15

Financial Shenanigans

15.1 INTRODUCTION

As discussed in Chapter 1, the accounting information is prepared by the management and used by a large number of stakeholders for taking economic decisions. The end result of the accounting cycle, i.e., the three key financial statements—balance sheet, the statement of profit and loss and cash flow statement—convey useful information about the financial health and performance of the enterprise and in turn can be used to make estimates about the future. By using common size & trend analysis and ratios, one can infer about the profitability, liquidity, solvency and efficiency of the enterprise as well as its cash generating ability. However, the quality of such analysis is dependent upon the quality of the information contained in financial statements. To be really useful, the information provided in financial statements must be reliable. Reliability is one of the key qualitative attribute desirable in financial statements to enhance their usefulness. ‘Information has the quality of reliability when it is free from material errors and bias, and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.’¹

 

To be considered reliable, financial statements must be free from bias and must faithfully represent the transactions and events that they are purporting to represent. All the material information that may have an influence over the decisions by the stakeholder must be disclosed (relevance principle). The information given must be guided by the substance of the transaction rather than the legal form (substance over form). Additionally, wherever in doubt, it is better to under-report the assets and incomes in the financial statements rather than overstate them. Likewise, while reporting expenses and liabilities, in case of doubt, overstatement is preferable than understatement (conservatism).

To ensure that the financial statements of a company have the attributes of reliability and they do give a ‘true and fair view’ of the state of affair of the enterprise, the following regulatory framework has been prescribed:

1. Standardized formats and disclosure requirement: The formats of the balance sheet and the profit and loss statement have been prescribed under Schedule III of the Companies Act, 2013 with the relevant details to be provided in the notes to accounts. This ensures that at least a certain minimum level of disclosure is provided to the users.
2. Accounting standards: The financial statements must comply with the applicable accounting standards issued by the ICAI². In case of non-compliance the reasons for non-compliance and the financial effect arising due to such deviation need to be disclosed³. The board of directors in their report to the shareholders needs to confirm that the applicable accounting standards had been followed in the preparation of the financial statements giving proper explanation in case of material departures⁴. The accounting standards to some extent reduce the management’s choice of accounting alternatives and also enforce a certain degree of disclosure.
3. Independent audit: Financial statements are required to be audited by a Chartered Accountant who is not an officer or employee of the company or in any other way associated with the company. Such an audit is called ‘external audit’ or ‘independent audit’ or ‘statutory audit’. The audit report is addressed to the shareholders of the company⁵. In case of any observations or audit qualifications, comments of the board of directors on each observation or qualification is also required to be given in the directors’ report to the shareholders.

   To ensure independence of the auditors, the Companies Act, 2013 provides for compulsory rotation of the auditor. Further, the auditor is also prohibited from providing specified services to the same firm.

4. Listing agreement: Section 177 of the Companies Act, 2013 requires every listed company to constitute an audit committee of the board of directors. As per the listing agreement, such a committee shall have a minimum three directors out of which at least two-thirds must be independent. The audit committee is chaired by an independent director and all members of the committee need to be financially literate. The audit committee is responsible for oversight of the company’s financial reporting process and the disclosure of its financial information to ensure that the financial statements are correct, sufficient and credible. Financial statements need to be reviewed and certified by the CEO and CFO of the company as to their reliability. The format of the CEO/CFO certificate is provided in the listing agreement.The purpose of CEO/CFO certification is to ensure accountability of the top management for financial disclosures.

The CEO/CFO certificate in case of Grasim Industries Limited is given in Box 15.1

The above framework consisting of accounting standards, standardized format and disclosure requirements, independent audit, approval of accounts by audit committee with independent directors and CEO/CFO certification has been put in place to enhance the reliability of the financial statements.

 

15.2 FINANCIAL SHENANIGANS

Notwithstanding all the regulatory safeguards discussed above, there have been an increasing number of cases of creative accounting and accounting frauds leading to massive losses to the investors and other stakeholders. Financial shenanigan refers to all actions of the management which attempt to depict financial performance of an enterprise different from what it really is. It may be in the form of creative accounting or aggressive accounting, or active manipulation of accounting records to falsify the information disclosed in financial statements. Various actions that constitutes financial shenanigan include creative accounting, window dressing, earnings management and accounting frauds. Whatever the name and form, there is an intent and action on the part of the preparer of financial statements (management) to manipulate the financial information to depict financial performance and financial position different from what the real performance and position are.

 

Some of the financial shenanigan may well be within the boundaries of law and hence not illegal, whereas some other may involve active concealment of relevant information, falsification of accounts and furnishing incorrect information with an intent to cheat. For example, change in method of accounting or using estimates which are aggressive with full disclosure in the annual report is not fraudulent. On the other extreme, falsifying accounts by recording fictitious revenue or omitting expenses are clearly fraudulent misrepresentations of the financial information to the stakeholders.

Financial shenanigan is a combined result of motivation and opportunity to manipulate. As discussed earlier, the reported financial numbers are used by external stakeholders for taking various economic decisions. The management may be motivated to manipulate financial statements to further its own objectives. At the same time there are opportunities also for financial statement manipulation. The reasons behind financial shenanigans (motivations) and the contributory factors (opportunities) are depicted in Figure 15.1.

15.3 MOTIVATIONS FOR FINANCIAL SHENANIGANS

15.3.1 Performance-based Compensation

Performance measurement system used by companies often starts with setting up of performance targets and concludes by comparing the actual performance against these targets. In order to motivate managers, monetary and non-monetary rewards are offered for meeting and exceeding these targets. Missing the target may meet with unfavorable consequences which may include loss of job. Such performance-based compensation does motivate the managers to work towards the organizational goals, but also has an undesirable side effect of earnings manipulation. For example, a CEO holding a large number of ESOP may be tempted to manipulate financial statements to increase the market price of the company’s shares so that the value of his own holding is maintained or improved upon.

15.3.2 Earnings Expectations

In case of listed companies, there is a requirement of disclosing quarterly results. These results are closely watched by a number of stakeholder including investors, prospective investors and market analysts. The management, on its part, gives earning guidance for the quarter ahead. Failure to meet earnings expectations so created often leads to sell off and plummeting of the share price of the company. As a result, the management may resort to financial shenanigans to meet the market expectations.

15.3.3 Conceal Deteriorating Financial Condition

Financial shenanigans may be put into practice by management when the enterprise is facing deterioration in its financial conditions. A sudden decline in the profitability due to internal or external reasons may prompt the management to resort to accounting actions to falsify the earnings.

15.3.4 Tax Evasion

One of the reasons often cited for financial shenanigans is a desire to lower the tax liability. The accounting policies and actions may be so arranged so as to either reduce tax liability of postpone tax liability.

