Comparative Analysis

A. Comparison with Enron Scandals

The purpose of the corporate governance provisions, as found in various legislations, rules, and regulations
in corporate law, is to act as a watchdog over the activities of the companies. Without stringent corporate
governance procedures in place, companies are likely to partake in various fraudulent activities, causing
huge amounts of loss to the shareholders and to the society overall. As the two most recent cases of large-
scale corporate governance failure, the 2001 Enron case in US and the 2009 Satyam scam in India can be
chosen.

The primary method by which the two companies were able to conduct such shady activities for so long, was
fraudulent accounting activities. The administrators cooked the books of the companies freely, as well as
created various hedging agreements. On the other hand, even though there were many spheres of fraudulent
activities within the internal workings of these two companies, the boards of directors and the auditing firms
of the companies are liable to a great extent for these incidents, due to the extreme failures in mitigating their
duties responsibly. Under such a light, it becomes essential to analyze the failings of the boards of directors
and auditing firms of both Satyam and Enron in order to understand exactly how much they contributed to
the debacles, and how such incidents can be avoided in the future.

The term ‘corporate governance’ means the way a company is regulated or governed, and a good corporate
governance system would balance the interests of all the stakeholders in the company. The Satyam and
Enron cases are often used as prominent examples of corporate governance failures. The primary reason
behind that is that all the mechanisms that are usually put in place to prevent such an instance from
happening, for example, the auditors, the board of directors, etc., either intentionally or unintentionally,
allowed tremendous amount of fraudulent activities to occur within the companies.The Enron debacle
happened in the United States in 2001, when Enron Corporation declared bankruptcy. The energy company,
formed in 1985, rose very quickly to unimaginable heights. However, most of their profits were cooked up
using a technique called mark to market accounting. Once the burden got too big to maintain this tactic, the
company collapsed very quickly.

The Satyam scam came into light in India in 2009, and it is often referred to as India’s Enron. The IT
Company was found by the Raju family in 1987 and was considered to be one of the most promising
companies in India. However, just like Enron, Satyam’s accounts had major discrepancies, and the
irregularities ranged to more than Rs. 7,000 crores. Fudging the figures in the books related to assets, profits,
revenues, and losses was something both the companies practiced. This is a grave example of poor corporate

1
governance as it kept the shareholders in the dark about the true accounts of the company. When Enron and
Satyam ultimately fell, the shareholders lost billions.

These fraudulent accounting techniques could be carried out due to the failure of the boards of directors and
the auditing firms of these two companies. While the directors signed off on the shady techniques, the
auditing firms overlooked the gaps in the financial reports and gave their approval to them. Thus, it can
honestly be said that the Enron and Satyam scandals could be possible due to a combined effort. This article
discusses the activities of the two companies in detail while looking exclusively at the failings of the
directors and auditors.

Fraud in Accounting

Enron Fraud in Accounting

While Enron was considered to be one of the most profitable companies in the USA, in reality, Enron used
to inflate its assets and revenues to remain profitable in the eyes of the shareholders. Enron’s CEO and CFO,
Jeffrey Skilling and Andrew Fastow, used a technique called mark to market for this purpose. In this
method, when building an asset or making an investment, its current market value or the projected profits
would be put on the books, instead of its real value. If the investment does not work out as expected, Enron
would transfer the losses to one of its Special Purpose Vehicles (SPVs) to make Enron look profitable.
Enron had created almost 3000 partnership for the purposes of using and controlling those as SPVs, for
example, Jedi, Jedi 2, Chewco, LJM1, LJM2, etc. These companies were fuelled almost completely by
Enron’s stock and were used to hide the loss-making assets of Enron. The SPVs were given Enron shares to
mitigate the concerning losses, thus, creating a network of hedging agreements. Even though this practice
was not strictly illegal, the SPVs should be independent of the concerned company to be legitimate.
However, these companies were maintained by Enron personnel themselves. As a result, the employees were
enriched, Fastow acquiring almost $30 million.
In any case, this practice could not be carried on indefinitely, and Enron collapsed under the weight of its
own lies. In 2001, it announced a loss of $544 million, which got the attention of SEBI. A thorough report,
provided on SEBI’s request, showed a reduced net income of $500 million and increased debt $2.5 billion.
This situation lost the confidence of the shareholders, and the price of Enron stock fell from $90 to 26 cents.
Enron filed for bankruptcy that year itself. Insider trading was also involved in this case, as the key
personnel of the company unloaded huge amounts of stock just before the bankruptcy was filed.

