Sometimes a story dominates headlines for a while, with endless chatter by the press and observers that’s mostly repetition of the same facts or themes. Then the story fades away, and years later, you wonder: how did that story turn out?
The saga of Hewlett-Packard’s misadventure in acquiring Autonomy Corporation is one of those “what became of…” stories. In 2011, HP paid $11.1 billion for Autonomy – a 64% premium for a company with nearly $1 billion of 2010 revenues. Little more than a year later, HP recorded an $8.8 billion impairment charge, citing Autonomy’s accounting improprieties, misrepresentation and disclosure failures as the driver of the charge. The press buzzed loudly, and so did investors: how could HP have gotten it so wrong? What kind of due diligence did they do before they plunked down $11.1 billion in cash? And what did they uncover after they got control, leading them to the writedown?
That last question was answered clearly a couple weeks ago, when the SEC ordered the former CEO of Autonomy’s U.S. operations, Christopher Egan, to “cease and desist” from violating several sections of the Securities Act. Additionally, Egan must disgorge over $800,000 of option compensation resulting from the HP takeover, in which HP relied on the figures he had helped inflate. No civil penalty for Egan, due to his cooperation in the case. Interesting that the SEC went after Christopher Egan: he was the CEO, not the firm’s CFO. They usually target the persons in charge of financial reporting. In this case, Egan was a prime mover in the wrongful actions, not the recorder of the actions – so it’s fitting that he was charged.
The related Accounting and Auditing Enforcement Release (AAER) outlined the steps Egan took to grow Autonomy’s revenues without substance. Although there was a brief buzz about the outcome in the press, not much has been said about the mechanics of the revenue growth schemes. Because it’s rooted in accounting, and of course, who cares?
It’s instructive to look at the case, anyway. In case you missed it, there’s a new revenue standard on the way in 2018. Revenue, and the way it may change, will be a topic of conversation again. This case centered on current revenue recognition rules under IFRS, and the chicanery used by Autonomy is timeless – it could be employed whether old or new rules are in place, on either a GAAP or IFRS basis. So, a refresher course in revenue misdeeds can’t hurt, and that’s just what this case study provides - courtesy of the SEC.
If nothing else, it should goose your personal skept-o-meter. One fact really stands out in the AAER: in each of the 10 quarters preceding HP’s acquisition of Autonomy, the company reported revenues that were within four percent of analyst expectations. That’s a level of precision that should arouse suspicion. There were no blindingly obvious clues that everyone missed, but in hindsight, achieving revenue targets like so much clockwork looks awfully strange.
Autonomy reported revenues under IFRS 18. Let’s set the table right now: here are the five IFRS 18 conditions for revenue recognition.
(1) There must be a transfer to the buyer of the significant risks and rewards and ownership of the goods;
(2) The seller retains neither continuing managerial involvement to the degree normally associated with ownership nor effective control over the goods sold;
(3) The seller can measure reliably the amount of revenue;
(4) It must be probable that the economic benefits from the transaction flow to seller; and
(5) The seller can measure reliably the costs to be incurred in respect of the transaction.
As the various transgressions are reviewed, we’ll refer to the different criteria that were violated.
The reseller transactions. Autonomy’s UK-based senior managers directed a program that swelled revenues by almost $200 million over ten quarters ending in the second quarter of 2011. It involved more than 30 transactions with just five U.S. firms acting, ostensibly, as resellers of Autonomy software to end users.
Autonomy sold its software through “value-added” resellers, companies who provide additional services and support to the end users of the product in addition to selling Autonomy’s software. Value-added resellers are a legitimate business operation. The five resellers at issue in the revenue scheme, however, provided services to Autonomy that didn’t fit the definition of “legitimate.”
When Autonomy was negotiating a sale to an end user, but couldn’t close the sale by quarter’s end, Egan would approach the resellers on or near the last day of the quarter and assert that the sale was nearing completion. Even though the resellers had no relationship with the end users - not even a purchase order from them - Egan coaxed the resellers to buy Autonomy software by paying them commissions amounting to 10 percent of the reseller’s purchase order to Autonomy. The resellers could then sell the software to a specified end user. Actually, Autonomy maintained control of the deals and handled negotiations with the end user without assistance from the resellers - even after the sales to the resellers.
On three counts, there’s no way these transactions could be called “revenue” under IFRS 18:
- First, Autonomy still retained the risks and rewards and ownership of the goods – not the resellers, and certainly not the end users.
- Second, Autonomy was still exercising “continuing managerial involvement” to a degree that would not be associated with a transfer of ownership of the goods.
- Third, the economic benefits linked to the transaction didn’t flow through to the seller – not until they were sold to an end user. The only reason these transactions came into being was to pump up Autonomy’s revenues. Hitting market expectations for revenues doesn’t qualify as an economic benefit of a transaction.
