Risk & Compliance

Satyam Overlooked Oversight

No one can stop a cheat from committing a crime. But the fraud at Satyam went undetected for five years, suggesting that governance failures bear s...
Marie LeoneJanuary 16, 2009

The $1 billion accounting scandal at India’s Satyam Computer Services has raised several key governance questions about the company’s board and its auditors. One of the most perplexing is: Where does the buck stop. That is, why didn’t oversight mechanisms uncover the fraud sooner?

One governance expert claims that a lax regulatory system in India bears at least some of the blame. “Corporate governance in India was late on the scene, it is more politically motivated than legally based, and regulatory laws and agencies are burdened with the complex, slow-moving legislative and judicial processes,” charges John Alan James, a governance expert and adjunct management professor at Pace University’s Lubin School of Business. “A governance disaster was predictable.”

James contends that until 1991, the attitudes and government policies in India toward capitalism and private businesses were “antagonistic and unhelpful,” as state-owned banks limited borrowing to “national superstars,” such as high-tech manufacturers or niche companies that helped satisfy central planning goals. But once capital markets became more liberalized, and the economy started to expand, India’s position as an outsourcing leader took hold, with governance best practices lagging the economic explosion, adds James.

The fraud was astonishing when it came to light. Last week, Satyam, Indian’s fourth largest computer software services outsourcer, revealed that its former chairman, CEO and founder, B. Ramalinga Raju, wrote a four-page letter to the Bombay Stock Exchange, confessing that he orchestrated a massive accounting scam and kept it alive for at least five years. In the letter, Raju admitted that he created at least $1 billion in fraudulent cash entries on the company’s books that went undetected for years. Raju, his brother B. Rama Raju, and company CFO Srinivas Vadlamani were arrested.

Then this week, Indian press reports said that in a statement to the courts, Vadlamani claimed he was not involved in improper bookkeeping, but was aware of suspicious behavior at the company for more than five years.

Many experts cast partial blame for the scandal on Satyam’s auditor Price Waterhouse India, because the fraud went undetected for so many years. Price Waterhouse India is a member company of the larger PricewaterhouseCoopers International network, but is legally separated from the larger organization. That legal “firewall” allows Big Four audit firms to have their cake and eat it too, says H. David Sherman, a former SEC academic fellow and current professor of accounting at Northeastern University.

Big four annual reports talk about one quality standard for the entire world network of offices, but that takes coordinated global training and quality assurance efforts. If the firms truly do create global training and coordinated quality standards, it could open up debate regarding the amount of liability protection that is or should be provided by the legal separation of offices in each country.

For its part, the Bangalore-based Price Waterhouse said it is working with Indian regulators and law enforcement agencies to sort out the accounting scam. It added that its auditors followed proper procedures and backed up their work with appropriate audit evidence. However, Price Waterhouse warned the Satyam board that the audits in question could no longer be relied upon. The audits span the period from the quarter ended June 2000 through the quarter ended Sept. 30, 2008, said Price Waterhouse.

So far, no legal action has been taken against Price Waterhouse. There’s only been speculation about a lawsuit against the Indian auditor, probably sparked by the recent lawsuit filed against BDO Seidman in connection with the alleged $50 billion Ponzi scheme run by Bernard Madoff. Seidman was not the auditor for Bernard L. Madoff Investment Securities (the private accounting firm Friehling & Horowitz is the Madoff auditor). But BDO Seidman was the auditor for Ascot Partners, which invested heavily with Madoff’s firm.

Despite the absence of a lawsuit, the audit firm is still left with a huge black eye. To be sure, the scandal does not seem to be a convoluted, off-balance-sheet, Enron-like scheme, but rather a straightforward overstatement of cash. That would sting the reputation of any accounting firm, considering that the first assignment any new auditor gets is to audit the client’s cash accountants.

The basics of such an audit are also straightforward, although it can be incredibly time consuming for an operation as large as Satyam. In general, bank statements are collected from the client and the client’s bank and matched up with entries, and cash accounts are rebalanced with respect to outstanding receivables.

To be fair, there were probably thousands of Satyam cash accounts that had to be confirmed by the auditor, as the outsourcer has nearly 700 customers — including 185 Fortune 500 companies — in 65 countries. The audits for a company of that size would have been staggered, with millions of dollars of outstanding receivables pouring in to different locations at any given time. So if the Raju brothers knew their auditor’s routine, it would have been relatively easy to create phony entries throughout the system.

Nonetheless, the failure to detect the Satyam fraud is “unimaginable [because] it involves basic audit procedures,” says Sherman. “[Auditing] cash is so basic that people don’t think twice about accepting the number, never thinking to ask questions about it.” Still, Sherman asserts: “Where was the audit committee.”

As an audit committee member, Sherman understands that board members are not responsible for reauditing financial statements. However, he says the directors have access to the auditors and the right and responsibility to question the audit. For instance, in the case of seeing an accumulated $1 billion on the books, the audit committee might have raised questions about what the company planned to do with the cash, or how much it was earning on the money.

It also has been suggested that the Public Accounting Oversight Board — the U.S. entity charged with auditing firm oversight — bears some responsibility for the alleged poor performance of Price Waterhouse India. The PCAOB inspects the work of public accounting firms that issue audits for companies listed on U.S. stock exchanges, which includes Satyam. Under the Sarbanes-Oxley Act of 2002, the law that created the PCAOB, accounting firms that are not registered with the board are barred from preparing or issuing audit reports on U.S. issuers.

At the start of this year, 1,879 accounting firms were registered with the PCAOB. Further, by the end of 2007, the PCAOB had conducted 123 inspections of non-U.S. firms in 24 jurisdictions.

The board issues inspection reports on the largest registered accounting firms — those with 100 or more issuers as clients — every year, and on smaller firms every three years. Price Waterhouse India is on the triannual schedule, as it is registered separately from the other 60 or so Price Waterhouse and PricewaterhouseCoopers firms. The PCAOB has not issued a report on the Bangalore-based firm, although a spokesperson for the board said it will likely be issued soon.

Price Waterhouse India registered with the PCAOB in 2004, and although the report has been completed, it can take up to a year before it is released publicly because the PCAOB and the audit firm are permitted to address deficiencies cited in the report and work out remediation plans in private.

The PCAOB also said that its most recent rule change regarding non-U.S. accounting firms will likely not affect the Satyam auditor. In December, Rule 4003 was adjusted to give the board flexibility regarding the frequency of non-U.S. inspections, as some legal and regulatory restrictions prevent inspectors from doing their job as frequently as U.S. law requires. Similarly, the board issued a proposed rule to address circumstances in which local laws prohibit a PCAOB inspection entirely.

One possible culprit that escaped blame for the Satyam scandal is the accounting rules used by the company. “I don’t think the Satyam case is a problem with accounting rules; it is a governance issue,” insists the Lubin School’s James.

Satyam uses both U.S. generally accepted accounting principles and international financial reporting standards to report its financial results, which means that one set of accounting standards didn’t trump the other with respect to shedding light on the fraud. The realization that accounting rules neither helped nor hindered the fraud should help to quell some of the fierce debate regarding which accounting standards are more transparent and therefore better for investors — U.S. GAAP or IFRS.