ByNirvikar Singh

It turns out that founder and CEO B. Ramalinga Raju invented $ 1 billion in cash, which never existed. How could the auditors miss this fraud?

Bernard Madoff relied on a classic Ponzi scheme, and the ability to hide from regulators. He could use a small, apparently renegade auditing firm, which had no reputational or ethical concerns, it seems. Madoff was called for suspicious reported actions and results, but the regulators chose to ignore these concerns. Madoff also benefited from operating in an industry where some degree of non-transparency is normal. Earlier, Enron used an incredibly elaborate scheme, with substantial off-balance sheet activities, to perpetrate its fraud. Its auditors bore some of the blame, and their firm also collapsed as a result.

The Satyam fraud is baffling because, unlike Madoff and Enron, it seems that it was so transparent it should have been spotted much earlier, before it grew to a point where it will likely bring down the firm. The auditors just have to be called to account, because checking on cash balances is both a simple and necessary part of their job. How could employees of one of the big four global accounting firms make such a mess of their assignment, year after year?

It’s true that the high profile board of directors and senior officers of the firm should also have smelled a rat. But in a large public corporation, where reputable auditors were certifying the financial statements, their laxness in monitoring might have been understandable. After all, Satyam’s performance (unlike Madoff’s) was not obviously “too good to be true” as measured by the benchmark of industry leaders. There is a lot of blame going around on poor corporate governance in India. In fact, though corporate governance in India is not great, the level of board inattention we saw here was not very different from most companies in the US.

Amazingly, one of Raju’s friends, who runs a non-profit funded by Raju, was quoted in the Wall Street Journal as blaming investors for the fraud, because of their short-termism and pressure for growth that they created for Raju. This is utter nonsense and one of the stupidest comments about this case. Investors, in fact, are the biggest victims, because they had no opportunity to independently verify the financials – they had to take the auditors’ word, and they were rational in having confidence in a publicly traded company with audited financial results.

The consequences of the Satyam scandal will depend partly on policy responses. The press is pointing out that many Indian companies could have similar hidden problems. If investors get suspicious, this could severely damage the corporate sector and the country’s chances of getting back to 9 percent growth. My guess is that Satyam itself will not survive. It already has liquidity problems. It has a large number of corporate customers, who are locked in to Satyam in the short run, but who will each be looking for an alternative: they cannot afford to rely on a firm that may not survive. The only exit strategy here is probably a buyout, which will allow a complete replacement of Satyam’s discredited senior management.

The government could play a role by facilitating some sort of acquisition of Satyam so that the company’s customers and service systems survive, but its failed financial systems and senior management are replaced. In fact, the latest news is that the government has superseded the interim management and will oversee constituting a new management and board of directors. The government’s main policy response should be to strengthen disclosure and monitoring requirements, especially making sure that auditing practice never again fails as blatantly and spectacularly as it did in this case.

Even though weak corporate governance is not the main culprit in the Satyam fiasco, the scandal is highlighting the poor state of India’s corporate governance, and provides a political opening to institute some reforms. Industry associations like the Confederation of Indian Industry should be proactive in this process, and work with the government in this reform process. Failing to strengthen corporate governance will hurt the entire economy. In particular, the structure and functioning of auditing committees is a central issue of concern. Here is a quote from the K.M. Birla Committee report of several years ago:

“9.3  A proper and well functioning system exists therefore, when the three main groups responsible for financial reporting – the board, the internal auditor and the outside auditors – form the three-legged stool that supports responsible financial disclosure and active and participatory oversight. The audit committee has an important role to play in this process, since the audit committee is a sub-group of the full board and hence the monitor of the process. Certainly, it is not the role of the audit committee to prepare financial statements or engage in the myriad of decisions relating to the preparation of those statements. The committee’s job is clearly one of oversight and monitoring and in carrying out this job it relies on senior financial management and the outside auditors. However it is important to ensure that the boards function efficiently for if the boards are dysfunctional, the audit committees will do no better. The Committee believes that the progressive standards of governance applicable to the full board should also be applicable to the audit committee.

9.4   The Committee therefore recommends that a qualified and independent audit committee should be set up by the board of a company. This would go a long way in enhancing the credibility of the financial disclosures of a company and promoting transparency.

This is a mandatory recommendation.”

Initial reports suggest that Satyam was violating such existing Indian guidelines, as well as those for US listed firms. This seems to be a common problem – the standards are already in place, but are just not being monitored or enforced. Negligence requires different policy responses than structural institutional deficiencies. Even though the external auditors are the primary defense against fraud, not instituting internal checks and balances as required by law only increases the probability of fraud.