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Research

Paper:
Bernard Madoff Ponzi scheme

Cherine Cherkaoui
Table of Contents

Introduction: ......................................................................................................................... 2

History: ................................................................................................................................. 3

Internal control weaknesses: ................................................................................................. 5

Future: .................................................................................................................................. 8

Conclusion: ............................................................................................................................ 9

Bibliography ........................................................................................................................ 12

pg. 2
Introduction:

The subject discussed in this paper related to the largest Ponzi scheme led by Bernard Madoff.

The scheme led by Bernard Madoff was one of the largest fraud occurring in Wall street and that

made several corporations out of business or go into an economic downturn. Also, this paper

will describe how these plots began and stayed undiscovered for several years. Moreover, we

will discuss how inadequate internal control contributed failed to detect the fraud. In addition,

there will be a section discussing the SEC investigation and what happened to the companies

after the discovery of the schemes.

History:
The introduction of Ponzi scheme was long known before Bernard Madoff. But in terms of

quantity the Bernard Madoff’s Ponzi scheme was the largest of all. The Bernie Madoff scheme is

one of the worst frauds of all time. Bernard Madoff convinced customers to invest by promising

them abnormal returns on their initial investments without investing on highly risky and volatile

investments by actually not engaging in any investors activity. The Bernard Madoff Investment

Securities was founded in 1960, it’s capital was mainly from Madoff’s saving and borrowing from

his stepfather. In the next years, the Bernard Madoff Investment Securities was a well-known firm

in Wall Street due to its largest buy and sell of securities at NASDAQ. The 2008 financial market

crisis was the catalyst to the discovering of the Ponzi scheme. The release of the financial

statements 2008 revealed that the advisory business was a fictitious account and that customers

that served with funds of $65 billion revealed that only $17.3 billion had existed. In the addition,

it seemed that the fund had no legal basis and was never conducted by any legitimate business to

earn profit. As a result, the plot was going around 20 years before the financial crisis uncovered

pg. 3
the scheme. Following the downturn of the financial market in 2008, investors started reclaiming

huge sums of money in the year after which summed to a reclamation of $7 billion from

investments that no longer existed, so it was named the longest and largest fraud. In other words,

he used the same strategy as Charles Ponzi did. Under his role as founder of the Wall Street

Madoff Investment Securities and former non-executive of the NASDAQ stock market, he was

not clear about the strategy used to invest nor any disclosure about where the money came from

and went, nor about his client’s list to verify their own account. The only outcome promised was a

steady and considerable rate of return.

Even though the design of Madoff’s Ponzi scheme was poorly designed and had many obvious

errors (Markopolos, 2010, p.37), the scheme expanded from the United States to Spain, Austria,

Britain, France, the Netherlands, Switzerland, Japan, Italy and Sweden (WSJ, 2009). Madoff’s

Ponzi scheme contained managements firms, commercial banks, individual investors along with

charity organizations. One of the author that wrote a book about Madoff’s investment

mechanism was Harry Markopolos’ Book No one would listen: A true financial thriller (2010),

the author go over how he discovered that something was not adding up to the Madoff’s

investment mechanism (2010, p.38):

At the end of the chart, the Madoff’s investment rose steadily at a 45 degree, which does not

make any sense in finance, there is no rate of return within a perfect 45-degree angle. So, I

concluded that there is no way this is real. This is a bogus.

pg. 4
Internal control weaknesses:
After the discovery of the Bernard Madoff’s unit was just a fictitious account within the Ponzi

scheme, the news outraged the whole economy and was classified as the largest financial crime

ever committed in the history of United States and on an international level. Madoff’s was liable

for approximately $65 billion and convicted for 150 years in prison with restoration of

$17billion (Frank et al., 2009).

Under the scope of auditors and auditors review, KPMG, PricewaterhouseCoopers and BDO

have recommended that investing large funds with Madoff’s Investment securities firm was

secure (Gandel, 2008). This auditors review was not very accurate since KPMG did not have all

of the documents necessary for the audit except for the statements he generated himself

(Gandel, 2008). One of the accounts Madoff was operating in called Rye select indicated that the

valuation provided by Madoff would not be audited independently (Gandel, 2008).

Although, the auditor’s responsibility was to plan and conduct the audit with reasonable

assurance and accuracy as well as professional skepticism where nothing should be questioned

(Gay & Simnett, 2015). In order to be effective in the audit, an auditor needs to have a deep

understanding about the business as well as have a good understanding about the management’s

practices and behaviors and be critical about any representations (Gay & Simnett, 2015).

