BERNIE MADOFF SCANDAL AND AUDITING ISSUES

AND IMPLICATIONS

ROHIT GOYAL- MASTERS IN FINANCE

Madoff Scandal

In December 2008, amidst the financial crisis, Bernie Madoff was arrested on charges of running a

ponzi hedge fund that was estimated by some sources to be a USD 65 bn scam. Labelled as the

largest individual market scam by the media, Madoff’s had cheated investors of their money by

claiming to deliver consistent returns in comparison to S&P 500. Bernard Madoff Investment

Securities (BMIS), the principal firm behind Madoff’s Ponzi scheme was audited by three man audit

firm called Friehling and Horowitz. Friehling and Horowitz which had David G. Friehling as the

partner involved with BMIS, has been auditing Madoff securities for over a decade. David Friehling

was charged by SEC on six counts. Moreover PWC, KPMG and other audit firms were sued by the

investors in several feeder funds that invested in BMIS on accounts of misrepresentation.

Issues

Accounting Issues.

A. Madoff had reported to its investors that his firms were investing in a particular strategy and

realising positive returns. These misrepresentations should have created liability (payable to

investors in the fund) in the balance sheet of BMIS that would have been required to be

reported under Statement of Financial Accounting Standards No 5: Accounting for

Contingencies. Such Liability was not reported by BMIS in its supposedly audited financial

statements.

B. Audit of hedge funds should involve verification of their reported assets and balances with

custodians and brokers/dealers. These are usually verified with hedge fund administrators and

custodians, brokerages with the firm holds annual account and other transaction parties. For

example, all hedge funds report their assets under Net Asset Valuation (NAV) methodology,

which are usually reported by an independent fund administrator. The fund administrator is

suppose to rely on independent estimates of prices and transaction statements from

brokers/counterparties with which the fund trades to value the assets of the hedge fund. While

performing the audit, the auditors need to verify the valuation of the assets and the cash

balances. In this case, none of such verification was done by Friehling as it relied on the

statements produced by BMIS- which also served as the administrator and custodian of its own

managed fund.

Madoff Fraud Triangle

Violation of Auditor’s responsibility of professionalism and integrity

A. The first violation for Friehling was to sign off BMIS annual financial statements claiming that the

financial statements are pursuant to US GAAP standards. However, the three man Friehling and

Horowitz firm had submitted in writing for 15 years since 1993 to American Institute of Certified

Public Accountants (AICPA) that it does not perform audits. This issue gives rise to the question

that if the company has claimed not to perform any audit over last 15 years, how it was allowed

to sign on annual financial statement of BMIS. By misrepresenting the facts to AICPA, Friehling

violated auditor’s responsibility. An auditor is responsible of planning and performing audit

engagements to provide reasonable assurance that the financial statements are free from

material misstatements so as to prevent fraudulent financial reporting. By certifying the

statements of BMIS, Friehling’s firm aided in the Ponzi scheme and prevented Madoff’s firm

from being exposed to greater scrutiny from regulators and investors. If Friehling had indeed

performed an audit on the BMIS and submitted its audit for peer review to AICPA, it would have

uncovered the nonexistent assets (investments) which were reported in annual statements of

MBIS.

B. Despite signing off on the annual statements of BMIS, Friehling did not perform any audit on the

validity of transactions reported by Madoff, the existence of the underlying investment assets,

internal controls in place BMIS, comparing BMIS with other hedge fund peers to identify the

business risk and risk of material misstatements and reasonableness of accounting estimates

(under SAS 57).

Misrepresentation

A. Friehling authorized BMIS to send account confirmation statements to BMIS’s investors falsely

identifying Friehling and Horowitz as an independent auditor. In addition, whenever there were

questions from potential and current investors regarding due diligence on BMIS, Friehling

Management Opportunities

Weak Auditor. Weak Internal Controls. Non regulation of

Broker/Dealers

Management Attitudes/Rationalizations

Disregard for Investors and Regulations. Misrepresent performance

and transactions.

