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Madoff Securities Bernie wanted to be rich; he dedicated his life to it. John Maccabee, longtime friend of Bernie Madoff Bernard Lawrence Madoff was born on April 29, 1938, in New York City. Madoff spent his childhood in a lower middle-class neighborhood in the borough of Queens. After graduating from high school, Madoff enrolled in the University of Alabama but transferred to Hofstra College on Long Island, now known as Hofstra University, at the beginning of his sophomore year. Three years later in 1960, he graduated with a political science degree from Hofstra. According to a longtime friend, the driving force in Madoff’s life since childhood was becoming wealthy. “Bernie wanted to be rich; he dedicated his life to it.” That compelling force no doubt accounted for Madoff’s lifelong fascination with the stock market. As a teenager, Madoff frequently visited Wall Street and dreamed of becoming a “major player” in the world of high finance. Because he did not have the educational training or personal connections to land a prime job on Wall Street after he graduated from college, Madoff decided that he would set up his own one-man brokerage firm. While in college, Madoff had accumulated a $5,000 nest egg by installing sprinkler systems during the summer months for wealthy New Yorkers living in the city’s affluent suburbs. In the summer of 1960, Madoff used those funds to establish Bernard L. Madoff Investment Securities LLC, which was typically referred to as Madoff Securities. Madoff operated the new business from office space that was provided to him by his father-in-law, who was a partner in a small accounting firm. For nearly five decades, Madoff served as the senior executive of Madoff Securities. During that time, the shy New Yorker who had an occasional stammer and several nervous tics would accumulate a fortune estimated at more than one billion dollars. Taking on Wall Street Madoff’s brokerage firm initially traded only securities of small overthe-counter companies, securities commonly referred to as “penny stocks.” At the time, the securities of most large companies were traded on the New York Stock Exchange (NYSE). The rules of that exchange made it extremely difficult for small brokerage firms such as Madoff’s to compete with the cartel of large brokerage firms that effectively controlled Wall Street. Madoff and many other small brokers insisted that the NYSE’s rules were anticompetitive and inconsistent with a free market economy. Madoff was also convinced that the major brokerage firms kept securities transaction costs artificially high to produce windfall profits for themselves to the detriment of investors, particularly small investors. Because of Madoff’s resentment of the major Wall Street brokerage firms, he made it his mission to “democratize” the securities markets in the United States while at the same time reducing the transaction costs of trading securities. “Bernie was the king of democratization. He was messianic about this. He pushed to automate the [securities trading] system, listing buyers and sellers on a computer that anyone could access.” In fact, Madoff Securities was one of the first brokerage firms to utilize computers to expedite the processing of securities transactions. Bernie Madoff is also credited as one of the founders of the NASDAQ stock exchange that was organized in 1971. The NASDAQ was destined to become the world’s largest electronic stock exchange and the largest global stock exchange in terms of trading volume. In the late 1980s and early 1990s, Madoff served three one-year terms as the chairman of the NASDAQ. Madoff’s leadership role in the development of electronic securities trading contributed significantly to his firm’s impressive growth throughout the latter decades of the twentieth century. By the early years of the twenty-first century, Madoff Securities was the largest “market maker” on the NASDAQ, meaning that the firm accounted for more daily transaction volume on that exchange than any other brokerage. By that time, the firm was also among the largest market makers for the New York Stock Exchange, accounting for as much as 5 percent of its daily transaction volume. This market-making service was lucrative with low risk for Madoff Securities and reportedly earned the firm, which was privately owned throughout its existence, annual profits measured in the tens of millions of dollars. In 1962, Madoff had expanded his firm to include investment advisory services. For several years, most of the individuals who set up investment accounts with Madoff Securities were referred to him by his father-in-law. Although the firm was a pioneer in electronic trading and made sizable profits from its brokerage operations, investment advisory services would prove to be its most important line of business. By late 2008, the total value of customer accounts managed by Madoff Securities reached $65 