SATYAM Scandal (Fraud Case): How can we detect rogue company??

Are we in Recession? This has become the common question everyone asking last year. When the economy deteriorated faster than you can imagine, coupled together with credit crunch, more crack signs have appeared at the once so-called SUPERSTAR company.

Warren Buffett once says that: “It's only when the tide goes out that you learn who's been swimming naked!” This quote exactly point out the scenario we have right now.

Recently, there are more and more accounting fraud cases happen. It is getting sophisticated! The most notorious one is SATYAM. A very promising rising star, which provides software services to mostly US & Europe companys. No one has noticed or detected it, even the company is well covered by the analysts. Is this really the case?

I am very curious with it and decided to run an analysis on their earning quality. In here, I need to explain a bit about accounting method. There is 2 type of accounting methods: one is Cash Accounting and the other one is Accrual Accounting, which is widely used and applied by I GAAP & US GAAP. Accrual accounting has a lot of weakness and is subjected to manipulation. I can’t suggest a better way of accounting method. I left it to those smartest brains from I GAAP member.

First of all, we need to calculate out Net Operating Asset (NOA) for the past 6 years for comparison purpose.

Below is the equation I used inside the analysis:

NOA = (TOTAL ASSETS-TOTAL CASH)-(TOTAL LIABILITIES-TOTAL DEBTS)

SALES-CASH COLLECTED = INCREASE ACCOUNT RECEIVABLE + INCREASE DEFERRED REVENUE

The result is self shocking. The rule of thumbs for Accrual ratio is it should be not exceed 10%. The CF Accrual ratio constantly above 20% signals that the earning quality is poor! This means that most of the earning you see at income statement is based on accrual basis. There is no real cash $$ coming in!

Furthermore, Sales/Cash collected ratio is on uptrend. These signify that Satyam management has been using aggressive revenue recognition to push up their revenue growing rate.

All of the accounting data is collected from Satyam India GAAP statement. Some adjustments are needed to perform on the statement, as India GAAP is different than US GAAP. I also do the same analysis on Satyam US GAAP. However, what puzzled me is that Satyam website stop providing financial statement on US GAAP standard from 2006! I have to dig out the data from NYSE website (SEC filing). The result from US GAAP is the same. The accrual ratio is above 10% and sales over cash collected ratio was not constant. The delta is huge!

The conclusion is that this kind of bad investment decision can be avoided if we perform analysis on the business earning quality. This Satyam case also serves as a good example, whereby growing revenue and income does not necessary means the business is doing fine! The most recent example happen in M’sia is Transmile Group. They bloated the account receivable to increase their revenue.