Investors, beware: Audits won't protect you from the likes of Madoff

Last week, David Friehling, the auditor who had purportedly handled Bernie Madoff's books for years, pleaded guilty to nine charges having to with his auditing work, or lack thereof. The charges included securities fraud, investment adviser fraud, false filings with the SEC and obstructing or impeding tax laws. Pointedly, the accountant denied knowing anything about Madoff's Ponzi scheme that cost investors billions.

Friehling operated Friehling & Horowitz, CPA's, P.C. as a solo practitioner and audited Bernard L. Madoff' Investment Securities from 1991 through 2008. Madoff paid Friehling a whopping $12,000 to $14,500 per month for auditing services from 2004 to 2007. Yet according to the government, Friehling didn't do much auditing. But even if he had, my experience as a fraud examiner and forensic accountant leads me to believe he might not have necessarily uncovered the fraud.
Prosecutors say Friehling never did an independent verification of assets, failed to look at sources of revenue, didn't look at bank accounts, didn't verify liabilities, and (most importantly) never "...verified the purchase and custody of securities..." by Madoff. That last one is important because it's at the heart of the Madoff Ponzi scheme: Madoff wasn't actually trading in securities as he represented to clients. Without any actual trading or other business to generate returns, the scheme is officially a scheme.

The certified public accountant was also violating the independence rules that auditors are supposed to follow, prosecutors say. Simply put, the auditors of financial statements can't have any financial interest in the company they're auditing -- and must not have any other ties to the company that might influence their opinions.

Friehling allegedly had an investment account with Madoff that had more than $500,000 in it for nearly 10 years. That fact alone meant he wasn't independent. He had a clear and significant financial interest in Madoff's scheme staying afloat.

What does all this boil down to? Friehling was bought and paid for to keep his mouth shut about Madoff. James Clarkson, Acting Director of the U.S. Securities and Exchange Commision's New York Regional Office, said, "As we allege in our complaint, Friehling's and F&H's misconduct is egregious. Friehling essentially sold his license to Madoff for more than 17 years while Madoff's Ponzi scheme went undetected. For all those years, Friehling deceived investors and regulators by declaring that Madoff's enterprise had a clean audit record."

Yet I have to wonder, if Friehling knew that Madoff was a total fraud, why would he have had $500,000 in an account with him? That fact alone lends at least some credence to Friehling's claim he didn't know Madoff was operating a Ponzi scheme. Unfortunately for him, lack of knowledge about the actual scheme doesn't absolve him of his sins of failing to perform audits and lying about his auditing activities.

News reports about Friehling referred to his audits as "rubber stamps" for Madoff and seemed to imply that somehow this rubber stamping is an anomaly. But is it really? I'm not going to suggest that Friehling did his job. It appears that he did little to no actual auditing. And there are plenty of auditors out there who doperform audit procedures and do follow the rules.

But I'd be doing a disservice to the public if I suggested that an audit would have stopped Madoff in his tracks. Let's think back to companies like Enron and WorldCom. I hope we haven't forgotten already. These companies had audits that were completed by reputable auditors at firms that had conducted thousands of audits. And they were still massive frauds in action.

How can that be? Audits have many limitations. They have never been designed to detect fraud. And when they do detect fraud, it is often a coincidence. What if Friehling had done his job? What if he had tried to verify transactions and account balances?

Madoff likely would have spent time creating phony documentation to provide the auditors. Think that can't go on for long? Of course it can. Audit work is often fairly predictable, so phony documentation can be tailored accordingly.

Auditors are also notorious for not being skeptical enough. They tend to accept the representations of their clients. After all, the auditors trust their clients and rely on them for a continuing paycheck. Successful fraudsters are also very good at diverting auditors' attention away from the evidence they seek.

What's the moral of the story here? Don't think that Friehling was just a rogue auditor and the good auditors will protect the public. Don't buy into the notion that regulations like Sarbanes-Oxley are going to stop corporate fraud. For the motivated fraudsters, auditors and regulations are merely nuisances which must be dealt with.

Tracy L. Coenen, CPA, MBA, CFE is a fraud examiner and forensic accountant who investigates corporate fraud and consumers scams, and is the author of Essentials of Corporate Fraud and Expert Fraud Investigation: A Step-by-Step Guide.
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