The Satyam scandal: Inside India’s Enron

In January 2009, Byrraju Ramalinga Raju, the founder and chairman of Satyam Computer Services, delivered a stunning five-page confession to his board of directors. He had inflated the company’s revenues and profits in the period from 2003 until 2008 and misappropriated approximately ₹7,136 crores (around $1.5 billion) of company funds. 

The manipulation created the illusion of a thriving company but share-price manipulation was not the main intent. The fraud was facilitated to secure loans from U.S. banks. Proceeds from these loans were then diverted into private real estate ventures in Andhra Pradesh. When the property market collapsed in late 2008, the scheme proved unsustainable. 

At the time, information technology services was a highly regarded segment of the Indian stockmarket: High profit, high growth and supposedly resilient in the event of recession. The scandal shook confidence in Indian corporate governance, especially among companies reliant upon outsourcing, causing lasting damage to the industry.

Following Raju’s confession, the Central Bureau of Investigation (CBI) initiated legal proceedings, eventually securing his conviction, along with two brothers and seven associates, in 2015. 

Although Satyam’s misconduct came as a shock, many aspects of the fraud were apparent in the accounting risk reports generated by the Transparently Risk Engine, which detected many red flags in the accounts as early as 1998 (the first year with sufficiently detailed accounts). These included:

• dissonant workforce efficiency versus measures of profitability,
• incongruous margins versus profitability ratios, 
• anomalous patterns in margins, production and inventory activity, 
• improbable interest expense relative to reported borrowings, 
• evidence of aggressive smoothing despite strong reported sales growth, 
• atypical volatility of net income and margins, especially versus peers,
• reliance on non-operating and non-core earnings, 
• suspicious levels of cash income, 
• heavy investment in associates, and 
• suspicious investment patterns. 

Although Satyam has been likened to Enron, the cases differed, both in motive and in execution. The motive for the Satyam scandal was misappropriation, whereas that for Enron was stock price manipulation. Satyam relied on falsification and lax auditing whereas Enron relied on complex exploitation of the rules of accounting. 

Satyam offers a valuable case study because we rarely see examples of misappropriation laid bare. Persons found guilty of accounting fraud seldom confess to embezzlement, due to the severity of the criminal punishment. In accounting scandals where embezzlement is suspected, it usually remains a matter for conjecture. 

Background

Byrraju Ramalinga Raju was born on 16 September 1954 in the West Godavari district of Andhra Pradesh. The eldest of four, his father was an agriculturist, providing Raju with an upbringing rooted in rural life but with sufficient means to pursue a university education.

Obtaining an MBA from Ohio University in 1977, Raju returned to India and ventured into hotel and cotton spinning ventures. Both failed. Undeterred, Raju shifted to real estate and established a construction company. The transition was successful and provided the financial underpinnings for Satyam, which he founded in Hyderabad in 1987.

Satyam began as a small IT services provider focused on software development and maintenance services, essential for businesses looking to leverage technology for operational efficiency. Satyam went public in 1991, listing on the Bombay Stock Exchange (BSE) and later on the National Stock Exchange (NSE). 

The listing provided capital for expansion and the timing was good. Thanks to fears of Y2K programming failures, the late 1990s witnessed a boom in IT outsourcing. Bangalore, Hyderabad, and Pune emerged as prominent IT hubs. These cities became centers of excellence for software development and business process outsourcing. The concentration of skilled labor combined with government support and the trend towards globalization of services facilitated a sustained boom through the 2000s.

Satyam prospered in this boom, expanding its offering to include systems integration, packaged software solutions, and engineering design services. Diversification allowed the company to cater to a broader range of clients across various industries. By the mid-2000s, Satyam was ranked among the top five IT companies in India, boasting a client base that included 185 Fortune 500 companies.

Details of the Satyam scandal

Details of the fraud at Satyam are better understood than most scandals because Raju stored thorough details of Satyam's accounts and minutes of meetings under two separate IP addresses. These were available to investigators.

For many years, Satyam’s financial reports indicated profits and cash balances that did not exist. Raju used Satyam’s extensive knowledge of various software applications to create fake invoices and bills. He allegedly altered the source code of Satyam’s invoice management system to create a user ID which had the power to hide or show invoices in the system. 

In another example, the employee management system (Ontime) was allegedly manipulated to input employee hours of fake employees. In 2008, Satyam claimed to have approximately 53,000 employees. 

