5 Tesco, HBOS and Autonomy

5 Tesco, HBOS and

Autonomy

The three cases we discuss in this chapter have a current impact or are currently ongoing. The Tesco case is under a re-trial by the SFO. Now the case has been ruled and the SFO lost its case. No Tesco director was found guilty. The judge raised doubts about the SFO investigation so much so that the SFO withdraw other cases inclining one dealing with RollsRoyce. HBOS, despite its global crisis origins, is still a case that is cited in evidence of FRC bias. Autonomy is still in the US and UK courts.

The Tesco scandal

The facts of the Tesco case

In September 2014, the Tesco management announced that it had discovered that profits for the previous two years had been overstated by approximately £250 million,1 later revised to £326 million. This announcement caused an immediate fall in the market value of Tesco’s shares and bonds – the fall in value was £2.1 billion at one point. The FRC, the SFO and the FCA started investigations and Tesco itself appointed Deloitte to examine the matter. PwC were the auditors at the time and had been in post since 1983. Over the next three years, more information became available, notably on the following matters:

• The amount of the overstatement is now estimated to be £284 million, being £76 million for the six months from March to August 2014, £53 million for the year to 22 February 2014, and £155 million for previous years.2 Finally the profit overstatement, identified three weeks after Dave Lewis took over as CEO from the outgoing Philip

Clarke, was later raised to £263 million. Hence Tesco’s assets had been overstated for at least two years. • In September 2016, the SFO charged three former Tesco executives with the criminal offences of fraud and false accounting. Their trial

52 Tesco, HBOS and Autonomy was stopped after five months due to one of the defendants having a heart attack. The re-trial was dismissed and SFO came under serious criticism. • In March 2017 (over two years after the discovery of the overstatement), the SFO announced that it had fined Tesco £129 million and had entered into a deferred prosecution agreement (DPA) covering the criminal liability relating to Tesco’s false accounting. Under the terms of the DPA, the SFO has undertaken to take no further action relating to the false accounting charge, provided that Tesco fulfils certain conditions as to its future behaviour. • Also in March 2017, the FCA announced that it had reached an agreement with Tesco that the firm would pay compensation to investors who had purchased Tesco’s securities between 29 August 2017 (when the erroneous interim accounts were published) and 22 September 2017 (when the correction was published). The total amount payable under the arrangement was to be £85 million. The FCA announced that, taking into account the SFO’s fine, it would impose no additional sanctions on Tesco. It should be noted that the compensation offered to Tesco’s investors was extremely limited. Tesco had been issuing misleading accounts for many years – at least since 2012.

Investors who bought Tesco’s securities on the basis of these misleading accounts (specifically the accounts for the years ending in February 2013 and in February 2014) undoubtedly suffered severe losses when the market value of their holdings fell following the September 2014 announcement. The FCA has acted to protect investors who were misled by the 2014 interim accounts, but has completely failed those investors who bought their securities prior to 29 August 2014. • To cover the £129 million fine and the £85 million shareholder compensation, the group booked an exceptional charge of £235 million in the 2017 financial year.

Analysis of the Tesco case

Why did Tesco present false accounts and what techniques did it use? The answers to these questions lie in the trading conditions that the firm faced in the previous decade. From the onset of the GFC onwards, the established UK grocery retailers (e.g. Tesco, Sainsbury, Asda and Morrisons) came under increasing pressure from the discount German chains Lidl and Aldi – both of which concentrated primarily on low prices. At that time, Tesco’s corporate culture was characterized by continued growth and maintenance of profits at all costs. Tesco decided not to compete on price but instead to try to grow its sales through promotions, thereby keeping up its profits through the associated commercial income.

Tesco, HBOS and Autonomy 53

In fact, the Tesco Group announced one of the biggest losses in corporate history in 2015, declaring a net loss under IFRS of £5.8 billion and a non-UK GAAP underlying profit before tax of £6.4 billion – which were mostly restructuring costs.

