Peeling away financial reporting issues one layer at a time

HP’s Autonomy Debacle: Mistakes were Made — and Capitalized?

Companies overpay to acquire other companies all the time; but Hewlett Packard Co. just might be the new record holder for getting fleeced. I don't have the exact amount, but let's say that the goodwill HP initially recorded from the E.D.S. and the Autonomy acquisitions combined was on the order of $20 billion. Given the subsequent goodwill impairment charges for most of it, and the revelations that surrounded those charges, it should come as no surprise that investors have expressed dissatisfaction with everyone – management and the board, their outside financial advisors and auditors – associated with the decision making and the accounting for these ill-fated investments.

One very compelling expression of dissatisfaction came recently in a letter from the CtW Investment Group to Rajiv Gupta, HP's lead director and chair of its corporate governance committee. CtW works with pension funds, which in the aggregate are substantial HP shareholders. Supported by a detailed nine-page analysis, CtW has called for nothing less than "…a comprehensive overhaul of the board's oversight of the audit process and the replacement of long-time outside auditor, Ernst & Young."

Highlights of the claims made by CtW against EY are as follows:

  • Large amounts of non-audit fees paid to EY in recent years, although not technically prohibited, challenge the presumption of its independence from HP.
  • However, HP was a lobbying client of Washington Counsel, which was owned by EY: "We further note that it has been reported that the SEC is investigating Ernst & Young for allowing its … subsidiary to lobby for audit clients."
  • The timing of the $8 billion goodwill impairment charge in 2012 relating to the 2008 acquisition of E.D.S. "reveals a significant performance failure on Ernst & Young's part." CtW's analysis of reported results indicate that significant goodwill impairment(s) should have been recognized in earlier years; and the delay in recognition resulted in misleading reported earnings for those years.

One of the motivations of this post was simply to bring to your attention this letter, which if substantiated, has important implications for EY and for financial reporting in general. But, a second motivation is to further discuss the accounting for goodwill, using the Autonomy debacle as a case study. This is the way that CtW teed up the issue I want to explore:

"Ernst & Young, as HP's independent auditor, had a duty to review HP goodwill accounting in its 2011 Form 10-K and for its 2012 financial statements. Ernst & Young did not discover any improper accounting practices [at Autonomy], nor does it appear to have objected to the amount of goodwill HP recorded in association with the Autonomy acquisition." [emphasis added]

Auditing Initial Goodwill is Not Necessarily about Goodwill

I'm sure that most readers already understand that goodwill is nothing more than the difference between the purchase price of the acquisition* and the opening measurements of all the identified assets acquired and liabilities assumed. Setting aside what goodwill on the balance actually means or doesn't mean, the CtW letter does not explicitly acknowledge that an auditor's responsibility for the initial amount of "goodwill" recognized actually begins with examining the non-goodwill amounts. In practice, goodwill itself would rarely be an object of scrutiny by the auditors; but more on that later.

The CtW letter does indicate a concern that EY missed something very important in its examination of Autonomy assets acquired and liabilities assumed. In this regard, it notes that a PwC forensic investigation of Autonomy's accounting uncovered "…a variety of inappropriate and arguably fraudulent accounting practices, including improper timing of revenue recognition…" But, while the PwC investigation doesn't bode well for EY it is not, as CtW seems to imply, because EY may have allowed initial goodwill to be overstated.

To illustrate this point, let's just focus on one particular asset acquired: customer accounts receivable. It has been alleged that Autonomy improperly recognized revenue from agreements to resellers of software licenses, even before a single license had been sold to an end user. Presumably, the improper revenue recognition would have caused customer receivables to be overstated.

But, if EY did not compel HP to back out any premature recognition of receivables, then the arithmetic business combination would not have been reflected in a misstatement of total assets. Even though customer receivables would have been overstated, it would have been offset by understated goodwill. That's why I wish CtW had framed its concerns in terms of the reported amounts for the non-goodwill assets acquired and liabilities assumed, instead of goodwill itself.

