Case 1. 12: Madoff Securities Questions: 1. Research recent developments involving this case. Summarize these developments in a bullet format. 2. Suppose that a large investment firm had approximately 10 percent of its total assets invested in funds managed by Madoff securities. What audit procedures should the investment firm’s independent auditors has applied to those assets? 3. Describe the nature and purpose of a “peer review. ” Would peer reviews of Friehling & Horowitz have likely resulted in the discovery of the Madoff fraud? Why or why not? 4.
Professional auditing standards discuss the three key “conditions” that are typically present when a financial fraud occurs and identify a lengthy list of “fraud risk factors. ” Briefly explain the difference between a fraud “condition” and a “fraud risk factors,” and provide examples of each. What fraud conditions and fraud risk factors were apparently present in the Madoff case? 5. In addition to the reforms mentioned in this case, recommend other financial reporting and auditing-related reforms that would likely be effective in preventing or detecting frauds similar to that perpetrated by Madoff. Answers: 1.
Recent developments involving the case Madoff Securities: •Bernie Madoff’s son, Mark Madoff committed suicide on December 11, 2010. His suicide may have been influenced because there was an investigation on Mark’s children on grounds that Bernie transferred funds to their accounts. •Peter Madoff pleaded guilty to his involvement in the Ponzi scheme run by his brother. Peter Madoff served as the chief compliance officer. •Irving Picard, the trustee in charge of liquidating Madoff’s assets, has asked a New York court for approval to distribute an additional $1. 5 billion to investors who lost money in Madoff’s fraudulent investments.
It is estimated that Picard has already recovered $9. 1 billion but has only been able to distribute $1. 1 billion so far. •In May 2010, about 720,000 Madoff investors outside the United States settled with their banks, receiving about $15. 5 billion in all, according to law firms representing them. •In June 2012, the Supreme Court said it would not take up a dispute over how the claims of victims of Mr. Madoff’s huge Ponzi scheme should be calculated. Without comment, the high court declined to hear an appeal from lawyers for investors who got back all the cash they had invested with Mr.
Madoff before his December 2008 arrest. 2. If a large investment firm had approximately 10 percent of its total assets invested in funds managed by Madoff Securities, the audit procedures that the firm’s independent auditors should look very closely are some procedures that will help the auditor to identify inherent and control risks that contribute to misstatements in balance sheets. He/she should make sure that the detection risk is as low as possible and the key transactions are confirmed for its accuracy.
By addressing issues of materiality, the auditor will eliminate misstatements to overstate the investment on the balance sheets. PCAOB AU Section 329A states that understanding financial relationships is essential in planning and evaluating results of analytical procedures and generally requires knowledge of the client industry. The auditor, by understanding the nature of the business can identify and categorize the types of risk that can be assessed. The auditor will have to do research about the business and how transactions are handled and processed.
Knowing about the client’s business the auditor will better obtain sufficient, reliable, and relevant evidence to achieve his audit objectives. Analytical procedures are used as a substantive test where the auditor considers the level of assurance he/she wants from the substantive test for audit objective. The independent auditor main goal is to be able to establish the accuracy of major accounts and confirm that the assets the firm has recorded actually exist. For instance, the auditor should to take key transactions of the assets and make sure that those transactions are accurate and recorded properly.
Also he may conduct bank reconciliations on pertinent accounts to make sure no discrepancies or misstatements are found. The auditor should also perform vertical and horizontal analysis for the income statements and balance sheets by the use of ratios. Moreover, the auditor should preform test for effectiveness of internal controls. He may interview management by asking questions on the process of the transactions and operational activities. He may discuss with management the process of some transactions from beginning to end and then test it by using sample testing.
Also he/she should make sure that there is proper control of activities; policies and procedures for adequate segregation of duties are met. 3. A peer review is a process of subjecting research methods and findings to the study of others who are experts in the same field. The purpose is designed to prevent dissemination of irrelevant findings, unwarranted claims, unacceptable interpretations, and personal views. It relies on colleagues that review one another’s work and make an informed decision about whether it is legitimate, and adds to the large dialogue or findings in the field.
A peer review of Frieshling & Horowitz would result in the discovery of the Madoff fraud because questions would have been raised about the resource capability of the firm to handle such a large account given that it only had one accountant. Moreover, the Standards for Performing and Reporting on Peer Reviews Section 1000 states that purpose is to provide standards for administrating, planning, preforming a good monitoring of the CPA firm’s accounting and auditing practice to promote good quality to serve the public interest. 4.
The SAS 99 describes three conditions of fraud: incentives/pressures to commit fraud, opportunities that circumstances provide opportunities to commit, and attitudes/rationalizations which is an attitude, a character or set of ethical values exists that allows management or employees to commit dishonest act. Some of the fraud risk factors in Madoff Securities case include: Incentives/Pressures Greenness- Madoff always wanted more. He wanted to maintain a rich lifestyle for him and his family, as well as to stay as one of the top investment firm.
Opportunities Madoff firm did not have proper monitoring controls as well as the ineffective accounting system, internal audit and information technology staff. Attitudes/Rationalizations No one understood his strategy; no one could communicate with him about investments SAS 99 requires the auditor to assess whether fraud risk factors exist. Fraud risk means that the likelihood of committing the fraud is high. For instance based on case some of fraud risk factors are: •high degree of competition or market saturation, accompanied by declining margins. assets, liabilities, revenues, or expenses based on significant estimates 5. Other reforms recommended are for the victims of the fraud would be that the victims need to be more aware of whom they are investing their money with. The victims should perform more research the company in which they would like to invest their money. They should ask them self-questions if the business owner has a good reputation, is he/she have a criminal record, and if he/she has experience in operating a business. Also, today the economy is hard and if a return on an investment seems too good to be true probably here is something wrong going on (fraud class, prof. Edward Mann). Moreover, the other ways that would effectively prevent or detect fraud similar to Madoff are: •organizing the enforcement division that will monitoring unusual investment returns, •improving fraud detection procedures for examiners, •recruiting staff with specialized experience, •expanding and targeting training to improving internal controls procedures, •introduce firms with whistleblower program •increasing educational request for specific licenses •oversight management and employees
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