15.3.5 Raising Funds

An enterprise may be planning to come up with a public offering of shares to finance its expansion plans. At this stage, it is critical to present financial numbers that will enable the enterprise to obtain a good pricing for its securities. Likewise, an enterprise planning to take a large loan or coming to the market for a debenture issue may also resort to window dressing to get a favourable credit rating or simply, to meet the lender’s covenants to be able to get the loan.

15.3.6 Diversion of Funds

Financial shenanigans may also be used to cover up diversion of funds by unscrupulous management. If funds or other assets of the enterprise have been diverted or otherwise misappropriated by the management, there may be attempts to cover up the hole so created by accounting manipulations.

An e-survey of over 1,000 Indian organizationsby a leading audit firm revealed that 81% of the respondents perceive financial statement frauds as a major issue in India. The survey also indicate pursuit of meeting market expectations (63%) and performance-based remuneration (61%) as the main reasons for financial statement frauds besides tax evasion (37%), raising finance or meeting debt covenants (35%), diversion of funds (25%) and continuation of employment (22%).⁶

15.4 OPPORTUNITIES FOR FINANCIAL SHENANIGANS

15.4.1 Accounting Flexibilities

Accounting statements are based upon the applicable GAAP and accounting standards. The accounting standards do limit the managerial choices of accounting policies but do not completely eliminate them. Furthermore, accounting information is based upon a number of estimates. For example, depreciation of fixed assets is based upon the estimate about their useful lives and also the residual value. The management may use these accounting choices and estimates to further their own purpose rather than choosing the most appropriate accounting policy. Some of the areas where significant managerial latitude existsand in which different accounting policies may be adopted by different enterprises are:

• Methods of depreciation, depletion and amortization
• Treatment of expenditure during construction
• Conversion or translation of foreign currency items
• Valuation of inventories
• Treatment of goodwill
• Valuation of investments
• Treatment of retirement benefits
• Recognition of profit on long-term contracts
• Valuation of fixed assets
• Treatment of contingent liabilities

15.4.2 Weak Internal Controls

Presence of internal controls including internal checks and internal audit acts a deterrent to financial shenanigans. However where internal controls are not strong or the senior management has the flexibility to by-pass the inter controls, the chances of accounting manipulations are severe. Not having a well drafted whistle-blower policy as an integral part of internal controls may also contribute to financial shenanigans.

15.4.3 Lack of Auditors’ Independence

Financial statements of a company are required to be audited by external auditors. These auditors are expected to be ‘independent’ as they are not on the pay roll of the company which is the subject of the audit. However the auditors’ independence may be compromised in real practice. For example, the auditor of a company may also be providing other consulting services to the same company. In such a case, it is difficult to maintain their objectivity in audit as any disagreement with the management may lead to loss of the consulting income as well. Such a conflict of interest may lead to compromising auditors’ independence, Likewise, the same audit firm continue to audit the financial statement of an enterprise year after year. In such a situation, there is always a possibility of a personal relationship getting developed between the auditors and the management of the company.

15.4.4 Poor Governance Structure

The financial statementsand the audit report are reviewed by the board of directors and the audit committee thereof. The board and the audit committee also have independent directors. It is expected that the presence of independent directors will serve as a deterrent to financial shenanigans. However, the board may be either dominated by the family members or friends of the promoters, or the board members may lack the necessary expertise to perform the duties assigned to them. Likewise, the independent directors receiving significant fees or commission or other benefits from the company may not perform their role objectively. The board of directors that either lacks competence or independence may not be effective in monitoring financial shenanigans.

The Fraud Survey 2010 by KPMG identifies management override of controls (66%), inadequate whistle blower mechanism and inadequate internal controls (56%), inadequate monitoring by the Board/audit committee (48%) and Lack of independent audit functions (40%) as the major factors facilitating financial statement frauds. It may be noted that financial shenanigans are often perpetrated by the senior management and usually more than one person is involved. It may also have either active involvement or tacit understanding with the auditors as well. As a result, detection of such shenanigans is quite difficult.

15.5 FINANCIAL SHENANIGANS TECHNIQUES

After having discussed the reasons for financial shenanigans and the factors that facilitate such practices, in the following section we discuss some of the commonly used financial shenanigan techniques. Normally these techniques are used to show a rosy picture of the earnings and financial position of the company but they may also be used to depict lower earnings than actual.

15.5.1 Revenue Recognition

Revenue recognition—both timing and quantum—is one of the most vulnerable areas for financial shenanigans. As per a study of 347 alleged cases of fraudulent financial reporting by US companies between1998 and 2007, over 60% of the companies covered were found to have overstated revenues.⁷ Financial shenanigan relating to revenue may involve advancing or postponing revenue recognition as well as recording sham revenue. Some of the techniques affecting revenue recognition are discussed below:

Consignment Sales

Revenue in respect of goods sent on consignment basis to a consignee (agent) for onwards sale to the customer is recognized only when the goods are actually sold by the consignee. The risk and rewards related to the goods gets transferred only when the goods are sold by the consignee. The financial shenanigan involves recording revenue in respect of goods sent on consignments as final sale even before the risk and rewards associated with the goods have been transferred to the buyer. The accounting practice deployed by Lucent Technologies in this regards has been described in Box 15.2.

 

 

Round Tripping

A ‘round-trip’ trade aims at artificially boosting the revenue by selling some goods, assets or securities to another entity with an understanding to buy it back at the same or almost the same price. The transaction lacks any economic justification other that increasing the revenue. As both the legs of the transaction are done at almost the same price, it may not have any impact on the bottom line of the company. A company which is likely to miss its revenue guidance may resort to this financial shenanigan to artificially recognize revenue. Round tripping practiced by Dynegy Inc. has been described in Box 15.3

 

Channel Stuffing

Channel Stuffing is the name given to the deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell.The channel partners are given the flexibility to return the goods later, incentives in the form of discounts and extended credit period. The channel partners may also be assured an agreed return on their investments in inventory by way of a side agreement.Channel stuffing as practiced by Bristol-Myers Squibb Company is described in Table 15.4.

 

 

Booking Future Income as Current Income

As the GAAP the revenue is recognized when earned using accrual principle of accounting. Revenue is deemed to have been earned when the goods have been sold or the services have been performed. The financial shenanigan involved here is booking the future income (which is not yet earned) as current income. By advancement of income by improper accounting the current period’s revenue as well as earnings gets inflated. It however will have a negative impact on the reported earnings in the future periods. Xerox Corporation deployed this accounting shenanigan as described in Box 15.5.

 

Reporting Cost Over Runs as Revenue

One of the conditions for booking revenue is the certainty that it will be realized. In case any uncertainty exists regarding realization, revenue recognition is postponed till the uncertainty is resolved. In case of construction projects cost over runs are not recorded as revenue unless the same has been accepted by the customer. The financial shenanigan involved here is booking of the revenue in case of cost over runs even before the same has been accepted by the customer. The financial shenanigan as used by Halliburton is described in Box 15.6.

