ISSUES IN ACCOUNTING EDUCATION

Vol. 29, No. 1

50597
2014
pp. 271285

The Madoff
Lessons?

American Accounting Association

DOI:
10.2308/iace-

Debacle: What are

the

Srinivasan C.
Ragothaman
ABSTRACT: This paper describes the implementation of a Ponzi scheme case study
in auditing classes at the undergraduate and the Masters level. This instructional case
is based on the much-publicized Madoff Ponzi scheme. The case exposes students to
several auditing-related concepts, including: (1) fraud auditing; (2) ethical reasoning
and utilitarian principles; (3) affinity fraud and Ponzi schemes; (4) internal control
evaluation;
(5) governance issues; (6 ) the Securities and Exchange Commission (SEC)
investigations; (7) investment strategies and terminologies; and (8) regulation. The
case provides students with an opportunity to assume the role of an external auditor
and participate in some active learning exercises. About 170 accounting majors
participated in this case project during a three-year period at a Midwestern university.
Students who worked in groups were genuinely engaged in the learning process, and
they came up with several red flags associated with the Madoff fraud and suggested
many new internal controls. This case provides a hands-on learning experience to
students that could be relevant for them in their future career in public accounting.
Student opinion surveys conducted about the learning outcomes of this project indicate
strong student engagement, active learning, and satisfaction.
Keywords: Ponzi scheme; fraud risk factors; afnity fraud; control environment;
utilitarian ethics; professional skepticism.

CASE INTRODUCTION

he Federal Bureau of Investigation (FBI) arrested Bernard L. Madoff (hereafter, Mr.

Madoff ) on a rainy morning in December 2008, based on tips from his two sons. They
confiscated dozens of checks, totaling $173 million, that were made out by him to his
close
friends, key employees, and family members. Mr. Madoff was charged with multiple felonies,
including securities fraud, investment advisor fraud, mail fraud, and wire fraud. The U.S. District
Court Judge in New York City released him on a $10 million bond, gave orders to put electronic
bracelets on him, and confined him to his Manhattan apartment. It was a disappointment for the
prosecutors, who wanted him jailed. However, the prosecutors got their wishes when the judge
also ordered Mr. Madoff and his immediate family members to not sell or transfer any personal
assets.
Srinivasan C. Ragothaman is a Professor at The University of South Dakota.
Comments received at the Effective Learning Strategies Forum of the American Accounting Association Annual Meeting
held in Denver in August 2011 and from Angeline Lavin, Nolan Goetzinger, Pearl Nielsen, the editor, and an associate
editor are appreciated. This manuscript has benefitted from substantial comments offered by two anonymous reviewers.
The usual disclaimer applies.
Editors note: Accepted by William R.

Pasewark

Published Online: August 2013

271

27
2

Ragothaman

The FBI confiscated the passports of Mr. Madoff and his wife, Ruth. A federal judge froze the
assets of Bernard L. Madoff Investment Securities LLC (BMIS) and a receiver was appointed to
handle the case (Henriques 2011).
Overview of Bernard Madoff Investment Securities LLC
After his high school graduation in 1956, Mr. Madoff attended The University of Alabama for
a year, where he was a member of a Jewish fraternity. He transferred to Hofstra University in
1957 and graduated with a degree in political science from Hofstra in 1960. Mr. Madoff and his
wife held several small jobs in the early years, including installing sprinklers, babysitting, and
performing lifeguard duties in Manhattan (Henriques 2011). He started his investment business in
1968 with a capital of $5,000, which he and his wife had saved during the previous six years.
Mr. Madoffs business grew slowly in the initial years. When he got a chance to become a
market maker on the National Association of Securities Dealers Automated Quotations
(NASDAQ) in 1984, he grabbed the opportunity. His eldest son, Mark, had just finished his
M.B.A. at Columbia University and was eager to enter the family business. While Mr. Madoff
looked after his investment management and advisory business, he put Mark in charge of the
market maker end of the business. BMIS directly executed orders from retail brokers. About the
same time, Mr. Madoff invested in computer equipment and software to automate the order
system (Henriques 2011). Peter Madoff, his brother, spearheaded the computerization project and
successfully developed a fast, automated system to handle customer orders. This automated
trading system pioneered by BMIS brought fame to the investment firm and added to the
mystique of the name: Bernard L. Madoff. By 2008, BMIS was the sixth largest market maker on
the NASDAQ.
BMIS paid a small commission to retail brokers for order flow. Mr. Madoff compared this to
stocking manufacturers paying for the racks that display their products in supermarkets. Some
academics have argued that this practice of paying for order flow is not ethical, as it causes the
broker to violate his or her fiduciary responsibility to obtain the best execution price for the
customer. The New York Stock Exchange (NYSE) did not like this Madoff business practice and
dubbed these payments bribes or kickbacks. The NYSE argued with the regulators that paying
for order flow is illegal and that the practice should be banned. However, the regulators eventually
sided with Mr. Madoff and the practice was declared legal (Henriques 2011).
BMIS was governed by a small, closely knit board of directors. Mr. Madoff was the founding
Chairman of BMIS and retained that position until his arrest in 2008. Brother Peter Madoff was
the Managing Director and the Chief Compliance Officer. Peters daughter, Shana Madoff, served
as the compliance attorney for the investment firm (Henriques 2011). In addition, Mr. Madoffs
two
sons (Mark and Andrew) served as the lead officers in the market maker division of the firm. The
chief financial officer, Frank DiPascali, was a long-term associate of Mr. Madoff. In short, the
management of BMIS was dominated by family members and friends.
Mr. Madoff was elected as the chair of the National Association of Securities Dealers
(NASD) in 1990 and held that prominent post for three years. As chair of the NASD, Mr. Madoff
vigorously championed the cause of transparency. He was a founding member of the International
Clearing Corporation in London. He portrayed himself as a person of unimpeachable integrity.
His (now
defunct) website used to say: In an era of faceless organizations owned by other equally faceless
organizations, Bernard L. Madoff Investment Securities LLC harks back to an earlier era in the
financial world: The owners name is on the door. Clients know that Bernie Madoff has a personal
interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards
that
Issues in Accounting Education
Volume 29, No. 1, 2014

