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
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.
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
Case 1.12 Madoff Securities 91
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
Instructional Objectives
92 Case 1.12 Madoff Securities
2. To identify fired flags” or risk factors typically indicative or symptomatic of fraud.
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
doubt, almost every business in the United States was affected directly or indirectly by Bernie
Suggested Solutions to Case Questions
1. Consider having individual students or individual student groups provide updates on the
2. The principal authoritative source relevant to auditing investments is Statement on Auditing
Standards No. 92, fiAuditing Derivative Instruments, Hedging Activities, and Investments in
Case 1.12 Madoff Securities 93
332.
◼ 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.”
reporting period.”
◼ fiConfirming significant terms” [of the given investment with the third party investee].
◼ fiReviewing 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.
◼ fiAssessing the reasonableness and appropriateness of the [fair value] model” used to
determine the reported value of the security.
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
94 Case 1.12 Madoff Securities
4. AU Section 316, fiConsideration 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 fiangles” of the so-called
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
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
problem—maybe their solutions would be more effective than the preventative measures
Case 1.12 Madoff Securities 95
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—see