ACC 435B Auditing II Hewlett Packard and the Autonomy Accounting Scandal Cristina Bingham National University December

r 21, 2012

In 2011, Hewlett Packard, the iconic and well-respected technology establishment, purchased Autonomy, a UK-based software-search engine and storage company, for a whopping $11 billion in cash. After the acquisition, when autonomy failed to meet their expected profitable earnings, Mike Lynch, Autonomys founder and CEO, was subsequently fired by May of 2012. His termination at the time was allegedly related to Autonomys disappointing numbers and difficulty settling into the corporate culture of HP, (Grainger, 2012). HP then proceeded to launch an investigation into their newly acquired division. From the investigation, Hewlett Packards management team learned that Autonomy recorded service revenue as product revenue. To begin, Autonomy developed a software package called Intelligent Data Operating Layer or IDOL. The software was designed to search and find company data. Autonomy grew through acquisitions of storage companies and enterprise software firms. Once these companies were acquired, Autonomy would then contact the customers and offer an incredible deal. Say a customer had $5 million and four years left on a data-storage contract, or disk, in the trade. Autonomy would offer them the same amount of storage for $4 million but structure it as a $3 million purchase of IDOL software, paid up front, and $1 million worth of disk, (Fisher, 2012). In other words, $3 million would be recorded as product revenue from the IDOL software and $1 million recorded as service revenue. Autonomy was essentially using the service contracts already established among the customers of their newly acquired businesses and using those contracts to record revenue. The company falsified their statements by recording astronomical numbers in IDOL software sales, when the company was giving it away as a part of the new agreement.

Mr. Lynch claimed Autonomy did nothing wrong. On November 27, 2012, Mike Lynch responded with an open letter addressed to the Board of Directors of Hewlett-Packard. In his letter, he states that he was shocked by the allegations, that he rejects the allegations, and that Autonomys finances , were handled in accordance with applicable regulations and accounting practices. He goes on to further note, Autonomys 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, (Savitz, 2012). He also called upon HP to respond to a number of his own questions for the sake of public record and for the interest of stakeholders. Hewlett Packards response to Lynchs letter stated there were a number of accounting improprieties and misrepresentations on behalf of Lynch and Autonomys management team and that the company failed to disclose significant representation prior to HPs acquisition of the division. HP also mentions that the company intentionally inflated the financial metrics of the company in order to mislead investors and potential buyers, (Savitz, 2012). HP ends their letter by mentioning the situation is now in the hands of authorities to include the UK Serious Fraud Office, the SECs Enforcement Division, and the US Department of Justice and that they will defer to these departments in their conflicts with Mr. Lynch. Since the investigation, HP wrote down the value of Autonomy by $8.8 billion, $5 billion of which HP claims is attributed to accounting fraud. HP CEO Meg Whitman said that HP believed Autonomys profit margin to be in the 40 percent range when it bought the company last year, but its margin is actually closer to 20 percent, (Goldman, 2012). Autonomys deceit created a tremendous shortfall of expected future revenues which HP might have calculated as synergy to the deal, (Furrier, 2012). Not too many days after the write-off, HPs shares

declined by 12%, a ten-year low for the company. Because of the drop in share prices, a lawsuit has been filed against Deloitte and KPMG. The allegation is breach of duty in HPs acquisition of Autonomy. HP relied on audits, done by Deloitte, and on KPMGs audits of Deloittes work, (Meves, 2012). With a lawsuit pending against the auditors of Deloitte and KPMG, further questions must be addressed: were the accounting practices at Autonomy in accordance with IFRS? To what degree should KPMG auditors be held accountable for the audits of Deloitte? Which auditing and accounting standards should be considered when both firms are under perjury? Did the auditors of Deloitte and KPMG behave in an ethical manner? To answer, AICPAs Code of Conduct Section 91 states: a member who is practicing outside the United States will not be subject to discipline for departing from any of the rules stated herein as long as the member's conduct is in accord with the rules of the organized accounting profession in the country in which he or she is practicing. However, where a member's name is associated with financial statements under circumstances that would entitle the reader to assume that United States practices were followed, the member must comply with the requirements of rules 202, (AICPA, 2012) In addition, if UK Autonomys financial statements contain an explicit and unreserved statement in a note stating that their financial statements are in compliance with IFRS as issued by the IASB, (Stuart, 2012), then the framework would be recognized by the AICPA. Therefore, the following rules of the AICPA Code of Professional Conduct may have been violated by the auditors of Deloitte and KPMG: Rule 102Integrity and objectivity In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others.