Percentage Completion Method

As discussed in Chapter 7, revenue from services and construction contracts is often recognized using percentage completion method. In this method of revenue recognition, revenue gets recognized well before the completion of the project based upon the degree of completion and even before raising invoice to the customer. The difference between the revenue recognized and invoice raised is recorded as ‘unbilled revenue’ which is disclosed in the Balance Sheet as a current asset. Revenue recognition in this method is based upon the estimate about the percentage of completion. By manipulating the estimated percentage of completion, revenue may be over or under recognized.

 

 

Sales versus Commission

An enterprise may be engaged in the business of trading in goods or financial securities for other entities. In such transactions, the enterprise may pay a certain price to the seller, adds its service charges or commission on it and receives the purchase price plus service charges from the buyer. In such backto-back transaction, the enterprise should recognize only the service charge or commission as revenue. However to inflate its revenue, management may decide to book revenue at the amount charged from the buyer (purchase price plus service charge) at the same time including the purchase price in the cost. This financial shenanigan is bottom-line neutral but has the effect of enhancing the top-line. For example, a stock broker bought shares worth ₹10 million for its client charging 1% as commission. It paid ₹10 million to the seller and collected ₹10.1 million from the buyer inclusive of commission. The broker should record only ₹0.1 million, i.e., the commission earned as revenue. To inflate revenue it may show ₹10.1 million as revenue and at the same time ₹10 million as expenses.

The audit report of MMTC Limited, a public sector company, was qualified by its auditors for improper revenue recognition as described in Box 15.7.

Backdating of Transactions

In order to increase revenue to meet the targets—internal or external—an enterprise may keep its accounts open for extended period of time. Sales of subsequent period may than can be backdated and included in the previous accounting period. For example, the accounts for the quarter ended 31st March 2017 may be kept open till say 15th of April 2017. Any sales order received till theextended date may be backdated and recognized as revenue for the quarter ended 31st March 2017 at the same time recording accounts receivable for the equivalent amount.

Fictitious Revenue

Revenue from sales of goods or services may be recognized by falsifying accounting records, raising false invoices, manipulating inventory records and booking non-existent receivables. This is the extreme form of financial shenanigans which involves active fraud by the management of the company. The modus operandi used by Satyam Computer Services Ltd (Satyam) for booking fictitious revenue is described in Box 15.8.

 

 

15.5.2 Treating Operating Expenses as Capital Expenditure

As discussed in Chapter 9, expenses incurred for day to day normal operations of the enterprise are charged off to the profit and loss statement of the period when incurred whereas expenditure likely to benefit the enterprise over a long period of time are capitalized. The capital expenditure so capitalized are depreciated or amortized over the useful life of the asset so created. The management may use its discretion to treat normal operating expenses as capital expenditure. This shenanigan impacts both the reported profit as well as assets in the balance sheet. By treating operating expenses as capital expenditure, the incidence in the profit and loss statement is deferred resulting is higher reported profits. At the same time by capitalizing the same, the assets as shown in the balance sheet are inflated. As these assets will be depreciated over their useful lives, the future profits will be adversely affected. The financial shenanigan as used by WorldCom is described in Box 15.9.

 

Similar effect can be achieved by postponing the date of completion of the project. As discussed in Chapter 9, expenses incurred, including interest during construction, till the asset is ready for its intended use can be capitalized. By postponing the cut-off date, it may be possible to book more expenses as capital expenditure thereby inflating both current profits and assets. However, future profits will be lower due to higher incidence of depreciation.

15.5.3 Under-provisioning of Expenses, Losses or Liabilities

Besides day-to-day expenses which are recognized on accrual basis, there are a number of expenses and losses which are required to be estimated and provided for. The management inflates earnings by under providing for these expenses, losses and liabilities. At the same time, in the balance sheet the assets get overstated and/or liabilities get understated. Some of the possible shenanigans in this category are:

Depreciation and Amortization

The amount of depreciation to be charged in the profit and loss statement is dependent upon the method of depreciation (WDV vs. SLM) and estimates about the useful life and residual value of the asset. It is expected that managerial estimates about these variables are guided by the pattern of benefits that the asset is likely to generate over its useful life. However the choice of depreciation methods, etc., may be used to manipulate earnings and assets. By stretching the estimate regarding the useful life of the asset, the company can boost its earnings (because of lower depreciation charge) as well overstate its assets.

Provisions for Doubtful Debts

Trade receivables in respect of goods sold or services provided are disclosed in the balance sheet at their realizable value. Suitable provision is made towards doubtful debts based upon the past experience. The amount of provision is charged as an expense in the profit and loss statement and trade receivables are shown in the balance sheet net of the provisions for doubtful debts. Such an accounting is warranted by conservatism principle and matching principle. Management may skip making appropriate provisions resulting in overstatement both of profits and assets. This may be of special significance in case of banks and other lending institutions, if they fail to provide for non-performing assets.

 

The auditors of ITI Limited issued a qualified report on the accounts for the year 2008-09 for under provision of doubtful debts as stated in Box 15.10.

Provisions for Warranties

Manufacturers and suppliers of machinery and equipment provide performance warranties to their customers. As the revenue in respect of such sales is booked in the current period, it is appropriate that costs expected towards those warranties are also recognized in the current period. For that purpose, suitable provisions towards cost of warranties are made in the books of accounts to ensure proper matching of revenue and costs. To inflate profits, the management may decide to not to make appropriate provision towards warranty, thereby resulting in higher reported profits and understatement of liabilities.

Provisions for Employees’ Costs

Companies in terms of the condition of employment provide certain retirement benefits to its employees. These defined benefit plans include pension, leave encashment, post-retirement medical benefits, etc. Suitable provisions are required to be made towards these obligations as they are being provided in lieu of the services rendered by the employees in the current period. Non-provision of employees’ cost results in overstatement of profits and understatement of liabilities. Further, as these provisions are based upon actuarial assumptions relating to return on investment, annual increments, employee iteration, etc., the management may under-provide towards these costs by making unrealistic assumptions.

15.5.4 Cookie Jar Accounting

This financial shenanigan essentially aims at income smoothening. This is based upon the assumption that companies reporting smooth profits are viewed to be less risky by the investors than the companies with fluctuating profits. For example, a company with quarterly profits of ₹400 million, ₹120 million, ₹360 million and ₹180 million will be considered volatile compared to another company with quarterly profits of ₹280 million, ₹240 million, ₹300 million and ₹240. In both the cases, the aggregate annual profit though is the same. As the second income stream is perceived to be more stable, the company will enjoy better valuations in the market. This perception leads the management to resort to ‘cookie-jar’ accounting. The management may shift profits from relatively ‘good periods’ to relatively ‘bad periods’. This can be achieved by creating secret reserves or over-provisioning of expenses in one accounting period and reversing the same in another accounting period when needed to support lower profits. The ‘cookie-jar’ accounting practiced by Dell Inc. is described in Box 15.11.

