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Mike Lynch says HP's allegations don't add up, attempts to reconcile some of the allegations

Consumer and enterprise electronics giant Hewlett-Packard Comp. (HPQ) is on a collision course with the former owners of its new subsidiary, Autonomy Corp., and their accountants.  At HP's behest, UK authorities, the U.S. Federal Bureau of Investigation, and the U.S. Security and Exchange Commission are investigating claims of a $5B USD accounting fraud scheme at the purchase.  But amid that unofficial probe, ex-Autonomy chief, co-owner, and co-founder Mike Lynch is speaking out, arguing HP's accusations don't add up.

I. Autonomy Founder Speaks Out

HP says it’s basing its claims on the account of an unnamed whistleblower within Autonomy's upper accounting echelon.  And it says a forensic audit by PricewaterhouseCoopers LLP confirmed these claims.  HP claims that Autonomy "invented" nearly $200M USD in bogus revenue over a two year period starting in 2009, a factor that led -- in part -- to its overvaluation.

Dr. Mike Richard Lynch, fired in May 2012 by HP after the merger, was among the owners of Autonomy to pocket a rich profit from the $10.3B USD sale.  A pioneer in adaptive pattern recognition Dr. Lynch received his Ph.D. in signal processing and communications research from Cambridge University.  He went on to found several startups, eventually creating the enterprise software giant-to-be Autonomy.

Autonomy CEO, Mike Lynch
Unsurprisingly, Dr. Lynch views the situation in a far different light and defends Autonomy's accounting, while stopping short of saying there were no mistakes.  Lynch says the accusations are "utterly wrong" and points out that under the looser International Financial Reporting Standards (IFRS) guidelines, published by the The International Accounting Standards Board (IASB), some kinds of revenue can be reported before deals are closed.

He comments to Reuters, "All of these deals went through (Autonomy's auditors) Deloitte themselves.  Deloitte apply the test independently of us, and it is a standard test, and it is explicitly stated in the annual report and accounts."

Revenue (or lack thereof) is one of the key bones of contention between HP and Autonomy's former owners -- HP claims Autonomy cooked the books to make it look like it had more revenue than it really had.

HP and other American companies tend to follow the stricter Generally Accepted Accounting Principles (GAAP).  Lynn E. Turner, former chief accountant of the Securities and Exchange Commission, told Reuters, that the problem could indeed merely be in part that Autonomy was following the looser rule IAS 18 standards in IFRS, which govern vendor revenue, versus the stricter VSOE, or vendor-specific objective evidence guideline, in GAAP.

Autonomy poster
HP claims it was blindsided by Autonomy's "hidden" downsides. [Image Source: Autonomy]

He remarks, "It shouldn't be a surprise this issue is coming up. It shows how loosey-goosey IFRS is."

Deloitte LLP, one of the world's top accounting firms, defends its track record, in a comment to Reuters stating, "[All Autonomy accounting was done] in full compliance with regulation and professional standards."

It "categorically denies" HP's accusations of impropriety, as far as its work is concerned.

II. IFRS v. GAAP -- When "Boring" Accounting Becomes Billions

Among the key GAAP and IFRS differences is how to handle licensing revenue.  When a company sells licenses to a reseller, the terms of the contract sometimes allow the reseller to be refunded if it can't move the licenses.  

Under GAAP revenue can only be recorded in such cases after the reseller resells the license.  But under IFRS the revenue can be recorded immediately.

The distinction is important, in the eyes of Autonomy's former owners, as they were operating by the IFRS rules.  As resellers like International Business Machines, Inc. (IBM) and Wipro Ltd. (WIPRO) are major business partners to Autonomy, the distinction could swing revenue by a small amount.

IBM sign
Mr. Lynch argues resellers like IBM moved 90 percent of the licenses, and that it was reasonable to count unsold licenses as revenue. [Image Source: Andrew Havis]

HP accuses Autonomy of selling to resellers with no end user yet found.  But Mr. Lynch says this wasn't misleading; the reseller could decide simply to use the product itself, internally.  

He also claims that 90 percent of Autonomy's licenses that are distributed to third parties are indeed sold.  Thus, he argues, the distinction is largely a moot point.

III. HP, ex-Autonomy Owners on Collision Course Amid Criminal Probes

Mr. Lynch tackles another key claim -- that Autonomy misrepresented hardware sales as software sales.  He defends the practice of calling sales of software/hardware bundles (with hardware often sold at a loss), saying that the package is built on Autonomy's software and thus it made sense to categorize it as "software" revenue.

He comments that the distinction "moves the gross margin a percent or two", but does not affect the company's overall profitability.