The term ‘commercial income’ refers to discounts and rebates that suppliers agree to pay based on sales achieved, and to their contributions to the costs of promotions. Suppliers will pay Tesco for featured space, block stacking, preferential placing within aisles, shelf height, foyer space and all types of in-store brand advertising. These payments from suppliers to supermarkets like Tesco can represent significant amounts of income especially during promotional periods, and it is this feature of commercial income among others which was manipulated.

The amount of commercial income recognized in an accounting period involves considerable judgement on the accountant’s part – for example in estimating the probable level of future rebates and in allocating promotion costs to the appropriate period. It is generally recognized that exercising judgement in this way can provide an opportunity for an unscrupulous accountant to manipulate profits, which is what happened with Tesco. Faced with the need to report consistently high profits when, in fact, its profits were being hit by the competition from the discount stores, Tesco resorted to overstating its commercial income by accelerating the recognition of income and delaying the recognition of costs. Too much of the revenue from deals done with suppliers involving payments back to Tesco over a multi-year period were deliberately front-loaded rather than spread over the life of the deal.

Such a fraud (as the SFO has labelled this) is certain to unravel in the longer run, as each year the assets representing claims on suppliers for future rebates, and the deferred costs of promotion, grow larger and ever more unrealistic. The denouement came in September 2014 with the appointment of a new chief executive.

Who was responsible?

It is obvious that Tesco’s corporate governance system was seriously at fault in permitting the company to issue financial statements that significantly misrepresented its profits and assets over a period of at least three years. But which elements of the system were principally to blame: Tesco’s auditors, its audit committee or its board of directors?

For the background, let’s review the historical performance shown in Table 5.1. The decline in profitability can be seen from the more profitable years of 2011 and 2012 – performance commonplace previously.

During 2015 and 2016 there were exceptional items and restructuring including the elimination of some business which represented some of the

Table 5.1 Tesco Group consolidated results (£ billion) for year ending February

2011 2012 2013 2013 2014 2015 2015 2016

Revenue £ billion Net profit £ billion Restated Restated* 67.6 63.9 64.8 63.4 63.6 62.2 56.9 54.4

2.7 2.8 0.1 0.0 0.1 −5.8 −6.3. −0.2‘

* In effect, though not labelled a restatement. Note 2011 is the financial year 2010/11 to near the end of February, 2012 is 2011/12 and so so.

reduction in revenue. Nevertheless £250 million (the initial amount of overstatement) is only 0.00038% of £65 billion revenue. That might seem insignificant. However, examining the profits in 2013 and 2014 – £250 million overstatement is significant in relation to the reported profits in those years - £24 million (2013) and £970 million (2014). Accounting measurements that impact on the revenue or the profit figure may cause quite marked variation in that (small compared with previous years) profit figure. In this context £250 million overstatement does seem a significant sum.

The role of the external auditor

Tesco’s auditor at the time was PwC. In 2013, it reported that Tesco’s accounts for the 12 months ending 23 February 2013 gave a true and fair view of its financial position and performance without any mention of problems with commercial income. Yet, at that time, Tesco’s commercial income assets were already overstated by £155 million. By the time PwC came to audit the next year’s accounts, it had clearly become aware of the risk of manipulation. Its audit report for the year ending 22 February 2014 includes a section on commercial income, which noted that the amount “recognised in the year is material to the income statement and the amounts accrued at the year end are judgemental”. It explained that PwC had “focussed on this area because of the judgement required in accounting for commercial income deals and the risk of manipulation of these balances”.

PwC reported that it had discussed the matter with Tesco’s audit committee and referred the reader to that committee’s report, which formed part of the annual report. Notwithstanding that PwC clearly had concerns about the reporting of commercial income, it nevertheless reported that the accounts presented a true and fair view of Tesco’s financial position and performance. In addition, in the following year (the 2014/15 accounts), PwC gave an unqualified audit report, but this was after Tesco’s management (not PwC) had discovered the fraud and made the appropriate corrections to the accounts.

