Corporate governance has been a hot cake particularly due to the high profile crumpling of a large number of firms such as Enron, WorldCom and the recent Satyam debacle. The US federal government passed the Sarbanes-Oxley Act in 2002 to reinforce the confidence of the masses in corporate governance, which had suffered a huge blow due to the accounting and corporate malpractices surrounding Enron Corporation, Tyco International, Adelphia, WorldCom and Peregrine Systems.

It looks as if these episodes were not the eye-openers anticipated since the global economy faces yet another scandal: the Satyam fiasco that has tarnished the image of India Inc., and is being referred to as “India’s Enron.” It was expected that corporate surveillance would be strengthened and the past litigations would keep at bay such scandals involving multi-billion dollars in costs imposed on millions of people and the world economy. Yet systems seem to have failed miserably again. In such circumstances one is forced to ask: Are we ignoring the early warning signs in our corporate governance system?

The corporate world was taken by a wave of shock when B Ramalinga Raju, the founder-chairman of the fourth largest information technology giant in India, confessed to years of fallacious profits and an audacious financial fraud of $1.6 billion. Price Waterhouse, the India-based statutory auditor of Satyam and a sister concern of Price Waterhouse Coopers (PwC) International, is now under the scanner and a one-on-one comparison is being drawn between Price Waterhouse and Arthur Andersen, which lost its mark among the “big five” accounting firms once the loopholes in its Enron audits were exposed. Andersen’s conviction also brought into light its faulty audits for other companies, such as Waste Management, Sunbeam and WorldCom.

Malpractice

Enron held the reputation of being “America’s most innovative company” for six consecutive years until it came under the spotlight for carrying out accounting malpractice. The Enron scandal of October 2001, found the company had artificially boosted the profits and covered the debts totalling over $1 billion by improperly using off-the-books partnerships. Enron had also manipulated the Texas and California power markets and bribed foreign governments to win contracts abroad.

Satyam had also won awards and accolades for innovation in corporate governance. With the Satyam scandal coming to light, one has to face the stark reality that India’s corporate governance system is in shambles and needs urgent reforms. In the current situation it would be extremely difficult, if not impossible, for Satyam to continue to exist. Should it survive, it will have challenges to face since other companies will refrain from acquiring a tainted company.

With this debacle all the competitors will smell an opportunity. It is to be seen whether Indian top IT companies popularly called as SWITCH (S-Satyam, W-Wipro, I-Infosys, T-TCS, C-Cognizant, H-HCL) will remain as is or  be rechristened as WITCH (without Satyam).

Such scams continue to tarnish world business practices and raise questions about the existing corporate governance system. Directors and managers across the globe may want to assess the following “early warning signs” to gauge the overall corporate health and the effectiveness of the management team.

1. High earning expectation is a potential “warning sign” as more often than not it leads to accounting irregularities that may result in “abusive earnings management.” Revenues that consistently match the analysts’ expectations should ring an alarm in the minds of the auditors and stakeholders.

Innovative company

Enron held the reputation of being “America’s most innovative company” for six consecutive years and consistently matched or exceeded analysts’ expectation until it came under the spotlight for carrying out accounting malpractice. The Bernard Madoff scandal illustrates yet another aspect of this where the multi-billion dollar ponzi scheme seemed “too good to be true.” Apparently regulators were alerted many times over the years by several outsiders that Madoff’s ability to deliver steady double-digit returns was Machiavellian.

2. Fraudulent accounting: cash flows that are not aligned with the earnings; receivables that are not parallel with the revenues; superfluous allowances for uncollectible accounts that are not connected with receivables; reserves that stand unparalleled with the balance sheet items; and questionable acquisition reserves should raise eyebrows. WorldCom overstated cash flow by booking $3.8 billion in operating expenses as capital expenses and gave founder Bernard Ebbers $400 million in off-the-books loans. In no time WorldCom surpassed Enron becoming the biggest bankruptcy in history and leading to a domino effect in corporate scandals.