billion. The key factor that accounted for the incredible growth in the amount of money entrusted to Madoff’s firm by investors worldwide was the impressive rates of return that the firm earned annually on the funds that it managed. For decades, those funds earned an average annual rate of return generally ranging from 10 to 15 percent. Although impressive, those rates of return were not spectacular. What was spectacular was the consistency of the returns. In 2001, Barron’s reported that some of the Madoff firm’s largest investment funds had never experienced a losing year despite significant stock market declines in several individual years. Even when the stock market collapsed in late 2008, individual Madoff funds continued to report net gains for the yearto-date period. Although Madoff would eventually serve as an investment advisor to dozens of celebrities, professional athletes, and other wealthy individuals, most of the money he managed came from so-called “feeder firms,” which were large hedge funds, banks, and other investment companies. The individuals who had committed their funds to these feeder firms were typically unaware that those funds had been turned over to Madoff. The reclusive Madoff and his subordinates disclosed as little as possible about the investment strategy responsible for their firm’s success in the stock market. On one occasion, Madoff told an executive of a feeder firm, “It’s no one’s business what goes on here.” The Wall Street Journal reported that Madoff commonly “brushed off” skeptics who questioned his firm’s investment results by pointing out that those results had been audited and by insisting that his investment strategy “was too complicated for outsiders to understand.” The only substantive information Madoff Securities provided regarding its investment policies was that it employed a “split-strike conversion” investment model. In simple terms, this strategy involved purchasing several dozen blue-chip stocks and then simultaneously selling both put options and call options on those securities. Supposedly, this strategy ensured a positive rate of return on those investments whether the stock market went up or went down. Competitors, financial analysts, and academics repeatedly attempted to replicate the success of Madoff Securities’ investment strategy. None of those attempts were successful, which only added to Bernie Madoff’s stature and mystique on Wall Street. As one industry insider noted in 2001, “Even knowledgeable people can’t really tell you what he’s doing.” A CNN reporter observed that by the turn of the century Madoff was widely regarded as a stock market wizard and that “everyone” on Wall Street, including his closest competitors, was “in awe of him.” The Bubble Bursts On December 10, 2008, Bernie Madoff asked his two sons, Andrew and Mark, who worked at Madoff Securities, to meet him at his apartment that evening. In this meeting, Madoff told his sons that the impressive returns earned for clients of his firm’s investment advisory division over the previous several decades had been fraudulent. Those returns had been produced by an elaborate Ponzi scheme engineered and overseen by Madoff without the knowledge of any of his employees or family members. The following day, an attorney representing Madoff’s sons notified the SEC of their father’s confession. That evening, FBI agents came to Madoff’s apartment. One of the agents asked Madoff “if there was an innocent explanation” for the information relayed to the SEC from his sons. Madoff replied, “There is no innocent explanation.” The agents then placed Madoff under arrest and within hours filed securities fraud charges against him. The public announcement of Madoff’s fraudulent scheme in December 2008 stunned investors worldwide. That announcement further undercut the stability of global stock markets that were already reeling from the subprime mortgage crisis in the United States, which had “frozen” the world’s credit markets, caused stock prices to drop precipitously, and threatened to plunge the global economy into a deep depression. Politicians, journalists, and everyday citizens were shocked to learn that a massive investment fraud, apparently the largest in history, could go undetected for decades within the capital markets of the world’s largest economic power. Even more disconcerting was the fact that the Madoff fraud went undetected for several years after the implementation of the far-reaching regulatory reforms mandated by the U.S. Congress in the wake of the Enron and WorldCom debacles. News of the Madoff fraud caused a wide range of parties to angrily demand that the federal government and law enforcement authorities determine why the nation’s “watchdog” system for the capital markets had failed once again. The accounting profession was among the first targets of the public’s anger. On the day that Madoff’s fraud was publicly reported, Floyd Norris, a New York Times reporter