Accounting Ethics (and fraud)

Postings by Art Berkowitz on ethics and fraud. Most of them are serious, but sometimes we also need to have a little fun.

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Location: Orange County, California, United States

Art Berkowitz, C.P.A. is an author, speaker, and consultant from Orange County, California. He writes ethics, fraud, and accounting courses (CPE) for accountants and other financial professionals. Art has also written a weekly online column for The Wall Street Journal and a book on the Enron debacle. To order any of his self-study courses go to

Thursday, March 19, 2009

The Bernard Madoff Quiz - What would you have done?

Although I retired from my accounting practice, I still author courses on ethics and fraud and occasionally present live programs on those topics. In my latest course on accounting fraud, I included a discussion of the Bernard Madoff scandal as personally experienced by me. Several of my clients had investments with Madoff and lost a substantial amount of money. The brief discussion is followed by a quiz asking what you would have done at the time and now with hindsight how would you have reacted.

Case Study – Bernie Madoff (Part I)
As part of your accounting services you provide limited financial planning services to your clients. One of your new clients (a middle aged married couple) asks you to review their portfolio and make recommendations for investing an additional $100,000 they currently have in cash. In reviewing their portfolio you note that the client is adequately diversified for their age between fixed income and equities.

The equity portion of their portfolio is heavily weighted (approximately 35%) in an investment with a private money manager named Bernard Madoff. Those securities have outperformed all the other investments by 3-4% per year. When you ask the client about the investment, they tell you that they feel lucky that they have been able to get Mr. Madoff to accept their account. His minimums are usually over $1 million, but because several of their friends also invested with him at the same time, he waived the minimum and took their investment of $250,000. They further told you that Mr. Madoff was formally president of the NASDQ and has a track record of over 25 years of beating the S&P 500. You do your due diligence and confirm your client’s statements about Mr. Madoff. He does indeed have a long term track record and was one of the founders of the NASDQ. On Wall Street, he is considered something of a guru, not unlike Warren Buffet, but with a different emphasis.

Questions (assuming no prior knowledge of the Madoff scandal):
What recommendations would you make to your client about the existing 35% investment with Bernie Madoff?

What recommendation would you make regarding the $100,000 they currently have in cash? How would your recommendation be affected if your client tells you that they would like to give the additional $100,000 to Madoff to invest?

With the information you have at this point in the case, is there anything else that you should do?

Case Study – Bernie Madoff (Part II)
It is now tax season and your new client has asked you to prepare their tax returns. You provide them with a tax organizer, which they fill-in reasonably well. You also ask them to include their W-2s, 1099s.

While reviewing their information you note that their investment in Madoff Investments does not have a 1099B for sales or a 1099 DIV or 1099 INT. Instead you receive a multi-page printout listing hundreds of transactions that were made during the year. You ask your client when they will be receiving the 1099s from Madoff and they show you the cover letter that says to call a specified number if you or your tax professional has any difficulty in using the information provided to prepare the client’s tax return.

So you call the number provided and speak with a representative from Madoff (later you learn it is his accounting firm). The Madoff representative explains how to use the summary sheet to record the total sales for the year, where to pick up the dividends and interest, and how to back into cost basis using the totals on the summary for gains and losses. In addition there is another printout that must be used for options trading, which is how you were told, Madoff makes the extra percentage gains on his investments. You also learn that the gains and losses for the options must be recorded on the tax return according to “the 60/40 rule” where 60% are recorded as long term and 40% as short term no matter how long they are actually held. In addition, all open options from regulated contracts are marked-to-market at year end.

In recording the information on the tax return, you notice that the total sales for the year are over $5 million.

Questions (assuming no prior knowledge of the Madoff scandal):
Should you mention to your client that the $5 million in sales may draw the attention of the IRS, because of the relative size of that number compared to the rest of the return?

Should you discuss with your client the possibility that their account is being “churned”[1]?

Based on the information you have thus far in the case, what further information do you believe you need in order to prepare the tax return with regard to the Madoff investment?

Case Study – Bernie Madoff (with hindsight)
We now know the Madoff investments for some period of time have been fraudulent.

Were there indicators that might have caused you to react differently with regard to your client’s investment?

With the advantage of hindsight, what additional due diligence could you have performed?