has always been the firms hallmark. His fame grew far and wide. By 1993, feeder funds had
started
investing heavily with Madoff. They were impressed with his steady returns. Some feeder funds
did not tell their investors that they were investing with Mr. Madoff. The managers of some of
these

The Madoff Debacle: What are the Lessons?

273

feeder funds rationalized that they were investing only a small portion (10 to 15 percent) of their
portfolio with Madoff. Other feeder fund managers invested substantial portions of their portfolio
with Madoff. For example, Fairfield Greenwich Advisors invested $7.5 billion with BMIS, which
was 53 percent of assets under its management. These feeder funds were paid a finders fee for
bringing investments to BMIS. Feeder funds also received substantial commissions from their
investors. Mr. Merkin, who managed three Madoff feeder funds, was alleged to have collected
$470 million in fees and commissions for bringing in $2.4 billion to BMIS (Chew 2009). Several
hedge fund managers also invested with BMIS. When it was all over, Mr. Madoff had cheated his
investors to the tune of approximately $20 billion through his Ponzi scheme (see:
http://www.madofftrustee.com).
Mr. Madoff was on the Board of New York City Center, an innovative cultural institution
supported by the Madoff couple for decades (Henriques 2011). He served as the Chairman of the
Board of Directors of the Sy Syms School of Business at Yeshiva University and as the Treasurer
of its Board of Trustees. He moved in the upper echelons of society with aplomb and quickly
established himself as a prominent philanthropist. His family foundation handed out sizable
donations to various noble causes: cancer, theater, lymphoma research, education, hospitals, and
other non-profit institutions. It appears that charlatans are often schizophrenic.
Mr. Madoff owned opulent mansions in New York, Palm Beach, the French Riviera, and
London (Kravitz 2009). His massive Montauk, New York, beach house alone is valued at $8.75
million. His Palm Beach and London homes were in the name of his wife exclusively, and other
mansions were co-owned by the couple. He and his wife also co-owned an $8 million dollar
luxury apartment in Manhattan (Kravitz 2009). Mr. Madoff owned a luxury boat nicknamed
Bull stationed in Miami, as well as a yacht on the Mediterranean. He had acquired fancy cars,
expensive
watches, exclusive country club memberships, Savile Row suits, and other luxury items. He
owned a Brazilian-built Embraer Regional Jet with a price tag of $29 million (Kravitz 2009). Mr.
Madoff had a lavish lifestyle befitting a king. While under house arrest, he tried to mail jewelry
and watches worth a million dollars to his family before he was stopped by the authorities.
Madoff Clientele
Mr. Madoff initially targeted rich people in his own community. People were kept waiting if
they wanted to invest with Madoff. Not everyone was allowed to invest. It was an honor and a
privilege to invest with BMIS. Mr. Madoff was an insider and a pillar of the community and,
hence, people trusted him too quickly. He soon started promising a steady return of 10 to 12
percent each year for his clients. These returns were guaranteed both in up and down markets. Mr.
Madoff promised positive and steady returnsalways. A 10 percent return appeared modest when
house prices were going up 20 percent or more every year. The Internet and real estate bubbles
made a 10 to 12 percent return look reasonable and feasible. Mr. Madoff advertised that he was
using a so
called fool-proof
investment strategythe split-strike conversion scheme or collar
trade
(Henriques 2011). Under this scheme, Mr. Madoff claimed he purchased 35 to 50 Standard &
Poors (S&P) 100 stocks, sold a call option (upside exposure) on the S&P 100 index, and bought a
put option (downside protection) on the S&P 100 index (Henriques 2011). Several analysts who
tried to replicate this strategy came to the conclusion that it would not generate steady returns of
10
to 12 percent over several years. It did not pass the sniff test. To secure a net return of 12 percent,
Madoff had to earn at least 16 percent so that he could pay a 4 percent fee to feeder fund
managers who brought in the investors (Markopolos 2005). Smart investors should have been
skeptical about these high levels of promised returns; perhaps their trust in Madoff blinded them.

Mr. Madoffs clientele spread far and wide over the years. Many of his clients shared
Madoffs religious affiliationthey were Jewish. His client list included prominent people in the
entertainment, business, and cable news industry. Celebrity Madoff investors included Steven
Issues in Accounting Education
Volume 29, No. 1, 2014