Tesco, HBOS and Autonomy 55

It seems obvious that PwC’s audits of the 2012/13 and 2013/14 accounts were seriously deficient. But what mistakes did PwC make? The authors have no inside knowledge of PwC’s audit procedures but a close reading of the relevant audit reports offer two clues as to the nature of PwC’s errors:

• Materiality: For the audit of the 2013/14 accounts, PwC adopted a materiality threshold of £150 million. This implies that it was prepared to give an unqualified opinion on accounts that over-reported profits by as much as £149 million. It was subsequently established that the accounts overstated Tesco’s profits by £155 million – just over the materiality threshold. To the non-expert, a materiality threshold of £150 million seems enormous. John and Krish suspect that PwC was prepared to give an unqualified opinion on a balance sheet which, in its estimate, overstated commercial income by an amount that was substantial, but which PwC judged (erroneously) to be less than the materiality threshold. It is surely significant that, for the 2014/15 audit, PwC adopted the far lower materiality threshold of £50 million. This would seem to be an implicit admission that the materiality threshold for the 2013/14 audit was too high, and a lower threshold would have led to PwC taking more consequential action in respect of that audit. • The wrong client: Who is the auditor’s client? For whose benefit does the auditor undertake the audit of a business? Whose interest should the auditor seek to promote in performing an audit? To whom should the auditor report? One can conceive of many different answers to these questions: (i) the management of the business (ii) the shareholders (iii) the stakeholders (not only the shareholders, but also the employees, suppliers, customers and others with a significant stake in the business) (iv) society in general.

In Britain, the legal position is clear. In the Caparo3 case, the court decided that the audit of a company is undertaken for the benefit of the existing shareholders and no other group (not even potential shareholders) have any rights arising from the audit. Hence, in law, the auditor’s client is the body of shareholders. In reality, many auditors consider that the management is their client. In virtually all

UK companies, the auditor is appointed by the management. When choosing an auditor, the ability of the audit team to have a comfortable relationship and to be able to communicate effectively and, in

56 Tesco, HBOS and Autonomy some senses, to be socially comfortable, is found to be important in winning the tendering process. Furthermore, as it is the management (and the audit committee) who pays the auditor, there is a profit motive to continue earning the auditor’s fees (for more discussion on this, see Volume 1 of the series, Disruption in the Audit Market).

Although the auditor is formally appointed by a resolution of the shareholders in the general meeting, in reality, the shareholders almost invariably follow the management’s recommendation. The same applies to the auditor’s remuneration. Since the auditor’s continued appointment and income depends on keeping the management happy, it is inevitable that auditor should regard the management as the client. There is a reason for believing that this was the case with PwC and Tesco. In respect of the 2013/14 audit, PwC gave the impression that it considered that it had completely fulfilled its responsibilities in respect of a contentious matter by reporting to Tesco’s audit committee. No doubt PwC would deny this charge; the firm is, of course, well aware of the formal legal position. But it seems to the authors that PwC was seriously at fault in failing to press in a determined and consequential manner its concerns over the reporting of commercial income on Tesco’s management, possibly because it treated the management, and not the shareholders, as its client.

Tesco’s audit committee

At the time of the fraud, Tesco’s audit committee consisted of four men, two of whom claimed to have recent and relevant financial experience. The audit committee’s functions include reviewing the financial statements (including interim statements) prior to publication. It reviewed the 2012/13 and 2013/14 financial statements, both of which contained material errors, as well as the August 2014 interim statements. The conclusion is that the committee failed miserably in this aspect of its responsibilities. PwC, in its report on its audit of the 2013/14 accounts, identified commercial income as one of a number of ‘areas of focus’ and stated “we discussed these areas of focus with the Audit Committee. Their report on those matters that they considered to be significant issues in relation to the financial statements is set out on page 33” of the annual report. The audit committee report in fact dismisses PwC’s concerns about commercial income in a few lines, as follows:

The Committee notes that commercial income was an area of focus for the external auditors based on their assessment of gross risks. It is the Committee’s view that whilst commercial income is a significant

Tesco, HBOS and Autonomy 57 income for the Group and involves an element of judgement, management operates an appropriate control environment which minimises risks in this area. As a result, the Committee does not consider that this is a significant issue for disclosure in its report.4

In effect, the Audit Committee sided with Tesco’s management on this matter. This raises serious doubts about the effectiveness of a committee whose members are effectively appointed by the management to control the actions of that management. While it is true that all the committee’s members are independent directors, this does not nullify the fact that these directors’ continued employment and remuneration are effectively determined by senior management.