acquainted with Madoff, asked a simple question that was on the minds of many people, namely, “Who were the auditors?” “Rubber-Stamped” Financial Statements Business journalists quickly determined that the auditor of Madoff Securities was Friehling & Horowitz, an accounting firm located in the small New York City suburb of New City. Friehling & Horowitz had issued unqualified opinions on the financial statements of Madoff Securities since at least the early 1990s, audits for which the small firm was paid as much as $200,000. Further investigation revealed that Friehling & Horowitz had only one active accountant, one nonprofessional employee (a secretary), and operated from a tiny office occupying approximately two hundred square feet. The active accountant was David Friehling who had performed the annual audits of Madoff’s firm and signed off on the firm’s unqualified audit opinions. Accounting and auditing experts interviewed by the Associated Press insisted that it was “preposterous” to conceive that any one individual could complete an audit of a company the size of Madoff Securities by himself. Friehling and his firm were members of the American Institute of Certified Public Accountants (AICPA). A spokesperson for that organization revealed that Friehling had reported to the AICPA each year that he did not perform any audits. As a result, Friehling’s firm was not required to submit to the AICPA’s peer review program for CPA firms. Friehling’s firm was also not required to have a periodic peer review at the state level. At the time, New York was one of six states that did not have a mandatory peer review program for accounting firms. In March 2009, the New York Times reported that Friehling had maintained dozens of investment accounts with Madoff Securities, according to documents obtained by the court-appointed trustee for that firm. Those same documents indicated that Friehling & Horowitz had another 17 investment accounts with Madoff’s firm. In total, Friehling, his accounting firm, and his family members had nearly $15 million invested in funds managed by Madoff. Federal prosecutors noted that these investments had “flouted” the accounting profession’s auditor independence rules and “disqualified” Friehling from serving as the auditor of Madoff Securities. David Friehling would be the second person arrested by federal law enforcement authorities investigating Madoff’s fraud. Among other charges, federal prosecutors indicted Friehling for securities fraud, aiding and abetting an investment fraud, and obstructing the IRS. The prosecutors did not allege that Friehling was aware of Madoff’s fraudulent scheme but rather that he had conducted “sham audits” of Madoff Securities that “helped foster the illusion that Mr. Madoff legitimately invested his clients’ money.” News reports of Friehling’s alleged sham audits caused him to be berated in the business press. A top FBI official observed that Friehling’s “job was not to merely rubber-stamp statements that he didn’t verify” and that Friehling had betrayed his “fiduciary duty to investors and his legal obligation to regulators.” An SEC official maintained that Friehling had “essentially sold his [CPA] license for more than 17 years while Madoff’s Ponzi scheme went undetected.” Many parties found this and other denigrating remarks made by SEC officials concerning Friehling ironic since the federal agency was itself the target of scornful criticism for its role in the Madoff fiasco. Sir Galahad and the SEC On at least eight occasions, the SEC investigated alleged violations of securities laws by Madoff Securities during the two decades prior to Bernie Madoff’s startling confession. In each case, however, the investigation concluded without the SEC charging Madoff with any serious infractions of those laws. Most of these investigations resulted from a series of complaints filed with the SEC by one individual, Harry Markopolos. On the March 1, 2009, edition of the CBS news program 60 Minutes, investigative reporter Steve Croft observed that until a few months earlier Harry Markopolos had been an “obscure financial analyst and mildly eccentric fraud investigator from Boston.” Beginning in 1999, Markopolos had repeatedly told the SEC that Bernie Madoff was operating what he referred to as the “world’s largest Ponzi scheme.” Between May 2000 and April 2008, Markopolos mailed or hand delivered documents and other evidence to the SEC that purportedly proved that assertion. Although SEC officials politely listened to Markopolos’s accusations, they failed to vigorously investigate them. One lengthy report that Markopolos sent to the SEC in 2005 identified 29 specific “red flags” suggesting that Madoff was perpetrating a massive fraud on his clients. Among these red flags was Madoff’s alleged refusal to allow the Big Four auditor of an investment syndicate to review his financial records. Another red flag was the fact that Madoff Securities was audited