Download Chapter 17: Evaluating Quality of Financial Reports

EVALUATING QUALITY OF FINANCIAL REPORTS
Presenter’s name
Presenter’s title
dd Month yyyy
FINANCIAL REPORTING QUALITY AND
EARNINGS QUALITY ARE INTERRELATED
2
QUALITY SPECTRUM OF FINANCIAL REPORTS
3
POTENTIAL PROBLEMS THAT AFFECT THE
QUALITY OF FINANCIAL REPORTS
• Reported amounts and timing of recognition
• Classification
• Biased choices
• Fraud
4
REPORTED AMOUNTS AND TIMING OF
RECOGNITION: REVENUE
Aggressive,
premature, and
fictitious revenue
recognition
Conservative
revenue
recognition
Overstated
income
Overstated
equity and
overstated net
assets
Understated
income
Understated
equity and
understated
net assets
5
REPORTED AMOUNTS AND TIMING OF
RECOGNITION: EXPENSES
Understatement
of bad debt
expense
Understatement
of depreciation
or amortization
Understatement
of interest or tax
Overstatement
of income
Overstated
equity and
overstated net
receivables
Overstatement
of income
Overstated
equity and
overstated net
PPE
Overstatement
of income
Overstated
equity and
understated
liability
6
REPORTED AMOUNTS AND TIMING OF
RECOGNITION: CASH FLOW
Defer payment
of payables
Increases
operating cash
flow for the
period
Accelerate
payments from
customers
Increases
operating cash
flow for the
period
Defer
purchases of
inventory
Increases
operating cash
flow for the
period
7
CLASSIFICATION
– Reclassification of accounts receivable or inventory from current to long-term
favorably affects company metrics, such as turnover ratios.
– Classification of revenue items as being derived from core, continuing
operations favorably affects the apparent sustainability of revenues.
– Classification of expense items as non-operating favorably affects reported
operating income.
– Classification of expense items and losses as non-recurring in non-GAAP/nonIFRS metrics favorably affects the apparent sustainability of profits.
– Classifications that result in items being reported in other comprehensive
income can favorably affect comparability.
– Classification choices on the statement of cash flow can distort operating cash
flows.
8
ACCOUNTING WARNING SIGNS
9
ACCOUNTING WARNING SIGNS (CONTINUED)
10
ACCOUNTING WARNING SIGNS (CONTINUED)
11
ACCOUNTING WARNING SIGNS (CONTINUED)
12
EVALUATING THE QUALITY OF FINANCIAL
REPORTS
– Understand company and industry
– Learn about management
– Identify important accounting areas
– Compare
– current year’s report with prior year’s report
– accounting policies with competitors’ policies
– ratios with competitors’ ratios
– Check for warning signs
– Review segment results
– Use quantitative predictors of misreporting
13
QUANTITATIVE TOOL TO ASSESS THE LIKELIHOOD
OF MISREPORTING—BENEISH MODEL
M-score = Score indicating probability of earnings manipulation
• The following slides describe each input variable and provide an
explanation of why it is included.
• Even if an analyst does not choose to use this particular model, it is
helpful to understand the input variables and their link with probable
earnings manipulation.
14
BENEISH MODEL: INPUT VARIABLES
• DSR (days sales receivable) = (Receivablest/Salest)/(Receivablest–1/Salest–1).
Changes in relationship between receivables and sales could indicate
inappropriate revenue recognition.
• GMI (gross margin index) = Gross margint–1/Gross margint.
Deterioration in margins could predispose a company to manipulate earnings.
• AQI (asset quality index)= [1 – (PPEt + CAt)/TAt]/[1 – (PPEt–1 + CAt–1)/TAt–1],
where PPE is property, plant, and equipment, CA is current assets, and TA is
total assets.
Change in percentage of assets other than PP&E and current assets could
indicate excessive expenditure capitalization.
• SGI (sales growth index) = Salest/Salest–1
Managing the perception of continuing growth and capital needs from actual
growth could predispose a company to manipulate sales and earnings.
