Learning from Satyam: How to Detect Fraud

Other Indian companies could watch for unusually large bank deposits. The board should know where they are located and who has access

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.