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Why and how global corporate accounting frauds happen

Introduction:

Time and again companies like Enron, WorldCom, Societe General, Parmalat, Ahold, Allied Irish, Bearings, Kidder Peabody, to name a few, have been involved in fraudulent financial activities. Last year, India saw a new name being added to this notorious list: Satyam Systems, a global Indian IT company, was accused guilty of broad accounting improprieties that overstated company revenues and profits and reported cash holdings of approximately $1.04 billion that simply did not exist, which Satyam's CEO, Ramalingam Raju, took full responsibility for. Being one of the pillar’s of India’s growing economy, the fallout of this scandal left analysts to sift through the rubble of compliance and governance concerns. However, there appears to be very little information about the actual truth behind this so called “India’s Madoff”. If there is “very little information about the actual truth behind this” fraud, can you research it?

This leads us to a very important question: how does this keep happening, despite several preventive measures undertaken by Governments and Regulatory Bodies all over the world? Thus, this dissertation will attempt to answer this very question. With the “Satyam Scandal” as a case-study, we shall try to find appropriate reasons behind the increasing number of companies being involved in “window-dressing their Balance Sheets” and how these big names get away. There seems to be two questions here, stated in the two sentences of this paragraph. The first question is imprecise about what “this” is. Depending on what it means, it is probably unfeasible for a Masters dissertation, for reasons given above as problems with the ‘Expected contribution’. The second question is unclear about what is meant here by ‘appropriate’. It also is unfeasible, because it implies an extensive study of ‘window dressing’ of balance sheets, including why this occurs, and why it is increasing, which requires studying why it occurred less in the past than today. Studies into window dressing, also known as ‘earnings management’ or ‘creative accounting’, are numerous, and a literature review of these studies would too big for a Masters dissertation. It is not yet clear in this proposal that ‘window dressing’ amounts to corporate accounting fraud, as much window dressing does not amount to fraud. Because of the problem of generalisation from a single case, study of the Satyam would take you very far in answering this question as stated here, or reasons behind corporate accounting fraud. Furthermore a single case study will not throw any light on whether or why there may be an increasing trend of window dressing or corporate accounting fraud.

The research question:

Why and how Global Corporate Accounting Frauds happen: The “Satyam” Story. This is a different question from those posed in the previous section. However, it is unfeasible because you cannot generalise from the Satyam story to an answer a question about corporate accounting frauds in general.

Motivation:

“Typically, the employee will not have set out to be dishonest, only to dodge a few rules. His fraud, small at first, will build, because the exit he thought just around the corner never appears” (Loomis, 1999 Not in your list of references). As Satyam's Raju states in his letter to the Board, "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..." Reference and page number needed for this quotation

Thus, it appears that past mechanisms have failed to control management’s “wrong incentives” (Johnson et al, 2005 Page needed for a quotation). We need other mechanisms to hold those incentives in check since the “white-collar crime” cannot be viewed as less of an evil than any other form of crime. This broad conclusion would need analysis to support it in a dissertation. For example, you would need to identify the “past mechanisms” and what the “wrong incentives are”. These might be related to the content of the previous paragraph about small innocent beginnings for typical accounting frauds. Then you might explain why further mechanisms are needed, whether these are to hold in check the innocent beginnings of fraud, or to prevent their growth into major global scandals. Although it is no doubt obvious to you and most people that major accounting frauds such as Enron and Satyam are evils that should be prevented, it may be that these frauds as with all crime can never be totally eliminated, and so there may a balance between benefit and cost that society is prepared to pay.

Key prior literature:

The literature on Global Corporate Accounting Frauds is very extensive. Different academics have drawn up varied conclusions to explain why and how of accounting frauds. Braithwaite (1985) blamed the “class structure, widespread use of international law evasion strategies, and a preference of control agencies for informal, direct action modes of social control over litigious regulation” (page needed for quotation), for growing white collar crimes. Beasley (1996) empirically analyzed the relation between Board of Directors composition of a company and its tendency to indulge in frauds, which was further supported by studies of Uzun et al (2004). Alexander and Cohen (1996) found weak evidence on the relationship between prior performance and corporate crime but established that larger firms are more likely to engage in manipulations as compared to smaller ones. Gerety and Lehn (1997) tested several hypotheses concerning why firms indulge in accounting frauds. Pressman (1998) tried to find an explanation for prevalency of financial frauds in the Behavioural Theory. While, Erickson et al (2004) found no consistent evidence on executive equity incentives being associated with frauds, Robison and Santore (2005) identified “an increase in the attractiveness of equity compensation and the value of the firm due to an increase in the likelihood of fraud” (Page needed for quotation. It seems to say that increase in equity compensation and firm value is caused by an increase in likelihood of fraud, which needs some explanation.) This was further supported by studies of Johnson et al (2005) who found optimal governance measures to depend on strength of executives’ financial incentives and that restrictions on an Executive’s ability to sell shares could deter fraud. Harris and Bromiley (2007) even developed hypotheses predicting that top management incentive compensation and poor organizational performance increase likelihood of financial misrepresentations. Crutchley et al (2007) established that corporate environments which “manifests significant growth and has accounting practices that are already pushing the envelope of earnings smoothing” always encourage accounting scandals. Ball (2009) tried to find the cause of frauds in either market failure or regulatory failure or both at the same time. This paragraph refers to a good selection of academic literature. It seems to indicate a variety of factors that contribute to corporate accounting fraud. I wonder if these 11 articles are the total extent of the “very extensive” literature on corporate accounting fraud, mentioned earlier. This is a good first step towards a literature review of corporate accounting fraud, which might follow what you have learnt about reviewing literature in your Research Methodology course. It needs some synthesis into (a) common theme(s), or a conclusion that this body of literature fails to reach any consistent picture of the topic.

