The Hindu Business Line : When a management is intent on committing fraud…

Of all the people, auditors — both internal and external — are guilty of gross negligence and dereliction of their duty, and the independent directors on the board of lack of adequate oversight.

MR N. MUTHURAMAN, FORMER DIRECTOR-RATINGS, CRISIL LTD

The Satyam episode is all over the place. Who are responsible for this largest ever corporate scam reported in the Indian context? “Obviously, the primary responsibility to report ‘true and fair’ representation of the company’s state of affairs rests with the CEO of the company, along with the CFO. In this specific instance, they seem to be perpetrators of the scam,” says Mr N. Muthuraman, former Director-Ratings, CRISIL Ltd ., and now a Co-founder of the Chennai-based RiverBridge Investment Advisors Pvt. Ltd., in the course of an email interaction with Business Line soon after the letter of the Satyam Chairman B. Ramalinga Raju was on the BSE site.

Mr Muthuraman hastens to add, however, that at the secondary level, a huge governance architecture comprising the internal auditors, external auditors, audit committee, independent directors on the board and other whistleblowers who may have come across some malfeasance across the hierarchy are responsible to safeguard interests of the various shareholders.

“Finally, other external agencies such as bankers, tax auditors and even Government agencies that awarded Satyam Computer Services Ltd for its ‘good corporate governance standards’ may be held responsible for this episode to an extent,” he notes

Of all these people, observes Mr Muthuraman, “I hold the auditors — both internal and external — guilty of gross negligence and dereliction of their duty and the independent directors on the board for their lack of adequate oversight.”

Excerpts from the interview:

What happened to the gate-keeping and various checks and balances by all these people?

In my view, just two people — Chairman and MD — alone cannot perpetrate a fraud of such a large magnitude. A huge machinery of people must be involved in, for instance, creating fictitious invoices, fictitious bank deposit slips, debtor confirmations, etc. The fact that Mr Raju has left out the CFO’s name from the list of executives who were not aware of this scam also throws some clues.

If a management is intent of committing fraud, large resources are required for conducting a forensic analysis to detect such fraud. Given the stature of the company prior to this episode, the auditors may not have approached these audits with such suspicion to do a forensic analysis.

Having said that, lack of attention to detail and over reliance on company statements by the auditors are big part of the problem. For instance, for large companies, most auditors do not take balance confirmations from banks or debtors seriously — and that is precisely where the problems are hidden in most such scams.

What are the common methods of such machinations? Are there any similar global examples of this episode?

The most common method adopted by managements to report inflated performance is to book fictitious income — book income from customers who are non-existent, or inflate income from existing customers. However, this will show up very soon in the ‘debtors’ statement as these incomes are never to be received. A popular global example is Baan, the ERP company that went under, after reporting large fictitious sales which inflated its debtors beyond control.

On the face of it, what appears in this particular instance is, the fraud has been taken to the next level — by showing fictitious cash and bank balance as well, as though most of these debtors were realised. One is not sure if any of the bank employees were involved in giving fraudulent bank deposit receipts and bank confirmations, or was it entirely fictitiously generated, though I won’t rule out the former.

And this is why, the size of the fraud does not surprise me — once you print deposit receipts or bank confirmation for Rs 1 crore, you can do the same for Rs 1,000 crore or Rs 10,000 crore also.

But what surprises me is that the company has only a handful of bankers — five to be precise. Even a casual exchange of notes between them about the deposit balances maintained by the company with them could have unearthed this fraud.

On the other hand, this may have escaped an auditor’s attention (one is presuming here that there is no complicity of the auditors) because the auditors may typically look only at the incremental cash accruals rather than confirming full outstanding balance.

Another most notorious method for corporate fraud is to hide liabilities/losses in SPVs (special purpose vehicles) such as in the case of Enron. Surprisingly, there are no SPVs in this episode as yet and I hope none emerges tomorrow.

What do you think was the motivation for the promoters to commit such a fraud?

Typically, the motivation for such frauds is to swindle public funds or drain resources from a healthy company to support the promoter’s other weak ventures. However, in this case, the key motivation appears to be to not lose management control of the company. The fear of sharp drop in share prices which may make the company vulnerable to takeover has prompted the promoters to continuously inflate profits. I think this was reasonably guessed by many equity analysts as price-earnings ratio (PE) of Satyam was always at a discount to other IT majors. Perhaps, no one guessed the magnitude of overstatement.

How to prevent such episodes in future?

Every crisis and fraud presents some opportunity to learn from mistakes. And this one is no different. In my view, some measures that may have helped detect such frauds earlier, if not prevent them altogether, include:

Mandatory change in external and internal auditors every three years.

Mandatory written confirmation of at least 80 per cent of cash balance and debtors.

Providing additional rights to auditors to contact third parties such as customers, bankers, employees directly for random verification.

Audit committee should have access to lower levels of management directly instead of restricting to CEO and CFO.

Role of audit committee should be more precisely defined and audit committee members should be held responsible.

Does it look like end of road for the accounting profession, because of involvement of such a reputed name?

No. Despite all the flaws, auditors are the only worthwhile gatekeepers representing all the stakeholders — the minority shareholders, lenders, taxman, etc. So the way out is not to point fingers at the entire profession. Instead, weak practices should be plugged and strict punitive actions should be enforced for offenders.

Can companies survive such collapse in credibility?

It is an extremely difficult phase for any company and its employees to go through, but I think Satyam will survive this crisis. My assessment is based on the fact that there are real clients, real employees, real offices, and after discounting for the scam, actual cash flows!

And at current prices, it also offers a compelling proposition for other Indian IT majors to acquire Satyam and turn it around.

Several heads across the hierarchy may roll in the process, but the company and vast majority of its employees, I guess, will be safe.

Two things are key to this assessment: employees should not desert the company (which is a reasonable assumption given the job market conditions today), and customers should stick on — which will happen only if Satyam is taken over by another IT major, preferably an Indian IT major.

We have other similar crises in the IT sector in the Indian context. DSQ Software continued with its operations for several years despite significant problems faced by promoters and all its associate companies. Aptech continued despite collapse of large NBFCs in the group. And NIIT had significant write-offs of their debtors, but the company survived to emerge stronger. So I am convinced Satyam will also survive the crisis.

Is there a flaw in the compensation system of directors which allows such frauds to be perpetrated?

Yes, the compensation structure of independent directors is flawed in my view. Either the compensation is too low, where independent directors view this as honorary service and put in only minimal efforts. Or the compensation is linked to profits, where the alignment of management’s objectives and that of directors present a conflict of interest.

Ideally, compensation should be healthy — commensurate with the size of the company and the efforts needed to exercise reasonable oversight, but should be fixed in nature and not linked to profits of the company.

D. MURALI

AccountSpeak.blogspot.com

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