Accounting Fraud

The news of the day is the resignation of the CEO of Satyam Computer, Ramalinga Raju, after admitting to fraud on a grand scale. Revenues and earnings were overstated massively over the last couple of years, and the company admitted that the cash that had been reported on the last balance sheet did not exist.

I would claim to be surprised and shocked by this news but I am not, becuase it is one in a long series of similar events - Enron, Parmalat, Worldcom etc. Rather than focus on Satyam and the sins of its managers, I would like to make some general points about accounting fraud and its consequences:

1. Self interest ultimately rules the day: The modern corporation is rife with conflicts of interests - between stockholders and bondholders, stockholders and managers, different classes of stockholders and different lenders. When decision makers are faced with a conflict of interest, self interest ultimately will win out. Note that Satyam's deception came to the surface when the company tried to buy stakes in two proprety companies owned by the Raju brothers.

2. Corporate governance matters: While we cannot do much about human beings acting in their self interest, we can put up roadblocks that prevent them from ripping off the rest of us. Having a board of directors tha asks tough questions and holds management accountable is critical to keeping managers/ founders in check. In this case, I have serious problems with the board of directors at Satyam and their oversight of the managers. I know at least 3 people on this board and believe that they are smart, honest people, but they were clearly led down the garden path. I have always had problems with the structuring of family companies in Asia, where families often control dozens of firms using a variety of devices including cross holdings and pyramid structures. When confronted, the families contend that they are "honorable and noble" and that they have the best interests of stockholders at heart. I don't think so!!!!

3. New Accounting and disclosure rules won't prevent fraud: The Indian government and accounting standards board will start writing new rules that they will claim will prevent this type of fraud. I seriously doubt it. Firms will always be one step ahead of the accounting rule makers when it comes to pulling off these heists.

What are the lessons for us as investors? When things look too good to be true, they are usually false. I am not familiar with Satyam's financials, but it may be worth looking at past statements to see if the clues were there that we chose to ignore. There is a strong need for forensic accounting... Just a warning! Fraud and malfeasance come to the surface when times are bad and I will expect to see a flood of Satyam-like cases all over India and China especially. Growth has masked the weaknesses of corporations in both countries and its absence will separate the wheat from the chaff.