UNIVERSITAS INDONESIA

CORPORATE GOVERNANCE FAILURES

SATYAM CASE STUDY

MAKALAH NON SKRIPSI

NURUL AGHNIA ZAHRAH

1106076505

FAKULTAS EKONOMI UNIVERSITAS INDONESIA

PROGRAM STUDI KELAS KHUSUS INTERNASIONAL
AKUNTANSI
UNIVERITY of QUEENSLAND
ACCOUNTING
DEPOK
JANUARI 2015

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 UNIVERSITAS INDONESIA

CORPORATE GOVERNANCE FAILURES

SATYAM CASE STUDY

MAKALAH NON SKRIPSI

Diajukan sebagai salah satu syarat untuk memperoleh gelar Sarjana Ekonomi

NURUL AGHNIA ZAHRAH

1106076505

FAKULTAS EKONOMI UNIVERSITAS INDONESIA

PROGRAM STUDI KELAS KHUSUS INTERNASIONAL
AKUNTANSI
UNIVERITY of QUEENSLAND
ACCOUNTING
DEPOK
JANUARI 2015

Kegagalan tata..., Nurul Aghnia Zahrah, FE UI, 2015

Kegagalan tata..., Nurul Aghnia Zahrah, FE UI, 2015
Kegagalan tata..., Nurul Aghnia Zahrah, FE UI, 2015
Kegagalan tata..., Nurul Aghnia Zahrah, FE UI, 2015
 ABSTRAK

Nama : Nurul Aghnia Zahrah

NPM : 1106076505 (Universitas Indonesia)
NPM : 43299007 (University of Queensland)
Program : KKI Fakultas Indonesia
Faculty of Economics and Business
Judul : Corporate Governance Failures Satyam Case Study

Abstrak

Makalah non skripsi ini membahas tentang kegagalan governance perusahaan dari
mantan perusahaan teknologi informasi terbesar keempat di India, Satyam Computer
Services, yang terlibat dalam skandal fraud akuntansi perusahaan pada tahun 2009.
Laporan ini mengkaji implikasi etis dari fraud akuntansi tersebut, jenis earning
managemen yang dipraktekkan dan peran dari mekanisme governance perusahaan
tertentu yang mungkin telah meringankan kegiatan penipuan (fraud) di Satyam.

Kata Kunci:
Governance perusahaan, Satyam, fraud, earning managemen

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 ABSTRACT

Name : Nurul Aghnia Zahrah

NPM : 1106076505 (Universitas Indonesia)
NPM : 43299007 (University of Queensland)
Program : KKI Fakultas Indonesia
Faculty of Ekonomics and Business
Title : Corporate Governance Failures Satyam Case Study

Abstract

This paper discusses the corporate governance failures of Indian’s former forth-
largest IT firm, Satyam Computer Services, that was involved in a corporate
accounting fraud scandal in 2009. It examines the ethical implication of the
accounting fraud, the type of earnings management practiced and the role of specific
corporate governance mechanism that may have alleviated the fraudulent activities at
Satyam.

Key Words:
Corporate governance, Satyam, fraud, earnings management

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1. Discuss the ethical implications of the fraud committed at Satyam Computer
Services. In your response you should refer to the facts of the case, and to Part A
of the Code of Ethics of the Australian Accounting Profession discussed in
Chapter 29 of the HPH text.

Answer:

Satyam Computer Services, Indian fourth-largest computer services company,

shocked the global corporate community after news of a US$1.4 billion corporate
fraud at Satyam surfaced in December 2008. According to U.S. Securities and
Exchange Commission (hereafter SEC), from at least 2003 through September
2008, Satyam deceived investors by falsifying the firm’s revenue, income, earnings
per share, and interest bearing deposit – the primary indicators upon which
investors rely when making decisions about whether to purchase or sell company
securities. Obsessed with billion-dollar targets, Raju practiced earnings
management to meet analysts’ expectations. When the fraud was revealed, many
investors suffered huge losses and lost their confidence in Satyam and other Indian
outsourcing companies. When Satyam’s then- senior management’s behavior of
creating false invoices to inflate cash balances is assessed against statute of
common law, it is considered as a tort of deceit as it involved false representation of
financial condition that was intended to deceive the users of the financial
statements. Hence, it is easily proven that Satyam breached a common law,
which makes the fraud unethical. Due to this, many legal actions were brought
against Satyam. That behavior must also be assessed aignst a set of rules called
‘Code of Ethics’. According to Part A of the Code of Ethics of the Australian
Accounting Profession, it is expected that accountants must maintain integrity,
objectivity, confidentiality, professional competence and due care and professional
behavior. Paragraph 110.1 of Accounting Professional and Ethical Standards
Boards requires that accountants must be straightforward and honest in professional
and business relationship. In this case, Satyam’s then-senior managers had been
involved in a corrupt and fraudulent act in presenting their business to the society