Tesco’s board of directors

In respect of all the relevant financial statements, Tesco’s board of directors confirmed that, to the best of their knowledge, the accounts gave a true and fair view, as they are required under the terms of the Companies Act 2006. This extra check seems to have done little to prevent the issue of fraudulent accounts in 2013 and 2014. Even though no one has been successfully prosecuted.

This is unsurprising. We believe that those directors whose areas of expertise did not cover accounting and finance would consider that they could rely on the judgement of financial experts (i.e. the CFO and the Audit Committee). It is noteworthy that the FCA has stated that it “does not suggest that the Tesco plc board knew, or reasonably be expected to have known, that the information in the August statement [the interim accounts issued in August 2014] was false or misleading”. But surely it’s reasonable to expect that the director with responsibility for the preparation of the accounts (the CFO) would be aware of the overstatement. It’s perhaps unsurprising that the discovery of the ‘fraud’ in September 2014 was largely the result of the appointment of a new chief executive.

Tesco: lessons for the future of financial reporting

It is evident that the three elements of Tesco’s corporate governance structure (the external auditor, the Audit Committee and the board of directors) failed to prevent the company from issuing financial statements that were seriously misleading. (John thinks they failed miserably.)

How can financial reporting be reformed so that the manipulation of accounts that occurred in the Tesco case is prevented, or at least, made much more difficult to perpetrate? We would suggest that changes are

58 Tesco, HBOS and Autonomy necessary in three areas: a) the company’s internal control system, b) external audit and c) enforcement.

The company’s internal control system

We feel that it is clear in the Tesco case that the two principal components of the company’s internal control system (the Audit Committee and the board of directors) failed completely.

The Audit Committee: We suspect that a major reason for the Committee’s failure to detect the fraud was that it did not challenge the management’s explanations with sufficient vigour and determination. There are two (fundamentally different) possible reasons for such behaviour. The first is that the members of the committee considered themselves to be part of the management system (that is, they were reluctant to be a source of difficulty for their colleagues). The second is that they did not have sufficient knowledge of Tesco’s internal control system to be able to discern the weaknesses in the explanations given to them. It would appear that there is a ‘catch 22’ situation for members of the Audit Committee: either they become experts in the company’s control system and risk being ‘captured’ by the other elements of that system, or they seek to remain fully independent of the company’s system and thereby risk failing to fully understand how it functions. There is no easy answer to this problem. We offer some suggestions later in the section on ‘Enforcement’.

The board of directors: We have already suggested that it is unreasonable to expect that those directors who have no specialized knowledge of accounting should be held liable for errors in the financial statements. But this consideration does not apply to the CFO.

Tesco: external audit

John believes that there is a major reason why PwC gave an unqualified opinion on accounts that contained a material error: it was too close to Tesco’s management and, for this reason, failed to challenge decisively Tesco’s treatment of commercial income. PwC may claim that they did everything in their power to challenge the management and the Audit Committee, but they could not persuade them to acknowledge the risk. This suggests that communications between the auditors and the audit committee should be published as part of the audit opinion or auditors report.

This is a vivid example of a problem encountered by auditors very frequently. In essence, the auditor of a firm’s financial statements serves two masters whose interests are in no way identical: the shareholders who

Tesco, HBOS and Autonomy 59 need assurance on the financial statements’ accuracy; and the firm’s management who (in practice) appoints and pays the auditor. George Staubus summarized the auditor’s dilemma as follows:

In simple terms the management uses owners’ money to hire auditors to provide a stamp of approval on management’s reports on its own performance to owners. The auditor . . . makes his living by pleasing management but his societal justification requires serving investors and creditors.5

In John’s opinion, it is absolutely essential that the strong influence that the management exercises over the auditor’s appointment and remuneration must be reduced. In his latest book, he makes some suggestions as to how this may be achieved.6 The group of people who decide on the auditor’s appointment and remuneration should be significantly expanded to include major stakeholders (such as employees and suppliers) and (more controversially) representatives of society in general.