27
4

Ragothaman

Spielberg, Kevin Bacon, Kyra Sedgwick, Jeffrey Katzenberg, Mort Zuckerman, Larry King, Elie
Wiesel, and others (Henriques 2011). Several other investors were well-to-do retirees who were
living in Florida, Arizona, Nevada, and Southern California. Many of them, unfortunately, did not
appear to properly diversify their investment. They trusted Madoff with their retirement funds.
The eight largest investors with Madoff had invested a whopping $21.42 billion. Exhibit 1
provides the details.
Desiring steady returns, several charitable foundations also invested their funds with Mr.
Madoff, the famed New York philanthropist. Many Jewish charitable organizations were severely
burnt by their trust in Madoff (Szep 2008). A few of them invested 100 percent of their corpus
with BMIS. For example, the Chais Family Foundation invested all of its money with Madoff. Its
annual distribution to various causes was approximately $12.5 million. This foundation had to fire
all of its employees and shut down. The Robert I. Lappin Foundation invested all $8 million of its
corpus with Madoff, and it was also forced to close down. The Carl and Ruth Shapiro Family
Foundation, a Boston-based organization, estimated its loss exposure at $145 million, which
represents between 40 percent and 45 percent of its total assets (Szep 2008). Yeshiva University
invested $110 million in Madoff investments, which was roughly 10 percent of its entire
endowment. Mort Zuckerman, who owns the New York Daily News, reported that his charitable
trust could lose $30 million, its entire endowment, due to Madoff shenanigans. The Elie Wiesel
Foundation for Humanity and the Wunderkinder Foundation run by Stephen Spielberg both had
substantial amounts of their corpus invested with BMIS. New Jersey Senator Frank Lautenberg
entrusted a substantial portion of his familys charitable funds to Madoff and was exposed to
heavy losses. Charities typically distribute 5 percent of their investment annually to various
recipients. Clients came from affinity groups and, hence, it was easier for them to trust Mr.
Madoff. Charities are typically satisfied with an annual income of 5 percent and seldom seek the
refund of their corpus. Thus, Mr. Madoff could pay them 5 percent per year even if he made no
real investments and could perpetuate the Ponzi scheme for 20 long years!
Shenanigans at Bernard L. Madoff Investment Securities
Professionals who sold Madoff investments included lawyers, accountants, bankers, brokers,
and even doctors. Many of these veterans thought Madoff had a system to make money.
Salespeople for Madoff investments in Europe were well trained and spoke multiple European
languages. They were wealthy and well connected. A large proportion of Madoffs business came
from well-to-do European investors. Mr. Madoff only had two dozen people working for him in
the
U.S. hedge fund business and another 28 working for him in his London office (Henriques 2011). A
key employee in accounting assisted Mr. Madoff by creating an elaborate phony paper trail and by
mailing falsified account statements to customers on a regular basis. His employees, including the
sales professionals, were well compensated. They were paid much above the industry norms. Key
employees were paid substantial bonuses, as well. Perhaps such exceedingly generous payments
should have raised some eyebrows.
Peter Madoff served as the Chief Compliance Officer and Senior Managing Director at BMIS
from 1969 to 2008. Peter was in charge of developing compliance policies and procedures and
overseeing their implementation. He created a comprehensive compliance manual and annual
compliance reports overseen by competent investment professionals. However, it was all an
illusion created with the fake filings and fictitious documentation. In June 2012, the Securities and
Exchange Commission (SEC) filed a criminal complaint against Peter Madoff in the U.S. District
Court for the Southern District of New York alleging:
that in addition to creating false compliance materials, Peter Madoff created false brokerdealer and investment advisor registration applications filed by BMIS. He also failed to
Issues in Accounting Education
Volume 29, No. 1, 2014

implement and review required policies and procedures, and falsified the firms books
and

Issue
s in
Acco
untin
g
Educ
ation
Volu
me
29,
No.
1,

EXHIBIT 1
Largest Madoff Investors
(Wall Street Journal, March 6,
2009)
Investor

Description

Exposure

Comment
More than half of Fairfield Greenwichs $14.1 billion in
assets under management, about $7.5 billion, was
connected to Madoff.
Tremonts Rye Investment Management business had $3.1
billion invested, and its fund of funds group invested
another $200 million. The loss was more than half of
all assets overseen by Tremont.
The losses were first disclosed on December 14, 2008.
2.01 billion euros belonged to institutional investors and
international private banking clients.
The bank had two funds with $2.1 billion (1.5 billion
euros) invested with Madoff. Hedge funds run by the
bank had almost all their money invested with Madoff.
The hedge fund had $1.8 billion under management as of
September 30, 2008; had substantially all of its assets
invested with Mr. Madoff.
Mr. De La Villehuchet (the co-founder) lost about $50
million, the bulk of his personal wealth.
Loss for Fortis Bank Nederland (Holding) N.V. could
amount to EUR 850 million to EUR 1 billion.
HSBC provided financing to a small number of
institutional clients who invested in funds with Madoff.

