The Hindu Business Line : There is a hole in my books, dear investor

We have just come to know of a gap in Satyam’s financial statements. For the first time in living memory, an iconic company in India is facing collapse because of financial reporting failure. The shocking revelations about Satyam’s accounting are even more worrisome because of all-round failure of many institutions that should have served as the company’s gatekeepers.

Fraud sans connivance?

Topping the list is the company’s finance function. As a company’s conscience-keeper and custodian, the chief financial officer is usually the first one to sense a cash-flow problem. Accounting fraud is impossible without the knowledge, connivance and cooperation of a company’s accountants. Most of them are CAs, who unlike the other employees of the company, are members of a statutory professional institution. To be fair, it is not only the CAs. Could senior managers in other functions, especially sales, have been unaware of recognition of non-existent revenue of Rs 588 crore?

The company’s board of directors sets the tone at the top, as the Treadway Commission on Fraudulent Financial Reporting pointed out in 1987. The board is the investors’ first line of defence against management fraud. The audit committee has a particular responsibility because it has direct, unlimited access to the company’s auditors and can consult with any experts of its choice.

Satyam’s audit committee consisted of M. Rammohan Rao, Managalam Srinivasan, T. R. Prasad, and V. S. Raju, none of whom conceivably has accounting expertise. The operations of global corporations are complex and can be understood only by persons with sound accounting and business knowledge. Satyam’s board also failed to consider the risk of the company being run by its promoter. Satyam’s independent directors have a lot to answer for.

Auditor apathy

The auditors have failed. This is not new. As a community, they let investors down in 1992 when the Harshad Mehta scam happened. The auditing community was not moved a bit then, and some of them were big names. The Institute of Chartered Accountants of India (ICAI) has not crowned itself with glory in its disciplinary action when it came to those firms. PWC is not just any other auditor, it is part of the big four, a select group that claims to follow high professional standards.

It is baffling that they missed accounting failure of this magnitude. The auditors also ignored the effect of the steady stream of bad economic news on the financial statements and the related risks.

Analysts pride themselves as being independent of the companies they track. Unlike auditors and independent directors, they do not owe any debt of gratitude to the company’s management. There have been occasional questions on Satyam’s accounting quality, but none of the major research firms recommended selling the company’s stock for low accounting quality. Are they incompetent, or worse?

Interestingly, analysts in the US also follow Satyam. SEBI should permit short-selling, because short-sellers can identify troubles well in advance and prick bubbles in the making. Currently, the market has place only for optimists. Let us have some pessimists too.

SEBI and the Ministry of Corporate Affairs appear to be clueless about the working of companies, despite the vast amounts they spend. Clearly, the quality of their technical resources, particularly the skill levels of their accountants and lawyers, are weak, and enforcement is poor.

Shareholder activism

In India, shareholders face huge risks in dealing with entrepreneurs and managers. Family ownership and management of companies ensures that outside shareholders receive a raw deal. The only simple solution is to let shareholders take on directors in class action suits.

The Companies Bill has a provision for this, but it is weak. Let us face it. Those who care most for the shareholders are the shareholders themselves, more than independent directors, auditors, analysts, SEBI and the government. Therefore, facilitating accessible, fast and inexpensive shareholder litigation is the best investor protection measure.

Satyam is one of the first Indian companies to adopt the International Financial Reporting Standards (IFRS). IFRS could have done without this brand ambassador.

(The author is Professor, Finance and Control Area, Indian Institute of Management, Bangalore. His views are personal. blfeedback@thehindu.co.in)

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