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in general; clients, employees, investors and the public at large. The conduct was
unethical as Satyam misled the users of financial statements to believe that Satyam
was more profitable and financially sound than it actually was. It implies that
Satyam put their self-interest at the expense of their shareholders’ interests. When
the truth was revealed, Satyam no longer enjoyed a reputation of a fair, honest and
highly respected company. Then, paragraph 120.1 states that accountants must
not compromise their professional or business judgment because of ‘bias, conflict
of interest or the undue influence of others’. In Satyam’s ce,asthe work of its Chief
Financial Officer and auditor, PwC, had clearly been influenced by Raju’s
obsession to meet targets. PwC could be applying reckless standards in its audits
due to conflict interest over the auditing fees Satyam offered. In all circumstances,
they should have done what is right by taking steps to prevent corrupt practices. In
addition, the principle of professional competence requires accountants to
maintain professional knowledge and skills at the level required to ensure that
clients or employers receive competent professional service. The fraud could still
be carried out because PwC failed to independently verify cash balances in Satyam
bank accounts. Thus, PwC’s serious neglect of fiduciary duties violated the
professional competence obligation. Furthermore, the principle of professional
behavior imposes an obligation on members to comply with recent laws and
regulations and avoid any action or omission that may bring discredit to the
profession. In this case, the fraudulent act not only violated Indian’s anti-corruption
and anti-fraud laws like the Prevention of Corruption Act or the Prevention of
Money Laundering Act and Rules but also the anti-fraud, reporting, record-
keeping, and internal controls provision U
ofnited S tates federal securities laws,
involving those involved in the fraud in professional misconduct. They should have
ensured that their work was always lawful and justified. Lastly, paragraph 100.1
notes that a member’s responsibility is not exclusively to satisfy the needs of a
client or employer but also to act in the public interest that the company serves. In
this case, when Raju tried to commit a fraud, both the CFO and PwC should not
have safeguarded his interest. They should have known that the fraud could impose

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risk to 53,000 jobs at Satyam and India’s IT sector could also face downturn as its
image was tarnished globally. They should have persuaded him to adopt different
policies or they should have either resigned or engaged in ‘whistle blowing’
although this will involve a financial sacrifice to them. In conclusion, it seems that
the roots to the fraud at Satyam are failure in top leadership and corporate culture.
When the truth broke out, Satyam’s CEO, managing director, and CFO were
immediately arrested with criminal charges. It shows that even the top executives
did not closely adhere to the values of Code of Conduct aseddi.scSuim
ssilarly, the
culture at Satyam symbolized an unethical culture. Satyam’s board failed to prevent
Raju’s and then-senior management’s act of falsifying firm’s account. Instead,
they went along with his actions and stood there as a blind spectator. It then
implies that the boards also did very little to help create an ethical environment
within the company.

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2. In Mr Raju’s letter to the board members, he disclosed that “he had been
manipulating the company’s accounting numbers for years”. As well as
overstating assets on the company’s balance sheet, he had also overstated income
nearly every quarter over several years to meet analyst expectations.

Required:

The activities above are examples of earnings management undertaken by

Satyam Computer Services. Gunny (2005) states that earnings management can
be classified into three categories: fraudulent accounting; accrual-based earnings
management; and real earnings (activities) management. Provide examples of
earnings management and distinguish between the different etyspof earnings
management. Which type of earnings management was practiced at Satyam
Computer Services? Refer to relevant research from at least three articles to
support your argument.

Answer:

Earnings management occurs “when managers use judgment in financial reporting

and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company or to
influence contractual outcomes that depend on reported accounting numbers”
(Healey and Wahlen 1999). According to Gunny (2005), the methods of earnings
management can be categorized into three categories: fraudulent accounting,
accruals management and real earnings management. Gunny (2005) recognizes that
fraudulent accounting involves accounting choices that violate Generally Accepted
Accounting Principles (hereafter GAAP). The real example for this can be best
described through WorldCom’s accounting scandal in 2002. The company used
fraudulent accounting methods to disguise its decreasing earnings to maintain the
price of its stock. According to the Report of Investigation by the Special
Investigative Committee of the Board of Directors of WorldCom, Inc, one of the
ways the fraud was accomplished was through transferring of line costs expenses