Corporate governance

3. Dormant or non-existence corporate governance committee: Often in an attempt to deceive the financial community, the company either has a dormant corporate governance surveillance committee or does not have one; as such frauds cannot be easily detected by outsiders.

The Maytas deal (where the Satyam chairman attempted to acquire two companies controlled by his sons - Maytas Properties and Maytas Infra - for $1.6 billion to cover-up for the lacunae in his books of accounts) acted as a red flag for the corporate world. There was outright disapproval by the investors claiming that it was an irresponsible misuse of funds and act of nepotism.

Later the travesty of inflating the company’s profitability by more than $1.6 billion in cash and assets on its books came out in the open. Satyam’s factitious accounts had been audited by Price Waterhouse since the financial year 2000-2001. It was notable that in seven years Price Waterhouse could not detect a problem, yet Merrill Lynch sensed the deceit in just ten days. The department of company affairs in India reportedly revisited norms regarding corporate governance after the Arthur Andersen-Enron scandal and later when WorldCom came to light in early 2000’s. Former cabinet secretary Naresh Chandra and his committee proposed a tighter regulation of the auditing and accounting practices of corporations in India and recommended that (i) a compulsory rotation of audit partners every five years and (ii) submission of an annual report by the audit firm to the board of directors and the auditing committee.

These suggestions were generally overlooked not only in the Companies Amendment Bill of 2003, but also in the New Companies Amendment Bill of 2008. Arguably, had the suggestions been adopted the Satyam debacle could have been averted or at least detected earlier.

Ethical practices

4. Ethical practices of the company: Many businesses pay lip service to ethics and as a result their practices still fall short relative to its importance. Businesses ought to think deeply about corporate social responsibility and appropriate standards of conduct in society. Milton Friedman’s contention that “the business of business is business,” and the slavish dedication of many businesses to focus on increasing short-term shareholder value and rewarding managers accordingly borders on myopia.

There is a possibility that Price Waterhouse (a sister concern of PwC; an IBM firm) may have been incompetent or might have had a vested interest and might not have reported the shortcomings in the Satyam audits. These interests could be using IBM’s products for Satyam and then recommending their products to Satyam’s patrons as part of their solution.

Just as in Enron’s scandal, debts in Satyam’s case were hidden and bribes were allegedly offered to get World Bank business. The World Bank is now reported to have barred Satyam from bidding on its projects.

5. The big lie theory: Although related to the ethical practices of a company, according to the proponents of “the big lie theory,” after having established their credibility, firms tend to get involved in “big lies,” that is, they commit frauds of prodigious magnitudes. The infamous Enron-Arthur Andersen-WorldCom and Satyam-Price Waterhouse episodes hold testimony to the theory. Andersen’s motto was “Think straight, talk straight.”

The firm’s culture was believed to be ingrained with honesty and ethics. But this did not last. After having established a reputation for IT consultancy in the 1980’s, the ethical standards of the firm went downhill as the accountancy firms in the US were having a tough time maintaining commitment to the auditing arms.

Commitment and honesty in audits were pitted against the desire to grow the consultancy practices, which were greater revenue generators from the existing audit clientele. Predictably, Andersen gave in to the pressures of the client’s desires to maximise profits and succumbed to fraudulent accounting and auditing practices in order to capitalise on the opportunities to increase consultancy fees. 

Hopefully, paying closer attention to Enron-Arthur Andersen-WorldCom-Satyam may help identify lacunas in the corporate governance system. However, some questions remain unanswered: How many WorldComs, Enrons and Satyams is it going to take for us to finally bring the systems in place? Will we keep on ignoring the early warning signs of the corporate governance system? Until when?

(The writer is a David M French Distinguished Professor at the Flint campus of the University of Michigan and the Honorary Dean at Alliance b-school, Bangalore.)