 

 

15.5.5 Big Bath Accounting

‘Big bath’ refers to massive one time writing off of assets or expenses. It actually involves advanced recognition of expenses and losses and is justified by unscrupulous management as a ‘cleaning up’ exercise or as a ‘conservative approach’. The company takes a big hit in the current period by accruing higher expenses, writing off assets and recording liabilities, but it will surely have a positive effect on the future earnings. ‘Big bath’ is often practiced in the face of expected poor results. As the company in any case is likely to disappoint the market by missing the earnings expectations, the management decides to take a ‘big bath’ by writing off higher expenses and assets. By advance accruals of future expenses and losses the company is ensuring that the future profits will show an increasing trend.

‘Big bath’ is also associated with a change in management or CEO. The new management may decide to write-off assets and investments or make large provisions towards anticipated losses or expenses. This way the blame for the poor reported earnings is shifted to the previous management and the new management is assured of better performance in the future. A ‘big-bath’ may also help the company is evading taxes by declaring lower taxable income due to excessive write-offs.

15.5.6 Direct Write-off from Reserves

In order to show higher earnings an enterprise may decide to write off certain expenses and losses directly from reserves rather than routing them through the profit and loss statement. Such an accounting policy overstates the reported profits having no other effect on the financial statements.The auditors of Dish TV India Limited qualified the audit report on the consolidated financial statements for the year 2010–11 as stated in Box 15.12.

 

 

Similarly, a number of companies which have issued debenture redeemable at a premium directly adjust the premium on redemption from the Securities Premium Account instead of treating the same as a financial cost. This shenanigan again has the effect of understating financial expenses and overstating reported profits. Companies can inflate their profits by offering higher redemption premium and thereby keeping the interest rate on debentures low.The accounting policy of Reliance Communications Limited in this regards is stated in Box 15.13.

15.5.7 Deferred Tax Assets

As discussed in Chapter 5, deferred tax assets are recognized in case the company has paid higher taxes in the current period which will be reversed in the future periods due to timing difference between the reported income and taxable income. The accounting for deferred tax asset involves taking a deferred tax credit in the profit and loss statement and at the same time recording it as an asset which will benefit the future periods. The deferred tax credit in the profit and loss statement has the effect of increasing reported profit after tax (or reducing the loss after tax). The carrying amount of deferred tax assets need to be reviewed at each balance sheet date. If it is no longer reasonably certain or virtually certain that sufficient future taxable income will be available against which direct tax assets can be realized, the carrying amount of deferred tax assets should be written down.

 

Such an assessment is usually left to the discretion of the management. By not writing down the deferred tax assets both profits and assets get overstated. The accounts of Kingfisher Airlines Limited were given a qualified audit report for similar accounting practice as stated in Box 15.14.

15.5.8 Change in Accounting Policies

The consistency principle requires that the accounting policies once adopted must be used consistently year after year. Consistency is an essential attribute for inter-period comparison and is prescribed as one of the fundamental attributes of accounting. Any change in accounting policy is justified either by a change in the requirements of law or accounting standards or for better disclosure. Accounting policies may be changed by management in some cases to inflate profits as well. The impact of change in accounting policy in respect of exchange rate fluctuation by Asahi India Glass Limited is described in Box 15.15.

15.5.9 Improper Classification

An enterprise may ‘window dress’ its financial statements by improper classification of incomes, expenses, assets, liabilities or cash flows in its financial statements. For example, extra-ordinary incomes may be clubbed with the operating income to create a wrong impression about the revenue growth of the company. Likewise,cash flows may be misclassified from say financing to operating or vice versa. The financial shenanigan here is not about wrong accounting but improper disclosure.

 

 

15.5.10 Linked Transactions

An enterprise may enter into a set of linked transactions with its customer or vendor to create a false impression in the books of account of both. These transactions when seen in isolation may appear to be genuine business transactions but the underlying intent may be to falsify the accounts. The financial shenanigan used by International Business Machine Corporation (IBM) with its customer is described in Box 15.16.

15.5.11 Related Party Transactions

One of the basic assumptions in commercials transactions that lends objectively is that parties to the transaction are at arm’s length relationship. Therefore, the price and other terms negotiated between such parties to the agreement are assumed to be genuine and form the basis of recording the transaction. However, if this essential condition is violated, the management gets an opportunity for financial shenanigan. Related party transaction may be used for recording fictitious revenues and also for hiding liabilities and unproductive assets. For example, an enterprise holding an asset at a book value of ₹10 million can sell the same to another enterprise (a related party) for say ₹15 million, thereby recording a fictitious gain of ₹5 million. This shenanigan may be adopted, especially in those cases where accounts of related entities are not required to be consolidated. Enron Corporation used the related party transactions to boost its profits as described below in Box 15.17.

The above list of financial shenanigans is only illustrative and not comprehensive. The Fraud Survey 2010 by KPMG identified

• Advance revenue recognition from a future financial period (42%).
• Unrecorded/concealed expenses (42%).
• Deferring expenses to a future financial period (32%).
• Creating fictitious revenue (29%).
• Capitalizing operating expenses (26%) as the most common forms of financial statement frauds.

15.6 REGULATORY REACTIONS

A large number of accounting frauds were reported in the Unites States in late nineties (Enron, WorldCom, Xerox, etc.) which lead to enactment of a new statute namely Sarbanes-Oxley Act, 2002 with an aim to ₹protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws and for other purposes’⁹. Some of the key focus areas of the act are described below:

Auditors’ Independence

To ensure independence of external auditors, the Act prohibits the auditors to provide any other service (like book keeping, internal audit, corporate advisory, etc.) to the enterprise being audited. This is necessary to avoid any conflict of interest. The Act also provides for rotation of the audit partners (with primary responsibility for the audit) as well as partner responsible for reviewing the audit every five year.

Corporate Responsibility for Financial Reports

The Act puts the responsibility of review of financial statements on the principal executive officer and the principal financial officer to ensure that they are free from any material error or fraud and for instituting necessary internal controls to that affect. Accordingly, all the filings with SEC need to accompany with a certificate signed by the CEO and CFO of the company to that affect. Such a provision is needed to ensure greater involvement of the top management in ensuring reliability of financial disclosures. The Act also provides for strengthening of Audit Committee of the Board of Directors for appointment, remuneration and oversight of external auditors.

Enhanced Financial Disclosures

The Act provides for enhanced disclosures in accordance with the generally accepted accounting principles. All material off balance sheet transactions, arrangements and obligations are required to be disclosed in the annual and quarterly reports.

Increased Criminal Penalties

Any willful certification of the statements as prescribed knowing they do not conform to all the requirements will attract a penalty up to $5,000,000 and/or imprisonment not exceeding 20 years.

