When Bernie Madoff decided to defraud his firm’s investors of what investigators ultimately estimate to be between $50 and $65 billion, it was clear that the case wouldn’t be a simple one.

Since Madoff was arrested last December, it’s still not clear where all the money is, or how the 70 year old financier was able to pull off a crime on such a grand scale
supposedly single-handedly. Most eyes have turned on his sons, who held senior roles at Madoff Investment Securities, but apparently that’s not who the Feds are after next…

On March 18, Madoff’s accountant, David Friehling, was arrested for his role – intentional or not – in helping the ponzi scheme take place.

Friehling, and his small accounting firm Friehling & Horowitz, were the auditors for Madoff Investment Securities since the early 1990s. What prosecutors only recently found out, however, was just how small Friehling’s firm was – it consisted of three people set up in a New York suburb storefront, with Friehling the sole certified public accountant.

That’s startling news considering that this scamming CPA was supposed to be responsible for making sure that Madoff’s reported operations were accurate for shareholders and regulators; a job much bigger than any single person can handle.

Audits of large financial institutions require entire teams of accountants, sometimes sequestered at their clients’ offices year-round. It seems as though Friehling did little more than rubber stamp Madoff’s stories with a good audit opinion.

While the government doesn’t content that Friehling knew about the fraud, as the sole CPA on the audit, Friehling bears the entire liability for not performing a complete audit that falls within generally accepted accounting principles.

What This Means For Small Cap Investors

The reverberations of Friehling’s arrest are sure to be felt throughout the financial services community – after all, it’s very uncommon for accountants to be held criminally responsible for a lousy audit. Remember Enron? The accounting scandal caused the collapse of Arthur Anderson, one of the biggest public accounting firms in the world.

One of the more immediate results of this will likely be tightened accounting standards, especially for over the counter penny stocks. After all, OTC stocks – too small to justify exacting financial reporting – have been known for having shifty books for a long time. It’s one of the biggest reasons most investors have eschewed OTC stocks, which don’t trade on major exchanges, in favor of “listed” stocks that hold tickers on exchanges like NYSE or NASDAQ.

Part of the reason for that accounting irregularity has been the fact that stocks that trade over the counter are able to get away with being delinquent with their SEC filings. Another is the fact that audit standards are so subjective.

The powers that be require auditors to exercise “due care” when performing an audit, but what that means isn’t entirely clear. It’s possible that Friehling will use the vagueness of due care as a defense to his incompetence in the Madoff case.

Tightening restrictions for audits isn’t without its downsides – namely the added costs that smaller companies will have to pay to get audited by a reputable firm. Still, getting an audit should be seen as a necessary cost to those who look to raise capital by issuing stock to investors.

We’ll keep you updated on the latest small cap happenings in the coming months.

Cheers,
Jonas Elmerraji

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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