HP's Accounts Bombshell: A Guide for the Perplexed

Agenda-Setting Financial Insight.
Nov. 26 2012 10:01 AM

HP's Accounts Bombshell: A Guide for the Perplexed

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HP still has to prove its claim that it was duped by fraud

Photo by Darren Carroll/Getty Images

Hewlett-Packard claims it was duped into hugely overpaying for Autonomy, prompting an $8.8 billion writedown. It blames at least $5 billion directly on dodgy book-keeping. Autonomy founder Mike Lynch says his company played by the rules. But complicated procedures for categorising sales and recognising revenue are critical to the strength of HP’s three central allegations. 

Sales mix

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Autonomy’s core product is search software called IDOL. HP claims Autonomy covertly lumped in loss-making hardware sales with deals for IDOL. The implication is that this inflated Autonomy’s valuation.

HP says there was no “appropriate” disclosure of the hardware sales. It’s not clear what that means. Autonomy did reveal in its annual reports that hardware was sometimes bundled in with software. This disclosure would probably have been lost on a casual reader: customers needing an IDOL solution in a hurry generated “appliance” revenue as part of a turnkey solution. But HP and its advisers arguably should have known this was an issue that needed clarifying. Moreover, the classification wouldn’t alter overall sales, profit or operating margins. 

Sales to resellers vs sales to real customers

Autonomy sold software to customers through so-called resellers. HP says Autonomy improperly booked revenue before resellers had found end-buyers. But under IFRS accounting standards, Autonomy was permitted to recognise revenue in such circumstances, if certain conditions were met. It is aggressive, but legal.

HP may not have realised its accounting policy here was legitimate, because U.S. GAAP accounting imposes stricter conditions. Without full access to the detail of the software contracts involved, it is hard to assess the force of the allegation. 

Long-term data-hosting revenue vs licence revenue

HP says Autonomy brought forward sales by converting long-term data-hosting deals into licence payments. But this would have been a very foolish move for Autonomy. Auditors allow companies to book upfront payments in full if they establish a predictable pricing framework, known as “Vendor Specific Objective Evidence” (VSOE).

It is hard for companies to abuse this by re-jigging the split of recurring and immediate payments in their favour: if pricing is inconsistent, VSOE no longer holds. Accountants can then push the company to recognise all revenue, including upfront payments, pro-rata over contract lifetimes. Again, without knowing the detailed terms of the contracts, it is hard to make an assessment.

HP says these allegations are only “examples”, so more may come out. As things stand, HP’s accusations are hard to judge. Both distortions in profitability and revenue growth would have affected valuation, but this would need to be extensive to create a $5 billion hole.

Many analysts had already accused Autonomy of aggressive accounting. HP still has to prove its claim that it was duped by fraud which could not be detected before acquisition. A complete refutation would mean yet more heads rolling at the gaffe-prone HP. But so too would an inconclusive result that showed Autonomy to be cavalier but no worse. 

Read more at Reuters Breakingviews.

Quentin Webb is a Reuters Breakingviews columnist, covering mergers and acquisitions, corporate finance and private equity.

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