Where were the auditors?

Lily Tomlin once famously said: No matter how cynical I get, I can’t keep up. I was reminded of how true this is on November 20 when I read about Hewlett-Packards’ disclosure 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 last year, after discovering that Autonomy misrepresented its finances. H-P said it has asked U.S. and U.K. regulators to launch criminal and civil investigations into the alleged fraud. The developments drove H-P’s already beaten-down stock because of disappointing earnings reports down another 12% to 10-year lows.

What I find amazing is no one seemed to know about the fraud – not H-P, not the external auditors, and certainly not the regulators. How is it that a major accounting fraud could occur and the auditors were kept in the dark? Didn’t audit firms learn their lesson after the frauds at Enron, WorldCom, Tyco and a multitude of other financial frauds? Apparently not. One again the refrain should be: Where were the auditors?

Now for the unbelievable details. H-P said its internal probe and forensic review had uncovered “accounting improprieties, misrepresentations and disclosure failures” in the financial statements of Autonomy, the U.K. and San Francisco-based enterprise software company H-P acquired in August 2011 for a final price of $11.1 billion.

HP’s earnings for the quarter ending on October 3, 2012, showed troubling results. Revenue is down 7 percent to $30 billion compared to the same quarter in 2011. But the real problem comes from so-called GAAP net income [Income based on Generally Accepted Accounting Principles], with a net loss of $6.9 billion, or $3.49 per share, compared to a slim net profit of $0.2 billion for the fourth quarter of 2011. Non-GAAP diluted earnings per share is at $1.16 compared to $1.17 year-over-year. Most of the bad news comes from a huge $8.8 billion write-down related to the Autonomy accounting fraud.

The Autonomy disclosures are the latest efforts by CEO Meg Whitman to clean up the mess she inherited from former CEO Leo Apotheker, who H-P 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."

Once again, how can this happen and top management was unawares? Where was the controller and CFO while the fraud was occurring? I can’t believe lower level accountants cooked up the fraud without the knowledge of higher-ups in H-P.

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. H-P said the whistleblower gave “numerous details” that H-P previously had no “knowledge or visibility” of.

In response, H-P tapped PricewaterhouseCoopers to do a forensic review of Autonomy’s historical financial results and put John Schultz, the company’s general counsel, in charge of the investigation.

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.

A spokeswoman for Mike Lynch, the former CEO and co-founder of Autonomy, told Reuters that the H-P allegations are "false" and Autonomy's management was "shocked to see" the fraud charges. Lynch said H-P's due diligence was intensive and the larger company's senior management was "closely involved with running Autonomy for the past year," Reuters reported. 

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.

He says some of the accusations are misleading because Autonomy was following International Financial Reporting Standards, as British companies do, not the GAAP standard used by HP, which means it recognizes revenue differently in certain situations from U.S. practices. I doubt that claim because IFRS is not that different from U.S.-GAAP although the devil may be in the details.

H-P said it has alerted the Securities and Exchange Commission’s Enforcement Division in the U.S. and the U.K.’s Serious Fraud Office. Further, H-P said it is preparing to aggressively “seek redress against various parties” in civil courts to recoup what it can for shareholders.

On a conference call, Whitman said the board, which approved the Autonomy transaction, relied on audited information from Deloitte & Touche and additional auditing from KPMG, though she said 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 was the auditor for Autonomy in the U.K., said in a statement that it "notes the allegations" made by H-P and that the charges have been referred to regulators. We cannot comment further on this matter due to client confidentiality. We will cooperate with the relevant authorities with any investigations into these allegations.”

In my experience as an accounting professor and ethicist I have found all too many audit firms cut corners in the audit and even send out less-than-qualified auditors in order to keep audit costs at a minimum and match the sometimes “low-ball” bid to gain the client. Independence problems abound and it appears the audit firms were guilty of it in their examination of the financial results of Autonomy. When will the accounting profession learn the public expects them to find fraud?

Blog posted by Steven Mintz, aka Ethics Sage, on November 26, 2012