Satyam Fraud in Accounting

2
On the other hand, Satyam’s CEO Ramalinga Raju went through a different route to make his company
appear profitable. Satyam Computer Services Limited, similar to Enron, was considered to be one of the
most promising companies in India before its fall. It dealt with outsourced IT services, worked with 65
countries and 690 companies. At its peak, Satyam’s share value was Rs. 526.25.
However, when the truth came out, it was found that the balance sheet was inflated by $1.47 billion. The
company’s founder, Mr. Ramalinga Raju, had overstated the company’s profits and bank reserve and
underreported its liabilities. He used the revenue of the company to purchase thousands of acres of land and
hoped to profit by selling them later. However, the real estate market declined, and it left a big hole in the
company’s revenue that he plugged up by cooking the books.

The tampering with accounts would be done by creating fake bills and invoices by Mr. Raju on his personal
computer with the use of special software. The fake invoices would increase the amount of profit as reflected
in the books, and the number was in thousands of crores. He also faked the number of employees in the
company, increasing it by 13,000, when no such employees existed. Crores of money were gained illegally
by those fake salary accounts. The assets and revenues of Satyam were inflated by adding thousands of
crores in the name of human resources value and brand value.
Additionally, 356 companies were created to siphon off money from Satyam. Mr. Raju was changing the
figures every year, and the gap between the actual and reported columns began to grow. The fraud came into
light when Satyam wanted to buy 51% of Maytas Infrastructure, and 100% of Maytas Properties. Both these
companies were owned by the family members of Mr. Raju. The Maytas acquisitions were planned to
mitigate the situations, in which no money would actually change hands, but the problem with overstating
figures could be resolved. This decision faced severe protest from the shareholders, and had to be reversed
within a few hours. Suits were filed in the US to protest these acquisitions, and that, ultimately, led to the
revelation of the irregularities at Satyam.
As the above discussion shows, the techniques used for the Satyam and Enron frauds were very different.
While Enron used the mark to market strategy, Satyam created fake bills and invoices. Additionally, the
SPVs were used for different purposes by the two companies. Enron used them to hide their loss-making
assets, but Satyam used it to siphon out cash. both Enron and Satyam are cases of accounting frauds, which
caused these giants to topple. However, both Enron and Satyam are, ultimately, cases of accounting frauds
caused by greed, which led these corporate giants to topple.
Role of Director and Auditor of Enron

Enron’s board of directors can be blamed to a great extent for letting the company go on with its fraudulent
activities. When the LJM partnerships were created, the board exempted Fastow from abiding by Enron’s
Code of Conduct, which prohibited its employees from making a profit from the business of another

3
company with Enron. As a result, Fastow was in a position of conflict between the interests of Enron and
LJM. He made millions of profit out of the LJM dealings, while Enron was on its path to bankruptcy.
The board also allowed the unusual partnerships between Enron and the LJM companies to be created
without proper analysis of the matter. Additionally, there were very little monitoring or control mechanisms
for the LJM partnerships. The directors themselves received hefty salaries and many of them had close
personal relationships with Skilling and Fastow, which might have swayed their loyalties as well.
Enron was able to carry on with its shady accounting tactics with the approval of its auditors, the prominent
accounting firm Arthur Anderson LLP. Due to the firm’s high reputation, the stakeholders did not question
Enron’s financial dealings once they had the sign off from Arthur Andersen. However, the auditing firm did
not act prudently and failed in its responsibility towards the shareholders. Thus, once the scenario came to
light, Arthur Andersen was blamed for not reporting Enron’s various SPE dealings earlier.
As the firm was also providing consulting services to Enron, it has been argued that there was a conflict of
interest. As much as 27% of Arthur Andersen’s total auditing fees came from Enron. An auditing firm is
supposed to act as a public watchdog and protect the interest of the investor, and Andersen failed in its duties
massively. Once Enron’s fell, Arthur Andersen followed soon after.
Role of Director and Auditor of Satyam