by a one-man accounting firm, namely, Friehling & Horowitz. Also suspicious was the fact that Madoff, despite his firm’s leadership role in electronic securities trading, refused to provide his clients with online access to their accounts, providing them instead with monthly account statements by mail. Among the most credible and impressive evidence Markopolos gave to the SEC were mathematical analyses and simulations allegedly proving that Madoff’s split-strike conversion investment strategy could not consistently produce the investment results that his firm reported. Markopolos noted that if such an investment strategy existed, it would be the “Holy Grail” of investing and eventually be replicated by other Wall Street investment advisors. Even if Madoff had discovered this “Holy Grail” of investing, Markopolos demonstrated there was not sufficient transaction volume in the options market to account for the huge number of options that his investment model would have required him to buy and sell for his customers’ accounts. In the months following the public disclosure of Madoff’s fraud, Harry Markopolos reached cult hero status within the business press. Markopolos was repeatedly asked to comment on and explain the scope and nature of Madoff’s scheme. Markopolos’s dissection of Madoff’s fraud suggested that three key factors accounted for it continuing unchecked for decades. First, Madoff targeted investors who were unlikely to question his investment strategy. According to Markopolos, a large number of “smart” investors had refused to invest with Madoff despite his sterling record. “Smart investors would stick to their investment discipline and walk away, refusing to invest in a black-box strategy they did not understand. Greedy investors would fall over themselves to hand Madoff money.” The second factor that allowed Madoff’s fraud to continue for decades was his impeccable credentials. Even if his impressive investment results were ignored, Madoff easily qualified as a Wall Street icon. He was a pioneer of electronic securities trading and throughout his career held numerous leadership positions within the securities industry, including his three stints as NASDAQ chairman. Madoff’s stature on Wall Street was also enhanced by his well-publicized philanthropy. He regularly contributed large sums to several charities. The final and most important factor that allowed Madoff to sustain his fraudulent scheme was the failure of the regulatory oversight function for the stock market. In testimony before Congress and media interviews, Harry Markopolos insisted that the Madoff debacle could have been avoided or at least mitigated significantly if federal regulators, particularly the SEC, had been more diligent in fulfilling their responsibilities. According to Markopolos, Madoff knew that the SEC’s accountants, attorneys, and stock market specialists were “incapable of understanding a derivatives-based Ponzi scheme” such as the one he masterminded. That knowledge apparently emboldened Madoff and encouraged him to continually expand the scope of his fraud. Even after Markopolos explained the nature of Madoff’s fraud to SEC officials, they apparently did not understand it. “I gift wrapped and delivered the largest Ponzi scheme in history to them … [but the SEC] did not understand the 29 red flags that I handed them.” The outspoken SEC critic went on to predict that “If the SEC does not improve soon, they risk being merged out of existence in the upcoming rewrite of the nation’s regulatory scheme.” Markopolos’s pointed criticism of the SEC and additional harsh criticism by several other parties forced the agency’s top officials to respond. An embarrassed SEC Chairman Christopher Cox admitted that he was “gravely concerned” by the SEC’s failure to uncover the fraud. In an extraordinary admission that the SEC was aware of numerous red flags raised about Bernard L. Madoff Investment Securities LLC, but failed to take them seriously enough, SEC Chairman Christopher Cox ordered a review of the agency’s oversight of the New York securities-trading and investment-management firm. Epilogue On March 12, 2009, Bernie Madoff appeared before Judge Denny Chin in a federal courthouse in New York City. After Judge Chin read the 11 counts of fraud, money laundering, perjury and theft pending against Madoff, he asked the well-dressed defendant how he pled. “Guilty,” was Madoff’s barely audible one-word reply. Judge Chin then told Madoff to explain what he had done. “Your honor, for many years up until my arrest on December 11, 2008, I operated a Ponzi scheme through the investment advisory side of my business.” Madoff then added, “I knew what I did was wrong, indeed criminal. When I began the Ponzi scheme, I believed it would end shortly and I would be able to extricate myself and my clients … [but] as the years went by I realized this day, and my arrest, would inevitably come.” Despite allegations his two sons, his