Accounting Chapter 1 Homework The driving force in Bernie Madoff’s life was his desire to become

CASE 1.12

MADOFF SECURITIES

Synopsis

A childhood friend summed up the driving force in Bernie Madoff’s life: fiBernie wanted to be

rich.” As a youngster growing up in New York City, Bernie realized that Wall Street was the

Unfortunately, Bernie Madoff will not be remembered as a pioneer of electronic securities

trading. Instead, the word fiMadoff” will always be associated with the phrase fiPonzi 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 fiWizard 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 Madoff’s secretive

investment strategy that produced them were fraudulent.

audits” of Madoff Securities.

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Case 1.12 Madoff Securities 93

Madoff Securities—Key Facts

1. The driving force in Bernie Madoff’s life was his desire to become wealthy.

2. Madoff founded Madoff Securities, which was one of the first brokerage firms to employ

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 firm’s impressive

6. Madoff’s auditor had been a tiny CPA firm, Friehling & Horowitz, with one professional

accountant, David Friehling.

8. In March 2009, Friehling was arrested and charged with securities fraud and aiding and abetting

9. The SEC was the target of harsh criticism when it was revealed that Harry Markopolos, a

10. 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.

11. KPMG became the first of the Big Four firms to be sued as a result of the Madoff fraud; the

12. The SEC has announced a series of reforms to prevent or detect future frauds similar to

Madoff’s; one proposal is that investment advisers be subjected to annual fisurprise audits” to ensure

that customer funds are properly safeguarded.

94 Case 1.12 Madoff Securities

Instructional Objectives

2. To identify fired 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

Suggestions for Use

This case is well suited to fikick 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

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 Madoff’s fifeeder

firms,” and regulatory reforms emanating from the Madoff fraud.

2. The principal authoritative source in the PCAOB’s Interim Standards vis-à-vis the auditing of

investments is AU Section 332, fiAuditing Derivative Instruments, Hedging Activities, and

Case 1.12 Madoff Securities 95

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 involving options and other

•fiConfirmation of settled transactions with the broker–dealer or counterparty.”

•fiConfirmation of unsettled transactions with the broker-dealer or counterparty.”

•fiInspecting underlying agreements and other forms of supporting documentation, in paper

or electronic form.”

•fiInspecting supporting documentation for subsequent realization or settlement after the end

of the reporting period.

•fiPerforming analytical procedures.”

•fiInspecting financial instruments and other agreements . . .”

Were these and other audit procedures performed by the auditors of Madoff’s fifeeder 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

3. A fipeer 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

96 Case 1.12 Madoff Securities

4. AU Section 316, fiConsideration of Fraud in a Financial Statement Audit” in the PCAOB’s

Interim Standards is an authoritative source to refer to in responding to this question. (The

corresponding section in the ficlarified” AICPA Professional Standards is AU-C Section 240.) AU

316.07 lists the three fiangles” 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

AU 316.31 introduces the phrase fifraud risk factors.” These factors are events or circumstances

or ficonditions” that indicate that one or more of the three elements of the fraud triangle are present.

[The use of the term ficonditions” 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 fifraud risk factors.” A few

examples: a high degree of competition or market saturation in a client’s 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).

Listed next are fraud risk factors that were apparently present in the Madoff scandal (these were

taken from Appendix A of AU Section 316):

•Excessive pressure exists to meet the requirements or expectations of third parties

•Management has a significant financial interest in the given entity

•Domination of management by a single person

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 fianswers” to this perplexing

Case 1.12 Madoff Securities 97

problem—maybe 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 fiproblem”:

—Requiring independent auditors to immediately report suspected fraud to regulatory and/or law

enforcement authorities. (This measure has been implemented recently in South Africa.)