Question

Explain the failure of proper internal controls in the Bernie Madoff Scheme

Answer 1

The internal governance failures could be analysed from the perspective of the fraud triangle. There are three basic elements of a fraud which consists of pressure, opportunity and characteristic, originated from Donald Cressey’s hypothesis (1973). The slow economic return at that time put pressure on Madoff and in order to maintain a high return to attract more customers, he started to perpetrate Ponzi scheme. As the founder and chief of the company and a high-social-status business man with a good public image, Madoff had all the opportunities needed to prepare false financial statements inside the company and continuously hide the truth from authorities. Meanwhile, Madoff got greedy due to his increased influence and found it hard to stop once started. That was when the fraud gradually came into existence.

Fraud generally happens if

1 There is an opportunity to commit a fraud.

a . For eg if there is excessive powers in a persons hand.

b. There are no checks

2 There is a motivation to commit a fraud

a. Pressure on employee's.

b. Financial obligations

3 Rationalization

This fraud almost involved all types of fraud including collusion with both insiders and outsiders, fraudulent financial statements and asset misappropriation. And there were many other people involved in this case in different ways, which indicated a number of control and governance failures.

Close relationships

Many family members were employed by the company. Madoff’s brother was the chief compliance officer who helped create the computer trading system. His sons worked as traders and his niece became a rules-compliance lawyer for trading division. All these close family relationships could pose a potential familiarity threat, which exposed the company to fraud risks.

Qualification of Staff

Enrica Cotellessa-Pitz, financial controller of Bernard L. Madoff Investment Securities LLC, was not a certified public accountant. She signed on checks from BLMIS to Cohmad Securities Corp. representing commission payments. She was also the connecting person between the company and SEC regarding financial statements. This cast doubt on the company’s recruitment and promotion procedures. If unqualified staffs are recruited or promoted to an important position, this could potentially cause a big problem for the company as they lack the necessary knowledge or experience, which could lead to unsatisfying performances.

Centralization of Power

Management power was substantially centralized in the company. As well as Madoff himself, the chief financial officer in Madoff securities was also involved in the fraud, who were charged with over 10 crimes. Executive power was concentrated and centralized in people at high positions, which could be a serious threat as they may seek for their own benefits. If power had been diversified among different people in the company, along with sound supervision of non-executive directors, the fraud would not have been hidden from public for such a long time.

Internal control system

There seemed to be a weak internal control system in the company. Friehling failed to test internal control as required under GAAP and GAAS standards (Henriques,2009). For example, Friehling did not take any steps to test internal controls over areas such as BLMIS’ redemption of client funds, the payment of invoices for corporate expenses, or the purchase of securities by BLMIS on behalf of its clients. If these had been tested, truth would have been revealed. Apart from external auditors, internal auditors have the responsibility of ensuring a sound internal control system as well. Apparently, internal auditors within the Madoff securities had not performed a standard duty. Meanwhile, document records and independent verification were displaced. Proper documentation would make the work more clearly traceable and easier to investigate.

The COSO framework

Control Environment Operating und Punction Entity Level Division Risk Assessment Control Activities Information & Communication Monitoring Activities

In Madoff’s case, the internal control mechanisms failed to a large degree. There are five components that should support the entity’s strategy and mission in an ’’effective ’’ internal control system. However, in this case, they have been ignored.

1. Control Environment

The control environment in Madoff’s business was not appropriate when, factors like integrity, management's operating style, ethics, delegation of authority system and the management process were minimised or ignored.

2. Risk assessment

Risk assessment was ignored by unskilled and understaffed accountancy firm.

3. Control activities

Activities like approvals, verification and reviews of assets were not performed in Madoff’s business in order to hide the fraud.

4. Information and communication

Effective communication with regulators did not occur in Madoff’s business and the information system played a significant role in Madoff’s scheme, because it didn’t give an insight to other authorities about the organization, the direct opposite of what it should have done.

5. Monitoring

The internal control system did not really exist in Madoff’s business, everything was designed to hide the Ponzi scheme. Therefore, there were not any monitoring of activities, separate evaluations and no actions were taken to correct them.