brother, and his wife were at least knowledgeable of his fraud and possibly complicit in it, Madoff refused to implicate any of them or any of his other subordinates. Madoff claimed that he alone had been responsible for the fraud and that the brokerage arm of his business, which had been overseen by his brother and his two sons, had not been affected by his Ponzi scheme. On June 29, 2009, Madoff appeared once more in federal court. After reprimanding Madoff for his actions, Judge Chin sentenced him to 150 years in federal prison, meaning the 71-year-old felon would spend the rest of his life incarcerated. In August 2009, Frank DiPascali, Madoff Securities’ former chief financial officer, pleaded guilty to complicity in Madoff’s fraudulent scheme. During an appearance in federal court, DiPascali testified, “It was all fake; it was all fictitious. It was wrong and I knew it at the time.” As a result of DiPascali’s cooperation with federal law enforcement authorities, more than one dozen other former subordinates or business associates of Bernie Madoff, including his brother Peter, would plead guilty or be convicted of various criminal charges. DiPascali died in May 2015 while awaiting sentencing for his role in Madoff’s fraud. David Freihling, Madoff’s long-time auditor, pleaded guilty in November 2009 to the nine-count indictment filed against him by federal prosecutors. Freihling’s sentencing hearing was delayed six times while he was cooperating with the ongoing investigations of the Madoff fraud. Finally, in May 2015, a federal judge sentenced Freihling to one year of home detention. The judge justified the lenient sentence by noting Friehling’s extensive cooperation with law enforcement authorities investigating the Madoff fraud. In 2009, the AICPA announced it had expelled Friehling for not cooperating with its investigation of his audits of Madoff Securities; one year later, Friehling was stripped of his CPA license by the state of New York. The controversy over the failure of Friehling’s firm to undergo any peer reviews persuaded the New York state legislature to pass a law in December 2008 requiring most New York accounting firms that provide attest services to be peer reviewed every three years. Although none of the Big Four accounting firms were directly linked to Madoff Securities, legal experts speculated those firms would face civil lawsuits in the wake of Madoff’s fraud. That potential liability stemmed from the Big Four’s audits of the large “feeder firms” that entrusted billions of dollars to Madoff. Lynn Turner, a former chief accountant of the SEC, contended that the auditors of the feeder firms had a responsibility to check out Madoff’s auditor. “If they didn’t, then investors will have to hold the auditors [of the feeder firms] accountable.” In February 2009, KPMG became the first of the Big Four firms to be named as a defendant in a civil lawsuit triggered by the Madoff fraud. A California charity sued the accounting firm to recover the millions of dollars it lost due to Madoff’s scheme. KPMG had served as the independent auditor of a large hedge fund that had hired Madoff to invest the charity’s funds. Among critical risk factors allegedly overlooked by the KPMG auditors was that Madoff’s huge organization was serviced by a tiny accounting firm operating out of a strip mall in a New York City suburb. In November 2015, Ernst & Young (E&Y) became the first of the Big Four firms to be held civilly liable for losses suffered by investors in a Madoff feeder firm. E&Y was ordered to pay those investors approximately $25 million. PricewaterhouseCoopers settled a similar lawsuit in January 2016 by agreeing to pay $55 million to the investors in another of Madoff’s feeder firms. In early 2009, President Obama appointed Mary Schapiro to replace Christopher Cox as the chairperson of the SEC. In the aftermath of the Madoff fraud, Schapiro reported her agency would revamp its oversight policies and procedures for investment advisers having physical custody of customer assets. Among the measures ultimately adopted by the SEC were annual surprise audits of such firms to ensure customer funds are being properly safe-guarded. Those investment advisory firms must also have internal control audits by independent accounting firms to determine whether they have “the proper controls in place.” Finally, Schapiro pledged the SEC would implement specific measures to ensure credible whistle-blowing allegations, such as those made by Harry Markopolos regarding Madoff’s firm, would be investigated on a thorough and timely basis. Bernie Madoff’s victims included a wide range of prominent organizations and individuals. The large asset management firm Fairfield Greenwich Advisers alone had more than one-half of its investment portfolio of $14 billion invested with Madoff. Other companies and organizations that had significant funds in the custody of Madoff Securities included the large Dutch bank