of a peer review requirement after the Madoff fraud. However, a firm the size of Friehling & Horowitz would be exempt from that requirement, as noted in a footnote to the case. 4.
AU Section 316, Consideration of Fraud in a Financial Statement Audit is the definitive source to consult when addressing this query. AU 316.07 provides a breakdown of the three elements comprising the fraud triangle: the presence of motivation and/or pressure to commit fraudulent acts, the existence of opportunities for fraudulent actions (usually due to inadequate internal controls), and the ability to justify engaging in fraudulent behavior by the alleged or potential perpetrator. These three conditions, referred to as precursors to fraud by AU Section 316, are integral to understanding the phenomenon.
The presence of these factors does not necessarily guarantee the occurrence of fraud, but an environment where these conditions exist is more likely to foster fraud. AU 316.31 introduces the term “fraud risk factors,” which are events, circumstances, or conditions indicating the presence of one or more elements of the fraud triangle. The use of “conditions” in professional auditing standards refers both to the precursors and indicators of fraud, presenting some difficulty. Appendix A of AU Section 316 lists numerous individual fraud risk factors, such as intense competition or market saturation in a client’s industry (incentive/pressure), negative cash flows (incentive/pressure), the need for additional debt or equity capital (incentive/pressure), significant related party transactions (opportunity), and a known history of violating securities laws or other laws (ability to rationalize). Recently, our nation has been plagued by financial fraud, including fraudulent accounting.
This question allows students to generate their own solutions to the problem, which may be more effective than current preventative measures implemented by experts. It is recommended to group the students together to come up with their recommendations and then have each group present and defend their choices. Some potential reforms that regulatory authorities could consider adopting to address fraud include:
- Requiring independent auditors to immediately report suspected fraud to regulatory and/or law enforcement authorities. This measure has already been implemented in South Africa as seen in the Registered Auditors, South Africa case.
- Establishing a government audit agency to take over the independent audit function. This idea was initially considered by Congress in the 1930s when the federal securities laws were passed.
- Implementing more rigorous training programs to ensure government regulators, such as SEC personnel, possess the necessary background to effectively carry out their oversight responsibilities.