But, it is also possible that EY discovered a misstatement in, say again, customer receivables; and it compelled HP to reduce the receivables accordingly. If this had been the case, then EY looks better in one respect and worse in another; because, if EY had permitted HP to offset the downward adjustment in customer receivables with an increase in goodwill, then the issue that CtW raises is manifest: goodwill was artificially inflated, and EY might have noted that fact.

My sense is that if EY missed something it is more likely that they failed to note an overstatement of customer receivables. But, the reason I wanted to discuss this alternative scenario is because the accounting for 'mistakes' in a business combination is frequently problematic.

'Mistake' Capitalization Happens All the Time

I suppose that one could justify initial capitalization in goodwill of some mistakes – like overvaluing future prospects – because they are impossible to detect at the time a transaction takes place. For example, shortly after an acquisition is consummated in good faith by both parties, and before the first financial statements are issued, an acquiror might learn that its forecast of future profitability was too optimistic. But, if customer receivables are found to actually not exist at some point before the financial statements are issued, how should that be handled?

The FASB Accounting Standards Codification is silent on this point, but it turns out that the SEC took a position on a similar matter a number of years ago. I stumbled upon that position in a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one impressed me the most:

"In the process of recording … [a business combination transaction, the acquiror] … discovered, by golly, that in a $300,000,000 acquisition, $100,000,000 of assets they thought they had didn't exist. And so the company tromped in with their auditors and said, the rules say the difference between what we got and what we paid is goodwill. I simply wasn't able to accept the fact that there should be $100,000,000 goodwill on their books, which didn't exist, and we told them to write it off." [emphasis added]

The amount of shareholder value destruction from the E.D.S. and Autonomy debacles were extreme, but the fact of the matter is that mistakes in major acquisitions happen with great frequency, if not most of the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down (i.e., shareholder value is destroyed) after plans to acquire another company are announced. During my part-time career as litigation consultant, I have been involved in at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or were worth much less than the amounts recorded on the balance sheet of the acquire.

In all of those cases how did a mistake get accounted for? Capitalized as goodwill, of course!

In a nutshell, Sampson stated the obvious: despite what the accounting rules say – or don't say – an asset that doesn't exist can't be goodwill. But, just so everyone should get the message, two things ought to happen:

First, no matter at what point subsequent to the acquisition date that the errors in Autonomy's financial statements were discovered, HP should not have capitalized them in goodwill; therefore, the SEC should require HP to correct its accounting error by restating all periods affect – and perhaps also by amending previously filed financial statements in which the erroneous amount of goodwill was reported.

Second, the FASB ought to use this case to echo that sentiment. It should amend U.S. GAAP to make it clear that when a company thought it bought it asset, but didn't, the asset that never existed is not goodwill.

I am not a supporter of recognizing goodwill as an asset under any circumstance, but if it is to be, then it should be clear that when it is discovered that an asset is overstated or does not exist, that's clearly not goodwill.

Perhaps, then, companies like HP will be more careful about: what they acquire; what they pay; and what the contracts state about what they are entitled to if assets that are purported to exist in fact do not.

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*To you accounting sticklers, I know that my description is technically accurate only if an acquiror purchases 100% of the outstanding shares of the acquiree. For the purposes of this post, that's close enough.

2 Comments

  1. Reply Vasiliy May 19, 2013

    Tom, isn’t there a period during which purchase accounting is “preliminary” until all fair values are determined to be final? Is that period up to a year? It would seem to me that a year should be a sufficient period of time to realize that some receivables didn’t exist (e.g., subsequent cash receipts testing).

    Of course, this may not necessarily address the question you are raising which is goodwill for something that doesn’t exist, but at least during the “measurement” period, management can figure out that they may have overpaid (and hopefully management included some language in the purchase agreement to the fact that within a period of time any changes to fair values will be adjusted through the escrow account).

    • Reply Tom Selling May 24, 2013

      Vasily,
      The period you are referring to is not, in my view, available for matters such as existence — only for valuation.

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