The Reasons Why SEC Did Not discover the Ponzi Scheme
The U.S. Securities and Exchange Commission, SEC, was the regulatory oversight that was in control while the Ponzi scheme was still operating. The SEC investigated Madoff Securities on a minimum of eight different occasions (Stolowy et al., 2014). The regulatory body investigated Madoff Securities to determine whether they were violating securities laws. The organization investigated Madoff Securities for two decades before Madoff confessed how he operated. In each of the cases, the investigation was concluded without them charging Madoff with any significant infractions of security laws (Knapp, 2014). Most of the investigations conducted after Harry Markopolos filed several complaints.
SEC investigated Madoff for several years but they did not understand how the scheme operated due to various reasons. First, Madoff’s main target was the greedy investors who had less likely to ask about his investment strategy (Stolowy et al., 2014). Most of the investors blindly followed the strategies laid out by Madoff without understanding the details. However, smart investors were quite cautious because they refused to invest in a strategy that they did not clearly understand. Since most Madoff Securities investors did not question the strategy used, SEC. raised no suspicions.
Secondly, Madoff’s fraud continued for decades due to his impeccable credentials. Most investors trusted Madoff because there were no previous mistrust issues. Additionally, Madoff was a Wall Street icon that that well respected (Knapp, 2014). Madoff also had a good reputation because held various leadership positions in the securities industry including being NASDAQ chair. He also pioneered the electronic securities trading and contributed to numerous charities, which made it difficult to suspect his greed for money.
The final main reason why Madoff remain undiscovered was the failure of SEC function for the stock market. The regulatory oversight was not diligent in fulfilling its responsibilities. Since SEC was not diligent in its duties, the officials made many false assumptions that favored Madoff. In addition, as Knapp (2014) outlines, Madoff understood that SEC’s attorneys, accountants, and stock market specialists could not comprehend a derivatives-based Ponzi scheme like his. As a result of such knowledge, Madoff continued to expand his frauds.
Audit Procedures that Should have been Applied on Madoff Securities
Audit procedures are generally adapted according to the system used by taxpayers for recordkeeping and accounting. According to Arens, Elder and Beasley (2012), the auditor should understand the method used by taxpayers to make sales tax returns to provide well-informed decisions and to conduct a correct analysis. In most cases, the auditor first conducts an analysis of the accounts system and comes up with a particular audit procedure for the audit.
The first step when auditing Madoff securities would be identification of the assertion tested. This refers to the assertions found in financial statement used to consider various types of misstatements, which may occur. Arens et al., (2012) posit that assertions may take the form of events and transactions, account balances at the end of the financial year, and disclosure and presentation. In this step, all transactions recorded should be taken into consideration.
Identifying the assertion to be tested would then follow. In this case, it is important to test completeness of transactions and accuracy by following up from the start of the transactions to the end. The other important thing is to identify the risks that may cause material misstatement. After identifying the risks, the value found in the valuation report should be checked to ensure that it matches the one found in financial statements. The other important step is to analyze, taxpayer’s reporting method and work papers to identify errors. (Arens et al., 2012). Finally, completion of the internal control checks follows after documenting the audit procedure.
How a Peer Review of Friehling and Horowitz Would have Worked
In Madoff Securities, a peer review would give valuable feedback since there is a wide range of variability across reviewers of selected issues. The feedback from such peer reviews is often contradictory in nature because they give different information about the same subject thus raising suspicion. Different peer reviewers would use different strategies leading to different results (Abramo & D’Angelo, 2011). An auditor would make sense out the different reviews made and give a substantive summary of the feedback.
Some of the differences notable in Friehling and Horowitz include how one individual could successfully conduct an audit for such a big company, the credibility of the documents used, and their completeness. The directions and procedures used by the audit firm would also be identified. The method used by Friehling is incomplete; thus it would raise suspicion in the results arrived at by the firm. Irregularities would be identified to reveal areas of weakness. Once weaknesses are identified, it would be easy to follow up to clarify whether the results are accurate.
