George M. Mangion | Wednesday, 18 February 2009

Satyam School of Scandal

Reading the financial press of late one is inundated with doom and gloom about the global recession and its effect on rising unemployment, reduced demand for consumer products and a hostile banking fraternity. Starting with Europe one reads with some remorse about the drop in its biggest economies such as that of Germany, France and Britain. Germany had the worst fall in its economy since the country was reunified in 1990. France and Italy both shrank while Spain followed suit registering 1 per cent drop. It seems that all this global recession has added a fresh impetus to unravel hidden skeletons lurking in our cupboard. All this mayhem seems to foster scary financial scandals such as the one perpetrated in the U.S. by Madoff’s ‘ponzi’ scheme running into €50 billions. But another story seems to have clouded the news pointing to a concealed scandal which hit India’s economy last month. This featured the Satyam episode the latter being a premium exporter of Indian software. Satyam which in Sanskrit means ‘truth’ is an apt name for a software company which expanded from a handful of employees into a back-office giant with a work force of 53,000 and operations spread over 66 countries. The company’s clients include multinationals such as Nestle, and US giants such as General Motors and General Electric. Satyam also serves as the back office for some of the largest banks, manufacturers, health care and media companies in the world, handling everything from computer systems to customer service.
The shock news was leaked last month by an explicit declaration of Satyam chairman Ramalinga Raju revealing his involvement in doctoring the company’s books. He dutifully resigned after admitting that he had systematically falsified accounts. Not unlike a horror story, he admitted that $1.04 billion of the cash and bank loans the company shown in the audited accounts were nonexistent. He said the board had no knowledge of the situation, nor did his or the managing director’s families. Naturally, the size and scope of the fraud raises questions about regulatory oversight in India and beyond. Mr Raju said in his statement that he “sincerely apologised” to shareholders and employees and asked them to stand by the company.
In the four-and-a-half page letter distributed by the Bombay stock exchange, Mr Raju described how a small discrepancy had grown beyond his control. “What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew,” he wrote. In an other instance he shockingly described the ordeal as riding a tiger, not knowing how to get off without being eaten.
It appears that we are only in the initial stages of that Satyam fallout, and the potential damaging effects on the Indian economy. Naturally it will, permeate its reverberations throughout the global economy. The scandal sent jitters through the Indian stock market, and the benchmark Sensex index fell more than 5 per cent whereas shares in Satyam fell more than 70 per cent.
There is a burning question that what has happened at Satyam is a huge backward step for India and for international back office business. On further investigation, it resulted that the chairman confessed he had artificially inflated the company’s profitability, falsely boosting its balance sheet undetected over a number of years.
The Satyam episode is only a part of the fallout experienced by a beleaguered Indian computer back office industry. Unfortunately the credit crunch which is currently hitting US and Europe does not help matters and a number of traditional Indian software companies are struggling. Competition is becoming harder and they realise that they lack skills to survive in the fast-changing business environment. The president of the Federation of Indian Chambers of Commerce and Industry thinks the decline in governance and financial institutions represents a formidable challenge. It impinges on the sorry plight of other software companies who are currently under siege from foreign competition. Investors are furious stating that in their opinion Raju who admitted cooking the books has been subject to scrutiny and audit since many years. They contend that the fraud is gigantic and only an immediate and thorough investigation by an independent agency can reveal the true extent of what actually happened.
They allege that there was possible collusion on the part of the company’s accountants, banks, and maybe even politicians, in the fraudulent financial engineering. It was a mystery how the fraud was so dexterously hidden from prying eyes for all those years. The financial tragedy closely resembles that which hit scandal ridden Enron. Enron was widely seen as a model for corporate innovation, having transformed itself from a modest sized energy business to a high-tech energy-trading company. In India, Satyam was similarly viewed as a paragon of corporate success, growing over two decades into one of the largest and most respected companies in India’s highly successful outsourcing industry. It comes as no surprise that investors and clients are going to want answers on why was the embezzlement remained concealed for so long. For instance, they’re demanding to know how Satyam’s auditor endorsed the company’s accounts. The Institute of Chartered Accountants of India (ICAI), a top body of chartered accountants, is likely to take a strict stand on the issue. ICAI said any member firm found guilty in the Satyam case would be severely punished and the auditors could even be barred from practising for lifetime. Typically, the investors are asking the familiar question of who checks the guardians when things go awry. In India as in many western countries, statutory auditors are typically appointed by shareholders to audit the balance sheet and to verify whether the accounts presented are a true and fair view of the financial state of affairs. Their appointment is ratified at the annual general meeting (AGM) and is typically valid for one year. The incumbent auditor was re-appointed uninterrupted since 2000.
To their defence, the auditors have sighted five major points. The first one being that the working papers of the Satyam audit had gone through Peer Review and the Public Company Accounting Oversight Board (PCAOB) (this unit was created by the Sarbanes Oxley Act of 2002 following Enron’s debacle). The PCAOB consists of five members who are appointed by the Securities and Exchange Commission of the US.
The second point in their defence was that Satyam has been a client of Price Waterhouse Bangalore, which is a separate legal entity from PwC India.
Point three shifts the onus of finding such gaps and mismatches in the balance sheet lies on the internal auditor.
As can be expected, point four reiterates that audits are not investigations and are not addressed to find frauds. The ultimate point in their defence strategy mentions that even in the eventuality of a liability falling on the auditor, the firm has a huge Preferential Indemnity Insurance. It is an open secret that partners at other so called Big Four audit firms were noncommittal in their assessment reserving their views until the time investigations by the India authorities are concluded.
The scandal was instantly compared with the collapse of Enron. Enron was near the top of the Fortune 500. Its auditors, Arthur Andersen, once one of the top five auditors, went out of business in 2002 after having approved the books of Enron which were discovered to be heavily overstated.
It looks like Satyam is evoking the sad memories of the Enron financial scandal which rocked the western world in 2001 and saw the creation of stiffer regulation to tighten up on auditing such as the Sarbanes Oxley Act. One may compare the Satyam saga as a gleaming ocean liner sailing in safe waters, its officers dining in luxury, while, below the deck, its chairman was happily cooking the navigation charts until the day of reckoning arrived when the vessel hit an uncharted iceberg.

George Mangion
Partner at PKF – an audit and business advisory firm



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18 February 2009

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