Wednesday, January 7, 2009

Accounting Fraud

The news of the day is the resignation of the CEO of Satyam Computer, Ramalinga Raju, after admitting to fraud on a grand scale. Revenues and earnings were overstated massively over the last couple of years, and the company admitted that the cash that had been reported on the last balance sheet did not exist.

I would claim to be surprised and shocked by this news but I am not, becuase it is one in a long series of similar events - Enron, Parmalat, Worldcom etc. Rather than focus on Satyam and the sins of its managers, I would like to make some general points about accounting fraud and its consequences:

1. Self interest ultimately rules the day: The modern corporation is rife with conflicts of interests - between stockholders and bondholders, stockholders and managers, different classes of stockholders and different lenders. When decision makers are faced with a conflict of interest, self interest ultimately will win out. Note that Satyam's deception came to the surface when the company tried to buy stakes in two proprety companies owned by the Raju brothers.

2. Corporate governance matters: While we cannot do much about human beings acting in their self interest, we can put up roadblocks that prevent them from ripping off the rest of us. Having a board of directors tha asks tough questions and holds management accountable is critical to keeping managers/ founders in check. In this case, I have serious problems with the board of directors at Satyam and their oversight of the managers. I know at least 3 people on this board and believe that they are smart, honest people, but they were clearly led down the garden path. I have always had problems with the structuring of family companies in Asia, where families often control dozens of firms using a variety of devices including cross holdings and pyramid structures. When confronted, the families contend that they are "honorable and noble" and that they have the best interests of stockholders at heart. I don't think so!!!!

3. New Accounting and disclosure rules won't prevent fraud: The Indian government and accounting standards board will start writing new rules that they will claim will prevent this type of fraud. I seriously doubt it. Firms will always be one step ahead of the accounting rule makers when it comes to pulling off these heists.

What are the lessons for us as investors? When things look too good to be true, they are usually false. I am not familiar with Satyam's financials, but it may be worth looking at past statements to see if the clues were there that we chose to ignore. There is a strong need for forensic accounting... Just a warning! Fraud and malfeasance come to the surface when times are bad and I will expect to see a flood of Satyam-like cases all over India and China especially. Growth has masked the weaknesses of corporations in both countries and its absence will separate the wheat from the chaff.

27 comments:

evileconboy said...

Do these companies in India have auditors?? I mean tying cash takes about 10 seconds.

Raj said...

Yes - These companies do have Auditors. In the case of Satyam its none other then PriceWater Coopers!.

Heshrulz said...

But how could they hide such huge amounts of cash? How did it go unchecked by the auditors? If promoters can't dilute their holdings without public knowledge, how could they be allowed to mortgage so that the lender does it on their behalf?

Apurv said...

just like Enron was also able to do.Buying out the auditors

JPM said...

MNC's with Indian Origin; I assume are equally or better regulated than US companies. It's the Big 4 Shark Accounting+Auditing firms who might not just be colluding but Sharing Amazing Accounting Insights to sex up Numbers.

PWC : I'm not sure how much of an Impact it will have on them.

randomthoughts said...

I think its now become a strong acquisition candidate.. The core business remains attractive but needs restructuring..

Little Bear said...

I am a student and just learning about this stuff. Are there any good books out that would help me learn accounting better, or what to look at to detect fraud on the financial statements?

Moosie said...

@Little Bear:

Prof. Damodaran's Valuation is excellent and touches on this in the context of understanding financials and valuing firms.

If you're just starting to learn, you may not find these books an easy read, but there's Quality of Earnings, and Financial Shenanigans.

dharma said...

satyam fraud isnt suprising..They have been carrying non existent cash balances for several quarters under the head "cash in current account". Just that this whole fudging up process never got noticed by any stakeholder. No enterprise would hold up cash in current account that doesnt even yield any interest income. PWC did not exercise discriminative intellect during its audit process and has plainly relied upon the bankers confirmation of balances..Its not that satyam business was not profitable. No clients have come forward so far to complain about their operational expertise or execution/delivery capabilities. Its just that a protion of the top management has colluded with Raju to siphon funds off balance sheet to group companies which resulted in inflated figures being carried in the books for a long time. The hawala mechanism has worked overtime in this whole scam. Whats puzzling is the laxity of PWC as an audit firm in the whole process of auditing satyam's books. Did they simply rely on management assertions without looking deeper into the financial statements for material mistatements?.A cursory glance at the cash flow statements of the company over the past few years would have given them enough room for doubts over the state of affairs. Whichever way u look at it now, PWC has an albatross hanging around its neck which its gonna find very difficult to shed off

dharma said...

In all probability to protect the interest of 50000 employees of the IT behemoth, the government may have to resort to the populist measure of bailing out the company by infusing liquidity to fulfill its working capital needs. Since L&T and LIC are stakeholders in the company and now with GOI deciding to place nominee directors on board, there is every possibility of an initial bail out from GOI and later on some merger arrangements with L&T infotech or a consortium of interested IT companies. Interesting events can unfold in the days ahead. The only issue bothering white knights now is the concealed liability on satyam's books as well as the legal claims that might be bestowed upon the company post this largest corporate fraud in Indian history.

aymru said...

Hi prof.

I want to add some questionable items I found in Satyam's case.

1. A company started in 1989. Company got FIFA world cup IT services license for 2010 and 2014 years. The matter of the fact is, India is never qualified for FIFA and still an Indian company; Satyam, got the license. Isn't it weired and suspicious?

2. The questionable role of Independent directors. Stakeholders believe that these directors would really question the CEO and other directors if they find something is wrong. Here four directors quit on or before 31st Jan 2008. and they were believed to be close to Ramalinga Raju.

