The $50 billion Madoff Securities scandal could have been prevented easily. So could much of the corporate and investment fraud that's taken place over the last couple of decades. Why? All these frauds shared at least one thing in common -- the people who committed them all produced their own financial statements. In my limited experience in academia, I have never seen a single student grade their own test or paper. So why should business executives be able to write their own report cards?
We don't know much about the Madoff scandal, but there's no question that Madoff securities could not have gotten away with it if a completely independent entity had been generating financial statements for investors. Instead of spending decades cranking out fraudulent statements that showed investors making 10% returns each year, an independent auditor would have stopped Madoff in his tracks.
Of course, for such an independent entity to work correctly, it would need to be structured, paid and staffed in the right way. As I suggested in Value Leadership back in 2003, the government would create an independent group of auditors who would create financial statements for investors. This group would be paid from taxes levied on corporations and its people would be promoted based on their ability to geneate timely, accurate, and thorough financial statements.
This group of auditors would have access to the details of each corporate transaction and it would be able to reconcile those transactions with bank records. I am not suggesting that this idea would eliminate all fraud but it would go a long way to reducing it to a trickle. It would be critical to keep this government entity from being corrupted -- but I am fairly confident that it would be better than the current system.
When corporate management has a huge financial incentive to cook its books and the auditors are getting paid by management, it is just too tempting to allow fraud to continue. And if people don't trust our financial and business leaders, they'll just keep their money in their mattresses.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits and edits The Cohan Letter.
Entrepreneur's Journal: Want to get a piece of the Buffett/Goldman honeypot?
The week in preview: No turkey earnings from Tyson, Hormel, Cracker Barrel ...
Comfort Zone Investing: Intel is saying something ... can you hear it?
Reader Comments (Page 1 of 1)
12-13-2008 @ 3:34PM
Peter said...
Simply have a third party custodian holding the assets and doing the monthly reporting. I don't think you need a government bureaucracy to accomplish this. Many registered investment advisors do not custody client assets but simply report performance to their clients. It would be pretty difficult to report 15% a year returns with a monthly statement from the custodian showing a zero balance.
12-13-2008 @ 9:37PM
hank said...
Sounds simple -- but isn't this one of the ideas that was quickly defeated during the New Deal, in favor of letting the accountants do what they thought was good enough and 'generally acceptable' in their profession?
I saved references when I was reading in this area years ago -- these used to be available online, but I think they're now paywalled --- they'd be worth finding, to consider what happened last time.
---------------------
Merino, Barbara D. Financial Reporting in the 1930s in the United States: Preserving the Status Quo, Accounting Forum, 2003, pp. 270-290.
Merino, Barbara D. and Mayper, Alan G. “Securities Legislation and the Accounting Profession in the 1930s: The Rhetoric and Reality of the American Dream.” Critical Perspectives onAccounting, August 2001, pp. 501-525
12-13-2008 @ 7:06PM
william lindblad said...
Better solution - INTEGRITY - 100% effective.
Unfortunately, in today's world it is little more than a word in the dictionary.
12-14-2008 @ 4:42AM
BHarrison said...
FINALLY, at last an article about the crux of the entire matter; it is all about the "common sense" of establishing INTEGRITY in the market.
A major problem that has paralleled and promoted most of the FRAUDS has been FRAUDULENT CCOUNTING PRACTICES . . . and the use of "creative accounting practices" that enabled corporations to hide the massive frauds of the "derivatives".
Gong back to the frauds of the Silverado Savings and Loan scandal in the 1980s, the ENRON debacle, and now AIG, etc., etc., etc., ALL of these pyramid and Ponzi schemes were possible because of the lack of INTEGRITY of the financial reports, even those that WERE provided by many financial auditing firms.
Too many of even MAJOR financial auditing firms became complicit in tacitly defrauding the investors by use and/or acceptance of "creative (and deceptive) accounting "pracitces" . . . and many of those accounting firms collapsed.
After the extent of the recent MASSIVE FRAUDS that have brought our national economy to the point of bankruptcy, the interest of the public and society as a whole, over rides the interests or "rights" of FIs or corporations.
The government needs to establish the structure and requirements for use of certified independent auditors . . . and there should be complete "oversight and regulation" of the financial auditing. As we have seen, and are experiencing this is simply too critical for the economic health of our nation.
To those who would oppose such actions, I would note that if we had had independent auditors in place since the 1980s, practically NONE of the financial debacles would have occurred. Those who do not want "oversight and regulation" are those who are in bed with the fraudsters. This current economic melt down based on the massive amount of pyramid and Ponzi schemes speaks for itself.
Industry "self-regulation" simply does not work; and government regulation be adequate to maintain integrity of the markets without being "stiffling".
Our national recovery will depend on establishing "INTEGRITY" in our stock markets and our corporate enterprises. Isn't it odd how the fraudsters always try to ignore or to bash "common sense"?
12-14-2008 @ 5:50AM
BHarrison said...
"Keeping things "simple"" and the use of "common sense" would probably eliminate 98% of the financial fraud that occurs.
As we have seen and experienced, overly "sophisticated" and "creative accounting practices" generally only "benefits" the special interests groups and "insiders" . . . . and more times than not, has some nefarious basis to defraud the "average investors".
The corporate attorneys and some accountants are always looking for ways to stretch the profit margins to satisfy management. There has to be independent auditors to maintain INTEGRITY in the business enterprises and markets. Industry self-regulation simply does NOT work in the long run.
Anyone with experience with the states' various DBPR - Depts. of Business and Professional Regulations, know that such government agencies tend to be highly "inefficient and ineffective"; it requires an enormous amount of time and effort to gain judgements against "wrong doers". But it doesn't have to be like that with financial auditing firms as long as overly "sophisticated", and "creative accounting practices" are not allowed. these normally turn out to be scams anyway.
The "best legitimate interests of society" must override the greedy corrupt interests of the "scammers and gamers" of our financial and business world. We now unequivocally see the end result of the lack of integrity in business and government; it has literaly destroyed our economy and business environment.