12 MADOFF CASE SECURITIES Synopsis A childhood friend summed up the driving force in Bernie Madoffs life: Bernie wanted to be rich - Madoff Case introduction. As a youngster growing up in New York City, Bernie realized that Wall Street was the greatest wealth creation machine the world had ever known. So, after graduating from college in 1960, he set his sights on joining the exclusive fraternity that ran Wall Street by organizing his own one-man brokerage firm, Madoff Securities.
Madoff was one of the first individuals to recognize that computer technology provided the means to democratize Wall Street by establishing a system that made securities trading much more efficient and much cheaper. In the early 1970s, Madoff and several other individuals organized the NASDAQ exchange, which was destined to become the world’s largest electronic stock market. Years later, the NYSE would be forced to follow suit and switch to electronic securities trading.
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Literally millions of investors have benefitted from the lower transaction costs of electronic securities trading that were in large part a result of the pioneering efforts of Bernie Madoff. Unfortunately, Bernie Madoff will not be remembered as a pioneer of electronic securities trading. Instead, the word Madoff will always be associated with the phrase Ponzi scheme. Although his stock brokerage firm was extremely lucrative, Madoff eventually established a parallel business, investment advisory services.
Over a period of several decades, Madoff became known as the Wizard of Wall Street for the incredibly consistent and impressive returns that he earned on the billions of dollars entrusted to him by investors. However, those returns and Madoffs secretive investment strategy that produced them were fraudulent. This case documents the Madoff fraud with a particular focus on its implications for the nation’s financial reporting system. Many critics have insisted that the ineffectiveness of the SEC was a major factor that allowed Madoff to sustain his fraud for so long.
Likewise, those critics insist that Madoffs independent auditor played a major role in allowing the fraud to go unchecked for decades. Throughout most of its existence, Madoff Securities was audited by a small accounting firm with one professional accountant. That accountant, David Friehling, would become the second individual arrested by federal prosecutors investigating Madoffs massive fraud. Friehling was charged with flouting the accounting professions auditor independence rules and with performing sham audits of Madoff Securities. 87 Case 1. 2 Madoff Securities Madoff Securities Key Facts 1. The driving force in Bernie Madoffs life was his desire to become wealthy. 2. Madoff founded Madoff Securities, which was one of the first brokerage firms to employ computer technology to reduce the cost of securities transactions; Madoff is also credited as one of the founders of the NASDAQ, the worlds largest electronic stock exchange. 3. The investment advisory division of Madoff Securities grew dramatically over the life of the firm due to the incredibly consistent and impressive rates of return that it earned for investors. 4.
In early December 2008, Madoff confessed to family members that his firms impressive investment results were fraudulent, the product of a massive Ponzi scheme that he had carried out over decades. 5. News of the massive fraud prompted an angry public to question why the nations watchdog function for the capital markets, particularly the independent audit function, had failed once again. 6. Madoffs auditor had been a tiny CPA firm, Friehling & Horowitz, with one professional accountant, David Friehling; accounting and auditing experts insisted that it was preposterous that one person could audit a firm the size of Madoff Securities. . In March 2009, Friehling was arrested and charged with securities fraud and aiding and abetting an investment fraud due to his allegedly sham audits of Madoff Securities; federal prosecutors also revealed that Friehling and his firm had a large amount of funds invested with Madoff Securities. 8. The SEC was the target of harsh criticism when it was revealed that Harry Markopolos, a Boston-based financial analyst, had repeatedly told the SEC that Madoff was operating the world’s largest Ponzi scheme and had provided evidence apparently proving that allegation. 9.
In March 2009, Madoff pleaded guilty to eleven counts of fraud, money laundering, perjury, and theft; in June 2009, Madoff was sentenced to 150 years in federal prison. 10. Fraud charges are still pending against David Friehling; he faces a prison sentence of more than 100 years if convicted of those charges. 11. KPMG became the first of the Big Four firms to be sued as a result of the Madoff fraud; the lawsuit alleges that KPMG failed to properly investigate Friehling & Horowitz while auditing the financial statements of a large feeder firm in which the plaintiff was an investor. 12.
The SEC has announced a series of reforms to prevent or detect future frauds similar to Madoffs; one proposal is that investment advisers be subjected to annual surprise audits to ensure that customer funds are properly safeguarded. Case 1. 12 Madoff Securities 88 Instructional Objectives 1. To identify the principal precursors of financial fraud. 2. To identify red flags or risk factors typically indicative or symptomatic of fraud. 3. To demonstrate the critical importance of a vigorous independent audit function for a free market economy. 4. To examine the regulatory role and responsibilities of the Securities and Exchange Commission. . To identify the nature and purpose of peer reviews. Suggestions for Use This case is well suited to kick off an auditing course, particularly an undergraduate auditing course. The case is high profile, fairly brief, not highly technical, and most importantly documents how vital the independent audit function is to our economy. After studying this case, students should have a crystal clear understanding of why it is so necessary that every large company, both private and public, undergo a truly independent and vigorous financial statement audit each year.