Peer reviewing of Madoff Securities would allow different opinions from professionals to be aired; thus, theoretically eliminating pre-set ideas and biases from the entire worksheet. The peer review process conducted by the auditing firm should stop several poor and substandard sciences from being published (Abramo & D’Angelo, 2011). Reviewers may reject duplicate research and irregularities thus detecting possible frauds. Lack of online access to clients’ accounts would raise suspicion among reviewers, triggering further action to determine why the firm was not clear on its operations. Peer reviewing would also seek to understand why other successful investors were reluctant from engaging in transactions with Madoff Securities. The suspicion raised would help to understand why they behaved in such a way yet they would have benefited significantly.
A Different Strategy to Expose the Potential Fraud by Madoff Securities
Detecting frauds from the auditor’s point of view would help to understand the operations of a company. In Madoff Securities, it would be important to find out the strategies and procedures used by the audit firm to come up with their conclusions. The company should have given the reasons for not involving other audit firms. The other important question is to ask whether the company conducted internal audit. Results from different audit perspectives would help to detect irregularities.
Arens et al., (2012) note that external auditors play a vital role in determining whether the financial information presented by a company is valid or not. Potential investors and lenders also get information from external auditors’ financial statements before they engage themselves in any business with the company. If the investor or lender finds out that the auditor has not detected material misstatements it shows that company is poorly run, leading to potential losses. Consequently, accounting bodies release audit expectations and standards to elaborate the functions of external audit firms (Hammersley, Johnstone & Kadous, 2011). This shows that the relationship between the internal and external auditors may be used to detect potential frauds. In Madoff Securities, getting information from both internal and external auditors would help to determine potential frauds. In case the company does not give the financial statements from the auditors, it should give a good explanation of how it operated without getting the financial statements.
The Role of the Audit Committee for Madoff Securities
The audit committee of Madoff Securities had a pivotal role in ensuring that quality audit was conducted. Effective auditors and committees have the responsibility to build confidence while reporting financial statements (Arens et al, 2012). The committee ensured that the information provided in the financial statements was right. In case of suspicion of any fraud, they had to conduct a deeper research to come up with concrete evidence. The committee was also responsible for creating a conducive environment that would accommodate discussion in a culture of respect, integrity, and transparency between the auditors and management, which would provide sufficient proof for any frauds. The audit committee was also responsible for ensuring that the auditors worked to provide detailed and rightful information. In addition, they ensured that they understood the audit strategy to determine audit risks. They also had to ensure that the auditors maintained professionalism in their field of work.
To prevent the frauds that occurred in Madoff Securities, the audit committee would have asked auditors what they were doing to promote consistency of the audit execution and whether the audit firm was responsible in case a fraud was detected. Other helpful questions include whether the individual responsible for frauds in the audit firm and additional resources used to conduct auditing. The audit committee should also have considered meeting the second partner reviewer to understand how quality was maintained and how the issues that arose were solved (Hammersley et al., 2011). Asking such questions would have helped to determine the credibility of the auditor and to alert them of potential risks.
References
Abramo, G., & D’Angelo, C. A. (2011). Evaluating research: from informed peer review to bibliometrics. Scientometrics, 87(3), 499-514. DOI: 10.1007/s11192-011-0352-7
Arens, A. A., Elder, R. J., & Beasley, M. S. (2012). Auditing and assurance services: an integrated approach. New Jersey: Prentice Hall.
Hammersley, J. S., Johnstone, K. M., & Kadous, K. (2011). How do audit seniors respond to heightened fraud risk? Auditing: A Journal of Practice & Theory, 30(3), 83-100. http://dx.doi.org/10.1016/j.aos.2014.07.005
Knapp, M. C. (2014). Contemporary auditing, (10th ed.). Boston: Cengage Learning.
Stolowy, H., Messner, M., Jeanjean, T., & Richard Baker, C. (2014). The construction of a trustworthy investment opportunity: Insights from the Madoff fraud. Contemporary Accounting Research, 31(2), 354-397.