In addition to that, the representation should be in accordance with the GAAP principle of

truthfulness and fairness and show due diligence while dealing with the engagement and the

planning of the audit, and evaluating scenarios of fraud occurrences. Hence, any material

misstatement would lead to the detection of a fraud. (Apostolou &Crumbley, 2008).

pg. 5
There were some red flags that I will illustrate in this paper. One instance is the fact that Madoff

Investment Securities did not use one of big four firm nor any large auditing firm. They used

instead a small accounting firm, Friehling & Horowitz (Gandel, 2008).

Even though Madoff’s firm had a good reputation in the financial market, it is the auditor

responsibility to give an accurate and fair opinions.

During the audit, the auditor should be more vigilant and concerned about the occurrence of a

fraud that may result in a material misstatement within the financial report. Even though the

auditor’s experience with Bernard’s Madoff Investment Securities regarding the management

integrity and those who are in charge of governance (Gay &Simnett, 2015). The occurrence of a

fraud has to be acknowledge by the auditor mainly during economic downturn or financial crisis.

The second instance is the lack of sufficient internal control. The segregation of duties in

Madoff’s firm is almost scarce in their composition of duties. One illustration is that accountants

are not in charge auditing and identifying issues of investments the company is involved in

(Gandel, 2008).

Even though internal control brings some assurance there is always the possibility of the

occurrence of a risk unexpectedly. Moreover, some commands could be used to override controls

designated to prevent fraud so as a result, internal control is not always the best solution to

overcome fraud.

Under the statement of auditing standard No.99, the corporate governance and the management

of the entity have a major responsibility to prevent and detect fraud (Gay & Simnett, 2015).

Even though with the statement of consideration of fraud in financial statements, the auditor

should have an excellent understanding of management’s practices and code of conduct.

pg. 6
The third instance was the fact that large accounting companies signed off on statements

indicating Madoff’s investment mechanism had billions of dollars in assets. Moreover, it showed

an unprecedented record of positive return.

The American Institute of Certified Public Accountants (AICPA, 2015) that regulates the

auditors and auditing firms sets Generally Accepted Accounting Standards (GAAS) through the

application of the audit of privately owned firms, whereas the Public Company Accounting

Oversight Board (PCAOB) sets standard of public organization’s audits.

As mentioned earlier, the SAS 99 “Consideration of fraud in a financial statement audit

characterize the conception of fraud in auditing and the function of external auditors, also

provides a ground rule in dealing with possible frauds during an audit. SAS 99 formulates that it

is management responsibility to manage fraud. On the other hand, auditors are obligated to

provide an opinion on the financial statements with reasonable assurance, in other words, they

should respect and follow all the guidelines and procedures to be fairly sure that there are no

material misstatements caused by errors or fraudulent activities. To be more specific professional

skepticism should be exercised by conducting discussion with team members if any suspected

fraud and also to make management enquiries and other staff members of the entity.

Furthermore, in case of fraud detection auditors are obligated to convey with the staff in charge

of governance and regulatory authorities.

In internal control, there are authorities that oversee auditors work and auditing firms, the

PCAOB an authority conceived to inspect audit quality under the Sarbanes-Oxley Act 2002

(SOX) to preserve the interest of investors. The SOX 2002 compel auditors who audited

non-public broker dealers, as Bernard Madoff Investment Securities, to be registered and

investigated by the PCAOB. Nonetheless, the time limit for the registration was postponed

pg. 7
several times. Hence, Friehling & Horowitz were not required to enroll and was never inspected

by PCAOB (Roybank, 2009).

Future:

December 2008, Bernard Madoff took a pledge in committing a hefty Ponzi scheme. Following

the purge of Bernard Madoff, the SEC deployed crucial and comprehensive steps to reduce the

possibility of such frauds occurring or being undetected in the future. Nowadays, the SEC is still

improving and making changes to advance in the way it operates. Along other proposals, the

SEC had a set of proposed rules to better conserve the interest of customer’s asset controlled at

broker-dealers. The recommendations would bolster SEC and SRO oversight of broker-dealer’s

conservation practices.

One of those practices is the audit enhancement 8, where a broker-dealer maintains the

guardianship of customers’ securities and cash that may need to experience a compliance

examination by a Public Accounting Oversight Board-registered public accounting firm

incorporating an audit of the controls the broker-dealer has in place to safeguards customer

assets.

Moreover, an integration of changes in the audit requirement for the broker-dealer would be

needed to simplify the inspection of broker-dealer’s registered public accounting firms by the

PCAOB.

pg. 8
One more integration that was added after the post-Madoff Ponzi scheme is advocacy for a

whistleblower program. After the discovery of Ponzi scheme led by Bernard Madoff, the SEC

appealed for the expansion of authority from Congress to support whistleblowers from

retribution and compensate those who bring forward substantial evidence about federal securities

violations.

