Madoff's "Auditors" -- Giving Self-Regulation a Bad Name

Jul 2, 2009

NOTE: This piece was originally posted on the American Solutions Website on July 2, 2009

Wow, they really threw the book at Bernie Madoff! 150 years. Should we be satisfied? Well, sort of. As crimes go, this was a doozy, and we can certainly point to this case as proof that white-collar criminals don’t always get off with lighter sentences. But if you polled Madoff’s victims, how many of them wouldn’t gladly trade the harsh punishment for not having been victims in the first place?

The sad thing is that the Madoff scheme was highly preventable, even under existing regulations. Even sadder is the strong possibility that our response as a society will be to go charging off in all directions, and legislate a “fix” – at staggering cost – to a “problem” that never really existed in the first place. And, in the ensuing complacency, ignore much simpler, virtually cost-free measures that would be useful. The whole sorry episode is a great example of how no amount of rules and procedures can compensate for failures of leadership, character, and plain old common sense. Read on.

A lot of blame has been hurled at the SEC for ignoring warnings, and justifiably so. Fingers have even been pointed at the investors, for not doing the kind of due diligence they should have done before making investments of that size. That’s a little harsh, maybe, but a fair point. But here’s the thing: Both groups of “culprits” were relying on audited financial statements. That’s the whole idea of an audit: some independent, responsible, competent professionals have looked at the financial statements and said they’re fine, so why look deeper?

An audit of Madoff’s books would have exposed the fraud. Instantly. The first thing the auditors would have asked for is Madoff’s brokerage account statements, which obviously didn’t exist. Case closed. If Madoff had forged those brokerage statements, having the brokerage firms confirm them would have revealed the forgery. Case closed again. What went wrong here? No audit was ever performed, even though Madoff’s financial statements each year were accompanied by a letter from an accounting firm saying that the statements had been audited.

Can this really happen? Well, technically no, since the AICPA – the private body that oversees the auditing profession – requires all accounting firms that perform audits to submit to an annual “peer review.” In a peer review, auditors have their audits audited by other audit firms. One look at the Madoff audit work papers would reveal the truth. Moreover, Friehling & Horowitz – the firm that signed Madoff’s audit opinion letters – is tiny, so it’s a virtual certainty that the client selected for the peer review would be their one huge one. What went wrong here? No peer review was ever performed, since every year F&H certified to the AICPA that they did no audits, and therefore did not require a peer review.

So what we have here is a complete breakdown of the system giving investors in American businesses assurance that the financial statements they rely on are valid. The idea that an accounting firm can avoid peer reviews simply by stating that they did no audits is a little like investigating a murder by simply appealing to the murderer to step forward and confess. Is this really the only mechanism the AICPA has to identify accounting firms that perform audits, or at least claim they perform audits? Is this the best that a bunch of professional auditors could come up with? We can’t really blame the AICPA or the audit profession as a whole for the Madoff fraud, but all this highlights the subtle but important distinctions between the words blame, cause, and responsibility.

Self-regulation is often the most reliable, cost-effective way to go. But in order for it to work, we have to be able to trust the self-regulators. The consequences of a breakdown in that trust are horrendous: the disappearance into thin air immense sums of money, a body blow to the credibility of the American investment system, and the risk that misguided efforts at “reform” by the uninformed and the agenda-driven will do even more damage than what we sustained in the first place.

All of this is so much like, uhhhh, what’s the phrase I’m groping for? Oh yes: Sarbanes-Oxley.

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