What Roles Do Auditors and Advisors Play in Ponzi Schemes?

Gusto Editors

Do you know what roles auditors and accounting advisors play in preventing Ponzi schemes?

As an accountant, you need to be aware of Ponzi schemes’ risks and warning signs, especially if you work as an advisor for your clients. Ponzi schemes cost investors billions of dollars each year, and your clients could become involved in these scams. If you suspect that an investment opportunity is a scam, you need to inform your clients. 

Gusto, along with our partners at CPA Academy, presented an edifying webinar all about investment fraud and its warning signs. We hosted our webinar titled, “Fraud: What CPAs Need to Know About Ponzi and Pyramid Schemes,” and you can watch the full presentation here.

In this article, we share key highlights from the webinar hosted by Greg Kyte, founder of Comedy CPE, and Caleb Newquist, Gusto’s Editor-at-Large. You’ll learn about Bernie Madoff’s auditor, why auditors should easily detect Ponzi schemes, and advisors’ ethical and professional responsibilities in protecting their clients from investment scams. 

David Friehling’s role in the Madoff investment scandal

Ponzi schemes cost investors between $10 and $15 billion every year. These schemes occur when someone convinces investors to allow an individual or business to invest their money. Ponzi scheme perpetrators claim they’re investing the money, but they actually pocket it or use it for non-investment purposes. They then pay back older investors by using money from newer investors. 

Professional man reaches out to other man to show reports.

Bernie Madoff perpetrated the most famous Ponzi scheme in history. Madoff stole billions of dollars over the course of two decades. Although Madoff was found guilty after defrauding thousands of investors, what about his auditor? Should his auditor have faced significant penalties for rubber-stamping Madoff’s financial statements? During Madoff’s trial, the auditor, David Friehling, claimed that he was ignorant of Madoff’s wrongdoing:

“According to David Friehling’s own testimony, he barely even looked at [the financial statements] and was just like, ‘Yeah. Unqualified,’ every year. … In his testimony, … he was like, ‘Yeah, I’ve never really been that great at auditing stuff.’”

Greg Kyte

David Friehling signed off on Madoff’s financial statements with an unqualified opinion, and he claimed ignorance of the fact that Bernie Madoff was swindling investors. Although one might expect authorities to hold Friehling accountable for his complicity in the Madoff scandal, he didn’t face significant charges: 

“He cooperated with investigators, so he, for the most part, got off the hook. … If they threw the book at him, he would’ve been convicted to over a hundred years in jail. Instead, he got one year home detention and one year supervised release. … All of this is to say that the Ponzi scheme [perpetrators] need to find somebody who either is willing to collude with them in the Ponzi scheme or find someone who’s dumb.”

Greg Kyte

Friehling should have been aware that the financial statements indicated fraudulent practices. Greg and Caleb speculated that Bernie Madoff chose Freihling’s firm, Friehling & Horowitz, because the firm was relatively insignificant compared to the Madoff investment firm: 

“[Bernie Madoff was this] mythic figure of [an] investor. If these investors were doing their due diligence, they would maybe ask questions like, ‘Oh, are your financial statements audited? Do you put out an audit?’ And he would say, ‘Yes. … It is by the firm Friehling & Horowitz.’ … You would probably say, ‘Hmm, I’ve never heard of that firm in my life, and you have billions of dollars under management.’”

Caleb Newquist

When a major investment firm hires insignificant auditors, it raises the question of whether they want expert auditing work or if they want to create the illusion of an objective examination.  

“To have a virtually unknown name as an auditor could be another red flag [for Ponzi schemes]. … An audit may help [prevent Ponzi schemes], but [a scammer can pull] a couple of [insignificant auditors] off the street and say, ‘Hey, can you be our auditors forever?’”

Caleb Newquist

Although we don’t know Bernie Madoff’s motivations for receiving auditing services from Friehling and Horowitz, the scandal would likely have come to light sooner if a more reputable firm had conducted the audits. 

Auditing financial statements in Ponzi schemes

Businessman holding pen while reading documents.

