This HP/Autonomy "Accounting Improprieties" Thing Hit the Big 4 Superfecta and Other Things We Learned Today

As luck would have it, we don't get to coast this Thanksgiving week as HP had to come along and screw it all up by announcing a $8.8 billion write-down, $5 billion of which is described as "serious accounting improprieties, misrepresentation and disclosure failures" at software company Autonomy, who HP acquired back in 2011. And where there are "accounting improprieties" there are any number of people asking, "where were the auditors?" out loud.  

Well, I guess that all depends on whose auditors you'd like to discuss. Ernst & Young is HP's auditor and has only been mentioned in passing so far, but it won't be long before they get dragged into this.

No, for now everyone is talking about Deloitte, who audited Autonomy and is in the immediate line of fire. The Wall Street Journatl's shotgun-Q&A with Autonomy founder Mike Lynch gets right to it:

WSJ: You have seen the allegations about irregular accounting practices, price inflation, presumably everything was cleared by auditors, you were a FTSE 100 company?
 
[Mike Lynch]: We were audited on a quarterly basis. It was Deloitte, who knew the company well. We had 10 years as a listed company; during that time Deloitte would have had their work reviewed by the various boards. Of course H-P did what its senior management called “a meticulous due diligence” involving hundreds of people that was highly intense, involving KPMG Barclays as BARC.LN -1.30% well. They threw everything at it.
 
And of course they have run the company for four quarters, they have been doing the books.
 
The figures are just mad. You are talking about handing them an asset worth $12 billion and they are saying $9 billion of that they are taking off. That would be such an obvious massive thing with 300 people and all these firms doing due diligence, how could you possibly not spot it?

Okay, well "audited on a quarterly basis" is obviously an incorrect statement since the 10-Qs are only reviewed, but Deloitte did give them a clean audit opinion (can be seen at Zero Hedge) last year, KPMG was on due diligence, and Ernst & Young was probably cool with it all, largely relying on their buddies work when HP was sniffing Autonomy for a deal. And yet, big "improprieties" that got by three professional service firms, two who were applying audit procedures. Seems unbelievable, right? 

Well, Matt Levine at Dealbreaker argues that Autonomy could pull a fast one on everybody, including HP, but even auditors and due diligencers: 

Being a public company subjects you to a certain amount of scrutiny, from auditors and investors and whatnot, but Autonomy seems to have managed fooling its auditors just fine. And putting yourself on the block exposes you to due diligence: a prospective buyer doesn’t need to be satisfied with public information, but can kick the tires more thoroughly, demanding nonpublic information and doing its own review of your accounts. There’s a chance they’ll discover any fraud. And if people are worrying about your aggressive accounting anyway, and a potential acquirer publicly walks away from a deal (as Oracle kind of did!), that’s not going to help your quest to avoid detection.
 
But Autonomy did it anyway.
 
[...]
 
[S]hopping yourself is only dangerous if due diligence is likely to actually discover fraud. That didn’t happen and I guess there’s no reason why it would – again, the M&A process is about extracting meaning from information, not checking its accuracy. That didn’t happen and I guess there’s no reason why it would – again, the M&A process is about extracting meaning from information, not checking its accuracy. Perhaps Autonomy decided that being a public company exposed them to motivated short sellers who would figure out their accounting problems much faster than HP and its bankers and auditors would.

To make matters worse, lots of journalists don't understand the difference between accountants and auditors and - AND! - audits are NOT designed to detect fraud anyway, as Tracy Coenen reminds us. This, of course, causes many to wonder what the value of an auditor's opinion really is. Or put another, less nice way, "are auditors worthless?" Unless you're a reputed short-seller, this whole thing probably feels like a Wile E. Coyote/anvil situation.

So how did this story get exposed for the rest of us? A whistleblower, naturally. Back to the HP press release:

HP launched its internal investigation into these issues after a senior member of Autonomy’s leadership team came forward, following the departure of Autonomy founder Mike Lynch, alleging that there had been a series of questionable accounting and business practices at Autonomy prior to the acquisition by HP. This individual provided numerous details about which HP previously had no knowledge or visibility.
HP initiated an intense internal investigation, including a forensic review by PricewaterhouseCoopers of Autonomy’s historical financial results, under the oversight of John Schultz, executive vice president and general counsel, HP. 

And there's our fourth horse! PwC, only after someone with direct knowledge of the matter came forward, helped dig up all the "sketchy accounting," as one guy put it

What was so sketchy? Arik Hesseldahl at All Things D has a good rundown of the details that Autonomy is accused of, including these gems:

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 a 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. At least some portion of the cost on these products, Whitman said, was booked as a marketing expense, not as cost of goods sold.

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.

Okay, so what did we learn so far? A few things, at least:

1. Any time a major accounting scandal hits, you can safely put your money on all of the Big 4 firms being involved in some form or another.

2. Technology and software companies seem to have lots of issues with revenue recognition. 

3. It's really, really easy to blame auditors even though you don't understand what they do. It's coo, everybody does it. 

4. THIS: "[I]t's tough to say that something isn't going on with Deloitte." 

5. Short sellers know more than everyone.

The good news is, this will drag on far beyond the holiday week, so maybe more revelations will come out after people have some tryptophan-induced dreams.

All the HP/Autonomy reading you can handle:
HP Issues Statement Regarding Autonomy Impairment Charge [HP]
Q&A With Autonomy Founder Mike Lynch on H-P Allegations [Digits/WSJ]
Deloitte Faces Questions After Hewlett-Packard's Allegations [WSJ]
With Autonomy, H-P Bought An Old-Fashioned Accounting Scandal. Here's How It Worked. [Forbes]
HP Thinks That Autonomy Extracted A Bit Too Much Meaning From Its Enterprise Data [DB]
What Exactly Happened at Autonomy? [AllThingsD]

Comments