WK.4 DISCUSSION QUESTIONS

Case 6-10 Autonomy

Background

On November 20, 2012, Hewlett-Packard (HP) disclosed that it discovered an accounting fraud and has written down $8.8 billion of the value of Autonomy, the British software company that it bought in 2011 for $11.1 billion, after discovering that Autonomy misrepresented its finances. In May 2012, HP had fired former Autonomy CEO, Dr. Michael Lynch, citing poor performance by his unit.

According to HP, its internal probe and forensic review had uncovered that the majority of the impairment charge, over $5 billion, is linked to serious accounting improprieties, disclosure failures, and outright misrepresentations discovered by HP’s internal investigation into Autonomy’s practices prior to and in connection with the acquisition.

The investigation began after an unnamed “senior member” of Autonomy’s leadership alleged there had been a “series of questionable accounting and business practices” prior to the acquisition. HP said that the whistleblower gave “numerous details” that HP previously had no “knowledge or visibility” of. HP said it has discovered “extensive evidence” that an unspecified number of former employees of Autonomy had cooked the books prior to HP’s $11.1 billion acquisition of the software company.

The probe determined that Autonomy was “substantially overvalued at the time of its acquisition” due to misstatements of financial performance, including revenue, core growth rate, and gross margins.

So what is alleged to have happened? For one thing, Autonomy, as HP tells it, was selling some hardware at a loss. During a period of about eight quarters prior to HP’s acquisition, Autonomy sold some hardware products that had Page 401a very low margin or on which it may have even taken a loss. It then allegedly turned around and booked those hardware sales as high-margin software sales and booked some of the cost as marketing expense.  

There’s a second piece of the puzzle, where HP says that Autonomy was selling software to value-added resellers—the middlemen in so many technology transactions—in which there are ultimately no end users. That, too, inflated apparent revenue.

Third, there were some long-term hosting deals—essentially, Autonomy hosting applications for its customers on a subscription basis—that were converted to short-term licensing deals. Future revenue for software subscriptions—that should have been deferred or recorded as coming in the future but not yet booked—were stripped out and booked all at once.

In a statement, former CEO, Leo Apotheker said he is both “stunned and disappointed to learn” of the alleged accounting improprieties, and the developments “are a shock to the many who believed in the company, myself included.”

Apotheker said the due diligence process was “meticulous and thorough” and “it’s apparent that Autonomy’s alleged accounting misrepresentations misled a number of people over time—not just HP’s leadership team, auditors, and directors.”

Autonomy’s Position

A spokeswoman for fired CEO Lynch told Reuters that the HP allegations are “false” and Autonomy’s management was “shocked to see” the fraud charges. Lynch said that HP’s due diligence was intensive and the larger company’s senior management was “closely involved with running Autonomy for the past year.”

Lynch further commented that 1

· HP was using this as a ruse to distract investors from its bigger problems: “People certainly realize I’m not going to be used as Hewlett-Packard’s scapegoat when it’s got itself in a mess.”

· HP’s numbers didn’t add up. It’s questioning about $100 million in revenues, yet blaming $5 billion of the write-off on fishy accounting.

· He wanted HP to explain in detail how it came up with the $5 billion in write-offs from alleged fraud.

· He not only denied all wrongdoing, but he had backup because Autonomy was audited quarterly and every invoice over €100,000 euros ($129,000) was approved by auditors.

Lynch also said that some of the accusations are misleading because Autonomy was following IFRS, as British companies do, not the GAAP standard used by HP, which means it recognizes revenue differently in certain situations from U.S. practices. Finally, Lynch said that Autonomy’s auditor, Deloitte, was aware of every transaction that had been questioned, and approved Autonomy’s accounting methods.

Exhibit 1  contains statements made by HP and Lynch in the Autonomy matter.

