Berny Madoff’s Ponzi scheme

Globalization has necessitated the need to develop a code of ethics for different professions, due to the need to streamline operations across the globe. The accounting profession is one of these professions which is regulated by the code of ethics. The major purpose it serves in this profession is to prevent misconduct of accounting professionals, and develop a standard way of presenting accounting information. However, despite the presence of these regulations, serious scandals such as fraud still occur in many companies. There has been an increase in financial scandals in various US companies, and most of them can be traced to lack of controls and disregard for the code of ethics. The code of ethics has been ignored by many professionals, a fact which has led to the emergence of these scandals. The Berny Madoff ponzi scheme is one such scandal, which has caused huge losses to various banks and other institutions. The paper will discuss this scandal in relation to the accounting code of ethics, and their role in preventing such scandals. Berny Madoff ponzi scheme. Bernard Madoff masterminded what may be the largest stock fraud in history committed by an individual. He confessed to having masterminded a ponzi scheme, through his firm Madoff Securities, which led to losses amounting to over $50 billion (Zambito and Smith 2008). A ponzi scheme is a fraud which involves payment to investors, out of funds received from previous investors, rather than profits. Madoff used a strategy of investment called the split-strike strategy. It involved purchasing stocks, and simultaneously purchasing options, to guard against losses, and these were known as ‘puts'. In case the cost of the ‘puts' went down, Madoff would trade in ‘calls', which involved trading these stocks to buyers who aimed at profiting from small gains. This strategy ensured that he made small profits in cases where shares appreciated in value, after numerous trades. However, with time, some financial analysts began questioning the profits that Bernard made from these transactions. They were concerned that his methods of investment were incapable of earning the level of profits he enjoyed, and recommended an investigation on his activities (Henriques A1). In fact, Madoff Securities were investigated for over eight times by the regulatory bodies. The investigations did not find major problems, since they were not looking at the in-depth operations of the firm. Some analysts actually suspected that it was a ponzi scheme way before it became clear to investigators. They questioned the use of an audit firm with only one auditor and accountant. They also questioned the unusual strategy which involved avoiding disclosure of SEC holdings, through selling them for cash after each period. In the beginning of 2008, the market downturn revealed that Madoff Securities were in fact dealing in a ponzi scheme (Naidu 2008). This was as a result of several requests by investors to withdraw their money, which amounted to $7 billion, and Madoff could not honor their requests. He was forced to confess the truth to his sons, who reported him to the authorities. He was subsequently indicted in December last year. Role of strict standards in the accounting profession. The accounting profession requires ethical guidelines which are used by both the accounting professionals and their clients (Carey and the American Institute of Certified Public Accountants 1-5). The strict standards are beneficial to all stakeholders in a business. We will analyze the role of these ethical standards according to various stakeholders. Accountants. In these modern times, globalization has transversed boundaries and connected the world. This has led to the emergence of multi-nationals, with branches in different countries. Since the parent company has to standardize its accounting reports across several branches, it is necessary to present a global standardized way of preparing and presenting accounting reports to stakeholders. Examples of accounting standards are the IFRS and GAAP accounting standards. This is one purpose that accounting ethics serve, and it enables companies to easily compare their performance with others. Accounting ethics also helps accountants to maintain integrity and professionalism in their profession so that it may remain respectable and profitable. Ethical standards such as professional competence, objectivity and confidentiality help the accountants to prepare accurate and complete financial reports. Flouting these standards leads to consequences such as de-registration from the professional body, suspension of the practicing license, criminal liability among other consequences. Madoff flouted these principles through committing fraud, a situation which led to criminal proceedings being preferred against him. He now faced the possibility of spending a long time in jail, as well as paying heavy fines. Investors. Investors require knowledge about market trends and stock movements before making investment decisions, in order to get favorable returns on their investment. After investing in a company, investors are very interested in knowing the performance of the company in order to make investment decisions. In order to facilitate this, it is important to prepare accurate financial statements which enable investors to make proper adjustments in investment. The accounting code of ethics helps in achieving this purpose through enabling accountants present the true state of affairs of a company. In the case of Madoff Securities, the disregard of the code of ethics has led to the apparent loss of over $40 billion by investors who include companies, banks and individuals. Some investors, such as Martin Roseman who lend Madoff $10 million, have sued him in order to get back money they are owed. Financiers. Before a company can receive a loan from a financier such as lending institutions, there are various aspects which are analyzed. One aspect is the financial performance of the company. If a firm performs financially well, then the financiers are confident that they will be paid back, with minimal risks. However, firms which perform poorly have higher chances of defaulting on payments and are less likely to receive loans from financial institutions. As a result of this, firms may be tempted to misrepresent their financial position in order to obtain financing. Madoff Securities can be said to be one firm which engaged in this practice, since the firm could not survive without additional funds from new investors, in line with operations of a ponzi scheme. The code of conduct comes in, in such a case, to discourage these practices. Accounting principles such as prudence requires that firms do not understate their expenses or overstate their assets, in contrast to operations of ponzi schemes. This is beneficial to financial institutions since it enables them to finance companies with minimal risk. Accounting principles responsible for Madoff Securities collapse. Several accounting principles which were broken, were responsible for the financial collapse of Madoff Securities. One principle, prudence, requires that accountants anticipate losses and make provisions for them early enough (Kwok 30-38). It also requires accountants not to overstate the value of their assets (Marriott et. al. 221-223). Madoff Securities did not provide for the losses attributable to fraud, and actually concealed them over several years, through the use of subsequent investor deposits. When they were finally revealed several stakeholders were affected, among them some charitable organizations which had to close down due to reliance on this firm (Storm 2008). According to Warren et. al. (34-35), another principle of accounting is the matching concept. This concept states that expenses which are incurred in the course of generating revenue should be recognized during this period. This is done to ensure that comparison between revenues and expenses of a similar accounting period can be achieved (Eskew and Jensen 40-42). This is very important in making business decisions. In the case of Madoff Securities, expenses which the company incurred were matched with future revenues in order to conceal the fraud. This means that the accountants did not follow the matching concept, which was responsible for the accrual of huge expenses over the years. Accounting standards require that the accountants present the true state of affairs of a company. Misrepresentation of the state of affairs is a violation of these standards. Madoff Securities misrepresented the financial position of the company, presenting it as a profitable firm, yet it had significant liabilities. This misrepresentation attracted new investors, which led to the company owing over $50 billion to investors at the time of collapse. Conclusion and recommendation. Bernard Madoff's ponzi scheme has been seen to have affected very many local and international investors. The ignorance of the code of ethics and accounting principles that have been discussed was a major factor which caused this scandal. The code of ethics in accounting helps to protect the interests of all stakeholders of a company. It also makes it easier for companies to compare performance, due to standardization of accounting report preparations and presentation. Madoff forgot one fact about ponzi schemes; they eventually collapse due to the inability to handle sudden withdrawals by investors. The economic meltdown played a role in exposing this scheme. It is important that the role of the market regulators with regards to the scheme be thoroughly investigated, since several warnings were given prior to detection of the scandal. If the authorities had acted sooner, the loss would have been lower than it currently is. The stock regulatory authorities need to establish measures that deter such practices. One of them would be to scrutinize transactions of companies with the aim of detecting irregular and unethical accounting practices. The next course of action would be to investigate the detected suspicious trends, even if the actions are not entirely illegal. This will minimize the risk of loss attributable to fraud, by investors in the stock market.