First, Bean All the Counters

by: Greg Newton

Did auditors ignore “look through” duty?

Only the most wakeful, experienced auditors
were assigned to the Madoff feeder funds
Three of the Big Flaw auditors — PricewaterhouseCoopers, Ernst & Young and KPMG — have already been caught with their fingers in the Bernard L. Madoff Investment Securities LLC cookie jar, as auditors of various Madoff feeder funds. They will be sued, for a large multiple of the assignments’ fees (which will anyway be far exceeded by their legal costs) in actions likely centered on their duty to “look through” the feeders into the performance reported by Madoff, and the existence of the alleged underlying assets.

For an assessment as to how this may play out, NakedShorts turned to A. Beancounter (not a real name) for insights from his decades of auditing alternative investment entities. He averred, mostly on the subject of US-domiciled entities audited by US-based auditors, thusly:

If the news reports concerning Madoff are only in the ballpark — and let’s remember that the $50 billion number is suspect given its source (Madoff himself) — this is a far worse auditing failure than Enron, the rock that finally killed Arthur Andersen. But let’s start with the relevant sections of the standard auditor’s opinion (emphasis added):

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on test basis, evidence supporting the amounts and disclosures in the financial statements...We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects the financial position of XYZ Company...and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

As the litigation goes forward, the firms will eventually have to prove that they met those standards. Moving right along.

The ‘AICPA Audit and Accounting Guide: Investment Companies’ is the more-or-less bible for auditing investment companies (whether public or private) and briefly describes the objectives of auditing investments in other funds. Perhaps most relevantly:

5.84 Significant audit risks may exist if management does not use strong procedural controls in selecting and monitoring a fund’s investments in investee companies and determining the investment’s fair value. The audit approach to an investor fund’s investments in investee funds might focus on two areas:

a. Evaluating the investor and investee funds’ control environments.

b. Substantiating the fair value attributed to investments in investee funds.

That standard creates a big problem for the auditors of the feeder funds. The fact that the assets were custodied with the broker making the trades would render useless the normal process of confirming assets with an independent administrator and/or custodian. And assessing Madoff’s control environment? Given Madoff’s apparently notorious aversion to inquiring minds, that almost certainly never happened.
Our experience is that many audit firms seem to think that funds underlying a fund of hedge funds investment are somehow exempt from testing and fair value presentation. They only rarely test asset values in the underlying, essentially gambling that it is OK.
That testing is even more critical in the case of a single manager fund, such the Madoff feeders. Indeed, in those cases, the auditor either has to practically audit the underlying fund, or issue a reliance report saying the underlying auditor is responsible for the audit.
And no CPA firm that can spell CPA would reply on the Three Stooges audit firm run by Madoff’s brother-in-law.
Of course, Madoff investors who went through non-US investment entities audited by the non-US (and mostly tropical island-based) affiliates of those auditors face a whole other can of worms. Not the least being that even if they get the auditors into court, and even if they win, the professional liability policies of the likes of PricewaterhouseCoopers Bermuda (Kingate), Caymans-based BDO Tortuga (Ascot Fund Ltd), and Ernst & Young Cayman Islands (M-Invest) are far less than their potential exposure. For a reason.
For those specifically interested in auditors’ responsibilities for alternative investment products, further guidance is provided by ‘Alternative Investments – Audit Considerations, A Practice Aid for Auditors.’ This 26-page guide (linked below) is not strictly authoritative, but was developed by an AICPA task force with the participation of all four of the Big Flaw auditors. It’s pretty much a goldmine of “Why didn’t you...?” gotchas with varying degrees of relevance to the Madoff event.

American Institute of Certified Public Accountants 2006

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