Subsequent investigations revealed that the actual number of employees was around 40,000. The inflation of employee numbers enabled Raju and others to siphon off the salaries and benefits of non-existent employees. CBI reports indicate that Raju was able to divert more than ₹200 million (approximately $4.5 million) per month in fake employee payments. 

More generally, by claiming a larger workforce and bigger sales and profits than actually existed, Satyam presented itself as a more substantial and successful company than it truly was. This enhanced investor confidence in the company’s financial health, allowed Raju and his associates to sell shares at artificially inflated prices and made the company a credible borrower in the US.

Raju began selling shares as early as 2003 due to increasing pressure from financial mismanagement at Satyam. Between 2003 and 2008, he reduced his family holdings by approximately 30 million shares. The family stake in Satyam fell from around 25% to less than 5% over the period. Funds raised from share sales were mostly invested in Maytas Infra and Maytas Properties, family-owned businesses focused on real estate development (“Maytas” is “Satyam” spelled backwards). The sale of shares also sometimes helped to plug year- and quarter-end gaps created by inflated profits on Satyam’s balance sheet.

Account manipulation overstated Satyam’s debt capacity, allowing the company to obtain loans under false pretenses from US banks. These loans were misappropriated and never recorded in the company’s public financial statements. A significant portion of the loans was diverted to purchase thousands of acres across Andhra Pradesh to ride the property boom.  

Raju allegedly used 356 investment companies to hide and divert funds from the loans. These companies engaged in inter-corporate transactions including investments, advances and loans. In one example, a company with paid up capital of just ₹5 lakh (around $9,500 at the time), received unsecured loans of  ₹600 crore (about $106 million) and made investments worth  ₹90.25 crore (about $16 million). 

In late 2008, the fraud began to unravel when Hyderabad property prices began to decline. In a desperate move, Raju attempted to sell the property companies to Satyam. The deal failed and led to increased scrutiny of Satyam’s financial practices. As the real estate market imploded, it became difficult to service the loans and impossible to show solid growth in Satyam with healthy profits. As Raju noted in his confession, “It was like riding a tiger, not knowing how to get off without being eaten."

Extreme risk in Satyam's account quality before 2003

The risk reports generated by the Transparently Risk Engine (TRE) for Satyam prior to 2003, the year in which manipulation supposedly began, suggested extreme manipulation risk. The risk engine awarded Satyam’s 2002 accounts a rating of “F” and a risk score that put the IT firm in the worst 2% of all listed companies globally for accounting quality. 

At the time, Satyam had a market capitalization of $1.7 billion. Risk scores of E or F are typically reserved for much smaller companies experiencing significant financial strain. 

Based on its reported figures, Satyam enjoyed exceptional profitability and remarkable growth with minimal debt. Life is good for companies in this condition. They  should have no need to inflate or smooth earnings, no need to hide credit issues and certainly no need to rely on sources of income beyond the core business. Exceptional companies, which Satayam appeared to be, invariably sell non-core businesses or sources of non-operating income since all available capital is best deployed in the rapidly growing core business. 

The juxtaposition of Satyam’s apparent business success and a barrage of risk signals was like seeing rats in a three-star Michelin restaurant

And yet, Satyam appeared to be doing the opposite. Its financial statements exhibited a preponderance of red flags and the pattern of risk signals was disturbing. It centred on issues related to income quality, margin signals, credit, corporate governance and a heavy reliance on smoothing activity and accruals. The juxtaposition of Satyam’s apparent business success and a barrage of risk signals was like seeing rats in a three-star Michelin restaurant. 

Although Raju only confessed to manipulation after 2002, there is considerable likelihood that a culture of dishonesty existed before this date. Corporate culture is set in the early years of a company and rarely changes unless there is a change of leadership. This is why it pays to look at a company’s risk reports in earlier years. It is also worthwhile because fraudulent companies get more sophisticated at manipulation over time, making their accounts increasingly undecipherable.

With respect to earnings, the TRE flagged numerous concerns:

• Profitability was suspiciously high in relation to workforce efficiency. 
• There was a concerning reliance on non-core business and non-operating income. 
• There were anomalies between cash generation, reported income and production activity. 

The numbers didn’t add up. The TRE also found potential risks with Satyam’s revenue recognition policies, mostly in relation to smoothing activity and accruals. Why on earth would a company registering five-year average sales growth north of 70% and an RoE above 30% feel compelled to smooth earnings or bring sales forward?  The TRE determined that income quality was very poor.

