L'Affaire Madoff: A Black Mark on the Auditing Profession

Mar 26, 2014

[This piece appeared originally on Proformative.com, an excellent website for senior finance professionals. It’s a little technical, and pretty long as my posts go, but very spicy – I take a novel perspective on what really went wrong in the Madoff fiasco. If it’s not your cup of tea, feel free to scroll down to the next post. Thanks for your interest.]

There is a theory of tort law that liability should be apportioned based on who could most efficiently have assured that a tortious event did not take place. If that standard were applied to the Bernie Madoff fiasco, the auditing profession would owe a whole lot of money to a whole lot of people. It’s a shame that the thoroughness, doggedness, and precision the profession is known for wasn’t applied to its own practitioners.

My nostalgia for this whole kerfuffle arises because after a six-month trial, a jury has just returned guilty verdicts against five of Madoff’s former employees. To understand why this event has raised unpleasant memories and unresolved concerns, let’s have a short Socratic dialogue:

Q: What was the Madoff fiasco?

A: Bernie Madoff ran a Ponzi scheme, for 20 years or more, in which investors lost billions when it finally unraveled.

Q: Why did people invest with him?

A: Because he reported astounding returns.

Q: Didn’t they know that if something seemed too good to be true, it probably was?

A: Normally yes, but he had audited financial statements proving his results.

Q: Really?

A: OK, actually it was just an annual letter saying that an audit had been performed. (We know this because David Friehling of Friehling & Horowitz, the accounting firm that signed the audit opinion letters from 1991 on, testified in 2009 that his firm never actually performed any audits.)

Q: But public accounting firms have a peer review process. Wouldn’t that process have uncovered the fact that audits were never performed, and that the whole thing was a fraud?

A: Yes. The process of confirming broker statements with the brokerage firms would have brought the whole house of cards down instantly.

Q: OK, so what happened with the peer reviews?

A: They were never performed – although Friehling & Horowitz nominally participated in the peer review process, they stated annually in writing that they were not subject to peer review because they had performed no audits. [In retrospect, I suppose those statements were factually correct. :-) ]

Q: But, but, but, loads of people – including the SEC and many journalists – saw Madoff’s “audited” financial statements. Didn’t the auditing profession get any sense that there was an inconsistency here?

A: The auditing profession did not appear to have any controls in place whereby it could compare audit opinion letters against its database of firms that acknowledged their obligation to have peer reviews done. (Mind you, I am not a CPA and I have not made finding this out my life’s work. Perhaps my Googling skills need to be improved.)

Q: In the wake of all this, have there been reforms?

A: Perhaps. My search has not uncovered anything from the AICPA, but a number of state CPA societies, including California and – stop the presses! – New York, have taken further steps toward “mandatory” peer reviews. That is a good thing, but what I have read does not make it clear whether these steps will ensure that any financial statements that are accompanied by an auditor’s opinion could end up being considered as subject to a peer review.

Q: How has the judicial system punished David Friehling?

A: No action so far. In 2009, he pleaded guilty to nine counts of fraud and other crimes, but his sentence has continually been deferred pending the resolution of other prosecutions he is helping with, including the trial of the five former Madoff employees that just ended. (I might add that the same uncertain fate awaits Frank DiPascali, Madoff’s self-characterized CFO. DiPascali was the star witness in the trial just ended.)

As a final aside, I find it absolutely shocking that this glaring and gigantic hole in how effectively stakeholders are protected from fraudulent financial statements has received so little coverage from the mainstream press. Criticism has been directed at many constituencies – Wall Street, the SEC, a greed-driven culture, careless investors who should have known better, George Bush, and global warming, just to name a few – but the whole sorry mess wouldn’t have lasted through more than one or two audit cycles if the audit work had been reviewed.

“Painting with Numbers” is my effort to get people to focus on making numbers understandable. I welcome your feedback and your favorite examples. Follow me on twitter at @RandallBolten.

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