Fraud Symptom 4- Growth strategies based on financial numbers

The core reason for failure of companies is adopting the wrong strategy and the worst thing to do is focus on a growth strategy that is driven by numbers. A strategy based on organic or inorganic growth maybe aimed at delivering the financial numbers in the stock market quarter on quarter. These companies are not developing on core skills, products, customers or long-term strategy. The COSO report Fraudulent Financial Reporting 1998-2007- An Analysis of U.S. Public Companies states the following –

The SEC’s most commonly cited motivations for fraud included the need to meet internal or external earnings expectations, an attempt to conceal the company’s deteriorating financial condition, the need to increase the stock price, the need to bolster financial performance for pending equity or debt financing, or the desire to increase management compensation based on financial results.”

To illustrate my point I am taking below cases of acquisitions that resulted in corporate disaster and internal focus on numbers that showed mismanagement and fraud.

If you consider the cases of WorldCom and Marconi both invested heavily, in telecom sector not realizing that in 2000, the market was saturated and there were limited growth opportunities.  Some of the acquisitions were done without adequate due diligence and purchased at a high price. That is, the boards ended up purchasing some bad apples at a huge cost. The new acquisitions were a huge financial drain on the existing company. In a couple of years, the companies were cash strapped. The initial high financial figures, which were reported, were fraudulent. The true financial status of the organization could be hidden because of the number of acquisitions, mergers and consolidations in numerous countries provided minimal transparency and one could not assess the real performance of the company.

In India, the Satyam case was again an attempt to show high growth and profit margins while the reality was significantly different. Fraudulent bills were passed at year-end to show higher turnover. The investment of Maytas was engineered to show growth and assets. The deal failure resulted in collapse of Satyam and disclosure of fraud as the reality could not be hidden any longer.  

At a macro level, the mergers and acquisitions scene in India needs to be viewed considering the foreign direct investment inflows and outflows and within country acquisitions. Indian companies in the last five years acquired a few companies outside India. Few group names, which forged ahead for acquisitions are Tata, Wipro, Bharti and Dabur.    Tata Steel’s purchase of Corus and Tata Motors purchase of Jaguar and Land Rover in the United Kingdom has already received some negative publicity. Reason being, that the companies are facing a severe cash crunch from the acquisitions and are surviving on domestic market. This aspect is raising questions whether the investment was required. In the next couple of years, we will know whether the acquisition could be considered a strategy good move.

The next issue is about acquisitions and investments in India. As such, more multinationals are either doing outright purchases to gain access to Indian domestic market or establishing an Indian arm by setting up business operations. Both these aspects are not free from flaws and I am giving below some insight on the issues.

The inward foreign direct investments are generally routed through Mauritius to take advantage of the tax breaks. Hence, the money trail from America or Europe does not flow directly into India. For operations also, the inflow and outflow is sometimes routed through the tax heavens. This creates opaqueness in the consolidated financial statements of the holding company.

The other aspect is Indian business are not transparent and sometimes proper due diligence may not be possible. Here is an example of a bad acquisition of an Indian company by a Japanese organization. Daiichi Sankyo from Japan acquired Ranbaxy Laboratories. Daiichi paid  $4.6 billion  to acquire a controlling interest in Ranbaxy. The price was very lucrative for Singh brothers – the sons of founder of Ranbaxy – as they got a 31% premium. However, this acquisition was bad for Daiichi as the FDA investigation details revealed. The FDA is alleging that Ranbaxy sold adulterated versions of HIV drugs in Africa and there is a patents dispute. The share prices of the company have fallen and the Singh brothers have resigned from the company after making a large profit. They are the only ones who appear to have benefitted from the acquisition. This case is a clear indication of acquiring a company for growth without adequate due diligence.

Now let us come to organic growth scenarios. As India is known as the center of for back office operations of multinationals, I am illustrating the normal operations of an in-house captive business process outsourcing. In my view the whole business process outsourcing industry is geared towards financial numbers. Multinationals invest in India for purpose of cost cutting.  As the focus is on cost reduction, the management layer is thinly spread and internal controls are compromised. To give you an example, in a business process outsourcing unit in India, a vice-president operations with 10 or more years of work experience can be managing between 150 to 800 customer service executives. Here is a table depicting the organization structure of a regular back office operations process in India.

Designation Years of experience Direct reports Number of direct reports
Vice President Operations 10 or more Assistant Vice Presidents 2-3
Assistant Vice President 8 or more Managers 2-3
Manager 5 or more Assistant Managers 2-3
Assistant Manager/ Team Leaders 2 or more Customer Service Executives 15 to 30

 In reality, the assistant managers are actually managing the process delivery. From a customer service executive they one fine day are promoted and are suddenly required to manage a team of 15-30 staff members. Normally, they have no formal training for management or team management. The reason why these structures are common is that more experienced assistant vice presidents and vice presidents come at a higher cost of USD 75,000 or more. Hence, if more vice presidents and assistant vice presidents are added to the structure, the cost advantage is lost. There is hardly any supervisory or management layer in the structure for implementing proper management controls. The high fraud risk processes operating in captive back office centers are at much higher risk.

