E.S.M.'s audit fraud cycle went unscathed for several years that is, until the chief fraudster, Alan Novick, died of a massive heart attack, which helped uncover the entire scheme. It was astoundingly revealed that auditors had been falsifying company records for seven years.
Novick and his cohorts cleverly orchestrated a fraudulent system that consisted of management's unauthorized use of company assets for personal gain, speculating with company securities, setting an unaudited affiliate entity to hide losses and bribing an audit firm partner. The nucleus of the fraud involvement and the major transaction of E.S.M.'s business activities pertained to selling "repos" or large blocks of federal securities and simultaneously repurchasing them at a later date at a preset price to small and medium-size banks and municipality clients. E.S.M also bought "reverse repos" whereas it purchased securities from its customers who agreed to repurchase them later from E.S.M at an agreed upon price. Two managers who used these securities in speculative deals for their own benefits hid losses from these deals by shifting them to the unaudited affiliated entity they established to avoid detection and the gains were credited to E.S.M.
In addition to suing the company for financial misconduct, its broker-dealer subsidiaries, and several affiliated individuals, the SEC filed a separate complaint charging E.S.M.'s auditor, Jose L. Gomez, a partner of Alexander Grant and Company, with violating Section 17(a) of the Securities Act of 1933, Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5. The primary basis for the fraud charges was Gomez's lack of independence from E.S.M., which was caused by his receipt of $200k in payments from several E.S.M. principals, and his knowledge that his firm's audit opinions were therefore false in stating that the audits were conducted in accordance with GAAS. In settling the matter, Gomez agreed not only to an injunction against future fraud violations, but also to an injunction against providing audit services to public companies and securities firms. Gomez further agreed to accept a follow-on Rule 102(e) order barring him from appearing or practicing before the Commission as an accountant.
In a related criminal proceeding, Gomez pled guilty to conspiracy and mail fraud and was sentenced to 12 years in prison.
Consequently, the U.S. Securities and Exchange Commission filed fraud charges against ESM Government Securities, which was ordered shut down by the federal government. ESM, according to the federal government, was short $250 million owed to customers throughout the nation. As punishment for AG's involvement, the audit firm was order to remit $175 million in civil payments.
Auditor Failure and Lack of Independence - Solutions
Auditing failure occurs as a result of collusion and auditor negligence or incompetence to discover a management's misrepresentations. While auditors need not prove the existence of intent to commit fraud, they must use professional skepticism, (i.e., suspect the presence of intentional schemes or motivation) when certain circumstances prevail. The essence of a successful auditor is to understand the motivations of the people involved in each function, from the highest to the lowest.
Auditors are obligated to a myriad of stakeholders to ensuring that financial information is free of falsification. E.S.M.'s audit failure centered on the company's audit partner, Gomez whom was unduly influenced by monetary bribes for exchange of more favorable audit reports than what was warranted. Greed overwhelmed Gomez's caution as auditing became less of a duty and more of a business and eventually led to increased difficulty to uncover financial wrongdoings because the perpetrators were motivated with money. It was quite apparent that E.S.M's management was the enabler in the scheme because they had no neutral party to supervise the audits or discourage wrongdoing between them and their audit firm. However, the addition of an independent fraud specialist conjoined with E.S.M.'s audit firm may have significantly increased improvement in fraud detection capability. If the company had harnessed the expertise of a fraud specialist during their audits, auditor misconduct and misrepresentation of the company's financial reported would have possibly not gone undetected for seven years.
The skills of the fraud specialist are more attuned to loss prevention or defalcation detection than that of an independent auditor because they are highly trained to detect frauds beyond the scope of a regular auditor. Employing fraud specialists during E.S.M audits would have provided a cost-effective way to mitigate the likelihood of major auditing failure. E.S.M could have diminished the collusion of fraud with the help of fraud specialists and perhaps minimized the magnitude of losses if duplicitous behavior had been identified at inception. The costs would have been only a fraction of the cost of what E.S.M. expended and would have likely been more effective preventing fraudulent audits. Strong technological skill, extensive legal training, investigative skill, and collusion detection methods enable fraud specialists to outperform regular auditors in detecting defalcation and fraudulent financial statements.
Loss prevention is important for SEC filers, but it does not directly relate to the mission of the independent auditor. Fraud specialists are trained in the criminal legal system and can operate without violating the rights of potential witnesses and fraud suspects. They understand the legalities of gathering evidence of fraud. Hence, interviews with E.S.M. management and staff, from highest to lowest would have been conducted in a manner that prevents successful defamation litigation against the auditor or client regarding allegations of fraud or illegal activities.
Fraud specialists have the same basic accounting and auditing skills as regular auditors, but also include the necessary legal and detective skills that are necessary in proving that occupational fraud exists. They regularly employ forensic accounting software and methods to detect computerized financial statement fraud. Examples include fraud data mining software (e.g., ACL), digital analysis (e.g., Benford's Law), autonomous suspicious activity logs, and forensic software applications.
Auditors are responsible for expressing an opinion as to whether the financial statements of a company is a fair representation and conform with GAAP along with identifying the circumstances which preclude the principles that were not consistent. Their position requires neutrality and independence from the firm in order to mitigate conflict of interests with the audited firm's management. Engaging fraud specialists in conjunction with auditors would have been a prudent solution for ESM.
Audit failure does not occur because of faulty audits of the financials, it takes place because of the failure to audit the business and the lack of patience to understand the key factors that drive the business and the financial statements.
The general state of the economy and client industry provide a macro vehicle to project the rise in fraudulent behavior, while regular aspects of fraud cases coupled with auditors' experience with fraud issues help predict such intentional acts. When captured within a comprehensive view, such as the same in E.S.M.'s debacle, fraud can more likely be detected at inception.