Fairfield Greenwich Advisors

An investment management firm

$7,500,000,000

Tremont Group Holdings

Asset management firm

$3,300,000,000

Banco Santander

Spanish bank

$2,870,000,000

Bank Medici

Austrian bank

$2,100,000,000

Ascot Partners

A hedge fund by J. Ezra Merkin

$1,800,000,000

Access International Advisors

A New York-based investment firm

$1,500,000,000

Fortis

Dutch bank

$1,350,000,000

HSBC

British bank

$1,000,000,000

Total

T
he
M
ad
of
f
D
eb
ac
le
:
W
ha
t
ar
e
th
e

$21,420,000,000

Source: http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html

275

27
6

Ragothaman

records. Peter Madoff was richly rewarded for his misconduct, pocketing tens of millions
of dollars through salary and bonuses, fake trades, sham loans, and direct, undocumented
transfers of investor funds to himself from the bank account that BMIS used to perpetrate
the Ponzi scheme. (SEC 2012)
Peter Madoff was sentenced to ten years in jail for his role in the Madoff fraud in December 2012.
The chief financial officer, Frank DiPascali, was in charge of maintaining the accounting
records and financial management at BMIS. A 33-year veteran at BMIS, Frank was the chief
lieutenant of Mr. Madoff. Frank was also the director of options trading at the firm. Every three
months, BMIS would mail quarterly statements to the firms investors. Many of these statements
showed investments in blue chip companies. These statements always showed a positive return of
3 to 4 percent every quarter. In earlier years, if investors requested a liquidation of their
investments, a
check for the balance was promptly mailed to them. Since most of the investors were individually
very wealthy, the refund requests were sporadic. In addition, some investors were charitable
organizations and were not seeking the return of their original investment. Mr. Madoff, his
brother, and Frank DiPascali formed a tight-knit group that engineered this massive fraud and kept
it secret for a long time, to the detriment of thousands of gullible investors.
BMIS claimed to be a private fund and did not register with the SEC. Hence, it was not filing
financial information with the SEC on a regular basis for many years. BMIS, however, was
audited by Friehling & Horowitz, a small CPA firm in New York City. This accounting firm
operated out of a 13 feet by 18 feet office in uptown New York (Abkowitz 2008). The CPA firm
consisted of three people, including a secretary. Jerome Horowitz, the senior accountant at the
firm, retired in 1991 and moved to Florida. The only active accountant at the firm, David G.
Friehling, was a past president of the Rockland County chapter of the New York State Society of
Certified Public Accountants and sat on the chapters executive board. David Friehling, a 49-yearold accountant, apparently worked sporadically, according to a nearby worker in the office
building (Abkowitz 2008). He was often seen driving a luxury Lexus. Mr. Friehling essentially
attested for 17 years that BMIS had a clean audit record. He collected a $250,000 audit fee for just
signing the audit report, and performed no audit procedures. Friehling & Horowitz did not submit
itself for peer review during the last 17 years (Abkowitz 2008). The firm had been consistently
telling the New York State CPA Society that they had not done any audits during those 17 years
and, therefore, were not subjected to any peer review. Mr. Friehling was also not registered with
the Public Company Accounting Oversight Board (PCAOB). The Madoff Trustee, Irving Picard,
sued JPMorgan Chase in December 2010. Picard alleged that the Madoff banker had known that
Friehling had neither registered with the PCAOB nor subjected himself to the American Institute
of Certified Public Accountants (AICPA) peer review as early as 2006. The Office of the
Comptroller of the Currency (OCC) is also unhappy with JPMorgan Chase and is faulting the
bank for not conducting due diligence and for failing to report suspicious activity at BMIS.
Fairfield Greenwich Group invested a staggering $7.5 billion with BMIS (see Exhibit 1). In
2008, the Fairfield Fund announced on its website that it was managing $14 billion in assets.
More than 95 percent of this $14 billion came from Europe, Asia, and the Middle East. Hence, a
little more than 50 percent of the funds were invested with one individual (Mr. Madoff ) by
Fairfield managers. As a feeder fund, it was Fairfields fiduciary duty to do due diligence about
BMIS before investing. It appears that Fairfield failed to perform this duty and did not exhibit
enough professional skepticism. Of course, Fairfield was receiving substantial fees from its own
clients and from BMIS (Henriques 2011).

Issues in Accounting Education

Volume 29, No. 1, 2014

Red Flags
The SEC received multiple complaints against Mr. Madoff over the years (Scannell 2009).
Whenever the SEC made inquiries about the trading practices at BMIS, Mr. Madoff used his
charm and manipulative ways to explain away his dealings to the SEC inspection teams. While
some of these complaints were anonymous, several were credible and had professional names
associated with them. The earliest complaint was in 1992 and was directed at an associate of Mr.
Madoff, Mr. Avellino (Berenson 2009). Avellino and Bienes initially had set up an accounting
firm in Manhattan in 1977 and soon shifted their focus to raising funds for Mr. Madoff. By 1992,
they had raised $441 million from 3,200 clients and had entrusted these funds to Madoff
(Berenson 2009). What caught the attention of SEC investigators was the promise made by
Avellino and Bienes that they would pay 13.5 to 20 percent annual returns to their clients. This
generous promise prompted the SEC to wonder whether Avellino and Bienes were running a
Ponzi scheme. When Avellino was questioned by SEC investigators, he told them that the money
has been entrusted to Mr. Madoff (Berenson 2009). At that time, Madoffs firm was an influential
brokerage house on Wall Street. Once Avellino assured the SEC investigators that he would return
the money to investors and paid a small fine to the SEC, the federal investigators concluded the
investigation. Avellino and Madoff had been connected for a long time; Mr. Avellino had worked
for Mr. Madoffs father-in-law since 1958 as an accountant. The SEC failed to ask the right
question in 1992Is Mr. Madoff (not Avellino) running a Ponzi scheme?
Harry Markopolos filed complaints against Mr. Madoff multiple times and put his
professional name on the line. He complained to the Boston office of the SEC, suggesting that
Madoff was either front running or deceiving his investors by running a Ponzi scheme in 2000. As
an example, front running would occur if a stockbroker learns that a large retirement fund has a
limit order in to purchase a certain stock, and the broker uses this private information to buy the
same stock just before the retirement funds large order is executed. The SEC has banned front
running. In an article published in Barrons, Arvedlund (2001) wondered how Madoff was getting
such steady returns. She was also critical of the secrecy associated with the Madoff methods to
generate the returns. A long memo was sent by Markopolos in 2005 to the SEC detailing why he
considered BMIS a fraud. Markopolos (2005) listed 29 red flags in support of his allegation that
Madoff had been committing a serious fraud. A few of his red flags are discussed below. He
pointed out that BMIS reported only seven small monthly losses in 174 months (14.5 years). This
defies logic. This is equivalent to a major league baseball player hitting a 0.960. There were not
enough index put option contracts in total in the market to hedge the way Madoff said he was
hedging. Several investors believed that Mr. Madoff subsidized down months. Other investors
believed that Mr. Madoff could time the market perfectly because of his insider status. This is
incredulous. There was a lot of secrecy associated with BMIS operations, and only family
members knew the Madoff investment strategy. The feeder fund (Fairfield Sentry) took
extraordinary pains to hide the fact that the real money manager was Mr. Madoff. Sometimes the
best advice financial advisors can offer their clients is to be conservative and diversify their
investments. Many of the financial advisors failed to offer this advice.
The Aftermath
Within a few weeks of his house arrest, Mr. Madoffs customers had confessed that their loss
exposure totaled several billion dollars. A CNN (2008) business story reported that several
prominent Madoff investors, including Royal Bank of Scotland, BNP Paribas, Banco Santander,
HSBC, and others, announced billions in expected losses. A few weeks later, the court-appointed
receiver reported that he had recovered a sum of $1.1 billion from several Madoff bank accounts
(see: http://www.madofftrustee.com). Some of the big accounting firms were staring at potential