Enforcement

A notable feature of the Tesco case is the failure of the regulatory authorities to take effective action to punish the entities and individuals whose failings made the fraud possible. Although criminal charges have been levied against the individuals (not successfully) who, according to the SFO, actually perpetrated the fraud, the actions taken against those whose responsibilities included the prevention and detection of the fraud have been very weak, specifically a fine of £129 million and an order to pay compensation of £85 million, both made in respect of Tesco plc and not of any named individual. We note that the FRC stated there was “not a realistic prospect that a tribunal would find PwC guilty of misconduct at Tesco”, which is their standard language.7

HBOS

One of the most significant failures of the global financial crisis was the collapse of HBOS and its rescue by Lloyds Bank in 2009, which in turn had to be rescued by the UK Government. (Note that this case should not be confused with the associated £1 billion fraud when Lloyds/HBOS forced clients to use the services of a so-called turnaround company which then levied huge fees, causing many of them to go bankrupt.)8

The complaint was that the auditors, KPMG, did not warn stakeholders that HBOS was in danger of collapsing but rather said that it was a

60 Tesco, HBOS and Autonomy going concern for the next 12 months. This was another case where the FRC failed to take any action and for our purposes, the significance of this case is increased as the FRC is fighting to avoid releasing its file on its investigations into KPMG. Following a 15-month investigation, the FRC originally concluded that:

• KPMG could not have anticipated the extreme market conditions that led to the bank’s downfall; • KPMG’s audit of HBOS’s 2007 results “did not fall significantly short of the standards reasonably to be expected”; • KPMG’s assessment of the bank’s health in 2008 “was not unreasonable at the time”.

This case is important because it raises the crucial question of whether the FRC is too close to the Big Four. Four former partners at KPMG were serving on the FRC’s conduct committee when it decided not to investigate their former firm’s role in the bank’s collapse.9

The FRC has admitted that in some cases it was operating under a set of rules that were more lenient. The ARD did not come into effect until 2016 and those rules have been tightened since then. That said, the FRC has come under criticism for being too lenient in this case and others.10 Alistair Osborne said in the Times on 30 January 2017:

Last time it was KPMG’s prowess at HBOS in 2007. The FRC verdict? Exemplary stuff. True, months after being signed off as a “going concern”, the bank inconveniently went bust: £5.5 billion profits transmogrified into £11 billion losses a year later, with HBOS requiring a £20 billion bailout. Yet, as [Stephen] Haddrill reasoned, how could KPMG have been expected to spot anything wrong. Its judgments were not “unreasonable at the time” and, besides, most analysts reckoned HBOS shares were “buy” or “hold”.11

Richard Books’s book (mentioned earlier) comes to this conclusion over HBOS:

The chairman of HBOS, arguably Britain’s most dubious lender of the boom years, explained to a subsequent parliamentary enquiry: “I met alone with the auditors – the two main partners – at least once a year, and, in our meeting, they could air anything that they found difficult. Although we had interesting discussions – they were very helpful about the business – there were never any issues raised.”

Tesco, HBOS and Autonomy 61

This insouciance typified the state auditing had reached. Subsequent investigations showed that rank-and-file auditors at KPMG had indeed questioned how much the bank was setting aside for losses. But such unhelpful matters were not something for the senior partners to bother about when their firm was pocketing handsome consulting income – £45m on top of its £56m audit fees over about seven years – and the junior bean counters’ concerns were not followed up by their superiors.12

Krish notes that the FRC has toughened its stance and seems to promise greater fines in future cases. However, these cases involving established household brand names do not inspire public confidence. The damage may have been done: in the post-Carillion environment, the FRC’s authority has been undermined further, and there are calls for a major overhaul of the statutory audit market and the regulatory regime. Though since the Carillion failure and much criticism of the FRC there has been much more activity at the FRC. The review of the FRC seems to have spurred the FRC into even greater activity and also higher fines.

The downfall of HBOS, once one of the UK’s largest lenders, is an issue that concerns both professional investors and politicians. After acquisition by Lloyds Banking Group, the UK Government provided £25 billion of emergency funding, leaving taxpayers with a 42% stake in the combined bank – now successfully sold off.