HP’s Official Statement HP has initiated an intense internal investigation into a series of accounting improprieties, disclosure failures, and outright misrepresentations that occurred prior to HP’s acquisition of Autonomy. We believe we have uncovered extensive evidence of a willful effort on behalf of certain former Autonomy employees to inflate the underlying financial metrics of the company in order to mislead investors and potential buyers. The matter is in the hands of the authorities, including the U.K. Serious Fraud Office (SFC), the U.S. Securities and Exchange Commission’s Enforcement Division and the U.S. Department of Justice, and we will defer to them as to how they wish to engage with Dr. Lynch. In addition, HP will take legal action against the parties involved at the appropriate time. Page 402While Dr. Lynch is eager for a debate, we believe the legal process is the correct method in which to bring out the facts and take action on behalf of our shareholders. In that setting, we look forward to hearing Dr. Lynch and other former Autonomy employees answer questions under penalty of perjury. For his part, Lynch offered a decidedly different narrative in a letter to HP’s board that he released publicly on November 27, 2012. To: The Board of Directors of Hewlett-Packard Company I utterly reject all allegations of impropriety. Autonomy’s finances, during its years as a public company and including the time period in question, were handled in accordance with applicable regulations and accounting practices. Autonomy’s accounts were overseen by independent auditors Deloitte LLC, who have confirmed the application of all appropriate procedures including those dictated by the International Financial Reporting Standards used in the U.K. Having no details beyond the limited public information provided last week, and still with no further contact from you, I am writing today to ask you, the board of HP, for immediate and specific explanations for the allegations HP is making. HP should provide me with the interim report and any other documents which you say you have provided to the SEC and the SFO so that I can answer whatever is alleged, instead of the selective disclosure of non-material information via background discussions with the media. I believe it is in the interest of all stakeholders, and the public record, for HP to respond to a number of questions that I have about the allegations. · Many observers are stunned by HP’s claim that these allegations account for a $5 billion write down and fail to understand how HP reaches that number. Please publish the calculations used to determine the $5 billion impairment charge. Please provide a breakdown of the relative contribution for revenue, cash flow, profit, and write-down in relation to: a. The alleged “mischaracterization” of hardware that HP did not realize Autonomy sold, as I understand this would have no effect on annual top or bottom lines and a minor effect on gross margin within normal fluctuations and no impact on growth, assuming a steady state over the period; b. The alleged “inappropriate acceleration of revenue recognition with value-added resellers” and the “[creation of] revenue where no end-user customer existed at the time of sale,” given their normal treatment under IFRS; and c. The allegations of incorrect revenue recognition of long-term arrangements of hosted deals, again given the normal treatment under IFRS. · In order to justify a $5 billion accounting write-down, a significant amount of revenue must be involved. Please explain how such issues could possibly have gone undetected during the extensive acquisition due diligence process and HP’s financial oversight of Autonomy for a year from acquisition until October 2012 (a period during which all of the Autonomy finance reported to HP’s CFO Cathie Lesjak). · Can HP really state that no part of the $5 billion write-down was, or should be, attributed to HP’s operational and financial mismanagement of Autonomy since the acquisition? · How many people employed by Autonomy in September 2011 have left or resigned under the management of HP? · HP raised issues about the inclusion of hardware in Autonomy’s IDOL Product revenue, notwithstanding this being in accordance with proper IFRS accounting practice. Please confirm that Ms. Whitman and other HP senior management were aware of Autonomy’s hardware sales before 2012. Did Autonomy, as part of HP, continue to sell third-party hardware of materially Page 403similar value after acquisition? Was this accounted for by HP and was this reported in the Autonomy segment of [its] accounts? · Were Ms. Whitman and Ms. Lesjak aware that Paul Curtis (HP’s Worldwide Director of Software Revenue Recognition), KPMG, and Ernst & Young undertook in December 2011 detailed studies of Autonomy’s software revenue recognition with a view to optimizing for U.S. GAAP? · Why did HP senior management apparently wait six months to inform its shareholders of the possibility of a material event related to Autonomy? Hewlett-Packard is an iconic technology company, which was historically admired and respected all over the world. Autonomy joined forces with HP with real hopes for the future and in the belief that together there was an opportunity to make HP great again. I have been truly saddened by the events of the past months, and am shocked and appalled by the events of the past week. I am placing this letter in the public domain in the interests of complete transparency. Yours faithfully, Dr. Mike Lynch

EXHIBIT 1 STATEMENTS BY HP AND DR. MICHAEL LYNCH AT AUTONOMY

Accounting and Auditing Issues

Interviews in California and England with former Autonomy employees, business partners, and attorneys close to the case paint a picture of a hard-driving sales culture shaped by Lynch’s desire for rapid growth. They describe him as a domineering figure, who on at least a few occasions berated employees he believed weren’t measuring up.

Along the way, these people say, Autonomy used aggressive accounting practices to make sure revenue from software licensing kept growing—thereby boosting the British company’s valuation. The firm recognized revenue upfront that under U.S. accounting rules would have been deferred, and struck “round-trip transactions”—deals where Autonomy agreed to buy a client’s products or services while at the same time the client purchased Autonomy software, according to these people.

“The rules aren’t that complicated,” said Dan Mahoney of the accounting research business organization Center for Financial Research and Analysis (CFRA), 2  who covered Autonomy until it was acquired. He said that Autonomy had the hallmarks of a company that recognized revenue too aggressively. He said neither U.S. nor international accounting rules would allow companies to recognize not-yet-collected revenue from customers that might be at risk.

In a statement issued on November 30, 2012, HP said its ongoing investigation into the activities of certain former Autonomy employees had uncovered numerous transactions clearly designed to inflate the underlying financial metrics of the company before its acquisition. The company said it is confident the deals are improper even under the international accounting standards Lynch cites.

In an interview with the British publication, The Guardian, on April 10, 2013, 3  Meg Whitman said that the board, which approved the Autonomy transaction, relied on audited information from Deloitte & Touche and additional auditing from KPMG, though she said that she’s not blaming the accountants.