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(cost of transmitting calls) to asset accounts. The transfer obviously was not made in
accordance with the GAAP as under GAAP such fees must be expensed and not
capitalized. As a result, WorldCom materially understated its expenses and
materially overstated its earnings, thereby misleading investors. Gunny (2005) also
recognizes that real earnings management (hereafter REM) occurs when
managers undertake actions that deviate from the first best practice to increase
reported earnings. Firms that employ REM employ real operational activities to
manipulate earnings numbers (Healy and Wahlen 1999). Real activities
manipulation affects cash flows and in some cases, accruals (Roychowdury 2006).
Example of this is when firms are trying to disguise its decreasing earnings by
offering price discounts to increase sales on current period, engaging in
overproduction to decrease cost of goods sold and reducing discretionary
expenditures such as Research and Development and Selling and General
administrative expenses to improve margin. Meanwhile, according to Dechow and
Skinner (2000), accruals management involves within-GAAP choices that try to
“obscure” or “mask” true economic performance. Roychowdury (2006) also states
that accruals management is manipulation of accruals with no direct cash flow
consequences. Examples include underprovisioning for bad debt expenses and
delaying asset write-off. Robb (1998) shows an example that bank managers make
greater use of the loan loss provision to manipulate earnings upward when analysts
have reached a consensus in their earnings predictions. The practice of accruals
management can be illustrated by Enron’s scandal in 2001. It is believed that Enron
began to use mark-to-market accounting that allowed them to recognize long-term
contracts’ present value of net future cash flow as current income to keep its share
prihceigh, ra ise investment against its own assets and stock and maintain the
impression of a highly successful company. As a result, this accounting method
allowed opportunistic behavior of the management to inflate Enron’s earnings. From
Gunny (2005), we can then conclude that the main difference of fraudulent
accounting, accruals management and real earnings management is that while
fraudulent accounting and accruals management are not accomplished by changing

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the underlying economic activities of the firm but through the choice of accounting
methods used to represent those underlying activities, REM is accomplished by
changing the firm’s underlying operations, such as through cutting prices to boost
sales. Therefore, in my opinion, the earnings management practiced at Satyam
is fraudulent accounting. Satyam’s manipulation of revenues, profits and cash
balances that simply did not exist is considered to be a fraud as Satyam intentionally
wanted to mislead investors into thinking that Satyam was in more profitable and
sound financial condition than it actually was. There was no channggoif underlying
economic activities involved by Satyam, but it simply overstated its assets and
earnings and understated liabilities numbers on its financial reports. For example, as
of March 31, 2006, Satyam’s intangible assets (Human Resource value and brand
value) constitute 87.72% of the total balance sheet value. However, it later
appeared that Satyam’s real number of employees had also been falsified; on paper
it was 53,000, when the actual number was no more than 40,000, which means that
there was an inflated of non-existent asset and expenses (employee salaries). False
representation of numbers violates the GAAP as financial reports must always
represent true and fair view of the business operations. Raju’s attempt to buy
Maytas’s stake would, however, be considered as real activities management
earnings as it involves a structuring of a real investment transaction in an effort to
influence the output of the accounting system (Gunny 2010). The purchase of the
stake at Maytas would cover up the deceit in Satyam’s balance sheets and the
transfer of cash was to be used as a smokescreen to set its financial books right.

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3. Summarize the failures in corporate governance at Satyam Computer Services.
Discuss the role of specific corporate governance mechanisms that may have
alleviated the fraudulent activities. You must provide examples of supporting
research from at least three articles. In your response you should refer to the
OECD Principles of Corporate Governance.

Answer:

Corporate governance refers to the set of systems, principles and process by which a
company is directed. They provide the guiding principles as to how the
company can be directed or controlled such that it can fulfill its goals and
objectives. Satyam’s corporate fraud is a prime example of poor governance
practice. Satyam had failed to show a good relationship between its owners, board
of directors and management. This is easily proven when the shareholders strongly
criticized Raju’s acquisition plan to acquire a controlling stake in Maytas Property
and Maytas Infrastructure with the consent from the boardism
. pItlies that th e
boards made decisions without incorporating shareholders’ interests. Satyam’s audit
committee also failed to ensure the integrity of the firm’s accounting and financial
reporting systems and compliance with the law and relevant standards. The role of
the Satyam’s independent directors also came into questions as they failed to
monitor closely to detect and prevent the fraud from happening. According to
Davidson, et al. (2005), the practice of earnings management is systematically
related to the strength of internal corporate governance mechanisms, including the
board of directors, the audit committee, the internal audit functiaonndthe choice of
external auditor. Their findings show that a majority of non-executive directors on
the board and on the audit committee are found to be significantly associated with a
lower likelihood of earnings management. In Satyam’s case, it is obvious that their
internal governance structure was weak as Raju was still able to manipulate firm’s
financial statements. Fama and Jensen (1983a) recognize the board of directors as
the most important control mechanism available because it forms the apex of a
firm’s internal governance structure. From an agency perspective, the ability of the