The Companies Act, 2013 incorporates significant provisions in the regard. It provides for compulsory auditors’ rotation, prohibition of specified non-audit services by the auditors, establishment of a vigil mechanism with protection to the whistleblower, and enhanced criminal penalties. As per Section 448 of the Act any person making a statement which is false, knowing it to be false in any return, report, certificate, financial statement, prospectus, statement or other document required by, or for, the purposes of any of the provisions of this Act will be punishable with imprisonment for a term which shall not be less than six months but which may extend to ten years and shall also be liable to fine which shall not be less than the amount involved in the fraud, but which may extend to three times the amount involved in the fraud.

The Act also imposes similar punishment to other persons involved in covering up the frauds as well. Section 447 of the Act defines ‘fraud in relation to affairs of a company includes any act, omission, concealment of any fact or abuse of position committed by any person or any other person with the connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss.’ Accordingly, even the auditors of the company and audit firms also may be implicated and penalized under the provisions of the proposed Act.

The listing agreement also prescribe a requirement to have a whistle-blower policy to establish a mechanism for employees to report to the management concerns about unethical behaviour, actual or suspected fraud or violation of the company’s code of conduct or ethics policy. Adequate safeguards against victimization of whistle blowers also need to be provided.

15.7 HOW TO DETECT FINANCIAL SHENANIGANS?

Notwithstanding all the regulatory provisions, financial shenanigans are here to stay. Unscrupulous management will continue to use accounting gimmicks to portray a picture different than the real financial health of the organization. The users of the financial statements will need to guard against such practices by being vigilant. As discussed earlier, such practices are perpetrated often by the top management working as a group and may be in connivance with the auditors making it difficult to detect the same. Some of the warning signs a user may look for are discussed below:

Governance Structure

Look at the board of director and audit committee composition. The presence of independent directors-persons of eminence with accounting/finance background—may act a deterrent to financial shenanigans. On the other hand, a board dominated by family members or friends of the promoters may not be conducive to check financial frauds.

Accounting Policies

Go through the accounting policies of the company closely. Aggressive and unusual accounting policies may indicate the management’s willingness for reporting better numbers than reality. Compare, for example, the depreciation rate used by a company with accounting policy being followed by other companies in the same industry. This may give an indication about the adequacy or otherwise of depreciation charged.

Change in Accounting Policies

Frequent changes in accounting policies without any reasonable justification with an object to overstate/understate earnings is again an indicator of financial shenanigans.

Auditors’ Report

The frequency and nature of audit qualification is another area to look for. An audit qualification signifies the auditors’ opinion is subject to the observations stated in the audit report. Not only audit qualifications, even the reference drawn by the auditors to specific comments in ‘notes to accounts’ also warrants a close scrutiny.

Notes to Accounts

Don’t ignore the details given in schedules and notes to accounts. A company may fulfill the disclosure requirements by giving the requisite details in small prints in the notes to accounts. For example, the break-up of other income as given in schedule/notes to accounts may reveal the presence of nonrecurring income. That will be useful while estimating the future revenues.

Ratio Analysis

Compare the key financial ratios of the enterprise in the current period with the earlier periods to identify any major deviation. The deviation may be genuine or may indicate the presence of financial shenanigans. For example, if the cost of goods sold as a percentage of sales has declined substantially compared to the previous trend, it may indicate under-booking of expenses or shenanigan involving inventory valuation. Similarly, comparing the ratios of an enterprise with other companies in the same industry may also be helpful. Companies in the same industry are expected to follow the same trend. For example, a sudden increase in the average collection period compared to the previous periods or compared to other companies in the industry may indicate the presence of sham transaction without intentto collect.

A company with super normal growth or continually beating expectations or outperforming industry aggregates or which is in significant deviation from the industry trends may be taken as leading indicators of financial shenanigans.

Related Party Disclosures

Related partytransactions are often used for financial shenanigans. The presence of a large number of subsidiary companies, a large percentage of total sales coming from related parties, transfer of assets or securities between related parties need to be looked closely for economic justifications.

Cash Flow Statement

The profit and loss statement and the balance sheet are based upon accrual principle, whereas the cash flow statement is not. A large deviation between cash flow from operation and EBITDA may be an indication of the presence of large non-cash transactions. For example, improper recognition of revenue (sale or return, consignment sale, etc.) will lead to larger blockage of funds in trade receivables which is reported separately in the cash flow statement.

Contingent Liabilities

An enterprise may try to hide real liabilities by stating the same as contingent liabilities. As discussed earlier, liabilities are on balance sheet items whereas contingent liabilities are disclosed in notes to account, and are off-balance sheet items. Contingent obligations like disputed tax demands are often classified as contingent liabilities. Likewise, a financial strong parent company may stand as a guarantor to a weak subsidiary. In the books of the parent company such a guarantee will appear only in notes to accounts.

15.8 PREVENTION OF FINANCIAL SHENANIGANS

The accounting gimmicks and frauds as discussed in the earlier paragraphs do have a positive impact on the reported financial results at least in the short run. A desire to meet internal and external expectations acts as a strong motivation for the managers to adopt deceptive and fraudulent accounting and disclosure practices. However, such gains are only short term. As the financial statements are continually under scrutiny by auditors, bankers, investors, analysts, rating agencies and other stakeholders, sooner or later such shenanigans will get detected. In such a situation, not only the company in question is liable to civil and criminal actions but also loss of credibility. Often it leads to even more serious consequences including liquidation of the company.

The conflict between short term gains from financial shenanigans and long term consequences there of creates an ethical dilemma for the management and they need to make the choice. ‘The primary responsibility for the prevention and detection of fraud is on the board of directors and managers of the company.’¹⁰ Though the auditors are also expected to be more vigilant but they are not responsible for prevention of fraud and errors. To effectively discharge this responsibility, the followings steps need to be taken by the management:

1. Create and maintain high standards of moral values, honesty and ethics throughout the organization. In long run ethical behavior lends credibility to the organization. Strong emphasis on compliances with the applicable laws in the letter and spirit need to be reinforced by the management.
2. Set realistic targets—both for external reporting as well for internal performance measurement. The pressure to meet unrealistically high targets often leads to financial shenanigans. Performance management system to focus not only on achievement of results but also achieving them in the right way.
3. Establish and maintain a strong internal control environment reducing the opportunity to manipulate. The internal controls to have adequate internal checks and balances including internal audit commensurate with the size and complexities of the business. No single person, howsoever high in hierarchy, can have complete control over a transaction. Deviations from established controls and procedures, e.g., ability to supersede the laid down procedure to be kept minimum and also be well documented.
4. Emphasis on regular reconciliations and confirmation of outstanding balances—large and long-standing entries in suspense account, un-reconciled inter-branch balances, gap between inventory records and physical inventory, non-confirmation of balances outstanding with the debtors, etc., provide opportunities for financial shenanigans.
5. Encourage an environment of openness and transparency where in employees and managers are encouraged to bring any dishonest practices being used in the organization to the attention of the top management without any fear of reprisal. Lay down a detailed ‘whistle-blower’ policy with adequate protection to the whistle blower.
6. Lay down a strong governance structure with presence of independent directors of high integrity and expertise on the Board of Directors and Audit Committee. Oversight by the audit committee on the accounts and audit functions—both internal and external will also be helpful in prevention and detection of financial shenanigans.
7. Proper corporate communication with the stakeholders so that the potential damage caused by below par financial results can be minimized.

