Peeling away financial reporting issues one layer at a time

Autonomy: Investors are Entitled to Know what HP’s Management Knows — by New Year’s Eve

Hewlett Packard Co. claims they were 'misled' (to put it mildly) by accounting 'misstatements' (to put it mildly) into overpaying, on the order of $8 billion, to acquire Autonomy. But, if anybody outside of HP has precise knowledge of those questionable accounting practices, they're not letting on in their public disclosures (e.g. Form 8-K):

"Following the completion of its annual review of its goodwill and purchased intangible assets for impairment, on November 20, 2012, HP announced that it recorded a non-cash charge for the impairment of goodwill and intangible assets within its Software segment of approximately $8.8 billion in the fourth quarter of its 2012 fiscal year. The majority of this impairment charge relates to accounting improprieties and disclosure failures at Autonomy Corporation plc ("Autonomy") that occurred prior to HP's acquisition of Autonomy, misrepresentations made to HP in connection with its acquisition of Autonomy, and the impact of those improprieties, failures and misrepresentations on the expected future financial performance [emphasis supplied] of the Autonomy business over the long-term…. HP does not expect the impairment charge to result in any future cash expenditures."

Which may explain why the reports in the press are all over the place. Roughly ordered from least to most egregious, here are some possibilities gleaned from what I have read thus far:

  • Autonomy, as a UK company, allegedly exploited the mutability of International Financial Reporting Standards (earnestly referred to by its promoters as "principles") to recognize revenues earlier than would have been permitted by U.S. GAAP. This allegation is founded on the belief that Autonomy often bundled two products in its contracts with customers: software and data storage services. If Autonomy wanted to be as aggressive as possible in its revenue recognition, it would maximize the allocation of the total consideration to be received under the arrangement to the software element under a contract (which might have been recognized upon delivery) and too little to the storage services (which is recognized over time).
  • To add insult to injury, the revenue from the software sales in the forgoing scenario could have been recognized prematurely if they were in the form of licenses, which perhaps should have been accrued over time. Again, I'm not sure that IFRS provides much in the way of practical constraints. The applicable standard (IAS 18, para. 20), provides that licensing revenue would be recognized up-front when the agreement is for a fixed fee and the licensor has no further obligations. But, whether that fits the facts and circumstances of Autonomy's business is not known. Moreover, IFRS does not explicitly state that these are the only fact patterns that would support up-front recognition of license fees.
  • Expenses were allegedly shifted out of 'cost of sales' and into marketing to give the impression of investments in the brand, and to inflate current gross margins.
  • Software was sold or licensed (I don't know which) through third-party resellers. The most serious allegations could be that either the resellers or Autonomy itself fabricated these transactions.

As an aside, it's also very curious that none of the information HP has put out squares with the views of Autonomy's auditor before the acquisition, Deloitte. They firmly stand by their audit – if you want to call it that, for if judged by U.S. rules (SEC, S-OX, PCAOB) Deloitte was not in a position to be considered independent. The very nature of the non-audit services provided – for example, providing advice on executive compensation schemes – makes it so. Moreover, Deloitte's revenues from those non-audit services were pretty lucrative: it has been reported that for every dollar collected from audit services, Deloitte collected approximately $1.10 from providing non-audit services. If Autonomy's accounting practices were too aggressive, would Deloitte's staff have had the gumption to push back given the stakes?  I'm just asking.

As another aside, I wonder about the accuracy of the last sentence in the disclosure tidbit I provided above:  "HP does not expect the impairment charge to result in any future cash expenditures."  In a narrow sense, this is too obvious to have to mention:  that recording an impairment charge does not affect cash flows in and of itself.  But if HP is actually stating that there will be no future cash outflow effects resulting from the Autonomy affair, then that should raise a big red flag.  What about future legal costs in an attempt to recover damages from Autonomy's former managers and shareholders?  Or, if business is a lot worse than they thought, are restructuring costs imminent?

Getting back to HP's disclosures about the facts and circumstances surrounding the goodwill impairment charge, it may have complied thus far with the letter of the SEC's rules, but there are still far too many unknowns to conclude that HP has been adequately forthcoming. What I do know, however, is that SEC rules will eventually compel HP to tell the public in clear language what all the fuss has been about.

The rules I am referring to are set forth in Item 303 of Regulation S-K, Management's Discussion and Analysis of financial Condition and Results of Operations (MD&A). According to my calculations, HP's next MD&A should be filed no later than the last day of 2012 in its annual report on Form 10-K.

The clearest indication of what that MD&A is supposed to contain with regard to the Autonomy affair is from well-known and oft-repeated SEC's interpretive guidance from 1989. It reminds filers that the purpose of MD&A has always been, from the time it was first proposed, to give investors the opportunity to see the company "through the eyes of management." In this instance, such a statement can only mean that investors are entitled to the following specifics: what management knows as of the date of the filing; how they know it and when they came to know it; how it changes expectations of future profitability and liquidity (quantified to the extent possible), and most important, the actions that management is currently taking, and may likely take, to mitigate the negative developments.

Sarbanes-Oxley only requires that the SEC review (in unspecified detail) HP's disclosures every once in three years. But, following on the heels of an announcement of an $8 billion impairment charge to goodwill and a 12% shock to the share price of such a high profile company, the only accetable staff response to the events at HP would be to review HP's MD&A and related disclosures with a fine-toothed comb as soon as its collective New Year's Eve buzz wears off.

One could reasonably argue that the SEC's interpretive guidance on MD&A is too general to be enforceable; and even if it were, that it takes disclosure regulation a bit too far. But, it seems to me that this is the kind of situation that belies such propositions.  We, the public, are counting on the SEC staff — under its new chair Elisse Walter – to hold HP's feet to the fire.

I hope that Ms. Walter's is thinking that this could be her first big test — and is eager to face the challenge.

2 Comments

  1. Reply Scott December 3, 2012

    Tom:
    Looking forward to any further insights you have as this story unfolds.
    Scott

  2. Reply Drew December 5, 2012

    Excellent post Tom – thank you,

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