Among the many cases of financial statement fraud that have hit the marketplace, one of the most intriguing is Satyam Computer Services’ $1.1 billion vanishing cash hoard.

A comparison of Satyam’s performance with its two major competitors among Indian outsourcing companies — Infosys and Wipro — would not have revealed any problems. Satyam consistently lagged in key performance metrics, including return on equity, receivables turnover and cash conversion cycle.

But, unlike in other frauds, the metrics do not show any reason to suspect financial statement manipulation. There is a relatively ignored line item that may tell the tale, however. Moreover, this story may help show how investigators should look for fraud in the future.

The vital clue is Satyam’s investments in bank deposits. As of March 31, 2008, Satyam reported approximately $825 million of its $1.1 billion cash and bank balances as investments in bank deposits in its consolidated balance sheet. The first time this line item was reported 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 under Indian generally accepted accounting principles), nor did they explain the reasons as to why a significant portion of the company’s assets were invested there.

Notwithstanding the fact that 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 could access 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 investigation is ongoing, 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. In order to put things into context as they are currently known, two plausible scenarios arise: the cash reflected in the cash and bank balances was fake to begin with (scenario I); or, that the cash was genuine but was subsequently misappropriated (scenario II). We’ll explore both of these scenarios and provide arguments both for and against each of them.

Scenario I: The Cash Generated Was Fake
As an initial reaction, one might logically presume that the revenues at Satyam must have been artificially inflated to generate the magnitude of cash and bank balances that Satyam fictitiously reported in its consolidated financial statements. This reaction assumes that the overstated cash and bank balances were a result of cash that never existed in the company’s bank accounts.

This type of financial statement fraud has a precedent, as in the case of Parmalat, a multinational Italian dairy and food company. Parmalat’s management allegedly generated fake invoices to inflate revenues, and also “created” cash to make the inflated revenues seem genuine. In an attempt to cover its tracks, Parmalat’s management is alleged to have forged a bank confirmation, purportedly showing a balance of $4.9 billion.

This type of fraud is rather difficult to execute without detection for a long period of time, such as over a seven-year period (2002-2008), as is reportedly the case with Satyam, mainly for two reasons. As a frame of reference, the Parmalat scandal was apparently undone in about one year when Parmalat imploded and filed for bankruptcy. (Note: Parmalat’s management was alleged to have fabricated other schemes.)

First, the income statement would have required too many manipulations, and even standard income manipulation predictions models would have caught it. The results appear to indicate that Satyam did not engage in income manipulation. Second, and more importantly, cash is cash, and is virtually impossible to “create” legitimately.

Scenario II: The Cash Generated Was Genuine
A company’s statement of cash flows shows its periodic cash position and both the sources (cash inflows) and uses (cash outflows) of the company’s cash during the given period broken down into the categories of operations, investing or financing activities. In Satyam’s case, cash flows from operations appear to be the primary driver of its cash inflows with minimal long-term debt and equity financing.

As discussed earlier, Satyam reported approximately $825 million as investments in bank deposits in its consolidated balance sheet as of March 31, 2008. If one were to substitute the line item “investments in bank deposits” with “Raju’s personal account,” this scenario assumes significance. As such, the hypothesis we raise is that Satyam was a legitimate cash-generating business over time, that Raju misappropriated Satyam’s cash, and that most of the misappropriation was probably not reflected on the company’s books.

We assume that Raju likely used the cash from these bank deposits to finance personal investments (many probably risky ventures). When the economy was good, Raju could borrow against his Satyam shares to fill in shortfalls in cash both for his personal investments and for Satyam, when needed.
We suspect that with the economic downturn, his myriad personal ventures likely failed. Since no cash could come in from these investments, they triggered more cash inputs. As the economy was faltering globally and credit was drying up, the shares of Satyam could not be pledged for more cash.

As such, Raju could not pull this trick of generating cash by borrowing more to meet Satyam's liabilities as before. Therefore, everything ended in a fiasco.

Further, his move to buy his sons’ investments in Maytas Properties and Maytas Infra in December 2008, through Satyam, also failed. The fact that these acquisitions were unsuccessful probably explains the timing of the admission. In Raju’s own words, “The aborted Maytas acquisition was the last attempt to fill the fictitious assets [of Satyam] with real ones.”

If one were to predict which scenario was more likely to have occurred, scenario II would seem to fit the bill because (a) the use of standard models of detecting income manipulation would have detected the type of fraud as discussed in scenario I. Accordingly, it is unlikely that the income statement was manipulated much; and, (b) the cash flow statement may be more informative during crisis situations than the income statement.

Standard models could not catch this fraud because they focus more on the income statement and the balance sheet rather than the cash flow statement. Only a detailed analysis of the cash flow statements could have caught it. When the dust finally settles, it is conceivable that a combination of both scenarios might have transpired.

It is shocking that Raju was able to perpetrate a fraud of this magnitude in a public company for a period of seven years undetected. Along with his accomplices, Raju appears to have taken advantage of the glaring weaknesses of corporate governance at the company. Raju, his brother, the former chief financial officer of Satyam, and two audit partners from Satyam’s former audit firm, Price Waterhouse, have been in the custody of the Indian authorities for over two months now.

Nevertheless, this episode should teach us that the lack of strong corporate governance, including an entity’s system of internal controls, leaves the door open for such debacles to occur. It also prepares us — whether we are investors, auditors, regulators or analysts — to be vigilant when discharging our duties, since financial fraud can sometimes be hidden in overlooked parts of the financial statements.

About the authors:
Vijay Sampath is a managing director with global strategic consulting and expert services firm LECG in New York. He has more than 20 years of experience providing auditing, accounting, forensic accounting and litigation consulting services. He can be reached at vsampath@lecg.com. Suresh Govindaraj is an associate professor of accounting, business ethics & information systems at Rutgers University. He received his Ph.D. from Columbia University.

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