With regard to the financial planning
With regard to the tax preparation

Do you currently have any clients that you might need to consider whether or not there may be some inappropriate actions taking place?

If you run across a similar situation in the future, do you feel any more comfortable about how to handle it? Would you report such a situation to the SEC, IRS, or other regulatory body?
[1] Churning – the excessive purchase and sale of investments to generate higher commissions.

Monday, August 21, 2006

This is One of those Moments

After 28 years in accounting, I will be taking down my shingle in just a little over a week.

I have been eagerly talking about the official date - September 1, 2006 - with a great deal of anticipation. But as I was driving to San Luis Obispo from my home in South Orange County to present my last three seminars, there was also a bit of sadness as the realization that a lifetime of work was coming to an end.

It was on the Pacific Coast Highway with the sun glistening off the water that I began to get a lump in my throat. Earlier in the day I had found it amusing that it took me nearly ten minutes to select which suit I was going to wear for that "final seminar". Now I was thinking about the multitude of clients that I had tried to help straighten out their books or get a loan or improve their personal financial condition so they could have that retirement or vacation or even that sports car they wanted.

But most of all I was thinking about the past half dozen or so years that I have spent working with my colleagues to help restore the nobility and sensibility of a profession that for far too many seems to have lost its direction.

Perhaps it was nothing more than being in the right place at the right time. But these last few years of challenging the direction we had taken, asking the tough questions, and sometimes even lecturing about professionalism and ethics seemed pretty important at that moment.

I was listening to a CD from the movie, Yentl, when these words from Alan & Marilyn Bergman seemed to capture everything I was feeling.

There are moments you remember all your life. There are moments you wait for and dream of all your life.
This is one of those moments.

Thursday, June 15, 2006

Some Fun with Accounting Definitions

I noticed that consulting giant Deloitte Consulting released a software program – Bullfighter - that identified and helped eliminate business jargon. Author’s Note: On Deloitte’s website it states that they are no longer associated with any product that tries to make financial information clearer to the investor (or something to that effect.)

I thought it might be helpful to investors if I defined a few important accounting terms in light of recent corporate events.

Balance sheet – a place to hide the other side of a fictitious transaction.

Income statement – a description of the money that companies don’t really make, but show to investors.

Cash flow statement – a description of how companies take money from their investors and give it to their top executives.

Accountant – someone hired to explain how companies really made more money than they actually did.

Accounting standards – a group of words that allow companies to do anything they want to do.

Big bath – How companies take a $2 per share loss and make it into a $4 per share loss so next year’s loss won’t look nearly so bad.

Bottom line – the tip of the iceberg.

Derivative – a financial instrument that is derived with the idea of stealing your money.

Financial instrument
– similar to a medical instrument used for small, dark places.

Off-balance-sheet financing
– a technique used when you can’t find a reasonable place to put the other side of the entry.

Principles vs. rules – a choice of ways that accountants and companies can use accounting standards to confuse investors.

Smoothing – a technique of reversing reserves that shouldn’t have been recorded in the first place.

Stock options – a financial instrument where the company has the option of screwing the IRS or the investors.

One of my favorite ways to use business jargon is through circular definitions – where one term is defined by another unintelligible term. However, sometimes this method can be very informative.

Enron – see Global Crossing
Global Crossing – see Adelphia
Adelphia – see Xerox
Xerox – see Tyco
Tyco – see Health South
Health South – see WorldCom
WorldCom – see Enron

Of course, every one knows that I am just kidding and having a little fun. Obviously a statement of cash flow is really a place where companies hide money they give to influential politicians so real solutions to serious problems will never take place.

Sunday, May 28, 2006

A Story of Moral Courage

In a sad, but uplifting story, I am writing this entry to tell you about the passing away of one of my hometown football legends who was much more than a great athlete. His name was Joe Brodsky. Joe passed away this past Thursday, May 25, after a long battle with prostate cancer. He was 71. Joe played for the FIRST local Miami football team ever to beat Miami High School. Miami High was a national power that in the earlier days of the 20th century often played junior college teams or out-of-state powerhouses, because there was no one locally who could compete with them.

Joe was an All American high school player at Miami Jackson High school and then became an All American college player at the University of Florida. If you go on the University of Florida website, you will find that some of his records still stand today! For over 40 years, his record for interception return yardage stood as an NCAA record.