Management Incentives/Pressures

Performance and Management Fees in Hedge Fund related to

performance of assets/investments.

represented to perform all the diligence procedures without actually performing them. This was

done to satisfy the need of the investors and their auditors who typically rely on due diligence

from independent auditors for their investment in hedge funds. In this case, Friehling violated

basic tenants of audit due diligence i.e. checking for the fairness of the presentation in BMIS

statements, checking on BMIS assertions- especially in case of valuations of the assets through

verification with specialists or independent parties and asking for confirmation and

documentation of the trades performed by BMIS.

B. Friehling and Horowitz had not submitted its audit for AICPA peer review for last 15 years based

on the claims that it did not perform audit. Even though the firm was based in New York and

during that time accounting firms based in New York were not required to submit them-selves to

AICPA peer review program. It could have been debated, had Friehling submitted itself to the

AICPA review on Madoff-its major client, the Ponzi scheme underlying BMIS would have been

uncovered.

Violation of Auditor Independence

A. Friehling also broke rules of auditor’s independence by making personal investment in BMIS-

the firm he was responsible for auditing. Friehling and his family’s personal account at Madoff

firm had a balance of USD 14 mn in November (Source: NYSSCPA.ORG).

B. Friehling and Horowitz have been the auditors of BMIS since 1991 and were paid between USD

12,000 to 14,500 a month from 2005 to 2008. (Source: The Times) It could be questioned about

the length of relationship between the two companies especially considering that Friehling was a

three man company that was auditing a hedge fund with under USD 65 bn in assets. Friehling

did not also consult specialists or independent parties during its audit process of BMIS. As such

it could be questioned that the length and the nature of the relationship between BMIS and

Friehling could have led to Friehling firm colluding with BMIS in hiding the true nature of its

strategy and fraud.

Non verification of Master Fund Statements and Transactions

A. PWC and KPMG which audited several feeder/funds of fund that invested in BMIS hedge fund,

did not raise red flags over the valuation of their client’s investment into BMIS. While it was clear

that BMIS was also acting as the custodian and the administrator of funds managed by itself,

PWC and KPMG solely relied on assurances from BMIS and Friehling for value of their feeder

fund investments and did not raise any red flag. By failing to verify the claims of BMIS,

PWC/KPMG assumed that the audit of BMIS was done in a legitimate manner under SEC rule

17a-13.

B. Friehling also failed in its responsibility to conduct tests and demand sufficient evidence of

internal control procedures in BMIS especially considering the high risk of material

misstatements in hedge fund industry. Infact Friehling had issued unqualified opinion on BMIS’s

internal controls. Questions such as who authorises the transactions, who records the

transactions, who values the transaction, etc should have been raised so as to test for the

validity of the securities transactions reported by Madoff.

Capability

A. Another interesting aspect was whether three men Friehling was capable to audit a hedge fund with

nearly 65 billion in investment. Investors and auditors of feeder funds in Madoff, never raised this as

a red flag when making their investment decision. Also interesting to note was that Madoff was the

biggest client of Friehling’s company. This would have raised severe issue of auditor’s independence.

Friehling’s other partner in the firm was his 80 year old father in law-Jerome Horowitz.

Implications and My Opinion

While Friehling were convicted correctly of aiding in Bernie Madoff’s fraud, it remains questionable

whether PWC and KPMG were guilty of aiding in the fraud. Both KPMG and PWC claimed to perform

full audit of its client- Rye Select Broad Market Fund and Fairfield Sentry Fund respectively-both of

which invested in BMIS’s Fund. Most of the times, the auditors of feeder funds are not in position of

testing the existence of the underlying investment especially in case of the funds of fund and have to

rely on valuation estimates by the administrator of the underlying investment- in this case BMIS

itself.

Implications- Auditing of Hedge Funds and Other Alternative Investments

Ever since Madoff scandal, auditing of hedge funds has become a critical issue for investors and

auditors alike. Both investors and auditors are increasingly stressing on the separation of fund

management from fund administration and brokerage functions to prevent conflict of interest as in

this case.

A. Hedge funds need to increasingly open themselves to greater scrutiny from independent parties

such as auditors or fund administrators. Post Madoff, most of the biggest hedge funds are now

being administered by independent fund administrator who manages and records the trade and

are audited by one of the big four auditing firms.

