Hewlett-Packard (HP) purchased British software maker Autonomy in an $11 billion deal in October 2011. Mike Lynch was the founder of Autonomy and was fired by HP in 2012 after a whistleblower informed HP of accounting improprieties, misrepresentations, and disclosure failures in the financial statements of Autonomy prior to the acquisition. HP had relied on those audited financial statements, along with due diligence performed during the acquisition process. On November 20, 2012, HP announced an $8.8 billion write-off of the goodwill that had been recorded on HP’s financial statements at the acquisition. It is alleged that about $5 billion of the write-off relates to the accounting improprieties. Following the write-off announcement, shareholders filed a class-action lawsuit, naming top management at HP, its auditors, and the accounting firm that performed the due diligence relating to the acquisition.
We spoke about the implications of this emerging accounting and auditing scandal with Karla Zehms, an associate professor in the Department of Accounting and Information Systems at the Wisconsin School of Business. Professor Zehms is an expert on auditing, having researched extensively on the topic and written an auditing textbook.
WSB: According to the class-action lawsuit, HP’s top management and board members violated their fiduciary duties by grossly overpaying for Autonomy. What information would those individuals have relied upon in making the decision to acquire Autonomy?
Professor Zehms: Top management and the board members would have relied on their knowledge of the industry, competitive trends, and strategic goals. They would have also been heavily influenced by the reported financial performance of Autonomy, and that financial information was audited by one of the Big 4 accounting firms in the United Kingdom. In addition, HP hired another Big 4 accounting firm to perform certain procedures in assessing those audited financial statements as part of the due diligence associated with the acquisition process.
WSB: What is the specific nature of the alleged accounting improprieties at Autonomy? And what are the auditing implications relating to those improprieties?
Professor Zehms: Early reports suggest several types of financial accounting manipulation. These include miscategorizing revenue (such as reselling computers and categorizing those sales as software revenue), aggressive application of international financial reporting standards (IFRS) on software revenue recognition, and aggressive capitalization of costs. One of the interesting things that will likely play out as the litigation proceeds is the extent to which the alleged accounting manipulations were truly violations of IFRS, since requirements for software accounting internationally are much more judgmental in nature than they are in the U.S. And that judgment in the underlying accounting makes auditing the software revenue recognition more judgmental as well.
WSB: Is it true that auditors are responsible for detecting material fraud at their clients’ organizations? Is there ever a situation in which the auditors might have conducted a quality audit and still not detected the fraud?
Professor Zehms: Yes, auditing standards and legal requirements dictate that auditors are responsible for detecting material fraud in the financial statements of audit clients. However, there is a classic “expectations gap” between what users expect and what auditors actually provide in terms of required service. Auditors are required to assess the risk of fraud at their clients’ organizations, and they are required to appropriately and fully respond to that risk assessment. The difficulty that arises, of course, is that management perpetrating a fraud will use collusion and concealment as part of their strategy to continue on their course of inappropriate financial reporting. So, it is certainly the case that an auditor may have conducted a quality audit, but because of management’s actions, the auditor may still not detect the fraud. This is a problem as old as financial reporting, auditing, and fraud itself. This is why litigation and practice protection costs for accounting firms are now, and likely always will be, one of the most significant costs that those firms bear as they do business in a world where management has significant incentives to perpetrate and conceal fraudulent financial reporting.
WSB: Early information from the legal complaints filed in this case, along with commentary in the press, includes allegations that the auditors in this situation ignored certain “red flags.” What were those red flags, and do you think there is merit to the allegations that auditors ignore them?
Professor Zehms: The “red flags” reported include the contention that HP’s CFO vocally opposed the acquisition of Autonomy, the purchase price was unusually high given valuation of software companies that were similar to Autonomy, and concerns were expressed by analysts and investors regarding Autonomy’s financial reporting and results. From an auditing standpoint, the fact that a CFO disagrees with a proposed acquisition is not necessarily relevant to whether the financial statements contain a material misstatement. Further, the auditor is not responsible for determining whether an acquiring company is paying the “correct” amount or whether they are overpaying; other accounting firms provided services to help HP complete due diligence regarding the financial statements of Autonomy, but that is not an auditing service. Further, it is management and the board’s choice what to ultimately pay in an acquisition, not the auditor’s or an accountant performing due diligence services. Finally, there is never consensus in the analyst community, and while hindsight shows that certain analysts or investors were right in their concerns, we know hindsight differs dramatically in its accuracy from foresight. Therefore, while auditors or accountants performing due diligence work may read analyst reports, they may not necessarily rely upon them in performing their respective duties.
WSB: What lessons can be learned from this situation by other companies preparing for an acquisition?
Professor Zehms: All the classic advice applies. Careful assessments of strategic fit are critical. Gaining comfort about the reliability of financial results is of fundamental importance. Understanding the economic incentives of auditing, accounting, and banking professionals and applying appropriate professional skepticism to the assertions and information that those professionals provide would be wise. And accepting and planning for the realistic fact that acquisitions do not always result in value-added outcomes would seem to be prudent.
WSB: How do you prepare your auditing and accounting students for the complex world that they will face upon graduation, given repeated instances of cases like the HP/Autonomy situation?
Professor Zehms: At a department level, our accounting faculty has implemented an ethics and professionalism program within our curriculum. This program helps students learn to recognize and appropriately respond to ethically challenging situations that they may encounter in their professional careers. The ethics and professionalism program also helps students understand their ethical obligations to other individuals, their clients, and to their profession. At an individual instructor level, students in my undergraduate and graduate-level auditing courses learn to apply an ethical decision-making framework through course activities. Further, I teach my students about professional skepticism, discuss why it is often difficult to apply in practice, and use cases to give students examples that they can remember about both the proper and improper application of professional skepticism and its consequences. In the HP/Autonomy situation, it appears that professional skepticism was lacking on the part of many of the professionals involved.