In short the management needs to reduce the motivations as well as opportunities for financial shenanigans.

 

Assignment Questions

1. Reliability is one of the key attributes of financial statements. Do you agree with the statement?
2. Briefly describe the regulatory environment to ensure that the financial statements are reliable.
3. Define the term ‘financial shenanigans’. Is it necessarily illegal?
4. Revenue recognition is one of the most vulnerable accounting areas. Describe some of the methods of manipulating revenue recognition.
5. Explain the following financial shenanigan techniques:
   1. ‘Big bath’ accounting
   2. ‘Cookie-jar’ accounting
   3. Channel-stuffing
   4. Round-tripping
6. What steps would you suggest for the management to take to prevent financial shenanigans?
7. How will you detect presence of financial shenanigans in the financial statements?
8. ‘Financial shenanigans are short-term measures’. Comment.

Cases

Case 15.1: Reliance Industries Limited:¹¹ Impact of Abnormal Item in the Profit and Loss Account

Reliance Industries Limited (RIL) is a fortune 500 company, and is the largest private sector company in India. It is the flagship company of Reliance Group founded by Mr. Dhirubhai Ambani. The company reported consolidated net profit after tax of ₹ 24,423 crore for the year 2009–10 compared to ₹ 14,950 crore during 2008–09. The excerpts from the consolidated profit and loss account of the company for the year ended 31st March 2010 and the previous year are given as follows:

 

Questions for Discussion

1. The PAT of the company has grown from ₹ 14,950 crore in 2008–09 to ₹ 24,423 crore in 2009–10. How do you rate the performance of the company?
2. What are the main contributors for increase in the profit of the company?
3. The schedule of ‘Other Income’ of RIL discloses an exceptional item amounting to ₹ 8,605.57 crore as ‘income from sale of Reliance Industries Limited shares by Petroleum Trust’. No other details regarding this gain have been provided in the annual report. Is it correct to include exceptional item in the Other Income category?
4. How should RIL have disclosed the exceptional items?
5. How do you rate the performance of the company excluding exceptional item?

Case 15.2: State Bank of India—Impact of Provisioning¹²

State Bank of India (SBI) is the oldest bank in India holding premier position in terms of balance sheet size, number of branches and market capitalization. It was adjudged as the best bank by the Business India in August 2009. The Government of India holds over 59% of the share capital of the bank with the balance 41% held by institutional investors (29%) and retail investors (12%).

‘State Bank of India surprised the market by posting a 99% decline in net profit to ₹ 21 crore for the fourth quarter ended 31st March 2011 against ₹ 1,867 Crore during the corresponding period last year. Profits were dragged down by higher provisioning towards pension and gratuity and loan loss and standard assets provision on special home loan schemes.’¹³ Though the income grew by 18% to ₹ 26,536 crore from ₹ 22,474 crore in the corresponding quarter in the past year, the net profit fell by 99%. The audited financial results as declared by the bank are reproduced below.

 

While announcing the result, Mr. Pratip Chaudhuri—newly appointed chairman of the bank—said that ‘whether it is pension, provision coverage ratio or standard assets provisioning we have done a considerable clean-up act. In the interest of transparency, we have taken the hit this year itself so that, going forward, we have no legacy issues. For gratuity too, we could have amortized this expense over five years, we decided to load it upfront, so that the impact over the next 16 quarters will only be ₹ 25 crore’.

The ‘clean up act’ of SBI did not go too well with all concerned. ‘We have decided to send a letter to SBI to enquire about the reasons, which led to an increase in provisions, to explain a rise in provisions in the March quarter over that in December (2010) quarter. We would like to know the factual position about such high provisioning’. said the Institute of Chartered Accountants president to the Indian Express.

RBI Deputy Governor, K C Chakrabarty, also commented ‘Reporting has to be credible. You see our banks, when the chairman retires profits decline. If we don’t make the system credible and create a standard, people will report anything. Reporting should not be according to chairman but according to books. So we need to improve the standard of reporting and examination’.

However, the outgoing RBI Deputy Governor, Shyamala Gopinath, who is also on the board of SBI argued that ‘If a bank chooses to make a one-time provision, it is their choice and there is nothing wrong with it. The provisions toward gratuity, pensions and other annuities that SBI made in Q4 could have been staggered’.

The stock market reacted on the expected line after the result announcement. The SBI stock fell by almost 8%, from ₹ 2,617 on 16th May to ₹ 2,413 on the next day. The stock continued to fall and closed at ₹ 2,175 on 25th May 2011, a fall of over 17% in seven trading sessions. In the same period, the sensitive index (SENSEX) of the Bombay Stock Exchange fell by about 3% and the stock index of banking companies (BANKEX) fell by about 5%.

Questions for Discussion

1. Why do companies make provisions? Which accounting principle supports this?
2. What is the impact of over-provisioning on the reported profits of the company?
3. The principle of conservatism or prudence is against over-reporting of profits. Does it justify under-reporting of profits?
4. What is the impact if in the subsequent year some of the provisions made in the current period are found to be excessive?
5. Can these provisions be used by companies for earnings management?

Case 15.3: Revenue Recognition by Real Estate Companies—DLF Limited

As per a report published in the Economic Times dated 23rd June 2011 titled ‘No standards, so real estate numbers remain a riddle’ in absence of any regulations in this regards, revenue recognition by real estate companies places question marks over the accuracy of reported revenue numbers and makes any comparison across peer group redundant. The report doubts the way ‘percentage completion’ method of revenue calculation is used by builders. As per the report, DLF has reported a total revenue of ₹ 9,560 crore for the year 2010–11. As against this, the company has ‘unbilled receivables’ of ₹ 7,200 crore, that is, over 75% of the total revenue. Similarly for the year 2009–10, the company reported consolidated revenue of ₹ 7,423 crore and unbilled receivables under ‘other current assets’ at ₹ 4,367 crore.

Revenue from constructed properties is generally recognized on the percentage of completion method. Total sale consideration as per the duly executed agreement to sell/application (containing salient terms of agreement to sell), is recognized as revenue based on the percentage of actual project costs incurred thereon to total estimated project cost, subject to such actual cost incurred being 30% or more of the total estimated project cost. Project cost includes cost of land, cost of development rights, estimated construction and development cost, and borrowing cost of such properties. The estimates of the saleable area and costs are reviewed periodically and effect of any changes in such estimates is recognized in the period such changes are determined. However, when the total project cost is estimated to exceed total revenues from the project, the loss is recognized immediately.