And he says that at cases where hardware was sold at a loss, Autonomy received compensatory marketing from the client -- a type of goodwill.  HP, however, sees things differently, arguing that 10 to 15 percent of Autonomy's revenue came from hardware and that it was a major impropriety to account for that stream as software revenue which may have padded the losses.

he said, she said
The war of words between Mr. Lynch, et al. and HP is likely to get uglier. [Image Source: NBC]

But Mr. Lynch argues that Autonomy has long been transparent that it sells hardware.  He points to reports HP had access to that show that in 2009-2010 hardware accounted for approximately 8 percent of the firm's revenue.  In other words, HP should have realized that hardware was part of the equation, from his perspective.

At the end of the day, Mr. Lynch argues that the "impropriety" is on HP's part and that the write-down and accusations just don't add up.  He comments, "There is nothing there that you can warrant such a big effect in terms of write-down."

With HP already committed to a write-down and pursuing potentially criminal accounting misconduct accusations against Autonomy and its accountants in both the U.S. and Britain, the two divergent views appear to be on a collision course that could have serious repercussions for either HP (on the one side) or Mr. Lynch and his co-owners (on the other side).

Source: Reuters

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By Twistedbro5 on 11/26/2012 1:00:54 PM , Rating: 2
Perhaps HP should actually take initiative on some of its own technology instead of scrapping those with potential and investing in garbage.

RE: Obviously
By JasonMick (blog) on 11/26/2012 1:22:05 PM , Rating: 2
Perhaps HP should actually take initiative on some of its own technology instead of scrapping those with potential and investing in garbage.
Sure, I agree with you there -- HP has been horribly mismanaged for the last couple years and really has missed out on the mobile demand. It had a potentially good thing going with webOS, but killed it for lack of effort.

That said, I don't really understand the situation with Autonomy fully, in that it doesn't really add up. The thing is, I'm not sure whether Mr. Lynch is right and it's not adding up w.r.t. HP's claims, or if there's something more to the claims that he's not addressing/mentioning.

Right now all of this stuff is pretty much behind closed doors, but it seems like HP must have something more compelling than just "Autonomy use IFRS accounting wahhhhhh!" in order to have the gumption to go to the FBI, SEC, and UK authorities crying fraud.

There's something somebody isn't saying or else HP has committed a PR and business disaster. I would bet on that it's the former (something that hasn't come to light is driving the claims), though you never do quite know with HP....

RE: Obviously
By tayb on 11/26/2012 1:48:07 PM , Rating: 2
It's incredibly hard for me to believe that Autonomy pulled a maneuver so clever that it tricked Deloitte. That would be extremely embarrassing for what I consider to be the top accounting firm in the world.

RE: Obviously
By othercents on 11/26/2012 3:08:54 PM , Rating: 2
Companies do hide things from the auditors. Enron was one that was showing sales to subsidiary companies that only existed on paper. This information was never found by the auditors until after Enron's financial collapse.

It is very possible that Autonomy could have been doing illegal cooking of the books and Deloitte not know. Deloitte is only there to confirm the accounting process and that bank statements matched up with what was in the books.

RE: Obviously
By someguy123 on 11/26/2012 6:12:22 PM , Rating: 2
Looking at past articles it seems more likely that HP themselves had horrible oversight, most likely due to Apotheker's terrible managerial decisions rather than accounting tricks. Every other company Autonomy attempted to sell to realized that they were grossly overvalued. It seems too unlikely that they would fudge the books explicitly for an HP buyout when everyone else had a clear view and showed no interest.

RE: Obviously
By maugrimtr on 11/27/2012 8:41:50 AM , Rating: 2
On Deloittes, the auditor of a company is not ultimately responsible for major fraud. Yes, they will test for it - but they rely on documenting controls, sample testing transactions and representations from management also. They can't test everything so it's very possible to get fraud past them if you are high enough up the management to be capable of influencing the documentation and evidence they have access to.

RE: Obviously
By rdhood on 11/29/2012 11:55:51 AM , Rating: 2
Every other company Autonomy attempted to sell to realized that they were grossly overvalued. It seems too unlikely that they would fudge the books explicitly for an HP buyout when everyone else had a clear view and showed no interest.

Bingo. It is why I say that HP KNEW what they were getting. HP KNEW they were paying too much. Everyone TOLD THEM that they were paying too much. Now, a few years later, hey are just now realizing what any Joe Sixpack knew then: they paid too much. The question is: what did everyone else see that HP missed OR What did HP THINK they saw that has turned out to be false and caused buyers remorse?

RE: Obviously
By drycrust3 on 11/27/2012 12:10:31 AM , Rating: 3
There's something somebody isn't saying or else HP has committed a PR and business disaster.