Again, the organization culture plays a crucial role in determining how growth is achieved. The recent Rs 300 crore (USD 65 million) Citibank fraud by a rogue employee Mr. Shivraj Puri depicts a scenario where internal controls were compromised to generate numbers. According to media reports, Mr. Shivraj Puri traded Rs 900 crore (USD 195 million) in the stock market and Citibank did not detect the fraud internally.

This fraud has a different interpretation when viewed with the recently released Boston Consulting group survey report on banking industry in India.   It stated that in 2009-2010 Citibank average employee cost of Rs 19 lakh (USD 41,350) was the highest amongst the banks. In comparison, the biggest Indian bank, namely State Bank of India and other reputed Indian private sector banks (HDFC, ICICI) had average salary costs ranging between Rs 5-7 lakhs (USD 10,000 to 15000 approximately) per employee. Reserve Bank India report showed that Citibank’s   average business per employee was Rs 20 crore (USD 4. 35 million) that was the highest. In contrast, State Bank of India’s was Rs 6.4 crore (USD 1.39 million). To me, it appears to be an organization culture driven by numbers. Seeing the numbers and with my experience in Indian banking sector, my personal view would be to take a closer look at Citibank’s processes and strategy. It is possible that costs are being cut on implementing internal controls, risk strategies, fraud detection and prevention to show business profits.

If an organization culture is geared towards financial numbers, chance increases of employees and management window dressing the financial statements and various other reports. Therefore, the next question is how the frauds are reflected in the financial statements.  According to the COSO report – “The majority of frauds (61 percent) involved revenue recognition, while 51 percent involved overstated assets primarily by overvaluing existing assets or capitalizing expenses.”  This in Indian context is primarily done by manipulating service delivery MIS to show better performance, adding fictitious sales contracts and billings, showing non-existent interest earnings and other accrued income etc.

While the COSO report states, the understatement of expenses and liabilities was reflected in only 31% cases, in India the problem is the opposite. Organizations prefer showing high sales and income, and higher expenses to avoid/ reduce taxation on profits. The expenses are increased by adding personal expenses of senior management under heads of gifts and entertainment, travel, membership & subscriptions, conveyance, salaries of personal house staff, personal telephone expenses etc. Hence, the problem is two-pronged in India, as neither the revenue nor the expense side figures are reliable.

Recommendations

This clearly shows that a growth strategy driven by numbers may not be the right solution if not supported by selecting right industry, developing new products, and establishing good management and systems. The number game can soon become pure gambling without proper controls and accurate financial statements. Hence, following should be kept in mind.

1.   Acquisitions should be done after through due diligence of internal organization and external factors. An analysis of industry, market, country risks and various statutory requirements is a must.

2.   Procedures and practices should be implemented to complement the business strategy. The business is likely to fail if adequate management control and supervision is not maintained.

3.   Financial statements should represent a true and fair view. There should be no manipulations and window dressing to reflect a distorted view of the business

4.    An organization culture should be developed on business ethics and not just numbers.

Hence, the final message is that a growth strategy needs to be developed and implemented with care.

References:

  1. COSO report Fraudulent Financial Reporting 1998-2007- An Analysis of U.S. Public Companies
  2. Boston consulting Indian Banking survey article in Asian Age-  Fraud-hit Citi emerges as best paying bank ( http://www.asianage.com/business/fraud-hit-citi-emerges-best-paying-bank-438 )
  3. Corus and Ranbaxy – Acquisitions gone wrong? by Sriram Vadlamani (http://trak.in/tags/business/2009/05/31/corus-and-ranbaxy-acquisitions-gone-wrong/ )
  4. India’s Ranbaxy Gives Headache To Japanese Drugmaking Parent (http://www.businessweek.com/globalbiz/blog/eyeonasia/archives/2009/05/indias_ranbaxy.html?chan=top+news_top+news+index+-+temp_global+business)
  5. Tata Steel’s Acquisition of Corus (B) (http://www.icmrindia.org/casestudies/catalogue/Business%20strategy/BSTR355. )
  6. Satyam Fraud Case- Confession letter of Ramlinga Raju (http://www.hindu.com/nic/satyam-chairman-statement.pdf)
  7. ‘Satyam Scam Tip of Corporate Fraud Iceberg’ ( Article in IPS News written by Praful Bidwai)  http://ipsnews.net/news.asp?idnews=45608

To read the full list of Fraud Symptoms, click here.