Fortis Bank, the large British bank HSBC, the International Olympic Committee, Massachusetts Mutual Life Insurance Company, New York University, Oppenheimer Funds, and Yeshiva University. One media outlet reported that the list of individuals who had investments with Madoff reads like a lineup from Lifestyles of the Rich and Famous, a popular television program of the 1980s. Those individuals included award-winning actors and actresses, Hollywood directors and screenwriters, media executives, journalists, professional athletes, a Nobel Prize winner, and high-profile politicians. Among these individuals were Kevin Bacon, Zsa Zsa Gabor, Jeffrey Katzenberg, Henry Kaufman, Larry King, Ed Koch, Sandy Koufax, Senator Frank Lautenberg, John Malkovich, Stephen Spielberg, Elie Wiesel, and Mort Zuckerman. By early 2016, Irving Picard, the court-appointed trustee charged with recovering the billions of dollars stolen or misused by Madoff, had filed more than 1,000 civil lawsuits against a wide range of defendants. To date, he has recouped more than $11 billion of the losses suffered by Madoff investors. Those recoveries, the seizure of assets by law enforcement authorities when Madoff revealed the fraud, and other collected amounts reduce the net estimated losses of Madoff’s victims to somewhere between $10 to $20 billion. Questions 1. Research recent developments involving this case. Summarize these developments in a bullet format. 2. Suppose that a large investment firm had approximately 10 percent of its total assets invested in funds managed by Madoff Securities. What audit procedures should the investment firm’s independent auditors have applied to those assets? 3. Describe the nature and purpose of a “peer review.” Would peer reviews of Friehling & Horowitz have likely resulted in the discovery of the Madoff fraud? Why or why not? 4. Professional auditing standards discuss the three key “conditions” that are typically present when a financial fraud occurs and identify a lengthy list of “fraud risk factors.” Briefly explain the difference between a fraud “condition” and a “fraud risk factor” and provide examples of each. What fraud conditions and fraud risk factors were apparently present in the Madoff case? 5. In addition to the reforms mentioned in this case, recommend other financial reporting and auditing-related reforms that would likely be effective in preventing or detecting frauds similar to that perpetrated by Madoff. The Trolley Dodgers In 1890, the Brooklyn Trolley Dodgers professional baseball team joined the National League. Over the following years, the Dodgers would have considerable difficulty competing with the other baseball teams in the New York City area. Those teams, principal among them the New York Yankees, were much better financed and generally stocked with players of higher caliber. After nearly seven decades of mostly frustration on and off the baseball field, the Dodgers shocked the sports world by moving to Los Angeles in 1958. Walter O’Malley, the flamboyant owner of the Dodgers, saw an opportunity to introduce professional baseball to the rapidly growing population of the West Coast. More important, O’Malley saw an opportunity to make his team more profitable. As an inducement to the Dodgers, Los Angeles County purchased a goat farm located in Chavez Ravine, an area two miles northwest of downtown Los Angeles, and gave the property to O’Malley for the site of his new baseball stadium. Since moving to Los Angeles, the Dodgers have been the envy of the baseball world: “In everything from profit to stadium maintenance … the Dodgers are the prototype of how a franchise should be run.” During the 1980s and 1990s, the Dodgers reigned as the most profitable franchise in baseball with a pretax profit margin approaching 25 percent in many years. In late 1997, Peter O’Malley, Walter O’Malley’s son and the Dodgers’ principal owner, sold the franchise for $350 million to media mogul Rupert Murdoch. A spokes-man for Murdoch complimented the O’Malley family for the long-standing success of the Dodgers organization: “The O’Malleys have set a gold standard for franchise ownership.” During an interview before he sold the Dodgers, Peter O’Malley attributed the success of his organization to the experts he had retained in all functional areas: “I don’t have to be an expert on taxes, split-fingered fastballs, or labor relations with our ushers. That talent is all available.” Edward Campos, a longtime accountant for the Dodgers, was a seemingly perfect example of one of those experts in the Dodgers organization. Campos accepted an entry-level position with the Dodgers as a young man. By 1986, after almost two decades with the club, he had worked his way up the employment hierarchy to become the operations payroll chief. After taking charge of the Dodgers’ payroll department, Campos designed and implemented a new payroll system, a system that only he fully understood. In fact, Campos