The difference between the revenue recognized on the basis of percentage of completion method and payment plan agreed with the customers is recorded as ‘unbilled receivables’ and the same are shown under ‘other current assets’. The use of percentage completion method avoids spiking of revenue when the project gets completed as the revenue recognition is spread over the construction period. There is no merit in deferring income to the end of the project. It is better to show income and profit periodically as they come. It also facilitates quarterly reporting says the group chief financial officer of DLF.

The revenue recognition using percentage completion method will depend upon some key questions. What constitutes cost to determine percentage completion? For example, DLF includes cost of land in the project cost, whereas other builder may exclude the same. As a result, DLF will be able to book more revenue upfront. Secondly, at what stage of project completion revenue can begin to be recognized. DLF starts revenue recognition once 30% of the estimated project cost has been incurred. Other builders may use a higher of lower percentage. Thirdly, who will certify as to how much of a project has been completed.

In the current environment where significant costs and time overruns in the construction projects are being witnessed, the accounting for revenue becomes even more complex.

Questions for Discussion

1. Why do real estate companies use percentage completion method?
2. What is unbilled revenue?
3. What will be the impact on the financial results of these companies if revenue is allowed to be booked only upon completion of the project?
4. List out your comments on the issues raised regarding use of percentage completion method.

Case 15.4: Satyam Computer Systems Limited—Riding a Tiger

The Indian business and investor community received a shock on 7th January 2009 when Mr. Ramalinga Raju, CEO of Satyam Computer Limited (Satyam), by a letter to the board of directors admitted falsification of account to the tune of over ₹ 70,000 million. Satyam at that time was the fourth largest IT Company in India with over $2 billion in turnover and employing over 50,000 employees. Just three months back, it declared its half yearly results for the six months ended 30th September 2008 with total income of ₹ 53,405 million and a net profit of ₹ 11,733 million. The company has been showing impressive results year after year. The excerpts from the balance sheet and profit and loss account of the company for five years up to 2007–08 are given in Annexure-I and Annexure-II, respectively.

The immediate trigger for this confession was provided by the aborted attempt by Satyam to acquire 51% stake in Maytas Infra and 100% stake in Maytas Properties—both companies promoted by Mr. Raju’s sons. On 16th December 2008, the company informed the stock exchanges that board of directors of the company has approved the proposals to acquire Maytas Infra Limited with controlling stake and Maytas Properties Limited as a wholly owned subsidiary. The company said that the acquisition of Maytas’ two companies will cost it $ 1.6 billion. The company justified the acquisition by saying that the move is driven by a need to adopt diversification strategy. It will de-risk the core business of the company as a new vertical—mitigated risk in developed markets. The two companies offer significant upside in the future. The move to acquire these companies invoked strong reactions from the stock market, institutional investors and the brokerage houses. It was taken as a major corporate governance issue and loss of credibility. The very next day, the company announced that it is not going ahead with its proposed acquisition in light of the feedback received from the investor community. Commenting on this decision, Mr. Raju said, ‘We have been surprised by the market reaction to this decision even though we were quite positive about the merits of the acquisition. However, in deference to the views expressed by many investors, we have decided to call off these acquisitions’.

The next two days witnessed resignations of non-executives directors including Krishna Palepu, Mangalam Srinivasan Vinod Dham and M. Rammohan Rao. Mr. Rao was the Dean of the prestigious Indian School of Business (ISB) Hyderabad and had chaired the meetings of the board of directors on 16th December 2008 where the controversial acquisitions were approved. He also stepped down as a Dean of ISB a few months advance of his term to save any kind of embarrassment to ISB. However, another independent director Mr. T. R. Prabhu stated that ‘I am of the view that resigning from the board now is like deserting a troubled ship. We should remember Satyam is a major player in global IT space, employing well over 50,000 of the best and the brightest of professionals, with vendor commitments to several global corporates and entities’.

Finally on 7th January 2009, Mr. Raju tendered his resignation by a letter addressed to the board of directors and admitting the massive fraud perpetuated over a period of time. The letter of resignation of Mr. Raju is given in Annexure-III.

Modus Operandi

It appears that Satyam inflated its revenue by booking fictitious invoices (refer Box 15.8) as a result false receivables were also recognized. Fictitious entries were passed to record the receipts from these non-existent debtors. These ‘cash balances’ were converted into bank deposits and interest was also accrued on these fictitious bank deposits. To create the necessary supporting documents fake invoices were created, banks’ statements were falsified and fake bank deposit receipts were created. The chain of sequence is depicted in Figure 15.2.

These fictitious debtors, bank balances and bank deposit should have been detected by the auditors as a part of standards audit procedures involving verification of bank deposits and receivables. That did not happen due to connivance with the auditors. Cash and cash equivalents (including bank deposits) constituted over 50% of the total assets of the company. The management attempted to bridge the hole so created by announcing acquisition of controlling stake in two related entities.

 

Auditors

The accounts of Satyam were audited by Price Waterhouse Coopers (PwC) from June 2000 until September 2008. Mr. Subramani Gopalakrishnan, partner at the PwC, has signed all the audit reports except one which was signed by Mr. Talluri Srinivas, another partner at PwC, during this period. After the outbreak of the scandal, both the partners were arrested. The firm is also being investigated by a committee set up by the Institute of Chartered Accountants of India (ICAI) for their role in the Satyam scam.

On 13th January 2009, PwC wrote to the board of Satyam stating that ‘we planned and performed the required audit and examined the books and records of the company produced before us by the company management. We placed reliance on management’s control over financial reporting and the information and explanation provided by the management as also the verbal and written representations made during the course of audit’. In February 2009, PwC resigned as statutory auditors of Satyam with a commitment to cooperate with the ongoing investigations.

Government’s Response

To ensure that there is no negative impact on India as an IT and BPO destination, the government moved swiftly and reconstituted the board of directors of the company on 11th January 2009. The newly constituted board said that the first priority of the board will be to ensure business continuity and to make sure that India continues to be a safe, secure and reliable destination for IT. The board decided to induct a strategic investor to buy Satyam by inviting bids. Expression of interest was received from bidders including Larsen & Toubro, Tech Mahindra, iGate and B K Modi’s Spice Corp. On 13th April 2009, Tech Mahindra won the bid for Satyam. The company was renamed as Mahindra Satyam in June 2009.

The government also moved Serious Fraud Investigation Office (SFIO) to look into the entire gamut of irregularities and other related anomalies in books of accounts and other acts of commission and omission including the role of directors, promoters and auditors.

Stock Market Reaction

The stock market reacted swiftly and severally. On 16th December 2008, over 500,000 shares were traded on the BSE and the shares closed at ₹ 226.50. The very next day when the deal for acquiring Maytas Properties and Maytas Infra was announced, the stock fell by over 30% and closed at ₹ 158.05 with over 33 million shares traded on the BSE alone. Again on 7th January 2009, after Mr. Raju’s confession, the stock closed at ₹ 39.95 on the BSE with a loss of 78% over the previous close. Over 143 million shares were traded on the BSE on that day. In 15 trading days between 17th December 2008 and 7th January 2009, the stock lost over 82% in value. The stock movement between 1st December 2008 and 31st March 2009 on the BSE is shown in Chart 15.1.