Nicky Morgan, chair of the Commons Treasury committee, said the committee wanted a full explanation of why the FRC exonerated the KPMG, particularly given that they initially declined to investigate them and only opened a probe under parliamentary pressure. She pointed out that a committee that investigated the causes of the financial crisis said that HBOS’s corporate governance was “a model of self-delusion” and that UK regulators had said its failure “lies not with external market ...but with the failure of its board to instil an appropriate culture, and to provide the necessary challenge to the executive”.13

Autonomy

This is a case that goes back to 2011, when HP (originally Hewlett Packard, now split into two: the giant computer hardware and now the software company) agreed to buy Autonomy. Founded by Mike Lynch, Autonomy was then categorized as the UK’s most successful software company with links to Cambridge University. The deal was then worth more than £7 billion. Autonomy had grown via a string of acquisitions over the previous decade.

62 Tesco, HBOS and Autonomy

The following quotation from Autonomy’s annual report of 2010 is helpful in explaining what Autonomy did:

Autonomy’s vision is to enable computers to be able to process human friendly, unstructured information such as emails, voice messages and videos, based on its meaning. So the computer can watch emails being sent within a bank and identify those that mean there is a compliance problem. Or listen to calls in a contact centre and identify a number of calls all about the same product issue, perhaps an exploding battery, and alert a supervisor. Autonomy does for unstructured information what the database is capable of doing for structured information.

But within the next two years, HP had written off most of Autonomy’s value and alleged that the finance director, Sushovan Hussain, Mike Lynch (CEO) and Autonomy’s other directors had dramatically overstated earnings to ‘dupe’ HP into overpaying. HP filed a $5 billion damages claim and there is a US criminal fraud case against the former finance director, who has been found guilty and is awaiting sentencing. Mike Lynch (who claims he is innocent and has a counter-claim against HP) is still awaiting trial. The successful conviction of the finance director may embolden others who claim they lost substantial sums due to Autonomy’s accounting actions. Some of the hedge funds placed bets that Autonomy was primed for a fall, but then lost money when HP made its high-priced bid. US courts will continue their deliberations into 2019.

Looking through the various accounts, HP realized early on in 2011 that they wanted to restate the 2010 and 2011 accounts of Autonomy. They also sold or restructured the company substantially through 2012 to 2014. This period marked underlying losses with large gains to be made from the disposal or sales to other parts of HP. However, HP concluded that the firm’s main UK trading company (Autonomy Systems Ltd) made 80% less profits and 54% less revenue than originally stated (see Table 5.2).

The outgoing auditors were Deloitte. The incoming one was EY, which refused to provide an audit opinion, saying that proper accounting records had not been kept. The dispute can be seen in Table 5.2. There was also a change in the period of accounting. The differences between the original reported figures and the restated figures are an order of magnitude apart and are almost unbelievably different.

Just about every accounting and financial number that was submitted in the accounts (stocks apart) was restated. The order and magnitude of restatement seems massive. HP claimed that:

Table 5.2 Autonomy Systems Ltd (a subsidiary of Autonomy Corporation Ltd) results

10 months ended Year ended Year ended

31 Oct 2011 31 Dec 2010

31 Dec 2010 £’000s £’000s £’000s (restated) (original)

Profit and loss restatement (selected items)

Turnover 73,482 81,293 175,632 Operating profit 11,705 42,780 135,610 Profit before tax or ordinary activities 11,579 43,110 135,732 Retained profit for the year 105,747 Profit for the financial period 12,155 19,626 Prior period adjustment −168,673 Losses recognized since last report −156,518

Balance sheet restatement (selected items)

Intangible assets 44,184 15,488 19,160 Tangible assets 1,562 3,575 1,613 Investments 2,653 1,573 46 Debtors 266,166 326,310 148,241 Cash and short-term deposits 24,999 4,353 24,775 Creditors falling within one year 36,424 93,518 64,358 Profit and loss account 293,757 146,781 129,515 (in capital and reserves)

Revenues were overstated typically by:

• revenue being recognized for products where payments were unlikely to be made by the buyer • barter-type transactions where the value of the sale could not be properly assessed • sales of hardware wrongly logged as software.