B. Separation of internal back office from front office in a hedge fund. Increasingly, investors are

demanding a clear demarcation of back offices functions (recording of transactions, cash

management) from front office (trading, research, portfolio management) in a hedge fund. This

is to prevent Madoff type situations where back office and front office functions were

intermingled.

C. The audit process for hedge funds need to involve scrutiny of internal control mechanisms, tests

of control, substantive tests of transactions, tests of details of balance along with separation of

back office from front office. At the same time, there needs to be increased verification of

hedge fund cash positions and transactions with independent parties such as brokerages, fund

administrators, etc.

D. Focussing on independence of relationship with the hedge funds. Due to very nature of the

asset management industry and the risk/rewards surrounding it, independency of fund

management, fund administration, brokerages and audit has become crucial. This is particularly

important in case of audit professionals. Most of the investors rely on annual audit reports

issued by the auditor to judge their investments in the funds. As such it’s important that

auditors are not only competent but professional and honest in their assessment.

Basic Model for Auditing of Hedge Funds

Auditors need to constantly improve their audit process to keep with the increased sophistication of

the hedge fund industry.

A. Know your client should be an important process in understanding the complexities of

hedge fund industries especially in case of funds of fund. Besides a strong understanding of

the hedge fund industry, the auditor needs to verify client’s strategy, placement of assets

and historic performance.

B. It is important for auditors of feeder funds to validate the audit process/auditor of the

master fund. If the auditor of the master fund is outside the usual big names, the auditor of

feeder fund would need to be more diligent in its approach and verification of the

statements of the master fund.

C. The rapid increase in complex over the counter financial instruments such as exotic

derivatives, mortgage backed securities, etc have made valuation of these assets rely on

large scale assumptions. Hedge funds are particularly notable in trading such types of

instruments. An audit process for such hedge funds should involve audit evidence of

risk/reward of such instruments along with testing and confirmation of the management

assertions in regards to valuations of such assets. In addition, auditors need to also establish

mechanism for independent valuation of such estimates or independent valuation of the

underlying price determinants. This would not only lend huge credibility to the audit process

for hedge funds but will also ascertain investors who are increasingly wary of the secrecy

behind hedge fund operations and strategies. To achieve such level of sophistication in the

audit process, it would be fairly important for auditors to constantly verse themselves with

financial industry.

Train and Build Knowledge Base- Valuation Methodologies, Risks, Frauds, Strategies, Instruments, etc

Verifications of Control, Transactions, Cash Balances, Statements, Valuation from Independent Parties

Internal Controls- Seperation of Back Office/Front Office-Broker/Dealer

Set materiality and Assess Acceptable Audit Risk and Inherent Risk

Assess client business risk- Performance, Market, Industry, Counterparties

Understand the Client, Industry- Performance, Strategy, Counterparties

Know Your Client- Industry, Structure, Investors, Fund Manager

Including training and education on valuing financial assets for auditors involved in auditing of

financial firms and increasing awareness of the frauds committed by hedge funds would go long

way in improving and planning the audit process for a hedge fund client.

Total words=1996

References

- Web links

o Madoff Related Issues on Accounting and Insurance

http://www.insurancenewsnet.org/html/CasualtyInsurance/2009/0813/Accountant

s--Liability-in-the-Madoff-Scheme--A-CPA-Journal-Symposium.html

o Wikipedia Description of Madoff Event

http://en.wikipedia.org/wiki/Madoff_investment_scandal

o Financial Times Coverage of Madoff Event http://www.ft.com/indepth/madoff-

scandal

o Website dedicated to Madoff Scandal http://www.madoffscandal.com/

o Hedge Fund Newsletter Story on Madoff Scandal

http://seekingalpha.com/article/110402-madoff-scandal-biggest-story-of-the-year

o NYSSCPA News story on Madoff Auditor-Friehling

http://www.nysscpa.org/blog/2009/3/18/madoff-auditor-charged

o TimeStory on Friehling

http://www.time.com/time/business/article/0,8599,1867092,00.html

o Business Insider Story on Freihling http://www.businessinsider.com/sec-charges-

madoff-auditor-with-fraud-too-2009-3

o Times Story on Friehling

http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finan

ce/article5934539.ece