Well, with grumpy Ed Ketz’s retirement from blogging, here is my first attempt to carry on his vision solo.  I really preferred being part of the dynamic duo that fought for financial reporting transparency.

Recently, the business press has flooded the markets with countless stories of H-P’s striking write-off of $8.8 billion in assets related to its 2011 acquisition of British software company Autonomy.  What’s gotten my attention, and that of many “bean counters,” is that over $5 billion of this “impairment charge” was attributed to questionable accounting practices (i.e., irregularities) that were not detected by three of the major international auditing  firms, as well as a number of “respected” investment advisors.  But what really makes my blood boil is the market’s cavalier attitude toward this “big bath” loss, which may well be one of the most cleverly executed earnings management strategies in recent financial history

A review of H-P’s 2011 10-K (notes 6 and 7) reveals that the Company recorded a total of $11.2 billion of intangible assets ($6.6 billion of goodwill and $4.6 billion of developed and core technology and patents).  The sizeable goodwill amount indicates that H-P paid more than “market value” for the $4.6 billion in technology assets that it acquired from Autonomy, as goodwill is nothing more than an excess purchase premium.  Given that goodwill represents almost 59 percent of the purchase price, it seems reasonable to assume that H-P spent some time tying down the numbers needed to come up with a purchase price.  In fact, according to Jim Petersen at Re:Balance, H-P’s acquisition team included some 300 financial and legal experts from KPMG, Perella Weinberg, Barclays, and a number of law firms. So, one might reasonably conclude that H-P knew what is what it was paying for, right? 

But on November 20, 2012, the Company wrote off $8.8 billion (almost 79 percent) of the intangible assets that it had acquired from Autonomy on October 3, 2011!  So, what happened?  Well, if you believe Meg Whitman, Autonomy made misrepresentations that created “financial illusions” upon which H-P relied in pricing the deal.  But should we be surprised that a seller would paint the best possible picture of the asset being sold?  Isn’t that what seller’s do…isn’t that what we call “puffing?”

 

And isn’t that why your merger team does due diligence?  So, what does Meg do?  She blames Deloitte, Autonomy’s auditor, and KPMG, an H-P due diligence team member, for not detecting the Autonomy accounting irregularities that allegedly caused over half of the recent write-off.  According to Peter Svensson of the AP, Meg stated:

"What I will say is that the board relied on audited financials. Audited by Deloitte—not 'Brand X' accounting firm, but Deloitte. During our very extensive due diligence process, we hired KPMG to audit Deloitte. And neither of them saw what we now see after someone came forward to point us in the right direction."

Yes, she threw her accountants under the bus!  And since she’s playing the blame game, why not include her own H-P auditors, Ernst & Young, who probably should have spotted the accounting irregularities at Autonomy, if they were material?

 

Now those of you that have followed the Grumpy Old Accountants in the past know that we are not Big Four softies.  In fact, the grumpies have been downright tough on the major accounting firms during 2012 by writing blogs with titles like Arrogance or Ignorance: Why the Big Four Don’t Do Better Audits and The Auditors Expectations Gap…Not Again! But in this case, I am inclined to give the big accounting firms a pass.  Why you ask?

Well, first of all, the three  Autonomy “accounting irregularities” to which Meg takes exception are NOT exactly unexpected or unknown financial reporting issues in the technology space.  Andrew Peaple of the Wall Street Journal does an excellent job summarizing these as:

  • Accelerated revenue recognition in software and service sales.  This is the classic multiple deliverables accounting issue.  See The Beauty of Internet Company Accounting.
  • Recording discounts (losses) on hardware sales as marketing expenses rather than cost of sales. Autonomy bought hardware and sold it at discounts to customers as part of software transactions.  By recording the discounts as marketing expenses rather than as a cost of sales, Autonomy inflated gross profit. Net income (loss) was NOT affected by this practice.
  • Accelerated revenue recognition by recording revenue from sales via agents when those agents had not yet agreed to an onward sale.  This particular issue is complicated by the vagaries of IFRS and its flexibility vis-a-vis US GAAP.

 

To blame the accountants in this case is simply ludicrous because these are precisely the type of reporting issues that experienced big accounting firms routinely look for in technology audits.  To imagine that Deloitte missed these red flags at Autonomy is believable given the firms recently troubles.  However, to believe that both KPMG and Ernst & Young AND Deloitte also failed to uncover the alleged “accounting irregularities” is preposterous. And don’t lend any credence to PwC’s forensic findings as they’re just doing what any consultant does…give the client what it wants. In this case, if you want us to find accounting problems, we will.  However, if you must find fault with an accountant, try the accounting standard-setters who crafted the ambiguous and judgmental revenue recognition rules in question…but not the auditors.

Then what’s really going on?  Some suggest that H-P is simply taking a page out of “Chainsaw” Al Dunlap’s earnings management playbook and cleansing its balance sheet via the “big bath.”  But if that’s the case, then H-P must be the cleanest company around, because it is a serial “big bather.”  Just look at the following charge summary prepared using data from H-P’s 2011 10-K (page 36):

 

Restructuring Table.png

And the “bathing” continued well into 2012 (even before the Autonomy write off) with the Company’s $10.8 billion August cleansing related primarily to its 2008 EDS acquisition.  Rolfe Winkler points out that H-P has booked total restructuring charges of $26.1 billion since fiscal year 2006.  So, H-P has a history of restructuring…that itself should tell you something!

What does this grumpy old accountant think is happening?  I tend to side with Bloomberg’s Jesse Druker who suggests that H-P’s accounting claims are masking the true story: management’s bad acquisitions.  Here’s why.  H-P’s stock price has steadily declined from a high of around $55 a share in May of 2010 to a low of $11.35 in November of this year according to BigCharts.com.  And YCharts reveals an even more telling plunge in the Company’s price to book ratio from about 2.65 to 1.17 during the same period.  These decreases likely played a major role in H-P’s impairment testing of goodwill and identifiable intangibles during 2012.  Simply put, the market is telling the Company that its reported asset values are questionable.  H-P HAD to write off the goodwill and identifiable intangibles to comply with GAAP when confronted with such market based evidence of value declines!

For H-P to blame “accounting irregularities” for this most recent charge is offensive and insulting.  Moreover, this behavior violates the basic tenets of financial reporting transparency.  And it also raises serious ethical questions given that the Company may have created a fictitious “witch hunt” (to divert attention from its bad decision-making) which now involves regulators in two countries, costing taxpayers untold sums.

Meg, face it…your Company can’t value acquisitions, nor can it seem to extract value from them.  You desperately need both a new merger and acquisition strategy, and a team to execute it.  Whatever you have been doing is NOT working.  Get a spine!  Own up to your Company’s bad investment decisions, and leave the bean counters out of it.

One last thing…I would like to call upon the SEC to begin an investigation of H-P’s accounting practices given all of the recent restructuring charges.  These write-offs suggest the need for possible report restatements related to prior acquisition accounting practices, and certainly raise questions about the Company’s internal controls over financial reporting (heads up E&Y…).

 


This essay reflects the opinion solely of the author.


Posted
AuthorAnthony Catanach