HP believed that Autonomy had mischaracterized revenue from lossmaking low-end hardware sales that represented as much as 15% of the company’s revenue. HP said Autonomy also presented licensing transactions, where no end customer existed at the time of sale as revenue.

A look at the debtor and creditor columns shows Autonomy’s original accounts claimed the company was owed more by third parties and its own subsidiaries abroad than HP thought appropriate. Just about everything

64 Tesco, HBOS and Autonomy else is disputed as can be seen in the restatement of the accounts in the second and third columns.

The previous management firmly denied any accounting errors or misstatements. It is difficult to make a judgement but the fact that two different auditors came to very different conclusions may be considered strange. Some of this is due to applying different accounting rules: HP used US GAAP while Autonomy used IFRS. Some of the differences can be explained by differences in other accounting policies. For example, the accounts show that nearly £14 million of the £86 million profit reduction at Autonomy is due to this reason. Research and development costs had been recognized across the lifetime of the product under Autonomy’s original accounting system. Under the new GAAP policy, they are fully charged to the year in which the costs were incurred.

But there is other evidence of what may be wrongdoing. The Sunday Times reported:14

As the takeovers piled up, however, analysts and short-sellers began to ask questions . . . why turnover was rising by 15% to 20% a year, yet deferred compensation – which, in the software sector, is mainly maintenance fees paid over the coming year – stayed flat. The company was recognizing that income too early . . . and could do that for only so long.

There were other concerns. The ‘goodwill’ on Autonomy’s balance sheet – the difference between what it had paid for companies and the net asset values – had ballooned to $1.4bn by 2010.

Based on incomplete information, Krish’s gut feeling is that the accounting differences (from IFRS to US GAAP) exacerbated any underlying misstatements. Some of the misclassifications might have been simply a cultural issue. HP was very strict on what was hardware and software. That was the way the company had been split in 2015 into the PC and printer business and the enterprise products and services business as two separate publicly traded companies: HP Inc. and Hewlett Packard Enterprise.

Nevertheless, there do seem to be some issues which remain. Krish does not believe that the full write-down of the value could be fully justified on misstatements alone. An examination of the accounts after the takeover saw a wholesale sale of assets and subsidiaries and systems. Perhaps some of these were not made at peak value. HP itself was undergoing a fundamental reorganization and once the disillusionment with the Autonomy purchase had set in, our supposition is that there was a fire sale of their assets (although we have no specific evidence to support this).

Tesco, HBOS and Autonomy 65

The drop in value noticed by HP may be due to a number of causes. Krish does not believe that Deloitte could have missed many of the claimed items. That some misstatement was made is possible, particularly where there is discretion, such as revenue recognition. But was it fraud? Probably not, but then the US courts have come to a different conclusion in its prosecution of the financial director.

The US Department of Justice prosecutors argued that Hussain was a devious financial engineer who bullied those who questioned him “to make it appear Autonomy was growing when it really was not”.14 They also cited three types of actions that led to a misstatement of the accounts. These were:

• Backdated contracts. Backdating involves writing a date on a contract or negotiable instrument that is earlier than the date on which it was signed. For example, a contract could be signed on 30 June, but backdated to 31 May. Doing so makes the contract or instrument valid as of the earlier date. • Round trips. The accounting slang term ‘round tripping’ refers to a series of transactions between companies that bolster the revenue of the companies involved but that, in the end, don’t provide real economic benefit to either company. A firm sells an asset to a third party whilst agreeing to buy back the same or similar assets at about the same price. • Channel stuffing. This is a deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public.

The first court case has been decided and it is clear that wrongdoing was detected by the US courts. However, the ability of Hussain’s lawyers to counter the government’s charges was hindered by the court’s refusal to grant immunity to potentially supportive witnesses. So, we await the full story.

