The importance of independent audits
The economic meltdown of the past two years has seen unprecedented redemptions from funds and other investments and a rush to liquidity - bringing to light a string of scandals including frauds, Ponzi schemes and other types of embezzlement that had been hidden during the boom years. A common denominator in many of these scandals has been the absence of a reputable independent auditor.
Take Arthur Nadel, whose Scoop Capital investment business was run from a high-street storefront in the beach resort of Sarasota, Florida. Nadel took as much as USD350m from clients, but six funds that were supposed to have USD300m in assets in fact were found to hold less than USD1m remaining when the business collapsed. Nadel had rejected his partners’ requests to hire an independent auditor for the funds until the discovery of Bernie Madoff’s fraud last December forced him to go on the run.
Albert Hu helped to raise more than USD5m for the Asenqua and Fireside hedge funds by falsely claiming several prominent international law firms as legal counsel and forging the signature of a purported chief financial officer who in fact had no association with the funds. Hu also provided investors with supposedly independently audited financial statements, in reality from an entity he set up with an address in San Francisco’s financial district.
Samuel Israel III was a third-generation trader respected on Wall Street, whose firm Bayou Management apparently had generated steady returns of 10 to 15 per cent since 1996 by taking short-term equity positions and at its peak claimed to manage USD440m. Israel told investors that the funds were audited by independent public accounting firm Richmond-Fairfield, which in fact was created by Bayou’s CFO to help conceal the fraud.
One of the red flags that caused some experienced investors to avoid Madoff was that the independent auditor of his multi-billion-dollar investment management business was a three-person firm located in a strip mall. Similarly, the investigation into Allen Stanford’s Antigua affiliate identified as its auditor a small firm in a quiet, largely residential neighbourhood of the island, an unlikely auditor for a USD8bn enterprise.
Just as important is the financial relationship between auditor and client. Arthur Andersen was accused of being reckless in its audit of Enron because of the conflict of interest represented by the consulting fees it earned from the company. In 2000 the relationship earned Andersen USD25m in audit fees and USD27m in consulting fees, around 27 per cent of the Houston office’s total audit fees from public clients.
All these frauds were aided by the lack of a properly independent audit – which is not only a deterrent against fraud but provides protection against casual errors arising from failure to follow proper procedures or honest accounting mistakes. Independent audits lead to increased trust, an enhanced reputation and financial credibility, increasing funds’ ability to raise additional capital as well as highlighting aspects of processes and controls that could or should be strengthened.
Although the BVI’s current Mutual Funds Act requires only public funds to be audited by an approved auditor, it is anticipated that the regulatory requirement will soon be extended to professional and private funds. In an environment where due diligence, transparency, segregation of duties and reliance on independent third-party service providers is of utmost importance, investor confidence can only be boosted by the independence and objectivity of a third-party audit by an experienced public accountant.
Nigel MacPhail is audit director at Baker Tilly (BVI)
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