Harry Markopolos, the man who uncovered Bernard Madoff’s Ponzi scheme, has slammed the current system of company audits and due diligence as ineffective in detecting fraud and called for its complete overhaul at the Cayman Investment Forum organized by the CFA Society on Oct. 13.

Mr. Markopolos, who unsuccessfully alerted the U.S. Securities and Exchange Commission about Madoff’s $65 billion Ponzi scheme on multiple occasions, used the case as an example on the basis that the accounting firms and third-party administrators had asserted that Madoff’s trades took place, that the performance was real and that the assets were there.

“That was not true, he never traded. Everybody missed it,” he said.Mr. Markopolos, who unsuccessfully alerted the U.S. Securities and Exchange Commission about Madoff’s $65 billion Ponzi scheme on multiple occasions, used the case as an example on the basis that the accounting firms and third-party administrators had asserted that Madoff’s trades took place, that the performance was real and that the assets were there.

In addition to the large banks that marketed the Madoff funds to clients worldwide and the regulators who failed to act, the independent forensic accountant singled out the auditors for special criticism.

Who does the audits, he asked. “People in their 20s. Auditors who do 80 to 90 hours in busy season and can barely stay awake.”

Checklists problematical

He said underpaid and overworked auditors did not get enough training on fraud, and they use audit checklists that “are carefully constructed to navigate around the fraud.” And all big four accounting firms had settled Madoff-related lawsuits.

“Name one big multimillion-dollar company-killing fraud scheme the big four [accounting firms] caught,” he asked. “You can’t. So what good is audit?”

Last year, external audits uncovered only 4 percent of all frauds in the United States, while the vast majority of fraud discoveries were based on tips from whistleblowers, who in most instances were employees of the firm that committed the fraud.

Audit had become a race to the bottom in fees for the accounting industry and functioned like a commodity for company managers who are most concerned with the cost of the exercise, he said.

“I think the investors should pay for audits, not companies. If you buy a share, you should pay X number of basis points for audit fees.”

The whole system should be “blown up and rejiggered,” Mr. Markopolos said.

“I think the investors should pay for audits, not companies. If you buy a share, you should pay X number of basis points for audit fees.”

The audit fees, in turn, should be higher to pay for auditors who have at least 10 to 15 years’ experience and significant fraud training.

Currently, 80 percent to 90 percent of the big four firms’ audit contact hours are with certified accountants who are between 21 and 28 years old.

Auditors should know every fraud in their industry, the independent fraud investigator said. “You want people with gray hair, no hair, thinning hair.”

In terms of due diligence, Mr. Markopolos noted, financial services providers could not rely on each other and they should not rely on their checklists, either. “The bad guys have their checklists too, and they know what you are checking.”

Instead of listening to the managers, who know what is on the checklist, due diligence should be based on conversations with back and middle office staff and risk managers and objectively analyzing the numbers.

Typically, accounting fraud is easy to spot because small changes affect too many variables for the fraudsters not to make any mistakes.

“Math is truth,” Mr. Markopolos said. “Just don’t listen to what they are telling you. Apply some analytical techniques and you find out if it is true or not.”

‘Hiding in plain sight’

Most fraud is hiding in plain sight and is not difficult to spot, he said. Madoff’s scheme, for instance, like other frauds, did not resemble the market. The performance of his funds stood out due to their consistent gains, the absence of volatility, no losing years or quarters, and no consecutive losing months, very little correlation to the overall stock markets and a largest single monthly loss of only 0.55 percent.

Assume fraud first until genius is proven, Mr. Markopolos concluded.

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  1. I completely agree with Mr. Markopolos that the shareholders should pay dues to have these fraudsters like Madoff privately Audited , by a private Licence / Bonded Auditor that would and should be responsible to shareholders / investors.
    Then every country and monetary organization should have Laws in place to protect against the kind of fraud that Madoff committed , and the lives he destroyed .

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