Madoff’s accountant: When is an auditor not an auditor?

The American Institute of Certified Public Accountants (AICPA) and the New York State Society of CPAs expelled David Friehling, of Friehling & Horowitz, CPAs (F&H) from membership on March 18th following an ethics investigation. Friehling was charged on that same day by the Securities and Exchange Commission (SEC) with falsely certifying that he prepared the audit statements of Bernard Madoff's broker-dealer firm (Bernard L. Madoff Investment Securities LLC – BMIS or BLMIS) in accordance with generally accepted accounting principles (GAAP). Beginning in 1993, Friehling had told the AICPA in writing that he did not perform audits and therefore would not need a peer review.

Mr. Friehling, who is 49 years old, was the sole auditor at Friehling & Horowitz, a three-person accounting firm in New City, N.Y. The firm also employed Friehling's father-in-law, Jerome Horowitz, who died of cancer on the day Friehling was charged, and an administrative assistant. Friehling is accused of misleading investors, not of knowing about the fraud. He faces a maximum sentence of 105 years in prison according to a statement issued by the U.S. Attorney's Office in New York.

The SEC alleges that Friehling knew that BMIS distributed the annual audit reports to Madoff customers and that the reports were filed with the SEC and other regulators. The complaint alleges that all of these statements were materially false because Friehling and F&H did not perform a meaningful audit of BMIS, and did not even perform procedures to verify transactions involving the securities BMIS said it held on behalf of its customers.

Court documents available through The New York Times outlining the SEC complaint say that, "Friehling failed to conduct audits that complied with GAAS and GAAP by, among other things, failing to:

(a) Conduct independent verification of BLMIS assets;
(b) Review material sources of BLMIS revenue, including commissions;
(c) Examine a bank account through which billions of dollars of BLMIS client funds flowed;
(d) Verify liabilities related to BLMIS client accounts; or
(e) Verify the purchase and custody of securities by BLMIS."

The SEC further alleges that Friehling failed to test internal controls as required under GAAP and GAAS standards and did not maintain professional independence. "For example, Friehling did not take any steps to test internal controls over areas such as BLMIS's redemption of client funds, the payment of invoices for corporate expenses, or the purchase of securities by BLMIS on behalf of its clients. Further, commencing at least as far back as 1995, Friehling did not maintain professional independence from his audit client, BLMIS, as required by SEC rules."

In a separate civil complaint, the SEC alleges that beginning in 1995, Mr. Friehling and his family had investment accounts at the Madoff firm which were worth more than $14 million, a "blatant" conflict of interest that violated auditing rules. He and his family withdrew at least $5.5 million since 2000, the SEC said.

Madoff, who has confessed to securities fraud and faces a long prison term, has admitted in court that he created false statements that were distributed to clients which purported to show transactions that generated profits from funds invested with his firm.

Among omissions on BMIS's balance sheets that would have pointed to transactions were line items allocations for transactions that had not been completed, under "customer receivables" or "customer payables," said Greg LaRoche, a broker-dealer researcher, The Wall Street Journal reports.

A bankruptcy trustee hired to liquidate Madoff's assets has said an investigation of Madoff's records show his investment advisory firm did not conduct a single transaction for at least the past 13 years.

AICPA spokesman Bill Roberts told The Wall Street Journal that with the AICPA's limited staff, checking on the 6,700 members who respond that they're not conducting audits was "just not feasible." Roberts said he believes the percentage of accounting firms that falsely deny doing audit work is "extremely low - about one in a million." He said, however, that his office would follow up any tips involving a specific company.

In a ruling that expired in January, the SEC exempted the auditors of nonpublic broker/dealers like Madoff's firm from PCAOB oversight.

The SEC is now considering making broker/dealers subject to audits. On March 26, SEC Chairman Mary Schapiro told members of the Senate Banking Committee that the SEC will propose that all investment advisers who have custody of customer assets undergo annual audits that are "unannounced." Money managers may also be subject to compliance audits by professional examiners to make sure they are adhering to securities laws, she said, according to Bloomberg.com.

Friehling is a former Rockland Chapter president of the New York State Society of CPAs.

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