Friday, August 28, 2009

Corporate Frauds; Earnings Management

One question that does not seems to have been fully answered in the last few months is whether the Satyam episode is truly an aberration or whether it is just the tip of the iceberg (thereby signalling a systemic problem generally in several Indian companies).

The Economic Times has an interesting report on various types of frauds that are practised in Indian companies and the role of various agencies (such as forensic auditors, investigators and the like) in trying to curb fraudulent activity in businesses. This seems to suggest the existence of a deeper malaise within the system. As regards timing, the possibility of such frauds are not only higher in times of downturns (as currently being witnessed), but the chances of detection are high during such times too. The famous quote by Warren Buffet in this behalf has been repeated too often in recent months: “Only when the tide goes out do you discover who's been swimming naked.”

At a broad level, there could be two types of incentives for persons involving in fraudulent activity, one which relates to the motives of individual employees towards personal aggrandizement at the cost of the company (and other stakeholders) involved, which amounts to pure fraud or cheating. The other is a larger issue, which revolves around the concept of earnings management where companies are under pressure to meet earnings estimates, especially where quarterly reporting is involved (as in the case of public listed companies in India), and may hence fail to truly represent the state of affairs of the company. These incentives get somewhat further distorted where performance-based pay and stock options are used to remunerate senior managers, thereby inducing companies to maintain their stock price.

While the pure-fraud cases are to be dealt with through criminal law, issues such as earnings management are also to be dealt with through stringent provisions securities regulation and corporate governance norms. The current evidence indicates a greater incidence of the former type of cases rather than the latter, but beyond a point the distinction between the two gets somewhat blurred (as in Satyam’s case) and hence caution must be exercised to prevent both types of occurrences.

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