controlled the system so completely that he personally filled out the weekly payroll cards for each of the Dodgers’ 400 employees. Campos was known not only for his work ethic but also for his loyalty to the club and its owners: “The Dodgers trusted him, and when he was on vacation, he even came back and did the payroll.” Unfortunately, the Dodgers’ trust in Campos was misplaced. Over a period of several years, Campos embezzled several hundred thousand dollars from his employer. According to court records, Campos padded the Dodgers’ payroll by adding fictitious employees to various departments in the organization. In addition, Campos routinely inflated the number of hours worked by several employees and then split the resulting overpayments 50-50 with those individuals. The fraudulent scheme came unraveled when appendicitis struck down Campos, forcing the Dodgers’ controller to temporarily assume his responsibilities. While completing the payroll one week, the controller noticed that several employees, including ushers, security guards, and ticket salespeople, were being paid unusually large amounts. In some cases, employees earning $7 an hour received weekly paychecks approaching $2,000. Following a criminal investigation and the filing of charges against Campos and his cohorts, all the individuals involved in the payroll fraud confessed. A state court sentenced Campos to eight years in prison and required him to make restitution of approximately $132,000 to the Dodgers. Another of the conspirators also received a prison sentence. The remaining individuals involved in the payroll scheme made restitution and were placed on probation. Epilogue The San Francisco Giants are easily the most heated, if not hated, rival of the Dodgers. In March 2012, a federal judge sentenced the Giants’ former payroll manager to 21 months in prison after she pleaded guilty to embezzling $2.2 million from the Giants organization. An attorney for the Giants testified that the payroll manager “wreaked havoc” on the Giants’ players, executives, and employees. The attorney said that the embezzlement “included more than 40 separate illegal transactions, including changing payroll records and stealing employees’ identities and diverting their tax payments.” A federal prosecutor reported that the payroll manager used the embezzled funds to buy a luxury car, to purchase a second home in San Diego, and to travel. When initially confronted about her embezzlement scheme, the payroll manager had “denied it completely.” She confessed when she was shown the proof that prosecutors had collected. During her sentencing hearing, the payroll manager pleaded with the federal judge to sentence her to five years probation but no jail term. She told the judge, “I cannot say how sorry that I am that I did this, because it’s not who I am. I have no excuse for it. There is no excuse in the world for taking something that doesn’t belong to you.” Questions 1. Identify the key audit objectives for a client’s payroll function. Comment on objectives related to tests of controls and substantive audit procedures. 2. What internal control weaknesses were evident in the Dodgers’ payroll system? 3. Identify audit procedures that might have led to the discovery of the fraudulent scheme masterminded by Campos. First Keystone Bank A Japanese bank introduced the concept of around-the-clock access to cash in the 1960s when it installed the world’s first cash-dispensing machine. In 1968, the first networked ATM appeared in Dallas, Texas. Two generations later, there are more than two million “cashpoints,” “bancomats,” and “holes-in-the-wall” worldwide, including one in Antarctica. Not surprisingly, ATMs have been a magnet for thieves since their inception. In 2009, an international gang of racketeers used a large stash of counterfeit ATM cards to steal $9 million from hundreds of ATMs scattered around the globe in a well-planned and coordinated 30-minute crime spree. Several hightech thieves have hacked into the computer networks of banks and modified their ATM software. One such miscreant reprogrammed a network of ATMs to change the denomination of bills recognized by the brainless machines—the ATMs treated $20 bills as if they were $5 bills. High-powered video cameras and miniature electronic devices attached to ATMs have been used to steal personal identification numbers (PINs) from a countless number of unsuspecting bank customers. A variety of low-tech schemes have also been used to rip off banks and their customers via ATMs, including forced withdrawals and postwithdrawal armed robberies. “Ram-raiding” involves using heavy-duty equipment to rip an ATM from its shorings. The ram-raiders then haul the ATM to a remote location and blast it open with explosives. The most common and lowest-tech type of ATM pilfering involves the aptly named tactic of “shoulder-surfing.” Many banks have suffered losses from their ATM operations due to embezzlement schemes