Madoff's Scheme

Most investors can't resist a sure thing; after all, Bernard Madoff was promising—and consistently delivering—annual returns of 10% to 25%. What investors didn't know, until recently, was that those returns didn't come from earnings on their investments, but allegedly from a return of capital—someone else's capital.

With the benefit of hindsight, and after reviewing the details of Madoff's alleged $50 billion Ponzi scheme, it is easy to recognize the red flags that should have given pause to the many investors who placed their money with him. Some news articles on this story have pointed to the lack of asset statements from an independent bank custodian as a tip-off that should have alerted the auditors. Additionally, questions have been raised about whether an auditing firm of three people, one of whom was the secretary, could have handled such an engagement adequately. But what about the auditors of those organizations that invested with Madoff? That list includes some of the largest accounting firms. Shouldn't they have been able to detect that something was wrong, given the size of the fraud?

Ironically—but not surprisingly for any-one familiar with the modus operandi of white-collar criminals—Madoff was a well-respected individual, professionally and personally, before his alleged fraud became public knowledge. He was the former chairman of the Nasdaq, and held positions of prominence in his community. It is the classic tale of betrayal of trust.

India's Enron

On the heels of the Madoff scandal came an international fraud involving a public company called Satyam Computer Services, Ltd., India's fourth-largest information technology company. This episode has been referred to in the international media as “India's Enron” because, like Enron, Satyam won recognition in its country for innovation and corporate governance; that is, until the company's founder and chairman, Ramalinga Raju, admitted in a recent letter to the company's board of directors to perpetrating a fraudulent financial statement scheme.

According to the letter, the company's September 30, 2008, financial statements included an inflated cash balance, nonexistent accrued interest, an understated liability, overstated receivables, and overstated revenue. Raju acknowledged that the fraud was ongoing for several years, and although it began with small amounts of fictitious profits and cash accounts, it grew to more than a billion dollars.

Unlike the Enron fraud, which used special-purpose entities and off–balance-sheet transactions to defraud investors, Satyam's scheme was ludicrously simple—reporting assets and revenue that didn't exist. In fact, approximately 94% of the cash reported on the company's balance sheet was fictitious. This has led many to ask the obvious question: How did the auditors audit cash that was nonexistent?

The sheer magnitude of these frauds makes one wonder how they slipped through the cracks of the financial reporting system for so long. Yet fraud was neither detected as a result of the regulatory process nor through an audit, but rather through self-incrimination. Madoff's family turned him in to authorities after he admitted the details of his scheme to them. Raju himself confessed the details of his fraud in a written announcement.

What's Beneath the Surface?

As the Madoff and Satyam scandals make glaringly clear, our financial reporting system has a long way to go in the area of fraud detection. Does an economic downturn cause an increase in fraud? Perhaps, but the Madoff and Satyam frauds began long before our current financial crisis struck.

It's been said that a rising tide raises all boats; maybe an economic downturn simply causes us to discover frauds that have been ongoing for years because, like low tide, it exposes all the rubbish that had been hidden beneath the surface.

As always, I welcome your comments.