It had a vibrant board of directors, which included famous personnel like Vinod K Dham, T.R. Prasad, M.
Srinivasan, etc. as independent directors. They were professors, politicians, inventors, and in general,
eminent personalities. Once the misdealing came into picture, all of the independent directors resigned from
their positions, arguing that they had no prior knowledge of the dealings. The fact that the independent
directors received a remuneration of Rs. 13 lakhs could have compromised their interests. The Maytas deal,
for example, was unanimously approved by the board of directors, which was completely against the
shareholders’ interests. CBI investigations found several of the directors guilty of fraud, as no protests were
made to the fraudulent techniques used by the company.
A significant role was also played by Satyam’s auditing firm, Price Waterhouse Coopers. It acted as an audit
firm for Satyam between the years 2000-2008. However, similar to Arthur Andersen in Enron, PwC showed
a complete lack of initiative in controlling or reporting the illegal activities by Satyam. The shareholders
believed that Satyam’s finances were reliable based on the reputed firm PwC’s approval, and paid heavily
for that. For years, PwC neglected to cross-check the accounts provided by Satyam with those of the bank
balances. The firm was found guilty in the Satyam fraud case and was banned from conducting audits for
two years by SEBI.
Thus, in both Enron and Satyam, the directors and the auditing firms failed or neglected to do their duties.
Both of them are supposed to keep a check on the activities of the company so that the interests of the
investors are protected. However, due to these corporate governance failures, the shareholders lost billions of
dollars as an aftermath of the scandals.

4
When Enron and Satyam fell, thousands of employees lost their jobs and pension funds. Investors lost
billions of their hard-earned money. In the case of Enron, Andrew Fastow received a jail sentence of ten
years and had 1to pay a penalty of $23 million due to multiple counts of fraud and conspiracy. Skilling was
also sentenced to twenty-four years of prison.
Satyam’s Ramalinga Raju resigned after he confessed to the fraud in his letter. He compared the scenario to
“riding a tiger, not knowing how to get off without being eaten”. He was arrested and charged with criminal
conspiracy and forgery. The Company Law Board appointed a new board of directors and CEO for the
company, following which Satyam was bought by Tech Mahindra and renamed as Mahindra Satyam.
Due to the poor decision making of the companies’ top managerial personnel and the misplaced support in
them by the directors, these scandals had a chance to happen. The various partnerships were created by
Enron and Satyam for unfair dealings, even though the purposes were different. Both companies took part in
fraudulent accounting activities by using different techniques, which were subsequently approved by the
auditing firms.2

However, the good news is that as an aftermath of these scandals, the corporate governance regulations in
both India and the USA have seen much reform. Still, how effective those are to prevent future scams, only
time will tell.

Table: Operating Performance of Satyam

(In Millions)

Particulars 2003-04 2004-05 2005-06 2006-07 2007-08 Average

Growth
Rate (%)
Net Sales 25415.4 34642.2 46343.1 62284.7 81372.8 38
Operating 7743 9717 15714.2 17107.3 20857.4 28
Profit
Net Profit 5557.9 7502.6 12397.5 14232.3 17157.4 33
Operating 4165.5 6386.6 7868.1 10390.6 13708.7 35
Cash Flow
ROCE (%) 27.95 29.85 31.34 31.18 29.57 30
ROE (%) 23.57 25.88 26.85 28.14 26.12 2
(Source: www.geogit.com)
From 2003-2008, in nearly all financial metrics of interest to investors, the company grew measurably, as
summarized in Table-1. Satyam generated Rs. 25,415.4 million in total sales in 2003-04. By March 2008,

1
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=537542
2
https://www.nytimes.com/2002/02/03/us/enron-s-many-strands-excerpts-report-special-committee-investigating-enron.html

5
the company sales revenue had grown by over three times. The company demonstrated ―an annual
compound growth rate of 38% over that period.‖ Operating profits, net profit and operating cash flows
averaged 28, 33 and 35%, respectively. In addition, earnings per share (EPS) similarly grew, from $0.12 to
$0.62, at a compound annual growth rate of 40%. Over the same period (2003‐ 2009), the company was
trading at an average trailing EBITDA multiple of 15.36. Finally, beginning in January 2003, at a share price
of Rs. 138.08, Satyam‘s stock would peak at Rs. 526.25: a 300% improvement in share price after nearly
five years. Satyam clearly generated significant corporate growth and shareholder value. The company was a
leading star (and a recognizable name) in a global IT marketplace.