lawsuits. Even though they were not the auditors of BMIS, the big accounting firms were the
target for the trial lawyers because of their role in auditing the feeder funds (Dugan and Crawford
2009). Mr. Madoff pled guilty to 11 felony charges (securities fraud, investment advisor fraud,
mail fraud, wire fraud, money laundering, false statements, and others) in March 2009. He was
awarded the maximum possible jail sentence of 150 years in July 2009 and was asked to pay a
restitution of
$170 billion (Henriques 2011). Mark Madoff (Mr. Madoffs eldest son) committed suicide in
December 2010. Frank DiPascali pled guilty to ten felony charges and is awaiting sentencing. He
is cooperating with the government in the investigation. David Friehling pled guilty to felony
charges against him and lost his CPA license in July 2010. His sentence has been postponed
multiple times, as he is also cooperating with the government. The auditors son, Jeremy
Friehling, committed suicide in November 2012. The SEC punished nine employees in November
2011 for their negligent roles in multiple Madoff investigations without firing any of them. These
sanctions included pay reductions, suspensions, and counseling memos. In November 2012, Irwin
Lipkin, former controller at BMIS, pled guilty to falsifying books and records. The Madoff
Recovery
Initiative (see: http://www.madofftrustee.com) reports that as of April 2013, the SIPA Trustee has
recovered or entered into agreements to recover more than $9.32 billion.
Based upon the reading of this case and other materials suggested by the instructor, answer the
following questions.
Case Questions
(1) What are the red flags (fraud risk factors) that are present in this case? Red flags should
be grouped under three categories: pressures/incentives, opportunities, and (ethical)
attitudes/rationalizations. Please refer to AU-C Section 240 (AICPA 2012).
(2) There are multiple approaches available to make ethical decisions. Describe Utilitarian
Theory, Rights Theory, and Justice Theory. Who are all individuals and groups affected
by the Madoff Ponzi scheme, and how are they affected?
(3)a What were the weaknesses in the control environment
of Bernard L.
Madoff
Investment Securities LLC?
(3)b What organizational controls, including internal controls, should be put in place to
prevent another Madoff fraud from occurring again? Suggest some regulatory controls
that can deter another Madoff fraud.
(4) Investors, the auditor, feeder funds, the Financial Industry Regulatory Authority, Inc.
(FINRA), SEC inspectorsall should have exhibited professional skepticism. What do
you understand by the phrase professional skepticism? Describe it in detail.
(5) Why did the SEC miss the fraud, even after receiving several complaints?
(6) Go to the SEC website or Google it to find and read the Markopolos complaint dated
November 7, 2005 (The Worlds Largest Hedge Fund is a Fraud19 pages
long), against Bernie Madoff. Please summarize the key points in the complaint in one
or two
pages of your own writing.
Possible Discussion Questions
(7) Why did no one blow the whistle from inside the Madoff investment firm for more than
20 years?

(8) Why did the Madoff Ponzi scheme continue for so long? Why was it not discovered
earlier?
(9) Is paying for order flow ethical? What is front running? Is it ethical?
(10)The concept of materiality requires professional judgment. Define the concept of
material misstatement and the concept of material investment. Are the investments

made (percentages reported in parentheses) by the following people/groups with Madoff

material from their individual perspectives? Steven Spielberg (2 percent of his wealth);
Chais Family Charitable Foundation (100 percent of its corpus); Fairfield Greenwich
Advisors (53 percent of assets under its management); Rene-Thierry Magon De
La Villehuchet (90 percent of his wealth); and Yeshiva University (10 percent of its total
endowment). Give your reasons.