perpetrated by employees. One such bank was the Swarthmore, Pennsylvania, branch of First Keystone Bank. Swarthmore, a quiet suburb of Philadelphia, is best known for being home to one of the nation’s most prestigious liberal arts colleges. In 2015, Forbes Magazine ranked Swarthmore College as the sixth best institution of higher learning in the United States—two slots below Yale, but two slots higher than Harvard. In January 2010, three tellers of First Keystone’s Swarthmore branch were arrested and charged with stealing more than $100,000 from its ATM over the previous two years. The alleged ringleader was Jean Moronese, who had worked at the branch since 2002 and served as its head teller since 2006. According to media reports, Moronese told law enforcement authorities that she initially began taking money from the branch’s ATM in 2008 to pay her credit card bills, rent, and day care expenses. No doubt emboldened by the ease with which she could steal the money, Moronese reportedly began taking cash from the ATM “just to spend” because she “got greedy.” Prior to taking a vacation in the fall of 2008, a tearful Moronese approached one of her subordinates and fellow tellers, Kelly Barksdale, and confessed that she had been stealing from the ATM. Moronese “begged” Barksdale to help her conceal her thefts “because she didn’t want her children to see her go to jail.” Barksdale was apparently persuaded by Moronese’s tearful plea and agreed to help her cover up the embezzlement scheme. In fact, the cover-up was easily accomplished. According to the local police, Moronese and Barksdale simply changed the ledger control sheets that were supposed to report the amount of cash stored in the ATM and in the locked vault within the ATM. First Keystone’s internal control procedures mandated that two employees be involved in resupplying the ATM and its locked vault and in maintaining the ATM ledger control sheets. However, either Moronese or Barksdale completed those tasks by themselves. In early 2009, a third teller, Tyneesha Richardson, overheard Moronese and Barksdale discussing the embezzlement scheme. Richardson then reportedly asked Moronese for money to pay off her car loan. Moronese agreed to give Richardson the money and told her that she shouldn’t worry because “the bank had a lot of money and they would never miss it.” After telling Barksdale that she had given money to Richardson, Moronese told Barksdale that if she ever needed any money “to let her know.” Not long thereafter, Barksdale allegedly asked Moronese for $600 to pay her rent. An internal audit eventually uncovered the embezzlement scheme at First Keystone’s Swarthmore branch. That internal audit revealed that $40,590 was missing from the branch’s ATM, while another $60,000 was missing from the locked vault within the ATM’s interior. While being interrogated by law enforcement authorities, Barksdale reportedly confessed that she and her colleagues had also stolen money from the local municipality. City employees periodically dropped off at the First Keystone branch large bags of coins collected from Swarthmore’s parking meters. Tellers at the branch were supposed to feed the coins into a coin-counting machine and then deposit the receipts printed by the machine into the city’s parking account. According to Barksdale, she and her two fellow conspirators diverted money from Swarthmore’s parking funds and split it among themselves. The police estimated that the three tellers stole approximately $24,000 of the parking funds. In January 2010, when the three tellers were arrested, they did not have far to go since the Swarthmore police station was across the street from the First Keystone branch where they worked. In commenting on the case, the local district attorney observed that Barksdale and Richardson had a choice to make when they learned of Moronese’s embezzlement scheme and that each had made the wrong choice. “So, the lesson is you can either be a witness or you can be a defendant. These two chose to be defendants.” The district attorney also commented on the branch’s failure to require employees to comply with internal control procedures. “The case is yet another example of the importance of not only implementing internal accounting safeguards, but ensuring that those safeguards are being followed by all employees at all levels of the business.” Questions 1. Prepare a list of internal control procedures that banks and other financial institutions have implemented, or should implement, for their ATM operations. 2. What general conditions or factors influence the audit approach or strategy applied to a bank client’s ATM operations by its independent auditors? 3. Identify specific audit procedures that may be applied to ATM operations. Which, if any, of these procedures might have resulted in the discovery of the embezzlement scheme at First Keystone’s Swarthmore branch? Explain.
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