Interpretation 102-1 states that if the auditor knows of misrepresentations that have occurred and fail to correct the entitys financial statements, the auditor will have knowingly misrepresented the facts in violation of this rule. If the auditors of Deloitte and KPMG were aware that service revenues were being recorded as product revenue, did nothing to correct and adjust this misrepresentation, and proceeded to issue a clean opinion, those auditors would have violated the integrity and objectivity of the profession. Rule 203-5 Financial Statements Prepared Pursuant to Financial Reporting Frameworks Other Than GAAP If the financial statements contain any deviation from an accounting principle, Rule 203 addresses that a member should not state the financial statements are in agreement with GAAP, nor should the member claim that he or she is unaware of any necessary modifications that need to be made in order for the financial statements to be in conformity with GAAP. Yet Rule 203-5 gives further insight and clarification that can address the needs of situations similar to the Hewlett Packard and Autonomy scenario. Rule 203-5 first makes known that in reference to GAAP, the accounting principles are simply those that are derived from Council. Any other accounting principles used to prepare financial statements would be considered financial reporting frameworks different from GAAP. But under this does not necessarily preclude or make it impossible to subject the auditor from consequence when reporting on financial statements that have been prepared pursuant to financial reporting frameworks other than GAAP. The auditor may still be violating AICPA Professional Conduct if they do not meet the requirements for full compliance with IFRS, (AICPA, 2012).

Therefore, the auditors of Deloitte and KPMG may have violated AICPA Professional Code of Conduct. The auditors at Deloitte gave a clean opinion on the financial statements of Autonomy, despite the recognition of service revenue for product revenue. In issuing the clean opinion, they were stating they were not aware of any necessary modifications necessary in order to be in conformance with IFRS. But it is very possible that they were aware and chose not to pursue the matter any further. It is also possible, but highly unlikely, that KPMG was aware of the misstatement of fraud and failed to bring it to the attention of HP when they audited Deloittes work. Nevertheless, both auditing firms will be subject to court proceedings. Assuming accounting fraud was committed, managers misguided, while auditors failed to provide the necessary presentation of Autonomys financial position to Hewlett Packard. As one expert commented, HP essentially paid $11 billion for a fancy search engine, (Fisher, 2012). The $8 billion write down had detrimental effects, to include the drop in the value of Hewlett Packard stock and, ultimately, a pending lawsuit against auditors at Deloitte & KPMG and decision makers at HP. When auditors review and audit financial statements and fail to uncover serious misstatements in revenue accounts, their independence, reputation, and judgment are deeply questioned.

References

AICPA American Institute of CPAs. CPA2Biz database AICPA Code of Professional Conduct. Retrieved December 17, 2012 from: http://www.aicpa.org/RESEARCH/STANDARDS/CODEOFCONDUCT/Pages/default.a spx Fisher, Daniel (Nov 2012). With Autonomy, H-P Bought An Old-Fashioned Accounting Scandal. Heres How It Worked. Forbes.com. Retrieved from:
http://www.forbes.com/sites/danielfisher/2012/11/20/with-autonomy-h-p-bought-an-oldfashioned-accounting-scandal/

Furrier, John (Nov 2012). Exclusive: Autonomy Missed Revenue by 90% - The Big, Bad Data-Crime of the Century. Silicon Angle. Retrieved from: http://siliconangle.com/blog/2012/11/20/exclusive-autonomy-missed-revenue-by-90-thebig-bad-data-crime-of-the-century/ Goldman, David (Nov 2012). Autonomy Founder Demands Details on HPs Fraud Allegations. CNN Money. Retrieved from: http://money.cnn.com/2012/11/27/technology/enterprise/hp-autonomy/index.html Grainger, Matt (May 2012). HP Fires Mike Lynch. PCR For The UKs PC & Tech Community. Retrieved from: http://www.pcr-online.biz/news/read/hp-fires-mike-lynch/028388 Meves, Anne-Kathrin (Nov 2012). Auditors, CFO and CEO Sued in Autonomy Lawsuit. CFO Insight. Retrieved from: http://www.cfo-insight.com/risk-management-it/compliance/auditors-cfo-and-ceo-suedin-autonomy-lawsuit/ Savitz, Eric (Nov 2012). Former Autonomy Chief Mike Lynch Lashes Out At HP. Forbes.com. Retrieved from:
http://www.forbes.com/sites/ericsavitz/2012/11/27/former-autonomy-chief-mike-lynch-lashesout-at-hp/ Stuart, Iris C. (2012). Auditing and Assurance Services: An Applied Approach. Boston: McGraw Hill