Satyam Systems always had a reputation of excellent corporate governance. In fact, it was awarded Sits Golden Peacock Award for Corporate Governance in 2008 by the World Council for Corporate Governance. Agrawal and Chadha (2005) explain this saying that several key corporate governance mechanisms are unrelated to the probability of a company restating earnings.

World renowned Pricewaterhouse Coopers audited and signed off Satyam’s financial reports, raising concerns that even increased auditing standards imposed by Sarbanes-Oxley may not be sufficient. (Was Satyam subject to Sarbanes-Oxley Act 2002?) However, Weil (2004) argues that “auditors can't check all of a company's numbers, since that would make audits too expensive, particularly in an age of sprawling multinationals. The tools at auditors' disposal can't ensure the reliability of a company's numbers with absolute certainty”.

Proposed research methodology and methods:

a. Proposed Methodology: For the research, available literature relating to Accounting Frauds will be reviewed first. This will be followed by a critical analysis of the case-study (The Satyam Scam). You will need to explain in your dissertation why you select these methods. This explanation of a rationale for selection of methods could constitute the methodology element of your dissertation. You might also go further in the following explanation of how the literature review informs your case study analysis, or what relationship there is between these two parts of your methods.

Primary Research

Publications (academic – e.g. articles and non-academic – e.g. magazines, books)

Internet articles

The primary research will provide an understanding of why and how corporate frauds have happened in past, as cited by authors of different publications. This will give an idea of the research work done so far in this field and will further help comprehend why suggested mechanisms to control frauds have failed. It might, but you should be prepared for the possibility that they do not support such a neat conclusion.

Secondary Research

Annual reports and company data

Newspaper articles on the scam

The secondary research might help unearth the real truth behind the Satyam Scandal: how and why it happened. Then perhaps a link might be established between this and outcomes of the primary research, while taking note of discrepancies that might arise. All this might help bring out precise reasons as to why and how frauds still happen despite all efforts to curb it. How will you identify what is “the real truth”? Because of the generalisation problem, this single company case study can no more than give an example of how corporate accounting frauds happen. It cannot lead to a conclusion of how and why frauds in general happen. Nevertheless an example from a single case of how fraud can happen could very provide useful knowledge as explanation; you may find it useful to distinguish between explanatory information and predictive knowledge.

b. Availability of sources: Annual reports, company data and other information are available on the internet. Academic journals required for literature reviewing can be accessed on the University Library’s database.

c. Ethical considerations: No ethical approval by the faculty is required since human subjects are not involved in the research.

Also, during the research, copies of Excel analysis files will be retained as evidence of it being one’s own work.

d. Literature Review Method: Full record of all reference works consulted will be kept, noting each one at the time consulted. When notes or extracts will be taken from reference sources, a careful note of where each extract comes from will be carefully noted. While this is necessary, it does not amount to ‘literature review method’.

Nature of potential results:

The possible root cause behind the frequency of such scandals in the corporate world could be found since prior research seems to have failed to do this as companies still indulge in fabricating their books of accounts. I am sceptical that there is a “root cause” of corporate accounting scandals, but accept that there might be one. I suggest that you consider the possibility that you might not find one.

Expected contribution to knowledge:

Accounting frauds have become common in today’s world, and their effects are not simply localized to company executives or employees. Corporate improprieties affect the global economy. If there isn't sufficient belief in the notion that business will act in good faith, then the capitalist system is itself at risk! Therefore, once the root cause of these activities is known, scandals as these could be impeded in the future by creating awareness. Yes, even awareness of how such fraud can occur would be an excellent contribution to knowledge.

Main limitations:

Since, the study is limited to only one particular scandal, the outcome might not be generalised. This means that the reason why Satyam got involved in fudging accounts might not necessarily be the same for others as situations differ, companies differ, people involved differ and regulations from country to country differ as well. Yes, this is a real problem, which is inherent in all single case study research. You need to think through the implications for your research design, so that you can justify your methods, and distinguish findings that amount to an answer to your research question from implications that follow from this answer. The basic design that you envisage of a literature based single case study is potentially viable.

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