15
BENEISH MODEL: INPUT VARIABLES CONTINUED
• DEPI (depreciation index) = Depreciation ratet–1/Depreciation ratet, where
Depreciation rate = Depreciation/(Depreciation + PPE).
Declining depreciation rates could indicate understated depreciation as a means
of manipulating earnings.
• SGAI (sales, general, and administrative expenses index) = (SGAt/Salest)/
(SGAt–1/Salest–1)
An increase in fixed SGA expenses suggests decreasing administrative and
marketing efficiency, which could predispose a company to manipulate earnings.
• Accruals = (Income before extraordinary items – Cash from operations)/Total
assets.
Higher accruals can indicate earnings manipulation.
• LEVI (leverage index) = Leveraget/Leveraget–1, where Leverage is calculated
as debt to assets.
Increasing leverage could predispose a company to manipulate earnings.
16
EARNINGS QUALITY
High Quality:
• Sustainable
• Returns ≥
Cost of capital
Low Quality:
• Non-recurring
• Returns <
Cost of capital
17
INDICATORS OF EARNINGS QUALITY
• Recurring earnings
• Earnings persistence and related measures of accruals
• Beating benchmarks
• After-the fact confirmations of poor-quality earnings, such as enforcement
actions and restatements
18
NON-RECURRING EARNINGS: EXAMPLE
19
NON-RECURRING EARNINGS: EXAMPLE
Highly
Variable
Smoothly
Upward
How does the trend in Enron’s operating income compare with
the trend in its income after other income and deductions?
20
NON-RECURRING EARNINGS: EXAMPLE
What items appear to be non-recurring as opposed to being a result of
routine operations?
21
CLASSIFICATION DECISIONS: EXAMPLES
• Borden, a food and chemicals company, misleadingly classified $146 million
of operating expenses as part of a special item (restructuring charges).
• AmeriServe Food Distribution Inc., which declared bankruptcy only four months
after completing a $200 million junk bond issuance, classified substantial
operating expense as restructuring charges, which masked the company’s
serious financial underperformance.
• Waste Management, which, in 1998, issued the then-largest restatement in
SEC history. It improperly inflated operating income by netting nonoperating gains from the sale of investments and discontinued
operations against unrelated operating expenses.
• IBM classified intellectual property income as an offset to selling,
general, and administrative expenses. This classification resulted in an
understatement of operating expenses and thus an overstatement of core
earnings by $1.5 billion and $1.7 billion in 2001 and 2000, respectively.
22
EARNINGS PERSISTENCE AND RELATED
MEASURES OF ACCRUALS
• Earnings persistence
Earningst+1 = a + b1Earningst + e
• Relative persistence of cash flows and accruals
Earningst+1 = a + b1Cash flowt + b2Accrualst + e
23
QUESTIONABLE EARNINGS QUALITY
EXAMPLE: ALLOU HEALTH & BEAUTY CARE
24
INCOME STATEMENT ONLY: QUESTION
Based on the income statement data, what is your evaluation of Allou’s
performance over the period shown?
25
INCOME STATEMENT ONLY: SOLUTION
Revenues grew each year, albeit more slowly in the latest year shown.
Gross and operating margins declined somewhat, but have been fairly stable.
Income from continuing operations was sharply lower in 2001.
Net income was positive in each year.
26
STATEMENT OF CASH FLOWS
Compare Allou’s income from continuing operations with operating cash
flows. Interpret the amounts shown as adjustments to reconcile income
from continuing operations to net cash used in operating activities.
27
STATEMENT OF CASH FLOWS
Allou reported positive income from continuing operations, but negative cash
from operating activities in each of the three years shown. Persistent negative
cash from operating activities is not sustainable for a going concern.
28
STATEMENT OF CASH FLOWS
Recall: The statement of cash flows,
prepared using the indirect method,
adjusts income to derive cash from
operating activities. An increase in
current assets is subtracted from the
income number to derive cash from
operating activities.
The excerpt from Allou’s Statement of Cash Flows shows that accounts
receivable and inventories increased each year. This increase can account for
most of the difference between the company’s income from continuing
operations and net cash used in operating activities. The company seems to be
accumulating inventory and not collecting on its receivables.
