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Accounting for the Madoff Fraud

Where's the Guidance?

Mary-Jo Kranacher, MBA, CPA, CFE

When the story of Bernard Madoff's $65 billion Ponzi scheme first broke, the wide-reaching effects of his fraud and the number of victims were unknown. While the scope of this scandal continues to grow, entities charged with providing guidance on accounting, auditing, and tax issues have been missing in action.

Investors and CPAs waited anxiously for the Internal Revenue Service to provide guidance on how losses from “investments” in Madoff's “funds” should be reported on 2008 tax returns. Should they be considered theft or investment losses? Should amended returns be filed for prior years to correct phantom earnings that were erroneously reported? Will Madoff investors be allowed to currently deduct their losses? Or will the IRS assert that there is a reasonable prospect of recovery of investors' losses? If this is the case, or if the IRS claims that the prospect of recovery is not able to be determined, then Madoff investors will not be allowed to deduct their losses on this year's tax return. Thus far, there have been lots of questions but few answers, and the IRS has been publicly silent on these matters.

But the IRS is not the only organization falling down on the job; on the accounting and auditing side, neither the FASB nor the AICPA has stepped up to the plate to address questions related to the Madoff fraud. Let's assume that the items in question are material: Should the balance sheets of companies affected by the Madoff scam be restated? Should these changes be handled as a prior period adjustment for the correction of an error, or as a current-year adjustment? SFAS 16, Prior Period Adjustments, states that correction of an error in the financial statements of a prior period should be accounted for and reported as a prior period adjustment. But what constitutes an error? According to SFAS 154, Accounting Changes and Error Corrections, the definition of an error in previously issued financial statements is “an error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of GAAP, or oversight or misuse of facts that existed at the time the financial statements were prepared.” Investments in a Madoff fund that were reported on a company's balance sheet in a prior year would seem to constitute an error in presentation in the financial statements, but it's not clear from the items listed in the FASB's definition, unless we apply a broader interpretation. Is this list meant to be all-inclusive? Is it appropriate not to consider this an error, because this particular scenario is not spelled out in the pronouncement? What about errors resulting from fraud?

Auditors are looking to SAS 1, AU section 561, Subsequent Discovery of Facts Existing at the Date of the Auditor's Report, for guidance on how the necessary changes should be reported. Essentially, AU 561 directs auditors to determine whether information that relates to financial statements on which the auditor previously reported—but which was not known at the date of the auditor's report—is reliable and existed at the report date. Some auditors are raising questions regarding whether this condition (i.e., the fraud loss) in fact existed in the prior year. If it didn't, the adjustment could be made to the current year's statements; this would bypass all the ugliness associated with restatements.

The Blame Game

When it comes to tough issues like the Madoff scheme, is this really the collective wisdom and judgment of the accounting profession? Or is it the fear of potential liability associated with restatements? Is financial statement restatement equivalent to management or audit failure? And by acknowledging that the financial statements included an error, is an auditor exposing his client and his firm to possible litigation?

The Madoff scheme continues to expose cracks in our financial reporting and tax reporting systems. A lack of leadership by those charged with providing guidance for our profession may tempt some to base their accounting decisions in this matter on their fear of litigation, and persuade others that there is safety in numbers. Let's not let the tail wag the dog.

The majority of CPAs want to do the right thing—to comply with the tax laws, to report the results of their company's operations fairly and in accordance with GAAP, and to render an audit opinion that investors and other interested parties can rely on. Unfortunately, it seems like they're on their own.

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA, CFE. Editor-in-Chief.

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