Designing accountants

What to take away from America’s experience with audit reform

Written by Vinay B. Nair | Published: January 13, 2009 2:23 am

In Satyam,India now has its own poster child for corporate governance failure: our very own Enron. In his account of how the financial manipulation reached a massive scale,Ramalinga Raju,the founder of Satyam wrote “We were riding a tiger,without knowing how to get rid off it without being eaten.” 

How can we prevent CEOs from “riding a tiger”? Satyam might be a first in India but in all likelihood not the last. How many other Satyams are out there and how can we detect them? These are questions that regulators and investors are asking themselves,and rightly so. 

The consequences of Satyam’s fraudulent actions are significant.  A large majority of Satyam’s 53,000 odd workers had no idea that their firm was dishonest. Yet,they are now in danger of losing their livelihood.  Many honest firms face the challenge of retaining investors,who are now uncertain about the information they receive from them. The dent in investor confidence is a big blow to Indian capital,especially at a time when capital is fleeing risky opportunities. 

This additional element of governance risk has regulators scrambling on what needs to be done to restore investor confidence. In the reactions and rules that are bound to follow,we also face the risk of taking ineffective and even potentially damaging actions. There is a lot that we can learn from scandals and from the responses to such scandals around the world — failing which we might simply be locking the stable gates after the horse has bolted. 

Traditionally,the system has relied on regulators such as SEBI and accounting firms who serve as auditors to detect such cases. Yet,their record in doing so is not very impressive. While studying over 216 cases of corporate fraud in US between 1996 and 2004 in the US,Luigi Zingales,Adair Morse and Alexander Dyck found that the securities regulators detected only 7 per cent of these instances. Auditors were successful 10 per cent of the time. These numbers suggest a story of information and incentives.  

Public information is not sufficient to detect cases of corporate fraud and the evidence suggests we need agents with access to inside information. But this alone is not enough — after all,auditors have inside information. Along with information,auditors need stronger incentives than what currently exists to blow the whistle. Reputational concerns alone do not seem to be sufficient. Prior to stricter rules being imposed due to the Enron and WorldCom scandals,auditors detected only 6 per cent of the cases.  With enhanced responsibility attributed to accountants by law (Statement on Auditing Standards No. 99,approved in the US on October 2002) after Enron and WorldCom,auditors detected 24 per cent of the cases. So India should look into borrowing a leaf from the SAS No.99.

Boards of directors are often expected to detect these cases.  Some proponents of this view have proposed independent directors. Independent directors were a prominent feature in Enron. Satyam itself had an illustrious group of these. To expect independent directors to detect cases is unrealistic. These directors often play the role of a sounding board to the CEO or to help him set the strategic direction – not to go over the operational details. It is simply unrealistic to expect them to detect a needle in the haystack. From a practical viewpoint,the relationship between the board and the management cannot be adversarial and ridden with suspicion if the board is to play a role in helping the CEO make better decisions.  It is easy to see why the board of directors cannot be both an effective advisor and an effective enforcer. Simply being an enforcer is also not realistic since even “independent” directors receive most of their information from the management themselves,and spend most of their time away from the company. So simply requiring majority of the board to be outsiders,or requiring a separate chairman and CEO will not solve the problem. After all,Satyam had an ADR listed in New York and was subject to the American Sarbanes-Oxley rules regarding boards. 

Too often,we view corporate governance as a top down disciplining mechanism that regulators and investors use to keep management in check. In doing so,we often undermine the importance of the bottom-up approach where managers keep each other in check.  Employees are much more likely to see something suspicious than outsiders or even the board. 17 per cent of the cases in US were detected by employees. Yet,the cost to these employee whistleblowers is significant. Many of them go through months of duress,and remain anonymous. Some quit,and some are fired or demoted before conclusion of the investigation. The whistleblower protection provided by the governance reform post Enron has had little effect. What does increase instances of employee reports is a monetary reward. In cases where employees receive a monetary reward,they detected fraudulent cases 41 per cent of the time. 

We should set up a separate agency (either within the SEBI or independent of the securities regulator) that can investigate such claims and reward the whistle-blower employee with a share of the discrepancy reported.  Such a “company oversight board” should also select penalties for officers involved in fraud. Outright cases of fraudulent reporting and manipulations should face criminal penalties,rather than civil. Criminal penalties are powerful deterrents for most top management. The criminal convictions of former top Enron executives,Jeffrey Skilling and Kenneth Lay in May 2006 was a painful reminder for anyone contemplating fraud. Such an agency should also focus on governance systems in private firms,lest firms have strong incentives to shift from a public to a private status. As long as these private firms issue debt,they have outside investors that need a protective environment. 

This agency is unlikely to play a significant role in directly detecting corporate fraud — but they can play an important role in designing governance systems. Properly designed governance systems will incentivise the relevant groups with access to information to blow the whistle. They can also research and publicise governance systems that will prevent someone from mounting the tiger in the first place.  It will however be a mistake for such an agency,or the current regulatory bodies,to throw a kitchen sink of compliance rules ala Sarbanes Oxley in the U.S. Investors do need some help but not hand-holding.  

The writer is founding partner of a New York-based asset management company,teaches at ISB and Wharton,and has written ‘Investing for Change’

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