29
MEAN REVERSION IN EARNINGS
• Mean reversion in earnings: Extreme levels of earnings, both high and low,
tend to revert to normal levels over time.
• If earnings have a significant accruals component, it may hasten the earnings’
reversion to the mean.
30
REVENUE RECOGNITION CASE: SUNBEAM
SALES TRANSACTIONS THAT INFLATED REVENUES
• Included one-time disposals of product lines in sales without indicating the nonrecurring aspect
• Induced customers to order more goods than they normally would through
offers of discounts and other incentives, which had the effect of inflating current
results by pulling future sales into the present. This practice is sometimes
referred to as “channel stuffing.”
• Booked revenue and income from “sales” to a wholesaler who held the
merchandise over the quarter’s end without accepting ownership risks, and
then returned all the products to Sunbeam in the next quarter
• Engaged in “bill-and-hold” transactions in which revenue is recognized when
the invoice is issued while the goods remain on the premises of the seller
31
REVENUE RECOGNITION CASE: SUNBEAM
(CONTINUED)
Information on Sunbeam’s Sales and Receivables, 1995–1997
32
REVENUE RECOGNITION CASE: SUNBEAM
(CONTINUED)
Information on Sunbeam’s Sales and Receivables, 1995–1997 and Pro
Forma Information, 1997
33
REVENUE RECOGNITION CASE: SUNBEAM
(CONTINUED)
Comparison of Sunbeam and Industry Median, 1995–1997
34
REVENUE RECOGNITION CASE: SUNBEAM
(CONTINUED)
“The Company recognizes
revenues from product sales
principally at the time of shipment
to customers. In limited
circumstances, at the customer’s
request the Company may sell
seasonal product on a bill and hold
basis provided that the goods are
completed, packaged and ready for
shipment, such goods are
segregated and the risks of
ownership and legal title have
passed to the customer. The
amount of such bill and hold
sales at December 29, 1997 was
approximately 3% of
consolidated revenues.”
35
REVENUE RECOGNITION CASE:
MICROSTRATEGY, INC.
“Revenue from product licensing arrangements is generally recognized after
execution of a licensing agreement and shipment of the product, provided that
no significant Company obligations remain and the resulting receivable is
deemed collectible by management. . . . Services revenue, which includes
training and consulting, is recognized at the time the service is performed. The
Company defers and recognizes maintenance revenue ratably over the terms of
the contract period, ranging from 12 to 36 months. (p. 49)
• Microstrategy’s multiple-element contracts involved both software licenses and
services.
• Revenue on software licenses is recognized immediately.
• Revenue on services and on maintenance is recognized over time.
• Allocating a greater proportion of the sale price to the software license
component increases the proportion that is recognized in income immediately.
36
REVENUE RECOGNITION CASE:
MICROSTRATEGY, INC. (CONTINUED)
MicroStrategy’s Revenue Mix by Quarters, 1Q1998–4Q1999
37
COST CAPITALIZATION CASE:
WORLDCOM CORP.
Common-Size Asset Portion of Balance Sheet for WorldCom, 1997–2001
38
CASH FLOW QUALITY
– Corporate life cycle and industry profile affect cash flow and must be
considered when analyzing the statement of cash flows.
– A startup company might be expected to have negative operating and
investing cash flows, which would be funded from borrowing or from equity
issuance (financing cash flows).
– In contrast, for established companies, high-quality cash flow would typically
have most or all of the following characteristics:
– Positive OCF(operating cash flow)
– OCF derived from sustainable sources
– OCF adequate to cover capital expenditures, dividends, and debt
repayments
– OCF with relatively low volatility (relative to industry participants).
