Insight

Learning from Satyam: How to Detect Fraud


The scandal at Satyam Computer Services (SAY) continues to rock India's outsourcing industry. The company, once the fourth-largest IT services provider in India, has been on the rocks since then-Chairman Ramalinga Raju announced in January a $1 billion accounting fraud. Prosecutors are pursuing cases against Satyam executives and auditor PricewaterhouseCoopers accountants. Rivals are busy trying to poach Satyam employees and clients. And smaller competitor Tech Mahindra (TEML.BO) in April took control of the company by buying 51% of Satyam stock for $1.5 billion.

As Indian investigators try to learn how to look for fraud in the future, they need to look at a relatively obscure line item in Satyam's books. A comparison of Satyam's performance with its two major competitors—Infosys (INFY) and Wipro (WIT)—would not have revealed any problems. The company consistently lagged in key performance metrics, including return on equity, receivables turnover, and cash conversion cycle, but (unlike in other frauds) the metrics would not have shown any reason to suspect financial statement manipulation.

Breakdown of Internal Controls

The vital clue, though, was Satyam's investments in bank deposits. As of Mar. 31, 2008, Satyam reported in its consolidated balance sheet approximately $825 million of its $1.1 billion cash and bank balances as investments in bank deposits. The first time this line item appeared in Satyam's consolidated financial statements was in fiscal year 2003. It is indeed telling, in retrospect, that the disclosures made by the company about these deposits did not include the names of the banks where the deposits were invested—customary in India under generally accepted accounting principles (GAAP)—nor did they explain the reasons as to why a significant portion of the company's assets were invested there.

Even though the disclosures were minimal at best, it is highly unusual that scant—if any—attention was paid internally to such large bank accounts without examining the supporting details on where they were located and who had access to them. It appears that management overrode the underlying internal controls, which would imply that there was a breakdown of such controls over financial reporting. Corporate governance at Satyam appears to have been virtually nonexistent, but this fraud should have been caught much earlier, particularly through the external or internal audit processes.

Since the criminal proceedings and the restatement of Satyam's consolidated financial statements are still under way, the underlying facts and circumstances of Satyam's fraud are not completely transparent yet. Perhaps the strength of the company's reported numbers concealed the imploding financial situation. Two plausible scenarios arise: One, the cash reflected in the cash and bank balances was fake from the beginning; or two, that the cash was genuine but was subsequently misappropriated.

Was It Fake?

Let's first consider the first scenario—the cash generated was fake. As an initial reaction, one might logically presume that the revenues at Satyam must have been artificially inflated to generate the magnitude of cash and bank balances that Satyam fictitiously reported in its consolidated financial statements. This reaction assumes that the overstated cash and bank balances were a result of cash that never existed in the company's accounts.

This type of financial statement fraud has a precedent, as in the case of Parmalat (PLT.MI), a multinational Italian dairy and food company. Parmalat's management apparently generated fake invoices to inflate revenues, and also "created" cash to make the inflated revenues seem genuine. In an attempt to cover its tracks, Parmalat's management forged a bank confirmation showing a balance of $4.9 billion. Calisto Tanzi, its founder and CEO, was charged with financial fraud and money laundering and sentenced to 10 years in prison in December. Seven other defendants were acquitted, while eight defendants settled out of court in September.

This type of fraud is rather difficult to execute for a long period of time, mainly for two reasons. The misdeeds at Satyam allegedly took place over seven years, while Parmalat imploded and filed for bankruptcy within one year after forging the $4.9 billion bank statement. (To be sure, Parmalat's management was alleged to have fabricated other schemes for more than a decade.) First, the income statement would have required too much manipulation and even standard income manipulation predictions models would have caught it. The results appear to indicate that Satyam did not engage in income manipulation. Second, and more important, cash is cash, and is virtually impossible to "create" legitimately.

Or Was It Real?

That leads to the second scenario—the cash was genuine. A company's statement of cash flows shows its periodic cash position and both the sources (cash inflows) and uses (cash outflows) during the given period, broken down into the categories of operations, investing or financing activities. In Satyam's case, cash flows from operations appeared to have been the primary driver of its cash inflows with minimal long-term debt and equity financing.

Consider, again, the $825 million Satyam reported as investments in bank deposits in its consolidated balance sheet as of Mar. 31, 2008. If one were to substitute the line item "investments in bank deposits" with "Chairman Raju's personal account," this scenario assumes significance. As such, the hypothesis we raise is that Satyam was a legitimate cash-generating business over time; that Raju misappropriated Satyam's cash; and, that most of the misappropriation was probably not reflected on the company's books.

We assume that Raju likely used the cash from these bank deposits to finance personal investments (many probably risky ventures). When the economy was good, Raju could borrow against his Satyam shares to fill in shortfalls in cash both for his personal investments and for Satyam, when needed. We suspect that with the economic downturn, his myriad personal ventures likely failed. Since no cash could come in from these investments, they triggered more cash inputs. As the economy was faltering globally and credit was drying up, the shares of Satyam could not be pledged for more cash. As such, Raju could not pull this trick of generating cash by borrowing more to meet Satyam's liabilities as before. Therefore, everything ended in a fiasco.

Glaring Weaknesses in Corporate Oversight

If one were to predict which scenario was more likely to have occurred, scenario No. 2 would seem to fit the bill because the use of standard models of detecting income manipulation would have detected the type of fraud as discussed in scenario No. 1. Accordingly, it is unlikely that the income statement was manipulated much. The cash flow statement may be more informative during crisis situations than the income statement, but standard models could not catch this fraud because they focus more on the income statement and the balance sheet rather than the cash flow statement. Only a detailed analysis of the cash flow statements could have caught it. When the dust finally settles, it is conceivable that a combination of both scenarios might have transpired.

It is shocking that Raju was able to perpetrate a fraud of this magnitude in a public company for seven years undetected. Along with his accomplices, Raju appears to have taken advantage of the glaring weaknesses of corporate governance at the company. This episode should teach us that the lack of strong corporate governance, including an entity's system of internal controls, leaves the door open for such debacles. It also prepares us—whether we are investors, auditors, regulators, or analysts—to be vigilant when discharging our duties, since financial fraud can sometimes be hidden in overlooked parts of the financial statements.

Suresh Govindaraj is an associate professor of accounting, business ethics, and information systems at Rutgers University. He received his PhD from Columbia University. He can be reached at sureshg@andromeda.rutgers.edu. Vijay Sampath is a managing director with global strategic consulting and expert services firm LECG in New York. He has more than 20 years of experience providing auditing, accounting, forensic accounting, and litigation consulting services. He can be reached at vsampath@lecg.com.

Suresh Govindaraj is an associate professor of accounting, business ethics, and information systems at Rutgers University. He received his PhD from Columbia University. He can be reached at sureshg@andromeda.rutgers.edu.
Vijay Sampath is a managing director with global strategic consulting and expert services firm LECG in New York. He has more than 20 years of experience providing auditing, accounting, forensic accounting, and litigation consulting services. He can be reached at vsampath@lecg.com.

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