Side note: apparently, Egan wasn’t the mastermind of these plans. According to the AAER, he was instructed to take these actions by the most senior of Autonomy’s financial managers – who, being in in London, are outside of the SECs reach. Egan, based in San Francisco, was not outside of that reach – and also was culpable.
These particular transactions “grew” Autonomy’s revenues by as much as 15 percent in some periods. They were critical for Autonomy to manufacture: they enabled the firm to report financial results within the boundaries of analyst expectations. Sometimes Autonomy was guilty of only accelerating revenue recognition because a real deal resulted; it closed such deals with end users after the makeshift sale to the reseller. Sometimes, no real revenue resulted when Autonomy could not close an end user deal – making the transaction a total sham.
The backdated transactions. Between 2009 and 2011, after a quarter’s close, Autonomy’s most senior finance executive directed Egan to procure backdated purchase orders from resellers four times, and once the executive obtained the dirty documentation personally. This happened at least five times in four different quarters, resulting in a pull of revenue from a subsequent quarter into the one just closed. Sometimes, the backdated transactions provided just enough revenues to enable Autonomy to reach its revenue target.
In anyone’s book, backdating purchase orders is a falsification of facts. Viewed through the lens of IFRS 18, these transactions couldn’t be called revenues, even charitably, because Autonomy didn’t transfer to the buyer the significant risk and rewards of ownership to the software, at quarter end, regardless of terms of the backdated purchase order. That transfer took place in the subsequent quarter. Further, any economic benefits associated with the transaction were not going to flow to Autonomy, regardless of the terms specified in a doctored purchase order. The substance of the transactions contradicted the form it took.
The round-trip transactions. Autonomy needed to get funds into the hands of the resellers so they could pay Autonomy for the sham sales, leaving a paper trail for the auditors demonstrating payments on the sales – a necessary optic, in order to avoid arousing auditor suspicions about the deals. The means for creating the illusion of payments to Autonomy: round-trip transactions with the resellers. Autonomy purchased unwanted, unused, or overpriced products from the resellers, resulting in almost simultaneous payment by the reseller back to Autonomy on debt owed to the software firm.
The round-trip transactions were improvised by Autonomy’s senior-most finance executive, and these “fixes,” as they were known inside the firm, amounted to at least $45 million of phony paybacks to Autonomy. Although they were not IFRS 18 violations in that they related to the creation of revenues for Autonomy, they were fabrications in support of other phony revenue. On the orders of the most senior financial executive, Egan was involved in some of the round-trip transactions: he served as the conduit between Autonomy and the resellers, and either knew, or should have known, that they didn’t represent genuine purchases by Autonomy. For instance, he knew Autonomy did not price the cost of such purchases with other vendors of the same products, nor did he negotiate agreement terms.
Autonomy’s machinations produced tantalizing results that persuaded Hewlett-Packard to plunk down $11.1 billion for a company possessing “a consistent track record of double-digit revenue growth, with 87 percent gross margins and 43 percent operating margins in calendar year 2010.” At least, that’s what HP thought when they announced the deal, as stated in their Form 8-K. And the rest, of course, is history: an $8.8 billion mistake, confessed a year later.
What to make of the facts addressed in the SEC’s enforcement release?
There’s more than one way to skin a cat. The AAER mentions frequently that the foreign-domiciled, most senior financial executive of Autonomy developed most of the illicit transactions; and being out the country, not directly subject to the SEC’s reach. Egan was more of a pawn than a mastermind, and carried out his boss’s plans - inside the United States, where at least one investor relied on the doctored financial statements. Egan was reachable by the SEC, and he provided them with assistance.
Would the sham transactions have been uncovered without HP buying Autonomy - and without Egan’s assistance? A big set of “what ifs?”, for certain. The guess here: no, it wouldn’t have been uncovered. The bogus transactions were designed to look real and throw anyone off the trail who might be suspicious. Backdated documents don’t look different from ones that aren’t backdated; the cash paid from the round-trip transactions was arranged to make dummy receivables look real. These are things that would satisfy auditors, if their suspicions were unaroused.
Should the Autonomy auditors have caught the fake transactions? Possibly. Had they investigated the reseller transactions to see if the initial sales to resellers resulted in sales to end users - not all of them did, remember - they might have been suspicious and probed further. Keep in mind that there were only 30 such transactions over a 10-quarter period. The auditors would have been awfully lucky to find a couple weird transactions that piqued their curiosity out of such a small population and such a long time frame. On the other hand, if weird transactions always showed in the last few days leading up to the quarter end, they should have noticed - and dug further. Remember that the company exhibited uncanny precision in meeting revenue estimates, and could not have achieved that level of precision without adjusting, right up to the last minute.
This occurred under IFRS rules. Could it have happened under GAAP? No doubt. The problem here isn’t with the standards: the problem is the intent of the players involved. Accounting standards can’t prevent the creation of false documents or backdated purchase orders. No set of rules, not even the forthcoming revenue recognition standard, can prevent malfeasance by parties expected to play by the rules.