Auditing Due Diligence in Law and Ethics: The Ponzi "Feeder Fund" Cases
Spalding, Albert D., Review of Business & Finance Studies
Financial accounting is an information conveyance process. When financial auditors issue an opinion in regard to financial statements, the auditors are providing assurance that those financial statements fairly represent the entity, and are prepared in accordance with the relevant standards. If there is a problem with the financial statements for which an unqualified audit opinion has been issued, the auditors may be questioned in regard to their compliance with professional technical and ethical standards that require competency, honesty, and full disclosure. These questions may be asked by the auditors' professional organizations, such as the American Institute of Certified Public Accountants (AICPA), by government regulators who authorize the performance of auditing services, and by the judges and juries of the judicial system. This paper considers how the judiciary, in particular, takes into account auditors' technical and ethical standards when auditors are sued for professional negligence and negligent misrepresentation. This investigation is done within the context of the recent lawsuits against auditors of "feeder funds" that invested with Ponzi scam artists such as Bernard Madoff. This paper concludes that the auditing profession has a "teachable moment" in the wake of the feeder fund failures, and should not overlook this opportunity to upgrade its ethical standards.
JEL: K23; M42; M48
KEYWORDS: Auditing, financial disclosure, due diligence, negligent misrepresentation, accountants' liability, professional ethics, Ponzi, feeder funds.
Financial auditing is a professional discipline that requires both the technical skills and ethics. In the United States, the technical skills include both a thorough understanding of generally accepted accounting principles (GAAP) employed by the audit client, and rigorous application of generally accepted auditing standards (GAAS) in order to ensure that the auditors' opinions are reliable. Auditors must also adhere to rigorous standards of due diligence, honesty and full disclosure in order to ensure that the auditors' opinions are trustworthy.
This paper provides a discussion of skills required of auditors. This paper considers how the judiciary, in particular, takes into account auditors' technical and ethical standards when auditors are sued for professional negligence and negligent misrepresentation. Specifically, we discuss the issue in relationship with the ? ernie Madoff fraud case. In the following section the relevant literature and background are provided. The paper continues with a discussion of Ponzi feeder funds. The next section provides a discussion of red flags in Ponzi feeder fund audits. This paper continues with sections on legal and ethical analyses of auditor due diligence. The paper closes with some concluding comments.
LITERATURE REVIEW AND BACKGROUND
Several systems operate to evaluate and assess financial auditors' skills and ethics. First, financial auditors attempt to self-regulate through organizations such as the American Institute of Certified Public Accountants (AICPA) and affiliated state accounting societies. These organizations monitor member compliance with the AICPA code of professional conduct and related industry-generated pronouncements. The AICPA maintains a joint ethics enforcement program that investigates complaints about members who may have violated professional standards. When investigators conclude that members have in fact failed to comply with these standards, disciplinary actions ranging from enhanced continuing education requirements to suspension or termination of membership are enforced.
State regulators provide a second tier of oversight. Certified public accountants are licensed by state licensure agencies who require licensees to abide by state laws and regulations designed to make sure that they are performing reliable and ethical services. Unlike the AICPA and state professional societies, whose primary objective is the enhancement and survival of the profession, state regulators are more concerned with protecting the interests of businesses and consumers who rely upon the services of these professionals. …