REFERENCES
Abkowitz, A. 2008. Madoffs auditor .. . doesnt audit? CNNMoney. Available at: http://money.cnn.com/
2008/12/17/news/companies/madoff.auditor.fortune/index.htm
American Institute of Certified Public Accountants (AICPA). 2012. Consideration of Fraud in a Financial
Statement Audit. AU-C Section 240. New York, NY: AICPA.
Arvedlund, E. 2001. Dont ask, dont tell. Barrons (May 7).
Arvedlund, E. 2009. Too Good to Be True: The Rise and Fall of Bernie Madoff. New York, NY: Portfolio
Hardcover.
Berenson, A. 2009. 1992 Ponzi case missed signals about Madoff. The New York Times (January 17).
Chew, R. 2009. Madoff feeder Merkin charged by Cuomo. Time (April 6).
CNN. 2008. Banks face huge losses from $50B scam.
Available at:
http://www.cnn.com/2008/
BUSINESS/12/15/madoff.arrest.exposure/index.html
Dugan, I. J., and D. Crawford. 2009. Accounting firms that missed fraud at Madoff may be liable. The Wall
Street Journal (February 18).
Henriques, D. 2011. Wizard of Lies: Bernie Madoff and the Death of Trust. New York, NY: Times Books,
Henry Holt and Company.
Kravitz, D. 2009. How much does Madoff still have? Washington Post. Available at: http://voices.
washingtonpost.com/washingtonpostinvestigations/2009/01/madoffs_money.html?hpidtopnews
Markopolos, H. 2005. The worlds largest hedge fund is a fraud. Scribd. (November). Available at: http://
www.scribd.com/doc/9189285/Markopolos-Madoff-Complaint
Scannell, K. 2009. Madoff charges dug for years to no avail. Wall Street Journal (January 5).
Securities and Exchange Commission (SEC). 2012. SEC vs. Peter Madoff, Complaint in the U.S. District
Court for the Southern District of New York (June). Available at: http://www.justice.gov/usao/nys/
madoff/20120629infopetermadofffinal%20%28Signed%29%20.pdf
Szep, J. 2008. Charities hit hard as Madoff losses mount. Available at: http://www.reuters.com/article/2008/
12/15/us-madoff-charities-sb-idUSTRE4BE6TP20081215

CASE LEARNING OBJECTIVES AND IMPLEMENTATION

GUIDANCE

A teaching case was developed based on an actual Ponzi scheme perpetrated by Mr. Madoff
at Bernard L. Madoff Investment Securities LLC (BMIS). Only facts that occurred in this fraud
were used to develop this case study. Cases provide an excellent opportunity to engage students in
judgment-oriented accounting courses such as auditing. Moreover, cases provide interesting
learning opportunities that can be invaluable to accounting majors as they enter the practitioner
world. This case provides an opportunity to examine the details of a massive Ponzi scheme that
has intrigued the publics imagination in recent years.
Learning Objectives
This case can be used in an auditing or a forensic accounting course. Cases offer an avenue
for students to develop higher-order learning skills such as analysis, synthesis, and evaluation.
Several notable committees, including the Accounting Education Change Commission (AECC)
(1995), the American Accounting Association (AAA) (1995), the Committee of Sponsoring
Organizations of the Treadway (COSO) (2006), and others, have strongly recommended using
cases in the accounting curriculum. Students are more actively engaged in the learning process
while solving a group case. Moreover, unstructured problems contained in case studies can be
similar to what they may see later on in their work life.
Instructors can assign this case to student teams or to individual students. The team approach
is suitable for developing students interpersonal, oral communication, and leadership skills.
Students are typically required to develop detailed written answers to the suggested questions. In
addition, students may be required to formally present their answers and conclusions in class.
These written answers and oral presentations are expected to positively impact students oral and
written communication skills.
The following specific educational objectives can be achieved by assigning this case to
students:
Provide students with an opportunity to understand how Ponzi schemes and affinity frauds
work.
Help students evaluate fraud risk factors.
Enable students to evaluate internal controls (AU-C 315).
Offer opportunities to design new controls.
Understand governance issues in investment firms.
Analyze materiality decisions (AU-C 320 [AICPA 2012b] and AS No. 11).
Apply AU-C 240, AS No. 5, AS No. 11, and SAB No. 99 (SEC 1999).
Analyze the SECs OIG-509 (SEC 2009) and material indirect investments (SEC 2000).
Provide students with a better understanding of the concept of professional skepticism.
Enable students to understand the role of a whistleblower.
Enable students to appreciate the causes and consequences of regulatory failures.
Intended Audience
This case was used in an undergraduate auditing class, an undergraduate systems class, and a
Masters-level auditing class. The university is medium-sized (10,400 students) and is located in
the Midwest. The undergraduate auditing class is required for all accounting seniors. Ideally,
students must have completed the two intermediate accounting classes and an accounting
information systems class before enrolling in the auditing course. Sometimes, students are
concurrently enrolled in Intermediate II and auditing classes. Where possible, the following topics
should be covered in the auditing course prior to assigning this case: Code of Professional Ethics,
ten generally accepted

auditing standards, professional skepticism, COSO framework, internal control, AU-C 315
(AICPA 2012c), AS No. 5 (PCAOB 2007), AS No. 11 (PCAOB 2010a), analytical procedures,
materiality and audit risk, the fraud auditing standard (AU-C 240 [AICPA 2012a] and AS No. 12
[PCAOB 2010b]), and audit planning. Since all of these topics and more would have been
covered in the senior auditing class, a few questions of this case may be assigned early in the
Masters-level auditing class. I have also assigned this case (questions 2 and 3 on utilitarian
ethical principles/ consequences and internal control evaluation) in the junior-level accounting
systems class. The assignment typically is scheduled after covering the ethics chapter and internal
controls in the sales, expenditure, and conversion cycles in the systems class. Most importantly,
all ten questions are not assigned in any one class. Questions 1, 2, and 3 are typically used in the
systems class, and the other seven questions are used in the two auditing classes, two to four
questions at a time.
Implementation