But his greatest accomplishments were as a coach and family man.

As coach, he led two different high schools to state championships - Miami Jackson and Hialeah Miami Lakes - and then was a coach of an NCAA (University of Miami) and a Super Bowl championship team (Dallas Cowboys). He is the only coach to have ever done that! (That's a good trivia question).

Joe helped develop numerous running backs who went on to successful pro careers. While at the Dallas Cowboys, he coached Herschel Walker and helped develop Emmitt Smith and Daryl Johnston, both of whom won Pro Bowl accolades. He also had a tremendous sense of humor and provided an honest and forthright assessment of what took place during a game or at the team’s practice. Reporters often sought him out for quotes for the next morning's news.

Joe also had two children who became star athletes after playing for him in high school. He had the added pleasure of coaching the Hialeah Miami Lakes football team to a state championship with his son Joe, Jr. playing quarterback and his other son, Larry, playing receiver. In an interesting twist of fate, Larry played with Herschel Walker when they both were with the New Jersey Generals of the USFL and played on the first USFL game ever televised.

For a coach to be monetarily successful, he has to be willing to constantly move from job to job and city to city. What impressed me most about Joe was that he turned down numerous offers so that he would not have his family traipsing around the country, even though he saw some of his closest friends become nationally recognized sports figures. One of them, Lee Corso, played high school football with Joe. Lee is one of the most prominent broadcasters in college football today and previously had successful stints at several colleges across the country. Lee could often be found over Joe’s house. I remember seeing them both at Thanksgiving dinner on more than one occasion. But Joe was satisfied being a great teacher and a wonderful husband and father.

How do I know all of this? You see Joe Brodsky was also my cousin and someone I am proud to say I knew. Joe was truly a man of moral courage.

Friday, April 21, 2006

Some Additional Thoughts on ENRON

I don't know how many of you have been following the trial of Jeffrey Skilling and Kenneth Lay of Enron infamy. But I have been reading the daily reports from the Wall Street Journal and Houston Chronicle - as well as a lawyer's blog, Enron Trial Legal Commentary. They give an interesting day to day perspective of what has gone on in the trial.

However, the New York Times just published an opinion column with a perspective on the eight days of testimony of Jeffrey Skilling. What I found particularly interesting was a quote from Mark C Zauderer, an attorney who deals in white collar criminal law, "At the end of the day a trial like this is a morality play. It is not just what happened, and who said what to whom, but who is an honest person."

If Mr. Zauderer is correct, I have considerable doubt whether the jury will be able to reach a guilty verdict in this trial. All that Mr. Skilling and Mr. Lay need is one juror who recognizes his own human frailties in the two defendants. The way things have been going in this world, the percentage of people in our society who are capable of greed or arrogance is a whole lot higher than one out of twelve. They might also identify with someone who could justify lying for a particular cause (or as Mr. Skilling put it, "Perhaps I loved Enron too much").

You might notice that the words guilt and innocence never enter into the equation; nor does the actual question of whether the actions were indeed moral or ethical. No, it is possible that Mr. Skilling and Mr. Lay may receive a pass from a society who seems to have no problem with cheering for their local sports hero who abuses women or enjoys watching strangers make secret deals to vote someone off an island.

After all, it is only a game...and what Enron and other similar companies did in the latest round of corporate scandals was also just a game, unless you happened to be one of the thousands who lost their jobs or savings or had their lights turned off just because someone could.

Wednesday, March 22, 2006

Open Letter to the California Board of Accountancy

Now that the issue of practice privilege has been temporarily dealt with, I would like to see the California Board of Accountancy (CBA) get back to its primary mission – to protect the public.

I understand that this may seem overly critical, but I believe the CBA has lost its focus over the past few years since the large accounting scandals hit the press. Too much time and energy has been spent in areas that should be addressed by the SEC, the PCAOB, the NYSE, NASDAQ, and other national regulatory agencies. The limited budgets, staff, and state-oriented focus do not make state boards of accountancy the most effective place to deal with large multi-state issues.

For example, I don’t believe that standard setting (such as California’s documentation standards) is the proper role for a state board of accountancy - not that the focus put on the issue did not have positive affects on getting the other organizations to act.

Let me share an example of what I believe are the more critical areas for state boards of accountancy and especially for CBA.

