Bernard Madoff recently confessed that his fund was in reality a fraud and could be as much as a $50 billion rip-off. When professional investors get taken for that much money, they naturally get angry, upset, flustered, and panicky. They also quickly look for somebody to blame.
Of course, Madoff’s auditor is culpable. Friehling & Horowitz is a three person firm, with one retired partner and one secretary, leaving only one able-bodied human to perform an audit. David Friehling appears to have numerous ethical problems. As many news agencies have reported, he was slow to enroll the accounting firm in the AICPA’s peer review program; and, having joined, he never bothered to obtain a peer review.
I speculate that Friehling has other issues as well. It is not clear that his firm was independent as the Madoff relationship probably accounts for a huge part of total billings. He may not have had the competence to audit a fund. He clearly did not have enough staff support to help him conduct an audit.
Worse, even if he were independent, had the competence, and could conduct the audit by himself, one wonders whether he was part of the fraud. After all, he should have been able to distinguish profits from capital transactions as well as differentiate operating cash flows from financing cash flows, and thereby understand the mammoth errors in the income statement and in the cash flow statement.
The case against Friehling will be easy. But, since his funds are limited and the number of aggrieved investors large, potential fund managers have to seek other deep pockets and scapegoats. Here is where some funds are suing their auditors after the fund managers invested money in Madoff.
Ascot Partners, which has lost about $1.8 billion, has sued their auditor BDO Seidman. Other feeder funds are considering bringing lawsuits against their auditors, so we might have a panoply of cases on this point.
Such lawsuits seem to have little merit. What Ascot Partners is forgetting is that BDO Seidman’s responsibility rests in the audit of Ascot Partners and not in the audit of its investees. There is no AICPA requirement, no PCAOB requirement, no SEC requirement, and no state requirement for such an audit.
To suggest that an investor’s auditor should audit the statements of investees is not only incorrect but impractical. If it were so, then potentially dozens of audit firms could be tripping over each other trying to examine the internal controls of the investee and performing various audit tests. The investee might not be able to operate in such conditions as the office could be heavily populated with auditors from all over.
In addition, audits are currently performed after the firm and its auditor sign a contract specifying the various terms of the agreement. There is no contract between an investor’s auditor and the investee, allowing the investee to bar the door to these would-be examiners. The investor’s auditor would have no recourse in that scenario; it could perform no audit of the investee.
Finally, let’s keep in mind what is really going on. The managers at Ascot Partners have a “due diligence” obligation whenever they examine a potential investment. It is their responsibility to examine the financial statements of the investee, including the audit report, and to determine the utility of the investment. The managers failed miserably in meeting this due diligence obligation with respect to Madoff’s funds.
Auditors have no such “due diligence” obligation (though they can assume such a responsibility if hired to assist in mergers and negotiations). They merely attest that the financial reports fairly present the actual results of the business enterprise they audited.
In conclusion, the managers at Ascot Partners are merely trying to shift the responsibility from themselves to somebody with deep pockets. The argument rests on quicksand: the auditors are not guilty. The managers at Ascot Partners and at the other feeder funds have a lot to worry about. After the suits against the accountants are dismissed, it should not take too long for investors in Ascot Partners to sue those truly at fault.
This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.
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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.