Friday, May 22, 2009

Detecting Fraud: Lessons from Satyam

BusinessWeek has an interesting article on the Satyam fraud. One of the most amazing thing about this fraud is that the fraud appears to have been primarily a cash fraud (i.e. the company claimed to have cash that didn't really exist). The authors of the article discuss two possible scenarios that could have resulted in the fictitious cash balance: (1) fake sales and (2) theft of real cash. Because of the inherent difficulty in creating fictitious sales and sustaining such a fraud over an extended period of time (the problems at Satyam allegedly took place over seven years), the latter possibility appears to be the most likely. In the words of the article:
Consider, again, the $825 million Satyam reported as investments in bank deposits in its consolidated balance sheet as of Mar. 31, 2008. If one were to substitute the line item "investments in bank deposits" with "Chairman 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.
If this is true, it implies a major failure in corporate governance, including a significant audit failure by Satyam's external auditors. Ironicly, cash is generally considered one of the easiest accounts to audit and junior auditors often complain when assigned to audit of a company's cash balance because the task is perceived to be very basic.

While the authors conclude that, "Only a detailed analysis of the cash flow statements could have caught [the fraud]," I am not completely convinced. While closer scrutiny of the cash flow statements may have helped raise some red flags, I am not sure that it would have been sufficient to uncover this fraud. Instead, I believe that Satyam's auditors would have been more likely to catch the fraud by engaging in additional strategic reasoning.

In other words, Satyam's management was most likely able to fool the auditors by considering the auditor's standard procedures for auditing cash and developing some method of fooling those audit procedures. If the auditors had considered how Satyam's behavior might change in response to their basic procedures, the auditors may have been able to develop better procedures that may have caught the fictitious balance.

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