Making matters worse, the TRA suggested potential manipulation to mask credit issues. Satyam’s debt-related expenses were disproportionate to its total debt costs, raising concerns of hidden debt or at least incompetent financing. 

The company's working capital levels were unusual and could not be adequately explained by operational factors, indicating potential manipulation to inflate its financial health (i.e. fake cash or receivables). The company's exceptionally low gearing ratio relative to its market capitalization raised concerns about potential manipulation to offset other financial risks. In the world of forensic accounting, too little debt can be just as concerning as too much debt.

Transparently’s AI system was already signaling a potential scam

In 2002 and before, Satyam was already showing risk of earnings manipulation, hidden debt, and possibly fake cash, although this usually requires a lax auditor. In other words, by 2002 Satyam already exhibited the type of manipulation to which Raju finally confessed to in 2009. Transparently’s AI system was already signaling a potential scam.

Satyam’s accounting quality after 2002

In 2003, something remarkable happened. Satyam’s risk rating suddenly jumped to a C- from an F and remained at this level until the wheels fell off in 2009. This improvement left Satyam in the bottom 20% of all companies globally for account quality.

Unfortunately, shifts in a company’s risk rating of this magnitude, especially coming from an exceptionally poor start, are rare and should be treated with suspicion. A large improvement in the risk score can be attributed to a dramatic improvement in business performance, a revolutionary change in accounting method, or the introduction of fake profits and cash.

It is difficult to envision how Satyam’s financial performance could have improved between 2002 and 2003. The three-year average sales growth slowed to 46% in 2003 from 65% in 2002. Even though reported growth remained strong, it is almost impossible to achieve dramatic improvements when sales growth is slowing and profitability is already stellar. Cash injections can sharply improve the risk rating of heavily indebted and failing companies but Satyam already had no debt and no fresh capital injections.

We can also rule out any improvement in accounting practices thanks to Raju’s confession. On the contrary, he suggests accounting quality fell.

The only possible cause of the rapid improvement in Satyam’s risk score after 2002 is that the company began to report fictitious numbers. Satyam’s reported return on productive assets rose from 26% in 2002, to 46% in 2003 and 60% in 2004. At the same time, employee productivity continued to languish. Somehow, the company was generating net income and cash from a vacuum. 

Sharp improvement in the risk score of an already high risk company can occur if it begins to hide debt or fake cash aggressively.

Satyam is an important case study because it demonstrates that sharp improvement in the risk score of an already high risk company can occur if a company begins to hide debt or fake cash aggressively. Wirecard is another important example where this occurred. 

This can happen because some risk measures pertaining to credit, gearing, business manipulation, cash quality and income quality will improve if a company fakes improvements in sales, margins and cash flow. Whether the cash flow is funded by hidden debt or simply imagined, the impact is the same.

However, a big improvement in the risk score will only occur if a company’s auditor is not checking bank balances and failing to review bank statements for round-trip or other suspicious transactions with related parties. PricewaterhouseCoopers (PwC) served as Satyam’s auditors during this period. It faced severe repercussions for its failure to detect or report Satyam’s fraudulent activities adequately. In 2018, PwC was barred from auditing any listed companies in India for two years due to complicity in the fraud and failure to adhere to auditing standards.

If the auditor is doing its job correctly, a terrible risk score will not improve sharply due to fake cash because fake cash will be detected. It might happen, however, due to hidden debt and thus this situation demands a very close inspection of a company’s relations with associated companies.

‍Efforts to fake numbers in one part of the accounts will always show indirectly as an anomaly in some other part of the accounts.

Notwithstanding, efforts to fake numbers in one part of the accounts will always show indirectly as an anomaly in some other part of the accounts. Hidden debt must still be serviced. If debt service is accurately reported as interest expense, this cost will look too high in relation to reported debt. If debt service is reported in some other part of the accounts, there will be anomalies in at least one of: operating expenses, cash generation, production activity or margins. 

These anomalies might include irregularities between a target company and its peers, unexplained volatility in certain measures, or inconsistent relationships between different areas of the accounts such as between sales and production costs. 

Most companies, especially service companies such as Satyam, typically demonstrate a strong and consistent relationship among accounting variables. This pattern should be similar to that seen in a company’s peers. The TRE is able to observe fictitious entries indirectly through various inconsistencies in margins, sales,  cash receipts, production activity and other metrics. This is precisely what happened at Satyam and illustrates why it is important to look beyond the overall risk score and understand what is happening in detail of the numbers. 