Suggestions

Students were required to work on the Madoff case in groups of three outside of the regular
class time. The instructor did not permit students to self-select their team members in the
undergraduate systems and auditing classes. Rather, student groups were randomly chosen. This
approach to forming teams more closely resembles the work environment, where management
assigns employees to groups or departments. Once the teams were formed, team members were
not allowed to change teams.
Students had approximately ten days to two weeks to work on the case and turn in a written
solution to the instructor. The instructor emailed the case to students and also used some class
time to discuss the case requirements. The instructor answered a few questions in class and a few
more through email. Questions posed by teams and the instructors answers were distributed to the
entire
class, when relevant. An oral summary of commonly made errors was provided to the class after
the cases were graded. In addition, the instructor covered the major points of the
recommended solution in the class using a PowerPoint presentation. All students in a group
received the same grade for the case. However, instructors could devise a system where students
in a group evaluate each others performance on the case, resulting in a different allocation of
assigned points. Such a scheme would likely increase the incentives for all students to
participate.
The case author experienced lively class discussion on this case. Students were generally
ready to talk about various issues related to the Madoff scandal. The instructor did not offer any
credit for class discussion. Other instructors may devise a scheme to offer points for class
participation and discussion, which may have positive influence on student engagement. Offering
some credit for class discussion can serve as a motivation tool for students to seriously study the
assigned readings and for participating in the class discussion. In order to encourage students to
take the assignment seriously, instructors might also want to consider including some case-related
questions on an exam or a quiz. Such exam-embedded questions might provide the much-needed
reinforcement of key auditing concepts to students.
Case Assessment
This case was assigned to auditing students (as a group project) in the spring of 2009 and
2010, and to students in a systems class in spring 2009. Only two to four questions are used at a
time, as explained earlier. The auditing students in spring classes were in the five-year M.P.A.
program, and a vast majority of them were traditional college students. However, some of them
had a two-month auditing internship experience. Parts of this case were assigned to undergraduate
accounting systems students, as well, during spring 2009, and to undergraduate auditing students

in fall 2009. Unfortunately, the survey was not administered in the auditing class during fall 2009.
The systems class was comprised mostly of traditional students having very limited relevant work
experience. I

also administered this case during the fall of 2012 to 58 undergraduate auditing students. Auditing
students in this class were traditional undergraduates who were in their senior year taking the
required auditing course.
Table 1 summarizes the student perceptions and their reactions to the case. A total of 123
accounting students (34 graduate students in auditing in spring 2009, 31 students in systems in
spring 2009, ten graduate students in auditing in spring 2010, and 48 undergraduate auditing
students in fall 2012) completed the survey. However, about 170 students in total completed the
actual case for class credit during the various semesters listed above.
Table 1 indicates that, in general, students responded favorably to the use of the case as a
group assignment. A majority of students either agreed or strongly agreed that completing the
case helped them better understand ethical concepts, the fraud triangle, red flags pertaining to
Ponzi schemes, and the consequences of unethical actions. A strong majority of students
understood the concept of
control environment. Likewise, a high percentage of students thought that the level of difficulty
associated with the case was appropriate for a systems or an auditing course, and that it was a
useful learning tool. More than 80 percent of the students who completed the case indicated that
they would recommend this case for use in future auditing classes. A few students wanted the
questions to be harder. Some students were appreciative that this was a group case, while others
felt that this case can be better handled as an individual student assignment. The overall
assessment was also very positive, and a vast majority of students agreed or strongly agreed that
this case was a useful learning tool.
CONCLUSION
The hands-on experience provided by this case to students could be meaningful for them in
their future professional jobs in public accounting. Auditing and undergraduate systems students
who completed this case were enthusiastic about learning the facts in this case. Because it is based
on one of the biggest Ponzi schemes in recent times, they appreciated the case narrative and could
easily access additional information from electronic resources identified by the instructor. Some of
the facts in this case shocked them and the students were stunned by the massive dollar amounts
involved in this fraud. Students were clearly motivated to learn. Some of them repeatedly
mentioned that they were at a loss to explain how so many prominent personalities could be so
easily fooled by Mr. Madoff. Perhaps a great benefit of using this case in auditing is the ease with
which students can be engaged to learn. Since the case is based on a fraud that actually occurred,
students were able to focus and apply themselves to issues on hand. Students who worked on this
case enhanced their critical thinking skills by developing detailed answers for key questions on
internal control assessment and the design of new controls. They also learned to apply other
auditing standards on materiality judgments, fraud risk assessment, and professional skepticism.
Students worked in teams and developed interpersonal skills, as well.
STUDENT COMMENTS
Here is a sample of student comments about the case:
Auditing Students
* I really enjoyed it because it helped me understand a major current event. It is really
helpful to see relevant examples based on real world cases.
* Very enjoyable. I learned a lot about controls.
* I cant help but think the Madoff case would have been more effective if we would have
reviewed SAS 99 for a few minutes in class prior to the assignment, but as a mini-research

TABLE 1
Student Evaluation for the Madoff Debacle Case Study
Item

Spring 2009A
Fall 2012A

Spring 2009S

Spring 2010A

1. Completing the Madoff Debacle Case

(MDC) study helped me understand
ethics (what is right and what is
wrong).
2. Completing the MDC study helped
me understand how the fraud triangle
can be applied to Ponzi schemes.
3. Completing the MDC study helped
me understand the red flags that are
related to Ponzi schemes.
4. Completing the MDC study helped
me understand how several groups
can be affected by a single (big)
unethical act.
5. Completing the MDC study helped
me understand the importance of a
good control environment to
prevent fraud.