The Dodd-Frank chartered the whistleblower program, although now it proscribes the retribution

of employers to employees about the communication of sensitive and violating to the

Commission. The implementation was made by May 2011.

Conclusion:
The auditor main responsibility to ensure that management has conveyed risk assessments test.

At the same time management duty is to handle risk assessment, during which auditors should

inspect the process. In addition, auditors should evaluate potential hazard ensure the ongoing

achievements. Professional skepticism should be handled during the inspection of financial

statements especially about internal control and industry-specific business risk that could result

in a material misstatement of contingencies for fraud.

Nevertheless, it is very crucial to ascertain the materiality, also due care needs to be shown in

detecting fraud regardless of materiality.

Under the Corporation Act and Crime act, it is the obligation of the auditor to report fraud.

Any suspicious event or circumstances arises it is the auditor’s duty to inform upper-level of

management.

pg. 9
Madoff’s wrongdoing was not inadvertent but it shocking for regulation and educating

authorities along with the general public the length of time it took regulating agencies to uncover

the scheme.

One consensus from this plot to be learned is that due diligence of auditors is not just about

dropping by for a visit or relying on external opinions. It is an approach that encloses all aspect

of investment strategies of an organization including investment policy, authentication of

investments returns and trading criterion.

Although there is no authoritative book or guideline for due diligence, a know-how of due

diligence gained from experience should complete the process.

The Bernard Madoff Ponzi scheme commemorated due to its longitude and excessive size of

money.

The matter that the scheme was never discovered before was due to the neglect of the SEC to

investigate the organization more in-depth and arrive to the conclusion that the whole

organization has been a Ponzi scheme for over 20 years along with the lack of investigating

practices and acts and follow-up investigations (Hilzenrath, D.S. (2011)).

As a critical analysis of the Bernie Madoff scheme, it elaborates the inefficiency of the SEC and

the missteps taken by the agency along with the changes taken to implement the investigation

process.

Furthermore, lessons were deduced from the Madoff’s plot and provided a framework for

sustaining investors and other regulatory bodies with discovering and preventing corporate fraud

as matter in fact even unrelated ones to Ponzi scheme.

pg. 10
Fraud detection and avoidance is important to discuss the matter and prevent future schemes.

By adopting a proactive model entrenched by investigation principles, companies can severally

reduce the risk exposure and administer their organizations with authentic risk strategies for

management and mitigation principles.

By implementing these strategies, all parties such as companies and investors and regulatory

agencies can minimize the occurrence of fraud and safeguard the investments of their

shareholders and stakeholders.

pg. 11
Bibliography
Markopolos H , 2010 p 37. No one would listen: A true financial thriller . New Jersey , NY,
USA : John Wiley .

Wall Street Journal (WSJ) 2009. ‘Exhibit A: Customers’. The Wall Street Journal online public
resources. Available at:
<http://online.wsj.com/public/resources/documents/madoffclientlist020409.pdf

Frank, R., A. Efrati, A. Lucchetti, and C. Bray. 2009. Madoff Jailed After Admitting Epic Scam.
The Wall Street Journal, Available at: <http://www.wsj.com/articles/SB123685693449906551>.

Gandel, J. 2008. The Madoff Fraud: How Culpable were the Auditors? Available at:
<http://content.time.com/time/business/article/0,8599,1867092,00.html>.

Gay, G. and R. Simnett. 2015. Auditing and Assurance Services in Australia. 6th edition.
McGraw-Hill Australia Pty Ltd, New Sales Wales.

Apostolou, N., and D. L. Crumbley. 2008. Auditors' Responsibilities with Respect to


Fraud: A Possible Shift? CPA Journal 78(2): 32-37.

American Institute of Certified Public Accountants (AICPA) 2015. Code of professional


conduct. Available at:
<http://www.aicpa.org/Research/Standards/CodeofConduct/DownloadableDocuments/2014Dece
mber15ContentAsof2015 April23CodeofConduct.pdf>

Roybark, H.M. 2009. Why Wasn't Madoff's Auditor Peer Reviewed or Inspected? CPA
Journal, 79 (5): 56-57.

Hilzenrath, D.S. (2011). Eight SEC employees disciplined over failures in Madoff fraud case;
none are fired. The Washington Post. Retrieved from
https://www.washingtonpost.com/business/economy/seven-sec-employees-disciplined-on-
failure-to-stop-madoff-fraud/2011/11/10/gIQA3kYYCN_story.html?utm_term=.5e067f6f1a1e.

https://www.sec.gov/spotlight/secpostmadoffreforms.htm

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