Madoff's Accountant and the Meaning of Words

Mar 18, 2009

A while ago, I wrote a deliberately uninformed post, suggesting that the whole Bernie Madoff fiasco wouldn’t have happened if Madoff’s fund had had an audit conducted by a reputable firm, and that this should be a requirement for all investment funds (see “Madoff and the ‘Idiot Plot’” 12/17/08).

Well, I was sort of wrong and sort of right: Madoff’s funds’ annual reports were accompanied by the opinion of outside auditors. However, it also appears that no audits were actually performed, and today the head of (and only practicing accountant in, it seems) Madoff’s accounting firm turned himself in, on fraud charges.

Yes, it appears that there is a subtle but very important distinction between writing an auditor’s opinion and actually performing the audit. Who knew?

All this makes me think of the meaning of words, and the word for today is regulation. Many have suggested that l’affaire Madoff is the result of inadequate “regulation.” Oh, really? But is “regulation” the establishment of laws and rules and procedures to ensure that a system behaves the way it was intended? Or is it the way those laws, rules, and procedures are administered and enforced? Or is it both?

It’s clear to me that inadequate rules is NOT the problem. A properly performed audit would have ended the Madoff fraud instantly. There was no problem with the existing rules, other than the fact that they weren’t enforced at all. What concerns me is that concerned legislators will glob all this together and develop a whole new set of laws and rules intended to “fix” the problem. What will emerge is a massive structure that
  1. most people, including the practitioners, won’t understand, that 
  2. might lead to some modest preventions of abuses, so the legislators can claim victory, but which 
  3. will have tangible benefits amounting to only a tiny fraction of the direct and indirect costs society bears as a result of the new “regulations.” In other words, can you say, “Sarbanes-Oxley”? (see “Sarbanes-Oxley, the Atomic Flyswatter” 11/5/08) 

The message I want to get across, and why this post is in Painting with Numbers, is that if we interpret words too broadly, bad and unintended things happen. Moreover, actions have costs, and those costs must be less than the benefits produced by the actions.

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

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