“Neither of them saw what we now see after someone came forward to point us in the right direction,” Whitman said.

Deloitte, which served as Autonomy’s auditor in the United Kingdom, and KPMG, which performed the acquisition work for HP, have been under fire for allegedly failing to detect the accounting issues.

Page 404Deloitte said in a statement that it cannot comment further on this matter due to client confidentiality and that it will cooperate with the relevant authorities with any investigations into the allegations.” 4

Post-Legal Filings

An interesting issue is that, after Deloitte lost the Autonomy audit to Ernst & Young and reportedly £5.422 million (about $6 million) for Autonomy’s audits during the four years prior to 2012, the firm was then free to engage in previously prohibited consulting activities that were banned for audit firm clients under Sarbanes-Oxley.

According to filings, Deloitte earned an additional £4.44 million (about $5 million) from Autonomy in those four years for services such as tax compliance, due diligence for acquisitions, and other services “pursuant to legislation.” HP’s auditor Ernst & Young started doing everything tax related for Autonomy after the acquisition. However, Deloitte was free to team with Autonomy and all of its technology products as an alliance partner for systems integration engagements. That could be worth billions in consulting revenue for Deloitte’s U.K. firm.

In April 2015, HP filed a lawsuit against Michael Lynch and former CFO Sushovan Hussain for $5.1 billion. The two former executives have vowed to countersue, calling HP’s statements “false and negligent” and the entire thing a “smear campaign.”

In 2012, HP had turned the matter over to the U.S. SEC and DOJ, as well as the U.K.’s Serious Fraud Office. The latter recently ended its probe after failing to find sufficient evidence for conviction and left everything in the hands of U.S. officials, which are still investigating.

It is worth noting that, if there really were accounting fraud, you’d think the auditors might in some way be liable and we believe that Deloitte and KPMG, which also did some auditing, would have way deeper pockets than Lynch and Hussain. HP has talked about suing Deloitte but has yet to follow through on its previous threats.

1.Do you believe a conflict of interest exists when audit firms earn about as much money from nonaudit services as audit services, given they are expected to make independent judgments on the financial transactions and financial reporting of their audit clients? 

2.Good points, Ivelisse, about whether the variance in fees constitutes a conflict of interest. The conflict is really about conflicting interests. The fee alone is one issue, but the more serious issue would be auditing your own work. Obviously, this would be a conflict of interest. The fee issue might induce pressure on the auditing firm to work a certain way, but, alone, it wouldn’t be enough. All of the big accounting firms do both accounting work and auditing work. However, the auditing work does subject them to certain extra requirements and exposure to liability.

Some of this liability is discussed in the text. For example, auditors can be sued by more than just the client. They could be sued by investors, creditors, or even the Government. (Mintz, 2017). The text explains how they can be subject to the common law, which is a court created liability, and statutory law, which include SOX and other legislation. (Mintz, 2017). Honestly, it’s hard for auditors to keep up with all of the potential ways that they can be liable.

So, in light of this liability, why would an accounting firm want to engage in auditing services? Whether they are conflicts of interest or not, the liability alone makes doing both challenging. If the provision of the services is billed at the same rate, how does the accounting firm recoup its investment, given its potential for liability? 

3. Nice description of what a conflict of interest is. I like understanding what the technical requirements are for conflicts of interest. That helps me better identify them when I see them. What is this really about? I think the reason why we are so concerned about conflicts of interest regarding auditors, in particular, is because of the auditor’s heightened duty to the public. As explained in the text, an auditor’s duty really comes from how their services impact third parties, rather than the client. It is important to note that accountants also have special duties to the public. However, an accountant also has an important duty to provide competent services to his/her client. The auditor’s duty is much less focused on the client and more on the public and ensuring the reliability of financial information released by the company being audited. (Mintz, 2017).

This relationship can seem odd when you think about it. The auditor is employed by the client, just like an accountant. They should certainly provide competent services. However, their role is to ultimately show stakeholders (including the public) what the client is doing.

Why is this so important? Why should the client be so interested in showing stakeholders the most accurate picture of what they are doing? Can this help their business and how?

4. Good points by Dave about having independent auditors. This really underscores the importance of oversight and catching mistakes. At my job, once we finish a determination, two reviewers look at it to try to catch any mistakes before the determination goes out to the public. I have not submitted a determination yet that hasn't had a least one mistake. We all make mistakes. It's important that we learn from them and improve our writing.

In the context of accounting work, it is important that accountants allow others to catch their mistakes. As much as it hurts to know that we are not perfect at our jobs, when mistakes are caught the accountant provides a better service to their client, and to the public. Accounting work can be complex, and it is important to learn how to minimize making the same kinds of errors.

What kinds of things to you all do to minimize mistakes? How will your techniques help you in a future accounting position?

5. What are some of the ways in which an accountant commits fraud? Explain at least two ways that fraud occurs.

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