978-0077862213 Chapter 8 Case Autonomy

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Case 8-5

Autonomy

Background

On November 20, 2012, Hewlett-Packard (HP) disclosed that it had discovered an accounting fraud and has written

down $8.8 billion of the value of Autonomy, the British software company it bought in 2011 for $11.1 billion, after

discovering that Autonomy misrepresented its finances. In May 2102, 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 Autonomy 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 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.

HP added that it was co-operating with the U.S. DOJ, the U.S. SEC and the UK’s Serious Fraud Office.

The Autonomy disclosures are the latest efforts by CEO Meg Whitman to clean up the mess she inherited

from former CEO Leo Apotheker, who HP reminded shareholders presided over the disastrous Autonomy deal.

In a statement, 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 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:

HP is 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 don’t add up. It’s questioning about $100 million in revenues, yet blaming $5 billion of the

write-off on fishy accounting.

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

He not only denies all wrongdoing but says he has 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.

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

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), 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-year 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 U.K., and KPMG, which performed the acquisition work

for HP, are under fire for allegedly failing to detect the accounting issues.

Deloitte, 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.”

Questions

1. What is meant by “earnings management” and how does it relate to the accounting techniques followed

by Autonomy?

Earnings management occurs when companies artificially inflate or deflate their revenues or profits, or earnings per

share figures. In the case of HP-Autonomy, Autonomy is alleged to have overstated revenue, core growth rate, and

gross margins at the time of its acquisition by HP. Autonomy recognized revenue upfront that under U.S. GAAP

2. In an analysis by the Association of Certified Financial Crime Specialists (ACFCS) about the

Autonomy merger with HP, the following statement is made: “The scandal is prompting questions about

who is to blame for the soured merger. As details emerge, the case is spotlighting the difficulties that

accountants and lawyers face in complex mergers and acquisitions and business deals. The case also

raises the issue of what responsibility these professionals have for detecting potentially fraudulent

business records where the line between accounting discrepancies and financial crime is blurred.” Given

the facts of the case, evaluate the ethical and professional responsibilities of the external auditors with

respect to the AICPA Code of Professional Conduct.

Deloitte and KPMG performed much of the due diligence and auditing work in the HP-Autonomy merger. Deloitte

served as Autonomy’s auditor and consultant for the four years prior to the merger. Deloitte charged Autonomy

The external auditors have ethical and professional responsibilities of independence (rule 101), integrity

and objectivity (rule 102), due care and competency (rule 201), compliance with auditing standards (rule 202),

compliance with accounting principles (rule 203), confidentiality (rule 301), and acts discreditable (rule 501). In

addition, the auditor has ethical duties and obligations to the public and all stakeholders other than the client; the

3. Meg Whitman is quoted in the case as saying that the board, which approved the Autonomy

transaction, relied on audited information from Deloitte & Touche and additional auditing from

KPMG. Given that auditing standards and legal requirements dictate that auditors are responsible for

detecting material fraud in the financial statements of audit clients, would you blame the auditors for

failing to uncover the improper accounting for revenue at Autonomy? Which audit standards are critical

in making that determination?

The auditors should plan (AU 300, AS 9) and perform (AU 330, 450) the audit to detect material misstatements (AU

315, AS 8, AS 13), whether due to errors, irregularities, or fraud. Materiality is determined in accordance with AU

320 and AS 11; errors and irregularities with AU 450 and AS 13, fraud with AU 240, 316, and AS 13, illegal acts

In November 2012, H.P. was hit with a shareholder lawsuit in federal court in San Jose, California, which

named Meg Whitman, H.P.’s board of directors, and auditing firms Deloitte and KPMG as defendants. The lawsuit

alleges that H.P. and its accountants were negligent in missing red flags related to the Autonomy purchase. The

So who’s to blame for this mess? Was it H.P.’s current and former management, which didn’t really have a

handle on what they were buying? Was it the company’s auditors, who were supposed to perform due diligence on

the deal? Was it Lynch and his Autonomy colleagues, who are alleged to have cooked the books at their company?

We really don’t know for sure yet. It takes a long time for the facts to be revealed and probed in discovery as part of

Optional Question

4. Revenue recognition transactions such as those described in question 2 are referred to as “linked

transactions” under IFRS. Research the revenue recognition rules for linked transactions and compare

them to what Autonomy did. Does it seem that Lynch’s position is valid as stated in the case that the

accusations against him and Autonomy for improper revenue recognition practices was not fair because

Autonomy was following IFRS and they are different than the GAAP standard used by HP, which means

it recognizes revenue differently in certain situations from U.S. practices?

IAS 18.13 revenue recognition criterion requires that linked transactions be accounted together;

this is the same treatment as is required under GAAP. This contradicts Lynch’s position that the

Exhibit 1

Statements by HP and Dr. Michael Lynch at Autonomy

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 UK Serious Fraud Office, the US Securities and Exchange

Commission’s Enforcement Division and the US 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.

While 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 UK.

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:

• 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 similar value after acquisition? Was this accounted

for by HP and was this reported in the Autonomy segment of their 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 US 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