Satyam under the Transparently microscope

Let’s look at what the Transparently.AI Risk Analyser (TRA) had to say about Satyam in a little more detail. Satyam looked high risk on a range of factors. We focus on some of the common accounting patterns and red-flag signals that pointed to risk of the fraudulent activities we know Satyam was engaged in, namely:

• faking sales,
• faking cash flow and cash balances,
• hiding debt, and 
• misappropriation.

Some of the red flags that could point to these kinds of activities would include:

• unexplained revenue or margin spikes/volatility,
• unusual revenue or profitability patterns versus peers,
• suspicious cash flow patterns reflecting mismatch between cash flow and other operating measures such as net income or operating expenses,
• aggressive revenue recognition reflected in smoothing activity or accruals,
• high proportion of non-recurring revenue or indeed expenses,
• unusual changes in working capital and/or asset ratios such as receivables turnover,
• unusual or off-balance sheet transactions, especially through related companies,
• lack of transparency in financial reporting including vague or inconsistent disclosures, frequent restatements, and unwillingness to provide detailed information to auditors can be warning signs.

A detailed reading of the TRE risk reports between 2003 and 2008 will reveal that Satyam displayed most of these warning signs. Figure 1 provides a taste of the red flags issued by the system for 2003. Most of these signals were repeated between that year and 2008. We can’t discuss all of these signals but we can focus on margin signals, which the risk engine rated as one of the most serious risks.

‍Figure 1: Satyam Risk Signals for 2003

Source: Transparently.AI

In the risk cluster for margin signals, the TRE repeatedly highlighted the fact that Satyam’s workforce efficiency was much lower than peers. This risk was flagged every year from 2003 until 2008. In 2008, for example, Satyam’s sales per employee ($28,301) was significantly lower than those of Tata Consultancy Services ($40,000), Infosys ($41,667), and Wipro ($52,173). Low workforce efficiency was a major red flag because the system also noted that Satyam had much higher margins and returns versus peers. Again looking at 2008, Satyam’s RoE was 38% versus 30% for TCS, 28% for Infosys and 25% for Wipro. This, despite having lower debt ratios.

Of course, the system didn’t know that Satyam had 13,000 imaginary workers whose wages were being siphoned to board members.The system only knew that the combination of poor workforce efficiency and superior profitability versus peers was highly irregular. 

To a well-informed user, the Transparently Risk Engine’s warning on Satyam’s margin signals was diabolical news

An informed user of the AI system, however, would have known that Satyam provided outsourcing of labor intensive IT work, and would have known that in any labor intensive business workforce efficiency determines margins and profitability. To a well-informed user, the Transparently Risk Engine’s warning on Satyam’s margin signals was diabolical news.

However, this was only part of the margin story. Prior to 2003, the EBITDA margin at Satyam consistently ranged between 35% and 40%. In 2003, the EBITDA margin fell to 25% and ranged between 25% and 30% thereafter. The system flagged this shift in EBITDA margin as a red flag in part because it was not shared by peer competitors. The drop in margin was all the more suspicious because return on productive assets began to lift inexorably after margins fell. Needless to say, if margins fall, it is difficult to see how the return on assets can rise. 

The TRE saw all of this and more. Of course suspicion was warranted because EBITDA margins fell due to misappropriation. 

‍Figure 2: Return on Productive Assets

Operating income as a proportion of fixed assets and inventory (%)

Notice the dip and subsequent rebound in RoA in 2002. The system noted this and similar volatility in revenue and accruals in 2003. We now know that this period marked a change and intensification of account manipulation. 

In this discussion, we have only considered one risk cluster, that related to margin signals. This risk cluster told users that there was something wrong with workforce efficiency and EBITDA margins were suspiciously low relative to return on assets, both in absolute terms and relative to peers. 

Equally troubling signals were evident in seven other risk clusters. 

The bottom line: It was very obvious from the Transparently.ai reports that there was a serious risk of account manipulation at Satyam. 

Conclusion

The fallout from the Satyam scandal had far-reaching implications for corporate governance in India. It prompted regulatory reforms aimed at improving transparency and accountability within Indian corporations. 

Combined with similar cases in China, the Satyam case made investors wary of investing in companies where the founder/chairman has extensive real estate interests. In fact, this has become a standard red flag for emerging-market companies. 

The scandal highlighted significant weaknesses within India’s auditing practices. Satyam, along with Wirecard, were the primary drivers of the crack-down on auditors over the past two decades. If an auditor is negligent, it becomes difficult to identify fraud.