39
CLASSIFICATION SHIFTING: NAUTICA
ENTERPRISES
AS REPORTED IN May 2001
2001
2000
2000
for fiscal years ending March
Net earnings
46,103 46,163
Net earnings
46,163 Adjustments to reconcile net
earnings to net cash provided Details omitted
Adjustments to reconcile net
earnings to net cash provided by Details omitted by operating activities
Changes in operating assets and liabilities
operating activities
Short-term investments
28,445 21,116
Net cash provided by operating
62,685
Accounts receivable
activities
(17,935)
(768)
Inventories
(24,142) (3,667)
AS REPORTED IN May 2000 for
the fiscal year ending March
Details omitted
Details omitted
Sale (purchase) of short-term
investments
Net cash used in investing
activities
21,116
Net cash provided by
operating activities
Net cash used in investing
(12,450) activities
78,018
83,801
(41,911) (33,566)
40
CLASSIFICATION SHIFTING: NAUTICA
ENTERPRISES
AS REPORTED IN May 2001
2001
2000
2000
for fiscal years ending March
Net earnings
46,103 46,163
Net earnings
46,163 Adjustments to reconcile net
earnings to net cash provided Details omitted
Adjustments to reconcile net
earnings to net cash provided by Details omitted by operating activities
Changes in operating assets and liabilities
operating activities
Short-term investments
28,445 21,116
Net cash provided by operating
62,685
Accounts receivable
activities
(17,935)
(768)
Inventories
(24,142) (3,667)
AS REPORTED IN May 2000 for
the fiscal year ending March
Details omitted
Details omitted
Sale (purchase) of short-term
investments
Net cash used in investing
activities
21,116
Net cash provided by
operating activities
Net cash used in investing
(12,450) activities
78,018
83,801
(41,911) (33,566)
41
BALANCE SHEET QUALITY INDICATORS
• High financial reporting quality requires
– completeness,
– unbiased measurement, and
– clear presentation.
• High financial results quality (i.e., a strong balance sheet) requires
– optimal amount of leverage,
– adequate liquidity, and
– economically successful asset allocation.
42
UNBIASED MEASUREMENT
• Understatement of impairment charges overstates profits on the income
statement and also results in overstatement of the assets on the balance
sheet.
– Inventory
– Property, plant, and equipment
– Goodwill
• Understatement of contra asset accounts overstates profits on the income
statement and also results in overstatement of the assets on the balance
sheet.
– Allowance for bad debt
– Deferred tax asset valuation allowance
• Assets and liabilities for which fair value is highly dependent on management
estimates warrant scrutiny.
43
OVERSTATED GOODWILL: SEALED AIR
CORPORATION (SEE)
Excerpt from Sealed Air Corporation Balance Sheets ($ millions)
SEE’s total market cap
was about $3,457
million in December
2011 and around
$2,689 million when the
Wall Street Journal
article was written in
August 2012.
44
OVERSTATED GOODWILL: SEALED AIR
CORPORATION (SEE)
Excerpt from Sealed Air Corporation Income Statements ($ millions)
45
SOURCES OF INFORMATION ABOUT RISK
• Financial statements, including notes
– Ratios derived from financial statements
– Prediction models (e.g., bankruptcy, misreporting)
– Notes on contingencies and litigation
– Notes on actuarial risks associated with pensions and post-employment
benefits
– Notes on credit risk, liquidity risk, and market risks that arise from the
company’s financial instruments
• Audit opinion
• Discretionary change in auditor
• Management commentary
• Disclosures pertaining to specific events (e.g., capital raising, non-timely filing
of financial reports, management changes, mergers and acquisitions)
• Financial press
46
SOURCES OF INFORMATION ABOUT RISK:
GROUPON
• The growth data, particularly coupled with specific disclosures in the IPO filing
about management inexperience, are a warning sign of potential reporting
risks.
• These reporting risks were observable many months before the company first
disclosed its internal control weakness in March 2012.
It is absolutely ludicrous to think that Groupon is anywhere close to
having an effective set of internal controls over financial reporting having
done 17 acquisitions in a little over a year. When a company expands to
45 countries, grows merchants from 212 to 78,466, and expands its
employee base from 37 to 9,625 in only two years, there is little doubt
that internal controls are not working somewhere.
