Abstract
The Madoff Securities scandal was one of the biggest Ponzi schemes to hit America. This essay would examine the Madoff scandal from an audit perspective since it was the complacency (or collusion) of the auditors that encouraged the perpetrator of this scam. While the scam that was pulled by Bernie Madoff, was both large and difficult to spot, its detection also helped expose a crucial flaw that existed in corporate America at the time. This was the lack of regulatory oversight in the Securities business. While one could lay the blame for this scandal on the Regulator, another important aspect that was revealed as a result of this scandal was the role of the auditor. An auditor plays a crucial role in the overall Economy since it is on the assurances provided by the auditor that investors or even lenders decide on the manner in which to proceed. The auditors in the Madoff scandal (including the audit committee) chose to look the other way and, in fact, allegedly colluded with Madoff in the scandal. The role of the audit committee also comes into the picture in this scandal.
Introduction
The Madoff Securities Fraud was a Ponzi scheme largely created by Bernie Madoff who was a securities broker. The fraud not only changed the way the SEC viewed these firms but also cast a doubt on the role of auditors, particularly those who weren’t peer reviewed but were still continuing their audit business. This essay will commence by examining the Madoff Case in brief and then go on to examine issues such as regulatory oversight, audit procedures, audit committee actions that may have prevented the fraud as well as a possible strategy different from the one Markopolos undertook to expose the fraud.
The Fraud
Bernie Madoff started this securities fraud scheme somewhere in the late eighties, and the whole thing ended in 2008 with his arrest. Madoff was one of the first individuals to recognize the fact that computer technology could completely change the manner in which business was done on Wall Street by establishing a system that made securities trading extremely efficient and cheap. (Knapp, 2015, p. 157). This led to Madoff estasblishing the NASDAQ, which eventually became the world’s largest electronic stock market. In the backdrop of such achievement, Madoff started a Ponzi scheme in which he displayed to the financial world an investment strategy that was proprietary and generated huge returns. (Knapp, 2015, p.155). The only thing Madoff revealed to the market was that his fund was following a ‘split strike conversion’ model that was responsible for the high returns. (p. 155). No one doubted the story even when competitors, financial analysts and others were unable to generate returns even close to what Madoff had achieved. But on December 10, 2008, the story changed when Madoff confessed to his sons about this long standing Ponzi scheme run by him. His sons blew the whistle on this scheme and the FBI subsequently arrested Madoff for this fraud. The scam destroyed wealth of numerous high networth individuals as well as institutions. The amazing thing was that most of the people who had their money in this scheme did not know they had lost their money since they had invested their money in other hedge funds who then invested money in Madoff’s company through various feeder funds. (Knapp, 2015, p. 154)
Regulatory Oversight
Madoff took undue advantage of the regulatory environment of that time. Madoff established the entire investment fund in a manner that left his company answering very questions to the SEC. Firstly, his firm did not collect a management fee for his advisory services so that the act would not raise red flags with regulators. (Moyer, 2009). His broker-dealer never had customer accounts because Madoff Securities held itself out as a wholesale market-making firm. In doing so, Madoff’s firm executed order flow for other broker-dealers and, sometimes, trading for its own accounts. (Moyer, 2009). Therefore, as per SEC norms, the law treated the firm as a counter party and not as a customer relationship management firm. Even shocking was the fact that Madoff’s firm wasn’t even registered as an investment advisor until 2006. The SEC never classified Madoff’s firm as an investment advisor, although with $50 billion it should have been among the largest hedge funds. Similarly, regulators failed to pursue potential red flags, including the fact that Madoff’s firm kept the assets in its own custody instead of using the services of a custodian and used a relatively unknown audit firm to sign off on its books. While regulators cite the potential rise in the registered firms and complaints thereof that is needed to be investigated as reasons for the oversight, one can understand that some of Madoff’s actions were very obvious. One could speculate that a possible reason for the oversight could also be due to Madoff’s stature in the market and his position heading NASDAQ – something which led regulators to ignore red flags. Overall, however, a combination of these factors led to a gross oversight on the part of the regulators that led to an unmitigated financial disaster for a number of investors in Madoff’s fund.
Fundamental Audit Procedures & Peer Review System
The fundamental audit procedures that an auditor should apply to an audit have been adequately established by the Auditing Standard AU Section 332. (AICPA, 2011, p. 1915). The auditor should have followed the basic procedure in the following manner as per AU Section 332 -- 1. The auditor would need to have an in-depth understanding of the funds’ information scheme for Securities (both Stocks and Derivatives). Therefore, the auditor might need access to extraordinary skills with respect information about securities and derivatives being processed, transmitted, maintained, or accessed through electronic means. 2. Identify controls positioned in process by a service association that gives services to an unit that are division of the entity’s information scheme for securities and derivatives. For instance, the auditor should have complete understanding of the operating uniqueness of entities in that particular business. 3. The auditor must follow and understand all the guidelines of generally accepted accounting principles (GAAP) for affirmations about derivatives. In all such cases, the auditor should have an exceptional knowledge given the complexity of such instruments. 4. A proper determination of the fair value of derivatives and securities also lies with the auditor. 5. The auditor must also assess inherent risk and control for assertions about derivatives used in hedging the activities. (AICPA, 2011, p. 1915 – 1916). Therefore, the auditor will need a thorough knowledge of all-purpose risk management concepts and characteristic Asset - Liability management strategies. In addition to the above standard procedures mentioned and the Audit Standards required, auditors must always behave in an manner that is ethical, maintaining independence of opinions on a constant basis.
