Once Again, Audits Don’t Find Fraud (But Short Sellers Do)

Anyone who is being honest will tell you that financial statement audits don’t find fraud. On the rare occasion they do, but by and large audits are not designed to detect fraud and the auditors don’t have enough fraud detection training.

One solution to this problem is the engagement of forensic accountants to look for fraud. But companies don’t seem to interested in going the extra step.

Today Hewlett-Packard announced that an internal investigation revealed accounting fraud by Autonomy, a company that was acquired by HP last year for more than $10 billion. More specifically, the company said:

HP today announced a non-cash impairment charge of $8.8 billion related to Autonomy in the fourth quarter of its 2012 fiscal year. The majority of this impairment charge, more than $5 billion, is linked to serious accounting improprieties, misrepresentation and disclosure failures discovered by an internal investigation by HP and forensic review into Autonomy’s accounting practices prior to its acquisition by HP. The balance of the impairment charge is linked to the recent trading value of HP stock and headwinds against anticipated synergies and marketplace performance.

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.

Meg Whitman said today in a conference call that the deal to buy Autonomy was “audited by Deloitte,” suggesting that the company had done enough to validate the financials beforehand.

Here’s a fact uncovered by Herb Greenberg: Jim Chanos was short Autonomy, and even published a report on it in July 2011 (before the HP deal closed). That report could have been a road map for HP and its auditors, since it:

  • Raised questions about Autonomy’s claimed size of its e-Discovery business
  • Said the claims of 20% revenue growth were out of line with competitors
  • Said the financial disclosures provided by Autonomy were very poor and didn’t use standard performance metrics
  • Identified problems with deferred revenue compared to recognized revenue
  • Said cash generation consistently underperformed profitability measures
  • Stated that the claimed margins of Autonomy were suspicious

One huge red flag in the world of financial accounting is cash never catching up to profitability. This was a problem at Enron: the company reported profitability, but never seemed to have the cash to prove it. (Hint: If a company truly has revenue and profits, the cash will materialize.) If we learned nothing else from the Enron case, it should be that results out of line with competitors, strange financial ratios, and illogical cash flow are huge red flags.

Did HP and the auditors ignore these red flags? Were they even aware that they existed?

After the whistleblower came forward, HP engaged PricewaterhouseCoopers to examine Autonomy’s financials. PwC found that revenue, gross margin, and other financial metrics were misstated, apparently intentionally. Essentially, Autonomy is being accused of inflating revenue and mischaracterizing the type of revenue.

HP is asking the Securities and Exchange Commission’s Enforcement Division and the UK’s Serious Fraud Office to investigate. And I imagine lawsuits will quickly be announced, both by HP and by class action lawyers representing shareholders of HP.

When will management and investors learn that financial statement audits are not enough?

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Comments (1)

  • Chris

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    Where were the investment bankers too? A buyside banker should have done a lot more diligence about what the Autonomy was doing. You win a lot more business in the long run by sometimes saying “No”. Did they not see the case flow statements?

    Reply

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