I don't think HP have a leg to stand on. As far as I can tell this company had a claimed profit in the region of $200M - $300M, so (and I guess this shows my lack of business acumen) was never worth more than $1B, and they are operating in a field where I'm guessing all the competition would have tied up the potential major clients with long term contracts, so getting new major clients was going to cost them an arm and a leg.
If someone wants to sell you a car, and says its a brand new Porsche, and the car has "Ford" on the bonnet, blows burnt oil from the exhaust, and has spots of rust, who's fault is it when you discover "the new Porsche" is actually a second hand Ford?
Larry Ellison of Oracle said that Autonomy was shopped to them and that it was "absurdly overpriced" (his exact words).
As far as I can tell, it was patently obvious this time last year that Autonomy wasn't worth anywhere near $10B.
Even if Autonomy wildly overcooked the books so as to make it look like they earned $200M - $300M, that was never enough to justify HP paying $10B for it. As far as I can tell, even if Autonomy only made a profit of $1.00, that wouldn't have stopped HP from buying it.
Actually, I'm slightly unfair, HP don't have themselves to blame for this blunder, the HP Board of Directors are the ones who are should bare the sole responsibility. All this FBI stuff is just nonsense, the Directors who voted to buy Autonomy should resign.

RE: Obviously
By Strunf on 11/27/2012 8:25:52 AM , Rating: 2
I don't think HP have a leg to stand on. As far as I can tell this company had a claimed profit in the region of $200M - $300M, so (and I guess this shows my lack of business acumen) was never worth more than $1B

Depends on the market the company is in and its potential, I would say any given company is worth at least 5x its net profit, why would you otherwise sell a company for any less when you could make that same money in 5 years.

RE: Obviously
By drycrust3 on 11/27/2012 3:00:36 PM , Rating: 2
I would say any given company is worth at least 5x its net profit,

So what value would you have placed upon this company?

RE: Obviously
By Strunf on 11/27/2012 4:14:10 PM , Rating: 2
I wouldn't buy it, the "right" price for a company depends not only on the company itself but also on the buyer, maybe for HP Autonomy was worth $10bln but for others it wouldn't necessarily be the case, Google for instance payed $12bln for motorola mobility when they weren't even making any profit at all.
The problem with Autonomy is that not only the aren't making the $400mln of net income but also seem to not be exactly what HP thought they were.
The Oracle CEO didn't just say HP payed too much he said Autonomy was already overvalued on the stock market, you can still access the Autonomy slides they used when they met with the Oracle CEO back in 2011.

Doubt it
By Trisped on 11/26/2012 1:42:51 PM , Rating: 2
I seriously doubt that HP would make this big of a deal and involve this many government officials unless it was truly concerned that something inappropriate was happening.

It could be HP is just playing it safe, trying to avoid allegations of wrong doing by immediately involving the authorities. Of course they probably feel that there is a 100% chance of an issue, otherwise they would have tried to keep it out of public knowledge until they knew for sure.

Time will tell
By Beenthere on 11/26/2012 5:04:00 PM , Rating: 2
With the FBI investigating, we'll know more when the dust settles. While HP is no angel, I doubt they'd be foolish enough to go public with this and call in the FBI if there wasn't some legit basis for their claims as the repercussions could get very expensive in addition to the losses they are already booking for Autonomy.

Due Diligence???
By Doh! on 11/27/2012 1:07:58 AM , Rating: 2
Although my assessment is solely based on this short article, I think most of HP's claims are really weak. For example, the difference between IFRS and GAAP... any proper due diligence performed by HP's advisors (PWC?) should have discussed the the difference and produced restatd financials based on GAAP to be reviewed by HP.
Other claims by HP are issues that should have been covered by any proper due diligence process. Perhaps all of these issues were properly noted but ignored by HP's ex-executives for their personal interest (which is a very common practice in M&A deals). In any event, the only losers are the non-institution, outside HP shareholders who might have lost a big chunk of their savings.

HP was stupid to fire mark hurd
By KOOLTIME on 11/28/2012 6:26:33 PM , Rating: 2
HP was not very smart in firing mark hurd over a small personal issue, but stock companies have ethic committees so its not always easy.

But still for the personal issue was so small to fire him over vs a warning slap on the hand would have been better.

look a track records

mark Hurd - Started 2004 stock 22 a share - fired in 2010 - 45 a share
Leo appotheker hired 2010 - stock 40 a share - fell to 25 a share
Meg whittman hired 2012 - 23 a share - currently 12 a share

easy choice one of the 3 more then doubled the companies revenue while at the helm, the other 2 dropped stock prices more then half current value while at the helm.

People can lay blame all they want, but numbers speak very easy, to drop more then double in value clearly shows a bad choice made and nothing but more bad choices in leader selection.

HP is playing politics with leaders, not choosing a replacement leader to actually fix it, after firing mark hurd.

Non current managment in HP can least stablize teh company from sinking farther, there is no upwards trend in sight, fireing 30K people to justify what more stock prices falling farther, how is that saving the company at all.

The leaders are just stupid and clueless at HP since Mark Hurd was fired. To much politics vs actually running a business and least trying to stabilize its share value, even if its not going up real soon. As of now its still dropping fast towards bankrupcy with leo and now meg running them.

"Spreading the rumors, it's very easy because the people who write about Apple want that story, and you can claim its credible because you spoke to someone at Apple." -- Investment guru Jim Cramer

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