Last week I received a call from a practitioner who wanted me to help him with the preparation of a reviewed financial statement of a not-for profit organization. After asking him a few questions, I learned that he had not prepared a financial statement of any kind (compiled, reviewed, or audited) in many years and was not familiar with the special characterisitcs of a not-for-profit organization. I soon learned that he did not feel he had the time and was not interested in taking appropriate courses or obtaining the appropriate resources such as Practitioners Publishing Company’s Compilation and Review or Not-for-Profit guides. Finally I suggested that he compare the situation to me being asked to prepare an estate tax return for the first time. I suggested that he joint venture the engagement with an experienced practitioner from his local area.

I could hear from his tone that this was not what he wanted to hear. He just wanted a quick fix.

I tell you this story because it is not uncommon for me to get these kinds of calls or questions at one of my seminars. It is way more common than many in our profession would want you and the public to believe. While certainly not a majority, I believe that the number of practitioners who do not see themselves as professionals, is large enough that significant harm is being done to the public and businesses in California.

What Can the California Board of Accountancy Do?

1. The CBA should immediately reinstate the Section 89.1 program of financial statement reviews.

2. Peer review should be made mandatory NOW, not years from now.

The focus of these programs should be on practitioners and firms that opt-out of the AICPA program. While we can all debate the relative merits of the AICPA program and the PCAOB program for public companies, these programs do exist. The most immediate problem is practitioners who skip through the system and have no inkling of what they are doing or that what they may be doing is wrong. They are not helping their clients who rely on their financial information or outside users, who lend, borrow, bond, or invest based on insufficient or erroneous information.

There is one other area, I believe should be of the highest priority for the CBA - that is improving the services to their constituencies. This means more staff and more funds.

I find it hard to believe that the Board chose to reduce their budget and reduce the fees charged to practitioners at a time when so much more needs to be done. Practitioners constantly complain to me that they cannot get anyone at the CBA to return their calls. The “Quarterly” Update from the CBA should be quarterly once more. The public also needs far better information of what they should expect from licensed practitioners and why it is important for them not to get slipshod work.

I hope this letter is not disregarded because of my strong positions, but is used as a first step in reexamining the CBA’s methods of meeting its mission for protecting the public.

Sunday, January 22, 2006

ENRON: The Smartest Guys in the Room

I just finished watching Bethany McLean and Peter Elkind's's movie, ENRON: The Smartest Guys in the Room. The authors and the movie deserve all the credit they are receiving. Apparently it has a good chance to win the Oscar for best documentary of the year.

The Culture of Enron

The movie focuses on the culture and influence inside Enron and how such a culture can subvert many normally ethical people. It also clearly delineates the key arguments against the "holy" triumvirate of Kenneth Lay, Jeffery Skilling, and Andy Fastow.

Bethany McLean, from Fortune Magazine, was one of the very first news reporters who questioned the accepted mantra on Wall Street that Enron's business plan was above reproach.

What makes this movie (and/or) book a must for accountants and others with review or regulatory responsibility is that it so clearly shows how easily this kind of abuse can take place...and what needs to be done to prevent it from happening again. I also liked the way the director presented the subject in a very entertaining way - describing the macho trips taken by key Enron executives and comparing them to the high risks taken inside the company. I watched the movie with a friend who initially had no interest in a movie on accounting, but she loved it. That's because Smartest Guys in the Room is really a human interest story told in a business setting.

California Electric Crisis

Special attention is given to the California electric crisis as the author and director have been able to obtain copies of the actual audiotapes used by Enron traders. It is both frightening and disheartening that these traders were able to disconnect the results of their actions - that millions of people would be without power - from their sole focus - making millions of dollars for Enron and themselves. So what if they had to create artificial shortages to do it. That was all part of the deregulation game.

There are some super bonus materials in the DVD including interviews with the director and authors.

Another Story that Must be Retold

The Enron story is an important one that needs to be told over and over and over again - from different perspectives and to different audiences. This is the one version that bridges the gap between the technical insider information version and the broad ethical perspective version of what and why it happened.

We should never forget,
Power tends to corrupt and absolute power corrupts absolutely. Great men are almost always bad men, even when they exercise influence and authority; still more when you superadd the tendency or the certainty of corruption by authority.
- Lord Acton (1887)

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