A peer review is a periodic external review of a firm's quality control system in accounting and auditing and is also known as the AICPA's practice monitoring program. (AICPA, 2011, p. 1921). The review process is comprehensive and includes, but is not limited to, examining working papers and ensuring the accounting procedures are being followed. A compulsory peer review applies to a CPA firm's Audit and Accounting services, but such a review is not applicable to tax and management advisory services. The following procedures are involved in the peer review process when appraising a CPA firm's quality control policies and procedures: (1) reviewing each organizational or functional level within the firm; (2) reviewing selected engagement working paper files and reports; and (3) reviewing documentation indicating the firm's compliance with membership requirements. (AICPA, 2011, p. 1923). In case of Friehling & Horowitz, although they were registered with the AICPA, they reported each year that they did not perform any audits. As a result, they were never included in the mandatory peer review, which could have potentially exposed the bigger problem. If Friehling and Horowitz had been reviewed by their peers in a proper manner, they would have failed on all the three points of control procedures mentioned earlier since they were conducting sham audits that did not have proper report and filings, including the fact that they did not have proper compliances with regard to their membership requirements.
Markopolos’ Strategy
Harry Markopolos was instrumental in acting as a whistleblower and in providing evidence to show Madoff’s role in the fraudulent activities. He tried numerous times to notify the SEC about Madoff's deception, and failed miserably since no one in the SEC was interested initially. However, Markopolos persisted and revealed Madoff's fraudulent activities in May 2000, after he became worried about Madoff activities, which were beginning to pick pace as more investors were investing the Madoff Fund. (Carozza, 2009). As per Markopolos, it took him approximately five minutes of reading through Madoff's advertising materials to understand that the scheme was a fraud, and a few more hours to construct mathematical models that could confirm the fraudulent nature of the scheme. However, a number of times, his entire evidence and models were brushed aside by regulators, including prominent bureaucrats in Boston and New York. In reality, Markopolos should have altered his strategy. Instead of attempting to provide constructed models as evidence, he should have masqueraded as a potential investor of Madoff Securities. Such a strategy would have yielded rich dividends, since it would have provided him with the complete operational knowledge of the business. With this knowledge he could have provided the SEC the exact layout as to how Madoff was operating therefore all the reasons provided by the SEC would have been invalid. In addition to the models and the evidence he had, the information gathered from this effort would have forced SEC to sit up. In addition, he should have also made a complaint to the FBI so that Federal Investigators would also have been in the loop.
Role of the Auditors
The most important role of an external auditor is to present a viewpoint on whether an organization's financial statements are free of material misstatements. (Gandel, 2008). In essence, auditors must ascertain that an organization's financial statements demonstrate its factual financial position. Therefore, independence of auditors is a very important point and auditors must ensure that their statements and assertions are free of any material conflicts.
The dissimilarity between other hedge fund frauds and in the case of Madoff’s fund is Madoff was not, in fact, a client of any of the big auditing firms. Madoff's company used the little New City, N.Y., accounting firm Friehling & Horowitz, which had offices in a strip mall with only three employees and numerous infractions to its credit. The audit committee, in this case, was compromised and hence no action was taken by the external auditors. In order to prevent the fraud, the auditors should have ideally carried out detailed investigation of the scheme documents and should have a thorough understanding of the scheme. They should have also refused to attest the audit conducted since the firm was severely lacking on many fronts, particularly on the fact that it did not have any underlying assets for the money collected. Such blaring instances of audit oversight would have been avoided had the audit committee done its job well.
In conclusion, one can understand that the Madoff scheme blew out of proportion largely due to regulatory oversight, but also due to the complacency displayed by auditors in the due audit process as well as failure to maintain standards.
Reference
American Institute of CPA’s [AICPA]. (2011). Auditing Derivative Instruments. Retrieved from https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU- 00332.pdf
Carozza, D. (2009). Chasing Madoff: An Interview with Harry Markopolos. Fraud Magazine. Retrieved from http://www.fraud-magazine.com/article.aspx?id=313
Gandel, S. (2008). The Madoff Fraud: How Culpable were the Auditors? Time Magazine. Retrieved from http://content.time.com/time/business/article/0,8599,1867092,00.html
Knapp, M. (2015). Contemporary Auditing. New York, NY: Cengage Learning.
Moyer, L. (2009). How Regulators missed Madoff. Forbes Online. Retrieved from http://www.forbes.com/2009/01/27/bernard-madoff-sec-business-wall- street_0127_regulators.html
