During the 1990s, Kenneth Lipper emerged as a leader of the rapidly growing hedge fund "industry" in the United States. Born in 1941, Lipper, the son of a shoe salesman, spent his childhood in a modest working-class neighborhood in New York City's South Bronx. As an adolescent, he enjoyed a wide range of interests, including sports, movies, and the stock market. Unlike his childhood friend, Alfredo "Sonny" Pacino, Lipper decided as a young adult to pursue a career on Wall Street rather than in Hollywood-at least initially.
Lipper was a brilliant student who relied on academic scholarships to finance an undergraduate degree at Columbia, a law degree at Harvard, and a master's degree from the New York University School of Law before pursuing postgraduate studies at the University of Paris. The charismatic Lipper developed an impressive list of wealthy and well-connected friends and acquaintances during his college years.
In 1966, when he was 25 years old, Lipper married the daughter of one of New York's richest philanthropists. That marriage placed Lipper's Wall Street career on the "fast track, according to Business Week."2 Shortly thereafter, he joined the prestigious Wall Street firm of Lehman Brothers; by the age of 32, Lipper was among that firm's youngest partners.
Lipper left Lehman in 1975 to become a partner and managing director of a competing firm, Salomon Brothers. His bright career was briefly derailed when the SEC accused him of aiding and abetting violations of the federal securities laws in a covert attempt to take over a large public company. Lipper settled those charges without admitting or denying any wrongdoing and escaped with only mild sanctions being imposed on him by the federal agency.
In 1983, one year after settling the SEC charges, Lipper took a sabbatical from the world of high finance to serve as deputy mayor of New York City. After three years in New York City's rough-and-tumble political arena, Lipper became involved in a Hollywood film project being developed by Oliver Stone. The famous movie director tapped Lipper to serve as a technical advisor for the film Wall Street starring Michael Douglas and Charlie Sheen. Following the release of the Academy Award-winning movie, Lipper wrote a novel of the same name based upon the film's screenplay.
Over the next two decades, Lipper lived a high-profile, bicoastal lifestyle in which he was a mainstay in both the West Coast's glitzy movie industry and Wall Street's economic powerhouse some 3,000 miles away. In Hollywood, Lipper enjoyed a successful career as a screenwriter and film producer and even collaborated with his old friend Al Pacino on a major film project.3 At the same time, Lipper oversaw a burgeoning financial empire on the East Coast through his investment firm, Lipper Holdings, LLC, that he organized in the late 1980s. Lipper's firm, for which he served as both president and chief executive officer (CEO), would eventually manage investments having a total market value exceeding $4 billion dollars.
Lipper's network of influential friends on both coasts served as a pipeline of clients to his Wall Street firm. Julia Roberts, Sylvester Stallone, and Disney CEO Michael Eisner were among the many Hollywood luminaries for whom Lipper served as a financial advisor. One-time presidential candidate U.S. Senator Fritz Hollings, former Federal Reserve Chairman Paul Volcker, and Lipper's former boss Ed Koch, the longtime and very popular mayor of New York City, were among the political heavyweights that entrusted much of their wealth to Lipper's firm. As Business Week reported, "The flashy pitchman [Kenneth Lipper] with his fancy connections and wealth was a magnet for investors who never questioned his ability to manage their money. . . . These were . . . people who were wowed by his blue-chip Wall Street credentials.^"4
Lipper delegated the day-to-day responsibility of managing his firm's investment funds to subordinates. One of his principal subordinates was Edward Strafaci, an executive vice president of Lipper Holdings. Strafaci served as the portfolio manager for three large hedge funds within the family of Lipper investment funds. Those three hedge funds were Lipper Convertibles, Lipper Convertibles Series II, and Lipper Fixed Income Fund. Each of the funds had been legally structured so that they were not required to register with the SEC as investment companies under the Investment Company Act of 1940. Because Lipper Convertibles and Lipper Convertibles Series II were legally "broker-dealers," however, they were required to file annual audited financial statements with the SEC pursuant to the requirements of the Securities Exchange Act of 1934.
Strafaci used financial leverage to enhance the rates of return earned by the investors in the three hedge funds, that is, he arranged for the funds to borrow large amounts of cash that were then invested along with the equity capital of the investors.
This financial leverage caused the rates of return earned by investors to be considerably higher than the returns earned on the funds' investment portfolios. Of course, the use of financial leverage also meant that when the funds suffered losses in a given year, the corresponding losses of the funds' investors were magnified.
The marketing materials Lipper's firm used to promote his hedge funds reported that 70 percent of their holdings were high quality, "investment grade" securities. In fact, the actual percentage of investment-grade securities held by the three hedge funds was considerably lower than that figure. To ensure that the funds continued to attract new investors, Strafaci believed it was imperative for them to earn impressive rates of return. Because investment-grade securities didn't yield such returns, he invested an increasingly large percentage of the hedge funds' assets in high-risk, high-return securities. These securities were typically convertible bonds and convertible preferred stocks issued by companies experiencing financial problems.

Questions
1. Identify specific fraud risk factors present during PwC's audits of the Lipper hedge funds. Explain how PwC should have responded to the fraud risk factors that you identified.
2. Provide examples of important audit objectives for complex financial instruments and transactions. For each audit objective that you identify, list one or more audit procedures that could be used to accomplish that objective.
3. Identify the factors that may have contributed to the alleged flaws in the audit procedures that PwC applied in testing the year-end market values of the Lipper hedge funds' investments. Discuss specific measures that audit firms can employ to reduce the likelihood that such factors will undercut the quality of their audits.