 

 

 

Annexure III: Resignation Letter of Mr. Ramalinga Raju to the Board Members

Dear Board Members,

It is with deep regret, at tremendous burden that I am carrying on my conscience, that I would like to bring the following facts to your notice:

1. The Balance Sheet carries as of 30th September 2008
   • Inflated (non-existent) cash and bank balances of ₹ 5,040 crore (as against ₹ 5,361 crore reflected in the books)
   • An accrued interest of ₹ 376 crore which is non-existent
   • An understated liability of ₹ 1,230 crore on account of funds arranged by me
   • An over stated debtors position of ₹ 490 crore (as against ₹ 2,651 crore reflected in the books)
2. For the September quarter (02) we reported a revenue of ₹ 2,700 crore and an operating margin of ₹ 649 crore (24% of revenues) as against the actual revenues of ₹ 2,112 crore and an actual operating margin of ₹ 61 crore (3% of revenues). This has resulted in artificial, cash and bank balances going up by ₹ 588 crore in Q2 alone.

The gap in the balance sheet has arisen purely on account of inflated profits over a period of last several years (limited only to Satyam standalone, books of subsidiaries reflecting true performance). What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew significantly (annualized revenue run rate of ₹ 11,276 crore in the September quarter, 2008 and official reserves of ₹ 8,392 crore). The differential in the real profits and the one reflected in the books was further accentuated by the fact that the company had to carry additional resources and assets to justify higher level of operations—thereby significantly increasing the costs.

Every attempt made to eliminate the gap failed. As the promoters held a small percentage of equity, the concern was that poor performance would result in a take-over; thereby exposing the gap. It was like riding a tiger, not knowing how to get off without being eaten.

The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones. Maytas’ investors were convinced that this is a good divestment opportunity and a strategic fit. Once Satyam’s problem was solved, it was hoped that Maytas’ payments can be delayed. But that was not to be. What followed in the last several days is common knowledge.

I would like the board to know:

1. That neither myself, nor the managing director (including our spouses) sold any shares in the last eight years—excepting for a small proportion declared and sold for philanthropic purposes.
2. That in the last two years, a net amount of ₹ 1,230 crore was arranged to Satyam (not reflected in the books of Satyam) to keep the operations going by resorting to pledging all the promoter shares and raising funds from known sources by giving all kinds of assurances (Statement enclosed, only to the members of the board). Significant dividend payments, acquisitions, capital expenditure to provide for growth did not help matters. Every attempt was made to keep the wheel moving and to ensure prompt payment of salaries to the associates. The last straw was the selling of most of the pledged share[s] by the lenders on account of margin triggers.
3. That neither me, nor the managing director took even one rupee/dollar from the company and have not benefited in financial terms on account of the inflated results.
4. None of the board members, past or present, had any knowledge of the situation in which the company is placed. Even business leaders and senior executives in the company such as Ram Mynampati, Subu D, T.R. Anand, Keshab Panda, Virender Agarwal, A.S. Murthy, Han T, S.V. Krishnan, Vijay Prasad, Manish Mehta, Murali V. Sriram Papani, Kavale, Joe Lagioia, Ravindra Penumetsa, Jayaraman and Prabhakar Gupta are unaware of the real situation as against the books of accounts. None of my or the managing director’s immediate or extended family members have any idea about these issues.

Having put these facts before you, I leave it to the wisdom of the board to take the matters forward. However, I am also taking the liberty to recommend the following steps:

1. A task force has been formed in the last few days to address the situation arising but of the failed Maytas acquisition attempt. This consists of some of the most accomplished leaders of Satyam; Subu D, T.R. Anand, Keshab Panda and Virender Agarwal, representing business functions; and A.S. Murthy, Han T and Murali V representing support functions. I suggest that Ram Mynampàti be made the Chairman of this task force to immediately address some of the operational matters on hand. Ram can also act as an interim CEO reporting to the board.
2. Merrill Lynch can be entrusted with the task of quickly exploring some merger opportunities.
3. You may have a restatement of accounts’ prepared by the auditors in light of the facts that I have placed before you.

I have promoted and have been associated with Satyam for well over 20 years now I have seen it grow from few people to 53,000 people, with 185 Fortune 500 companies as customers and operations in 66 countries. Satyam has established an excellent leadership and competency base at all levels. I sincerely apologize to all Satyamites and stakeholders, who have made Satyam a special organization, for the current situation. I am confident they will stand by the company in this hour of crisis.

In light of the above, I fervently appeal to the board to hold together to take some important steps Mr. T.R. Prasad is well placed to mobilize support from the government at this crucial time. With the hope that members of the task force arid the financial advisor, Merrill Lynch (now Bank of America) will stand by the company at this crucial hour, I am marking copies of this statement to them as well.

Under the circumstances, I am tendering my resignation as the chairman of Satyam and shall continue in this position only till such time the current board is expanded. My continuance is just to ensure enhancement of the board over the next several days or as early as possible.

I am now prepared to subject myself to the laws of the land and face consequences thereof.

(B. Ramalinga Raju)

Copies marked to:

1. Chairman SEBI
2. Stock Exchanges

Questions for Discussion

1. Mr. Raju in his letter stated that ‘It was like riding a tiger, not knowing how to get off without being eaten’. What does ‘riding a tiger’ mean in this context?
2. Identify the financial shenanigans deployed by the management of Satyam and discuss the same within the framework of ‘motivations’ and ‘opportunities’.
3. Critically evaluate the role of independent directors and auditors of Satyam.
4. In his resignation letter Mr. Raju stated that none of the directors, senior executives or family members had any knowledge of the situation. Do you think such a massive fraud is possible without collusion?

Endnotes

1. Exposure draft on ‘Framework for the Preparation and Presentation of Financial Statements’, ICAI, 2011.
2. Section 129(1) of the Companies Act, 2013.
3. Section 129 (5) of the Companies Act, 2013.
4. Section 134 of the Companies Act, 2013.
5. Section 143 of the Companies Act, 2013.
6. India Fraud Survey Report 2010, KPMG.
7. Fraudulent Financial Reporting:1998–2007, An Analysis of US public companies, Committee of Sponsoring Organizations of the Treadway Commission, May 2010, downloaded from www.coso.org.
8. www.corpwatch.org.
9. Preamble to Sarbanes-Oxley Act, 2002.
10. SA240 (AAS 4), ‘The auditor’s responsibility to consider fraud and error in an audit of financial statements’, ICAI.
11. Annual Report of Reliance Industries Limited for the year 2009–10.
12. Based upon reports in Economic Times, Business Standard and Financial Express.
13. Business Line, 17th May 2011