THE COLLAPSE OF ENRON CORPORATION: A FINANCIAL PERSPECTIVE

INTRODUCTION

Enron Corporation was formed in 1985 by Kenneth Lay. This was after the merger of Huston Natural Gas
and InterNorth. The company was based in Houston, Texas. Enron originally was involved in transmitting
and distributing electricity and natural gas throughout the United States. The company was engaged in
developing, building and operating power plants and pipelines within the legal framework. It owned a large
network of natural gas pipelines that stretched from borders to borders including Northern Natural Gas,
Florida Gas Transmission, Transwestern Pipeline Company and a partnership in Northern Border Pipeline
from Canada. Enron ventured into water in 1998 by creating Azurix Corporation. It was also engaged in
communication, pulp and paper production. Enron was the seventh largest Company in the Unites States of
America and was named “America’s Most Innovative Company” by “Fortune Magazine” for six consecutive
years, from 1996 to 2001. Enron’s sterling performance pushed its stock price to $83.19 by December 31,
2000. The stock increased by 56% in 1999 and a further 87% in 2000, compared to a 20% increase and a
10% decline for the index during the same years. The company filed for bankruptcy protection in December
2001. Unknowingly, the excellent performance of Enron was as a result of crafted fraudulent activities of the
Company’s executives. Enron’s revenues had hit $101 billion by the year 2000 and it employed about
22,000 staff. A revelation of the Enron scandal in October 2001 with its stock price dropping from $90.00 to
less than $1.00 by the end of November, 2001 caused a loss to shareholders of about $11 billion and resulted
in the investigation of the company’s operations by the U. S. Securities and Exchange Commission (SEC).
The company then filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code on
December 2, 2001 in the Southern District of New York.

ERNON REVENUE RECOGNITION

Revenue recognition criteria according Nugent (2010) include: the existence of a valid contract, assurance
of payment, the work is complete or essentially complete, and title passes between the parties. The
6
fulfillment of these criteria mandates the recognition of revenue within any financial reporting period. Enron
earned its profits by providing services such as wholesale trading and risk management, in addition to
developing electric power plants, natural gas pipelines, and storage and processing facilities. Service
providers, when considered as an agent, report only trading and brokerage fees as revenues as against the
merchant model which reports the total selling price as revenues and the product costs as cost of goods sold.
Enron, however, in contrast to practice developed an aggressive approach to reporting revenues by adopting
the merchant model where the entire value of its trade was reported as revenue instead of process employed
in the agent (fee only) model. This inflated Enron’s reported revenue astronomically from 1997 to 2000.
Enron Corporation’s net revenues were: $20,273 million for 1997, $31,260 million for 1998, $40,112
million for 1999 and $100,789 million for the year 2000. (Source: Enron Corporation: 1998, 1999 and
2000). In percentage terms, Enron’s sales increased by 53% in 1997, 54% in 1998, 28% in 1999 and 151%
in 2000, each from the previous year. Astronomical by anyone’s measure. These increases in revenues
without significant acquisitions were meteoric and resulted from the manipulation of revenue recognition
policies that Enron adopted during these reporting periods. Enron’s revenue growth on average was 72%
from 1997 to 2000. This growth was unprecedented where the energy industry’s growth on average was 2 –
3% per year5. Akin to the revenue recognition policies of Enron was also the fact that it adopted mark-to-
market accounting for its complex long-term contracts. Mark-to-market accounting as employed by Enron
required that once a long-term contract was signed, income was estimated as the present value of net future
cash flows. Unfortunately, due to the complex nature of Enron’s contracts, the viability of these contracts
and their related costs were difficult to estimate. In using this method, income from projects could be
recorded presently, which increased financial earnings. However, in future years, the profits could not be
included, so new and additional income had to be shown from more projects to develop additional growth.
By advancing revenues to current periods via the ‘marked to market’ Enron inflated its revenues. For
example, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on demand
entertainment to various United States of America cities by year end.

GROSS MARGIN ANALYSIS

Nugent (2003) defines “gross margin as simply the difference between net sales and cost of goods or
services sold”. It measures the operational efficiency of an organization. By employing the concept of
converging/diverging gross margin slope analysis one is trying to determine if gross margin is increasing as
a percentage, or decreasing as a percentage of net sales over the reporting period. If gross margin slope is
converging with that of the net sales slope, then it implies that gross margin is increasing as a percentage of
net sales. It means that each additional sale is more profitable operationally than the preceding sale. On the
other hand, if the gross margin slope is diverging from the net sales slope, it means that each successive sale
is less operationally profitable than the preceding one.

7
Table below indicates the sales and gross margins of Enron for the various periods under-review.

TABLE:- ENRON NET SALES AND GROSS MARGINS

Year 1997 1998 1999 2000

($ Million) ($ Million) ($ Million) ($ Million)

Gross Margin 15 1,378 802 1,953

Sales 20,273 31,260 40,112 100,782

Percent .07 4.4 2.0 1.94

(Source: Enron Corporation 1997, 1998, 1999 & 2000).