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board to act as an effective monitoring mechanism is dependent upon its
independence from management (Beasley, 1996). Satyam’s board had almost the
majority of independent directors as five of the nine directors are listed as
“independent of management”. A sufficient numbers of independent directors are
needed to exercise independent judgment in times of conflict of interest.
Furthermore, Xie, et al. (2003) suggests that a director with corporate or financial
background may be more familiar with the ways that earnings can be managed and
may better understand the implications of earnings manipulation, yet of the six
nonmanagement directors snergvion Satyam board, four were academic s, one from
government and only one had corporate background. Also, it is not enough that
directors are independent, they must also be active. Xie, et al. (2003) demonstrates
that the more active boards, as proxied by the number of board meetings, is
associated with a lower level of earnings management. However, Satyam's Form 20-
F states: "Our non-management directors do not meet periodically without
management directors.” More number of meetings means that boards are more
likely to discuss firm’s pressing issues like earnings management. Davidson, et al.
(2005) argues that another importanartach teristic of boards is whether there is a
separation of the roles of the chairperson and Chief Executive Officer. However,
their finding does not find any negative relationship between the two. On the
contrary, Loebbecke et al. (1989) argues that CEO-duality firms are likely to
exhibit lower financial reporting quality because CEOs can manipulate financial
reporting to achieve their own aims. In Satyam’s case, although it may have divided
the roles of CEO and chairman of board, people who served these roles were
brothers and both were part of the management. Fraud would not have been
committed if only the chairman was unrelated to Raju, so the chairman could
saafergduthe intere st of shareholders. Therefore, it is insufficient for Satyam’s
majority board to only be independent from management but one of them must at
least have financial or corporate background and meet frequently so they can be
more effective in monitoring the management’s decisions regarding earnings
management. The audit committee’s role at Satyam is also vital in alleviating the

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fraudulent activities. Their primary role is to help ensure high quality financial
reporting. As indicated by the BRC (1999), the audit committee is the “ultimate
monitor of the financial reporting process.” The committee may reduce opportunistic
earnings management by “evaluating the competence and independence of the
external auditors,” by engaging in proactive discussions with company’s
management and outside auditors regarding key accounting judgments, and by
probing “to find out the nature and extent of issues that management and auditors
gave considerable attention to” as well as “the outcome of these discussions.”
Bedard, et al. (2004) finds tahnataudit committee whose members have more
expertise is more effective in constraining earnings management. They specifically
found that the presence of at least one member with financial expertise, which is
Sarbanes-Oxley Act (hereafter SOX) requirement, is associated with a lower
likelihood of aggressive earnings management. Satyam admits in its August 2008
Form 20-F filing with the Securities and Exchange Commission (hereafter SEC)
that “We do not have an individual serving on our Audit Committee as an ‘Audit
Committee Financial Expert’ as defined in applicable rule of the SEC. This is
because our board of directors has determined that no individual am
udiitt com tee
member possesses all the attributes required by the definition ‘Audit Committee
Financial Expert.’” The fraud could be detected at an early stage if they were to
have at least one member from the audit committee who has accounting or financial
management expertise that understand how earnings are usually managed. Since the
roles of the committee are to oversight and protect the interest of shareholders, it
is necessary that they must be independent from the management so that they are
free from management’s influence. Bedard, et al. (2004) results support the SOX
requirements that all members of the audit committee be independent. T
fohuenyd
that there is a significant reduction in the likelihood of aggressive earnings
management when 100% of members are independent. Furthermore, like the board
of directors, Menon and Williams (1994) argue that, for the audit committee to be
effective, it is not enough to be independent but it must also be active and vigilant.
This is also supported by Ebrahim (2007) that abnormal accruals are even much

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lower when independent audit committee is more active and vigilant. Committees
that meet frequently allow directors more time, on average, to carry out their
monitoring duties and are more likely to exercise effective control over the quality
of financial information that is conveyed to shareholders (Menon and Williams
1994).

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