Although Friehling acted like he was completely ignorant of Bernie Madoff’s schemes, he should have been aware of them since he has an accounting license:

“Did you pass the CPA exam? Then you can spot a Ponzi scheme because it’s the basic audit assertions of existence. Do the investments that you say that you’ve made for your clients exist? That’s just simple confirmations with the counterparties of those investments. … A Ponzi scheme can’t escape notice by anyone who does just the basics of their audit testing with that.”

Greg Kyte

Auditors should detect a Ponzi scheme easily by merely looking over the paperwork to see the legitimacy of purported investments. Greg noted that Madoff started his business with legitimate investments, but an auditor should have noted fraudulent practices when new investment assets didn’t fluctuate over a year:

“Madoff started off with some legit investments. … I guess the dumb way of looking at is you got investment money in, so your assets must have gone up the same amount [as the] investments that came in that dollar amount, but that’s not entirely true because you’re looking at an entire year that you’re auditing, so there’s going to be fluctuations in your investments, so it’s not going to be a one-to-one.”

Greg Kyte

The amount that people invest in a company wouldn’t be the same as the company’s new assets because there will be market fluctuations that shift the value of invested assets. Additionally, when people invest in a fund, a paper trail should indicate where the company invested the money. 

“You’ve got to think that there are some very specific auditing tasks that are required when you’re auditing … to make sure … that the money that came in from investors actually went to investments and not just out the back door as dividends to your investors.”

Greg Kyte

In Ponzi schemes, scammers don’t actually invest the people’s money—they use it to pay returns on older investments. The financial statements should indicate that the company didn’t invest the funds unless the financial statements are fake. 

Accounting advisors’ roles in detecting Ponzi scheme red flags

Accountants play a critical role for their clients, and they often assist them with financial guidance. As an accountant, you need to caution your clients if they become interested in investing in a scam:

“As CPAs … you get the moniker of trusted business advisors. … [If your client says], ‘Hey, should I invest in this?’ and you look at it, and you go, ‘Wow, that’s a really high return. It seems like they’re saying there’s almost no risk,’ … they want their really smart accountant to give them a pat on the back and go, ‘You’re such a smart guy. Go ahead and make all the money.’ … They don’t want you to say, ‘No.’”

Greg Kyte

Even if your client is excited about a supposed investment opportunity, you need to advise them to avoid it if you suspect that it’s a scheme. Ponzi schemes often promise unrealistically high returns and low risk, so an investment opportunity that appears too good to be true is likely a scam. 

Financial advisor discussing reports to his clients.

As an accountant, it’s also your responsibility to avoid conflicts of interest when it comes to advising clients. For example, it’s illegal to accept commission on service products that you recommend for assurance clients: 

“You can’t accept a commission for referring a service product to an assurance client. That means if you do assurance work for some company and they say, ‘Hey, how about you sell our product? We’ll give you a commission.’ That’s forbidden. You can’t do that.”

Greg Kyte

When guiding clients through investment opportunities, it’s also important to note that bad investment decisions will likely fall back on you and affect your professional relationship with your client:

“If you end up having clients who lose lots of money in a Ponzi scheme … [and] you had fingerprints on it at all, they’re going to come back to you and say, ‘You’re the [advising] guy. Why didn’t you figure it out?’ … You can’t wash your hands of this.”

Greg Kyte

If you fail to warn your clients about a poor investment decision, you’ll hurt your reputation and professional standing. 

Learn more about fraudulent investments

As an accountant, you have an ethical and professional responsibility to protect your clients from fraudulent investment opportunities such as Ponzi schemes. Additionally, auditors are responsible for assessing financial statements to the best of their abilities. If David Friehling had audited Madoff’s financial statements accurately rather than rubber-stamping them, thousands of swindled investors could have saved billions of dollars.

If you want to learn more about investment scams so you can protect yourself and your clients, read Part One and Part Three of this webinar article series. Part One goes into more detail about the Bernie Madoff investment scandal, and Part Three discusses pyramid schemes. You can also watch the entire webinar here.

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