This morning the New York Times profiled the case of two imprisoned accountants from the Indian office of Pricewaterhouse-Coopers who have been linked to the Satyam scandal. Though they operated as independent auditors for the computer services firm, they have been charged with multiple offenses, including falsification of accounts.

Their imprisonment is nearly unprecedented in the purview of corporate accounting scandals. Hence, some view it as unfair that they must await trial in prison. However, their imprisonment must be seen as part of a system of action that is seeking to preserve investor confidence and limit the collateral damage of Satyam’s ruin. It also underscores the importance of accountability by independent auditors. The auditors were responsible for pro-active audit work which they, by their own admission, did not conduct. Indeed, the defense of, “No concerns were ever brought to us by anyone…,” which the Satyam Auditors gave in the Times article, rings a bit hollow for me.

In 2007, the audit committee of Satyam, and ultimately the shareholders, paid the auditors $873.9 thousand in audit fees and $1.802 million in total fees including fees for tax and other non-audit services. In 2008, they paid $1.172 million in audit fees and $1.918 in total fees. These fees are paid for the auditor to “audit” actively, not passively. Auditors typically do not wait for concerns to be brought. They investigate independently and to a set of professional standards, and so the imprisoned auditors’ claim of innocence by inaction is implausible given the makeup of the assets on Satyam’s balance sheet. Consider the assets reported on Satyam’s 20-F filed on March 31, 2008:

  As of March 2008 As of March 2007
Cash and cash equivalents 290.5 152.2
Investments in bank deposits 826.7 --
Accounts receivable, net allowance for doubtful debts 508.4 364.2
Unbilled revenue 81.5 38.6
Deferred income tax assets 23.7 17.1
Prepaid expenses and other receivables 131.7 37.1
Total current assets 1,862.5 609.2
Investments in bank deposits -- 767.6
Investments in associated companies 4.7 4.6
Premises and equipment, net 236.6 163.1
Goodwill, net 80.0 32.7
Intangible assets, net 15.6 7.4
Other assets 43.9 39.5
Total assets 2,243.3 1,624.1

Two numbers are important. First, cash (and cash equivalents) and second, investment in bank deposits (short term in 2008, and long term in 2007). These accounts are approximately 52% of the balance sheet in 2007, and approximately 49% of the balance sheet in 2008.

Roughly half of Satyam’s balance sheet was either cash (which is typically held by its bank) or a bank deposit (similar to a certificate of deposit that any of us may hold at our local bank). Given the large holding of these assets I find it hard to believe that the auditor could be paid in the ballpark of one million dollars in audit fees and then not proactively investigate the details of half of the balance sheet. It’s also hard to believe that they did not look at these accounts given how easy cash and bank deposits are to audit.

Typically one audits cash and deposits by contacting the bank to get a statement with the company’s account balance and then compares the statement to the balance sheet. If the two amounts match then the auditor offers an opinion that account has been stated accurately, confirming that the company indeed has the money it claims to have on its balance sheet.

Satyam’s auditors claim that they relied on bank statement documents provided by the company, which ultimately turned out to be false statements. This is not a typical practice among auditors in India who instead independently ask the bank to provide statements directly. It is further shocking that Satyam’s auditors did not pursue independent verification given the unusually large holdings of cash and deposits on the balance sheet.

The auditors also argued that there were many bank accounts and that made independent verification more difficult. But the number of accounts should have been a tip-off. If you are company like Walmart, with stores covering many locations that do a lot of daily cash business, you need to be banking with many banks and accounts so that each store can get cash to the bank quickly.

In contrast, at a professional business service firm like Satyam, clients pay by check or electronically, and payments are processed in a centralized system and so there is less need for numerous bank accounts. A seasoned accountant with 31 years of experience (which Satyam auditor Mr. S. Gopalakrishnan had) would know this, and should have raised a red flag. They should have taken more initiative.

An audit is part of what an accounting firm calls an “assurance” service, and it is hard to provide assurance if auditors don’t occasionally challenge company management and seek independent verification.

Professor Balachandran would like to thank professors Ray Fisman, Andrew Schmidt and Catherine Thomas of the Columbia Business School and Prof. K Ramesh of the Broad School of Business at Michigan State University for their input to this post.

Photo credit: nav in atl