August 2011 accounting blog (Catanach and Ketz)
47
SUMMARY
• Potential problems that affect the quality of financial reporting broadly include
revenue and expense recognition on the income statement; classification on
the statement of cash flows; and the recognition, classification, and
measurement of assets and liabilities on the balance sheet.
• Typical steps involved in evaluating financial reporting quality include
– an understanding of the company’s business and industry;
– comparison of the financial statements in the current period and the previous
period;
– evaluation of the company’s accounting policies compared with those of
other companies in the same industry;
– financial ratio analysis;
– examination of the statement of cash flows with particular focus on
differences between net income and operating cash flows;
– perusal of risk disclosures; and
– review of management compensation and insider transactions.
48
SATYAM COMPUTER SERVICES
Extended Example
49
EXAMPLE: SATYAM COMPUTER SERVICES
Satyam Computer Services Limited, an Indian information technology company,
was founded in 1987 and grew rapidly by providing business process
outsourcing (BPO) on a global basis. In 2007, its CEO, Ramalinga Raju, was
named “Entrepreneur of the Year” by Ernst & Young, and in 2008, the World
Council for Corporate Governance recognized the company for “global
excellence in corporate accountability.”
50
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined massive financial
fraud at the company. The company’s decline was so rapid and significant that it
came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
Based on the information provided, characterize Satyam’s financial
reports, with reference to the quality spectrum of financial reports.
51
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
Explain each of the following misconducts with reference to the basic
accounting equation: Transactions with World Bank; fictitious interest
income; CEO’s embezzlement; fictitious revenue
52
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, transactions with the
World Bank would…
53
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, Transactions with World
Bank would…
54
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, fictitious interest income
would…
55
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, Fictitious interest income
would…
56
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, the CEO’s embezzlement
would…
57
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, the CEO’s embezzlement
would…
58
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, fictitious revenue
would…
59
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
With reference to the basic accounting equation, Fictitious revenue
would…
60
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
Based on the information provided, what documents were falsified to
support the misconducts?
61
EXAMPLE: SATYAM COMPUTER SERVICES
(CONTINUED)
In 2009, the CEO submitted a letter of resignation that outlined a massive
financial fraud at the company. The company’s decline was so rapid and
significant that it came to be referred to as “India’s Enron.”
In late 2008, the World Bank terminated its relationship with the company after
finding that Satyam gave kickbacks to bank staff and billed for services that were
not provided. These initial revelations of wrongdoing had the effect of putting the
company under increased scrutiny. Among other misconduct, the CEO
eventually admitted that he created fictitious bank statements to inflate cash and
to show interest income. The CEO also created fake salary accounts and took
the money paid to those “employees.” The company’s head of internal auditing
created fictitious customer accounts and invoices to inflate revenues.
Based on the information provided, what documents were falsified to
support the misconducts?
62
EVIDENCE FROM THE STATEMENT OF CASH
FLOWS: SATYAM COMPUTER SERVICES
• An analyst “used a computer model to examine India’s 500 largest public
companies for signs of accounting manipulation. He found that more than 20
percent of them were potentially engaged in aggressive accounting, but
Satyam was not on the list. This is because the automated screens that
analysts . . . use to pick up signs of fraud begin by searching for large
discrepancies between reported earnings and cash flow. In Satyam’s case, the
cash seemed to keep pace with profits.”
New York Times article (Kahn 2009)
63
EVIDENCE FROM THE STATEMENT OF CASH
FLOWS: SATYAM COMPUTER SERVICES
Excerpt from Satyam’s IFRS Consolidated Interim Cash Flow
Statement ($ millions)
64
EVIDENCE FROM THE STATEMENT OF CASH
FLOWS: SATYAM COMPUTER SERVICES
Excerpt from Conference Call regarding Quarterly Results of Satyam, 18
July 2008
65
ACCOUNTS RECEIVABLE: SATYAM COMPUTER
SERVICES
Selected Annual Data on Accounts Receivable for Satyam, 2005–2008
66
SATYAM COMPUTER SERVICES
Excerpt from Conference Call regarding Quarterly Results for Satyam,
17 October 2008
67