No doubt, almost every business in the United States was affected directly or indirectly by Bernie Madoffs massive fraud. If the allegations against Mr. Friehling are proven, then the substandard audits he performed played a central role in allowing Madoff to sustain his fraud for as long as he did. If you don’t choose to launch your auditing course with this case, you could use it to compliment your coverage of several important auditing topics including internal controls, auditor independence, and fraud.
This case also provides an opportunity to discuss a technical topic that doesn’t arise in many alleged audit failures, namely, the audit procedures that should be applied to a clients major stock market investments. Another technical topic in this case that is seldom touched on in other problematic audits, at least the ones that I have researched, is peer reviews. As with all of the live cases in this text, you will likely want to have your students research recent developments in this case. see the initial case question. No doubt, there ill be interesting revelations and new developments in this case for years to come. Suggested Solutions to Case Questions 1. Consider having individual students or individual student groups provide updates on the following facets of this case: additional criminal charges filed in the case, developments involving Friehling and his audits of Madoff Securities, litigation involving the auditors of Madoffs feeder firms, and regulatory reforms emanating from the Madoff fraud. 2. The principal authoritative source relevant to investments 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 for investment companies. Understandably, the increasing complexity of securities investments in recent years has greatly complicated the auditing of investments, particularly investments 89 Case 1. 12 Madoff Securities involving options and other exotic transactionsas noted in the case, the buying and selling of put and call options was a central feature of Bernie Madoffs alleged investment strategy.
Listed next are examples of suggested audit procedures for material investments that are included 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 subsequent to the reporting period. Confirming significant terms [of the given investment with the third party investee]. Reviewing minutes of meetings of the board of directors and reading contracts and other agreements to gain additional insight on the nature of the given 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 given investment. Comparing the fair value with subsequent or recent transactions.
Ascertain whether the accounting principles selected and applied have general acceptance. Determine whether the accounting principles are appropriate in the circumstances. Determine whether the clients financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation. Were these and other audit procedures performed by the auditors of Madoffs feeder firms? I have no idea. To date, there has been no public disclosure of the specific audit procedures applied by those feeder firms to their clients Madoff-held investments.
As a point of information, there has also been no public disclosure regarding specific details of the Friehling & Horowitzs audits of Madoff Securities financial data. Hopefully, the resolution of the pending lawsuits in this case and the resolution of similar lawsuits that will almost certainly be filed in the future will provide us with some insight on the nature and scope of the feeder firm audits and Friehling & Horowitzs audits of Madoff Securities. You might consider having one or more student groups research and provide an in-class report on SAS No. 92 and/or the accounting and audit guide for investment companies.
You might 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 firms quality control system and its compliance with the requirements of that system by one or more accounting professionals. You Case 1. 2 Madoff Securities 90 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 & Horowitzs 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 resulting peer review report filed with the relevant regulatory or oversight body would very likely have resulted in Friehling & Horowitz being disqualified as Madoffs audit firm. As discussed in the case, New York adopted a peer review requirement following the Madoff fraud. However, as pointed out in a footnote to the case, a firm the size of Friehling & Horowitz would be exempt from that requirement! 4.
AU Section 316, Consideration of Fraud in a Financial Statement Audit is the authoritative source to refer to in responding to this question. AU 316. 07 lists the three angles of the so-called fraud triangle: the existence of an incentive and/or pressure to commit a fraud, the opportunity to commit a fraud is present (typically due to ineffective internal controls), and the ability to rationalize fraudulent conduct on the part of the given or potential fraudster. These three conditions (the term used by AU Section 316) are effectively precursors to fraud.
The presence of these factors does not necessarily mean that fraud will occur but an environment in which these conditions are present is much more likely to spawn fraud. AU 316. 31 introduces the phrase fraud risk factors. These factors are events or circumstances or conditions that indicate that one or more of the three elements of the fraud triangle are present. [The use of the term conditions within the professional auditing standards to refer to both the precursors of fraud and the symptoms or indicators of those precursors is somewhat problematic. Appendix A of AU Section 316 identifies dozens of individual fraud risk factors. A few examples: a high degree of competition or market saturation in a clients industry (incentive/pressure), negative cash flows (incentive/pressure), need to obtain additional debt or equity capital (incentive/pressure), significant related party transactions (opportunity), and known history of violating securities laws or other laws (ability to rationalize). 5. Financial fraud, including fraudulent accounting, has plagued our nation recently.
This question provides your students with an opportunity to come up with their own answers to this perplexing problemmaybe their solutions would be more effective than the preventative measures implemented in recent years by so-called experts. Consider placing your students in groups to come up with their recommendations and then have each group present and defend their choices. Listed next are a few random reforms that regulatory authorities could consider adopting to address the fraud problem: –Requiring independent auditors to immediately report suspected fraud to egulatory and/or law enforcement authorities. (This measure has been implemented recently in South Africasee the Registered Auditors, South Africa case. ) –Establishing a government audit agency to take over the independent audit function. In the 1930s, Congress initially considered creating a government agency to perform the independent audit function when it passed the federal securities laws. –More rigorous training programs to ensure that government regulators, such as SEC personnel, have the proper background to carry out their oversight responsibilities.