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Corporate governance goes kaput--again
Sudhakar V. Balachandran, Forbes | January 08, 2009
Satyam Computers, a global IT company based in India, has just been added to a notorious list of companies involved in fraudulent financial activities, one that includes such names as Enron, WorldCom, Societe General, Parmalat, Ahold, Allied Irish, Bearings and Kidder Peabody.
Satyam's [Get Quote] CEO, Ramalingam Raju, took responsibility for broad accounting improprieties that overstated the company's revenues and profits and reported a cash holding of approximately $1.04 billion that simply did not exist.
This leads one to ask a simple question: How does this keep happening?
At the Columbia Business School, we teach a course called Performance Measurement in which we study some of the dynamics that lead to this type of accounting scandal. In our course, we study the fraud committed at WorldCom and Kidder Peabody in detail. In our studies, a distinct pattern emerges.
It starts small. Typically, executives do not wake up one morning and say, "I feel like adding 5 billion rupees to our revenue today." They usually start by fudging the number a little--and then it grows.
It is usually a response to competitive pressures. Companies have targets that they need to reach every month, quarter and year. These targets can come from their internal budgets or from the expectations of their shareholders and stock market analysts.
The fiddle is easy to rationalize at first. Managers typically have confidence in their skills and believe that their company is fundamentally sound. Given that, it's easy to rationalize that while we're just a little short on the numbers now, we will make it up in the future, and nobody will know.
It gets out of control. When the company is unable to make up the gap, a larger distortion is needed to cover it up. This in turn creates pressure to deliver even better results--which leads to bigger cover-ups, and so on.
In his letter to his board, Satyam's Raju shows the markers of this pathology. He states that, "What started as a marginal gap between actual operating profits and ones reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions. ..." Later, he describes the process as "like riding a tiger, not knowing how to get off without being eaten."
Unfortunately, it appears that several of the mechanisms we rely upon today have not gone far enough. When management has the wrong incentives, we need other mechanisms to hold those incentives in check.
Typically, we rely on corporate governance, audit and legal consequences.
Historically, several characteristics have been considered important ingredients of excellent corporate governance. These include outsider representation on the board, boards that aren't too large, boards that meet often, etc. Unfortunately, these characteristics don't seem sufficient. Satyam, for example, had a reputation of excellent corporate governance.
In fact, the World Council for Corporate Governance awarded Satyam its Golden Peacock Award for Corporate Governance in 2008. This suggests that we need to fundamentally rethink the criteria that we require in order for boards to provide effective governance.
When an accounting fraud involves reporting cash that is not there, it is typically the result of adding fraudulent transactions, such as cash sales, to customers that never happened. These types of transactions should have been audited to assure their legitimacy. In the case of Satyam, the auditors signed off on the financial reports, raising concerns that even the increased auditing standards imposed by Sarbanes-Oxley may not be sufficient.
Finally, we also need stiffer penalties. Simply put, "white collar" crime cannot be viewed as less of an evil than any other form of crime.
The fact that white collar crime continues to occur, and seemingly at an increasing rate, suggests that the expected costs do not outweigh the expected benefits from cheating. Stronger penalties are needed.
Despite my calls for improvements in governance, audit and legal penalties, I'm left with the nagging concern that whatever we do may be insufficient. At the end of the day, the actions at Satyam were perpetrated by one or two individuals who simply may not have realized that the small distortions they created in the past would lead to massive problems today. Hopefully, creating an awareness of the large consequences of small lies may help some to avoid this trap.
Actions such as those of Satyam are being observed all over the world, and their effects are not simply localized to their executives, employees or even their countries. Whether it is accounting fraud, excessive trading risks, a Ponzi scheme or making loans to those who can't pay, many are hurt by corporate improprieties. These types of actions affect the global economy. In other words, they affect us all. If there isn't sufficient belief in the notion that business will act in good faith, then the capitalist system is itself at risk.
Professor Sudhakar V Balachandran teaches accounting at the Columbia Business School, where he is the faculty director of the executive programs "Finance & Accounting for Non-Financial Executives" and "Essentials of Financial Management."
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