Notes

1 On 29 August 2014 Tesco had announced that profits for the six months to 24

August 2014 were expected to be about £1.1 billion. Three weeks later, on 22

September 2014, Tesco issued a correction, stating that the earlier announcement had overstated profits by about £250 million. The three-week delay in publicly admitting the misstatement was to cost Tesco dearly, as explained later in the text. 2 FCA, 2017, FCA’s Final Notice to Tesco Plc, Financial Conduct Authority, 28 March, paragraph 4.4. Available at: www.fca.org.uk/publication/final-notices/tesco2017.pdf Accessed July 2018.

3 An engineering group that went into administration and was later sold to the

Gupta’s Liberty Industries Group. For the precedent relying on this case, see for example: ACCA Factsheet, 2009, ‘Professional Liability of Accountants and Auditors’, ACCA Global, January. Available at: www.accaglobal.com/content/dam/ acca/global/PDF-members/2012/2012p/Prof_liability.pdf Accessed July 2018. 4 Tesco Plc Annual Report, 2014, p. 34. Available at: www.tescoplc.com/ media/264147/annual_report_14.pdf Accessed July 2018. 5 Staubus, G., 2005, ‘Ethics Failures in Corporate Financial Reporting’, Journal of

Business Ethics, Volume 57, Issue 1, pp. 5–15. 6 Flower, J., 2017, The Social Function of Accounts, Routledge, Abingdon, pp. 206–208.

Available at: https://books.google.co.uk/books/about/The_Social_Function_ of_Accounts.html?id=DTYlDwAAQBAJ&redir_esc=y Accessed July 2018. 7 The role of the FRC in conducting any investigation is to conclude whether there is a realistic prospect a tribunal would find the accountant guilty of misconduct. That is the sole purpose of the initial investigation under the disciplinary rules. Even if the audit were perfect in every respect (if such a possibility even exists given the degree of judgement involved), they would still say the same thing. This is a different regime to the one used by the FRC for annual inspection of a sample of audits. Here the audit is graded and anonymized and results published for each firm (i.e. required ‘significant improvements’ or classed as ‘good or limited improvements required’). 8 Chapman, B., 2017, ‘Lloyds Bank Misses Own Deadline to Pay Compensation to

Victims of £1bn Fraud’, The Independent, 30 June. Available at: www.independent. co.uk/news/business/news/lloyds-bank-compensation-victims-1-billion-fraudcustomers-deadline-miss-payments-a7816776.html Accessed July 2018. 9 See for example: Hosking, P., 2018, ‘Regulator in Fight to Halt Release of KPMG

Files: Concern over Links between FRC and Auditors’, The Sunday Times, 2 April.

Available at: www.thetimes.co.uk/article/regulator-in-fight-to-halt-release-ofkpmg-files-2vhs9vd5r Accessed July 2018. 10 See for example: Marriage, M., and Martin, K., 2017, ‘Watchdog Admits It

Was Slow to Investigate HBOS Audit: FRC Cleared KPMG of Wrongdoing

Even Though Bank Collapsed Shortly after Examination’, Financial Times, 30

November 2018. Available at: www.ft.com/content/484265bc-d5cb-11e7-8c9ad9c0a5c8d5c9 Accessed July 2018. 11 Osborne, A., 2018, ‘Regulator Cannot Afford Whitewash’, The Sunday Times, 30

January. Available at: www.thetimes.co.uk/article/regulator-cannot-afford-white wash-7bln8906b Accessed July 2018. 12 Ibid. 13 Dunkley, E., Marriage, M., and Martin, K., 2017, ‘KPMG Cleared over Audit of HBOS before Collapse: Regulator Finds Assessment of Market Conditions

Not “Unreasonable” at Time’, Financial Times, 19 September. Available at: www. ft.com/content/34fa0fdc-9d13-11e7-9a86-4d5a475ba4c5 Accessed July 2018. 14 ‘Autonomy Has Lost a Battle, but Will Founder Mike Lynch Lose the War? As the

Software Company’s Former Finance Chief Is Convicted in the US, All Eyes Turn to Its Founder’, The Sunday Times, 6 May 2018. Available at: www.thetimes.co.uk/ article/autonomy-has-lost-a-battle-but-will-founder-mike-lynch-lose-the-wark32xtllcz Accessed July 2018.