3. When one of the Satyam's major client, Merrill Lynch was bankrupt in Sep 2008 company could still managed to show 133 mn profit in Oct 2008 quarterly report.

4. Company's share decreased drastically when founder- promoter's capital decreased lesses than 4%. The story is quite visible in stock exchange here.
5. on top of that World Bank also blacklisted Satyam for bribing the officers there.

Sir, I want to know whether there is any method to find whether a company is really into such frauds or anything by looking at its Financial report? Is there anything written about unveiling such wrongdoings of company and creative accounting techniques other than we study it in Financial statement Analysis? Is there similar cases we can analyze which has happened in past?

Thanks...

Aswath Damodaran said...

Detecting fraud in financial accounting, i.e. forensic accounting, is still in its infancy. It is developing, though, but I am afraid that the perpetrators of accounting fraud are reading the same books that we are....

Ashish said...
This comment has been removed by the author.
Ashish said...

Hi Prof,

You stated very correct. They do not read the books which we read but the one which we do not. US govt might have learned something from ENRON case but surely the small growing companies in developing countries learned a lot.
They found another way of showing the same story. I think it would be quite impossible to stop such kind of internal fraud unless it comes out in public to make more personal profit. We all know greed is very bad.
As an Investor, I avoid companies with such kind of revenues but I know it is not a very right way of investing in market. I m kinda different investor but i like the market much better than i liked it before.

Sanjiv Barve said...

Cash balances were real as on 31st March 2008 i.e.end of fiscal year. Auditors, it seems, have verified them. They have disappeared thereafter, partly in market meltdown and partly pure sifoning. It also appeara that there was plenty odf inside trading, mostly by Satyam executives.

Reg 'independent'board members their independence is dubious. Most of these people are honorable, respected guys but were unable to give serious time to their job. Had they done it, they would not have ended with egg on their face. This saga will continue to hound Indain businesses, its vibrant IT sector and government for many months.

Harry said...

Professor,

I totally agree on everything and specific to your last statement, which is shaking the credibility of the India inc. as a whole.
True, this is a great lesson to learn when it comes to Family/Owner owned business. Most of the big businesses in India are managed by the owners. No room for Agency problems.

But what is the role of an auditor? How about their opinion? Qualified /Unqualified Financial Statements, Internal control process etc… looks like all of them gone for a toss.
Why you left them behind?

Like to hear more from you…

Hariharan Mahadevan

kiran said...

Window Dressing is a serious problem in India, Auditors are in connivence with the promoters and give tacid support to the management.

Guru said...

There are no easychair methods of detecting accounting frauds.

Probably a Financial Statement (Profit & Loss Statement) on cash basis (as against accrual system) could be made mandatory to be annexed with the normal financial statement. The chanelled sources of cash should be madatorily certified by the concerned banking channel.

This will probably separate the wheat from the chaff

Shivagurunathan

H said...

Dear Prof.,

You have stated that "self interest ultimately rules the day". Are you implying that the principal-agent conflict simply cannot be done away with - "corporate governance" measures are a wishy-washy concept that got plenty of nails in the coffin around the Worldcom, Parmalat, and Enron scandals in 2001, and are getting plenty more with the collapse of GM, ML, BSC, etc.

There is no plausible reason for an investor ever to toss a red nickel into the equity markets, ever again. By now, they must realize that whatever money they allocate to company executives will lead to "creative accounting", high-risk projects that shouldn't have been adopted, or overblown perks and salaries.

In short, what has happened and is still happening does not bode well for the future of equity markets. Corporations will have to find other forms to finance themselves, as the bond markets appear moribund, too. Since there are few other mechanisms for the large-scale allocation of capital, then the corollary is that companies will have to downsize dramatically. Is this a fair assessment of your ideas?

Guru said...

To rely on listed equities for returns, one is perforced required to in turn rely on the company's/promoters' ability to transparently exit profitably, notwithstanding the actual state(ment) of affairs of the Company in question.

Of course, the other option is to keep invested in closely held entities (where available) where one can expect more transperancy in operations.

Aswath Damodaran said...

I would not go as far as to wash my hands off publicly traded equities. True, there are agency problems but these problems can be kept in check using a combination of activist investing, significant board oversight and sensible compensation systems. After all, much of the wealth created globally the last century has been created by the corporate system.

gopi kumar v said...

Sir,
Do you think a the presence of debt in the capital structure can be a disciplining device which also generates information useful to investors as managers do not always behave in the best interest of investors.The mere ability of the firms to make contractual payments to debtholders provides lot of comforting information to investors as well.Your views sir?

shiv said...

i have covered extensively satyam in my blog shiv.instablogs.com
i feel there was a collusion of majority of stake holders including the most obvious one
i would not like to comment on any big brand to avoid litigation but a fraud of such magnitude can not go undetected for so long unless one prefers to look the other way or himself becomes a party
the auditors signing the accounts are extremely intelligent & one of them was a central council member of icai for 11 years & may have lead it in due course

dharma said...

Professor, i personally feel its better to trust and beleive family owned companies where the stakes of promoters are pretty high..anything in the range of 60% and above.Yes there may be problems with transparency issues but the scope for a fraud of satyam's magnitude is minimal or even non existent. Raju brothers had less than 8% stake in satyam and thats why they became shenanigans, whereas cos where promoter's stakes are high would still be better as even their personal interest will be more focussed on growing the company which will benefit the minority shareholders at large.

Sam said...

All these 3 aspects in Accounting can be properly used in writing
Accounting papers in college.

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