1.94

2.11

1.90

2.29

2.01

1.85

1.70

1.95

1.77

1.89

1.50

1.77

1.50

1.61

1.30

1.91

1.66

1.78

1.70

1.93

6. Completing the MDC study helped

me understand new terminology, such
as front running, paying for order
flow, Ponzi scheme, and others.

1.80

2.42

1.70

2.35

7. The time allotted to this case was

sufficient.
8. I would recommend that this case be
part of the accounting systems/
auditing class in future semesters.
9. The level of difficulty in this case
was appropriate for an introductory
systems/auditing course.
10. Analyzing this case as a group project
was beneficial.
11. Overall, this case was a useful
learning tool.

2.22

2.18

1.50

1.72

1.97

1.86

1.60

1.95

1.88

1.93

2.00

2.14

1.88

1.78

2.62

2.29

1.72

1.86

1.60

1.89

SA Strongly Agree (1); A Agree (2); N Neutral (3); D Disagree (4); SD Strongly Disagree (5).

project it was very informative. Also reviewing all of the possible answers in class may
have been beneficial.
* Interesting. I was able to learn more and understand the actual Bernie Madoff scandal.
* This was a very good case to cover. I hope it is continued for future classes.
* Could be harder. The group part of the project only made it easier to do less.

* There is more to the story that has yet to be discovered. It was too big for no more not to be
out there.

* I enjoy having real life cases examined in conjunction with the course material because its
easier for me to tie the concepts we read about to actual events. I would have preferred to
have done the entire case individually.
* Madoff case did a good job of showing bad internal controls.
* The Madoff case shows you that it can be difficult to trust anyone in the business sector no
matter who they are, how famous or rich, or what charitable things they do. You always
have to keep one eye open to make sure no one plays a trick on you.
* I think that this case helps students apply what they learn in class.
* We should be able to grade our group members at the end of the semester because some
group members did more work than the others. Please list at least how many responses
each questions should have.
* I enjoyed the fact that this case pertained to a real life situation.
* Would be more beneficial if individually analyzed, so everybody gets to understand all
aspects of the project.
* I would have liked to see more depth on how the fraud was committed.
Systems Students
*
*
*
*
*
*
*
*
*
*

It was helpful in understanding ethics and the implementation of SOX standards.

Should be given better instructions. Like how many examples you want.
Good learning experience.
It was interesting.
It was an interesting case to examine. The content was not boring and therefore easy to
read and examine.
Great real-life simulation, helps connect class to real-life examples, makes learning easier.
The cases were lots of fun.
Kind of hard. Expected a higher grade than what was given.
I liked learning about it. Useful information.
I enjoyed reading and analyzing the case. Thanks.
TEACHING NOTES

Teaching Notes are available only to non-student-member subscribers to Issues in Accounting

Education through the American Accounting Associations electronic publications system at
http:// aaapubs.org/. Non-student-member subscribers should use their usernames and passwords
for entry into the system where the Teaching Notes can be reviewed and printed. Please do not
make the Teaching Notes available to students or post them on websites.
If you are a non-student-member of AAA with a subscription to Issues in Accounting
Education and have any trouble accessing this material, then please contact the AAA headquarters
office at info@aaahq.org or (941) 921-7747.

REFERENCES
American Institute of Certified Public Accountants (AICPA). 2012a. Consideration of Fraud in a Financial
Statement Audit. AU-C Section 240. New York, NY: AICPA.
American Institute of Certified Public Accountants (AICPA). 2012b. Materiality in Planning and
Performing an Audit. AU-C Section 320. New York, NY: AICPA.
American Institute of Certified Public Accountants (AICPA). 2012c. Understanding the Entity and Its
Environment and Assessing the Risks of Material Misstatement. AU-C Section 315. New York, NY:
AICPA.

Committee of Sponsoring Organizations of the Treadway Commission (COSO). 2006. Internal Control
over Financial ReportingGuidance for Smaller Public Companies. Available at: http://aaahq.org/
newsarc/COSO_Executive_Summary.pdf
Public Company Accounting Oversight Board (PCAOB). 2007. An Audit of Internal Control over Financial
Reporting that is Integrated with an Audit of Financial Statements and Related Independence Rule
and Conforming Amendments. PCAOB Release No. 2007-005A. Auditing Standard No. 5 (June 12).
Washington, DC: PCAOB.
Public Company Accounting Oversight Board (PCAOB). 2010a. Consideration of Materiality in Planning
and Performing an Audit. PCAOB Release No. 2010-004. Auditing Standard No. 11 (December 23).
Washington, DC: PCAOB.
Public Company Accounting Oversight Board (PCAOB). 2010b. Identifying and Assessing Risks of
Material Misstatement. PCAOB Release No. 2010-004. Auditing Standard No. 12 (December 23).
Washington, DC: PCAOB.
Securities and Exchange Commission (SEC). 1999. Materiality. Staff Accounting Bulletin No.
99.
Washington DC: SEC. Available at: http://www.sec.gov/interps/account/sab99.htm
Securities and Exchange Commission (SEC). 2000. Material Indirect Investments. Reg. 210.2- 01(c)(1)(i)
(D)(1). Available at: http://www.sec.gov/rules/proposed/3442994c.htm
Securities and Exchange Commission (SEC). 2009. Investigation of Failure of the SEC to Uncover Bernard
Madoffs Ponzi Scheme. OIG-509. Available at: http://www.sec.gov/spotlight/secpostmadoffreforms/
oig-509-exec-summary.pdf

Copyright of Issues in Accounting Education is the property of American Accounting

Association and its content may not be copied or emailed to multiple sites or posted to a
listserv without the copyright holder's express written permission. However, users may print,
download, or email articles for individual use.