H.P. Claim Highlights a Gray Area in Software Sales

H.P. Claim Highlights a Gray Area in Software Sales

Hewlett-Packard’s accusations of “serious accounting improprieties” at Autonomy are eerily reminiscent of accounting missteps uncovered over a decade ago at software firms like MicroStrategy, Computer Associates and Lernout & Hauspie.

“It looks like a throwback to the bubble era,” said Jack T. Ciesielski, publisher of The Analyst’s Accounting Observer.

Indeed, the claims made on Tuesday suggest that there is something about the nature of the software business that makes it easier for executives to indulge in questionable accounting.

Hewlett-Packard contends that Autonomy, the British software firm that it acquired for $ 10 billion last year, misclassified revenue, including sales of hardware with sales of software licenses. Investors care far more about software sales, and this purported strategy made it look as if software was doing better than it was.

The hardware sales were unprofitable, Hewlett says, and accounted for 10 to 15 percent of Autonomy’s revenue before the purchase. In addition, Hewlett contends that this practice made a measure of profitability called gross margin look stronger than it really was.

Revenue was inflated by other means, Hewlett said. Autonomy also booked revenue too early and when a proper sale hadn’t taken place, the company said.

Catherine A. Lesjak, Hewlett’s chief financial officer, said that without the help from such aggressive accounting, Autonomy most likely had operating margins of 28 to 30 percent, rather than 40 to 45 percent.

Mike Lynch, the former chief executive of Autonomy, denies that the company’s financial statements were misleading or contained improprieties.

“We were shocked and very surprised because no one had actually been in touch with us,” he said.

How companies recognize revenue is critical to analysts who track the performance of software companies. They have learned to watch the process very closely. Both Computer Associates and MicroStrategy had booked revenue prematurely, according to the Securities and Exchange Commission cases at the time.

Analysts focus on a balance-sheet liability called deferred revenue. This is unearned revenue that represents software services that are still owed to clients. When this doesn’t keep up with investors’ expectations, a software company’s shares can fall. As a result, there may be a temptation to make this item look bigger than it was.

“Revenue recognition has always been difficult with these kinds of companies,” Mr. Ciesielski said. The problem, he says, is that software contracts bundle different types of sales. That can make it easier to conceal expenses, inflate certain types of revenue and tweak the timing of when revenue is recognized.

“There are different ways to tug and stretch the numbers,” he said.

The claims by Hewlett surprised investors, who sent the company’s shares down sharply, off 12 percent on the day.

Even so, some hedge fund investors have been skeptical about Autonomy for a several years, and questions about its numbers have bubbled in the marketplace.

“It was dead easy to spot that Autonomy’s statements weren’t right,” said John Hempton, the manager of Bronte Capital, a hedge fund based in Sydney, Australia. “The extent of it I didn’t know.” Mr. Hempton voiced his suspicions about Autonomy last month in a presentation to an investment forum in New York.

Some were raising questions even earlier. In July 2009, Kynikos Associates, the firm founded by the investor James S. Chanos, wrote a detailed report that criticized Autonomy’s accounting in ways that now appear prescient.

In its 2009 note, Kynikos said that Autonomy’s deferred revenue appeared lackluster. It added that the company might have masked the underperformance with acquisitions.

Hewlett said a whistle-blower came forward in May, prompting it to conduct an internal investigation, which it says turned up the accounting missteps at Autonomy. Its disclosure raises another uncomfortable question: Why Hewlett — and its auditors — could not spot what it now says it has uncovered. Hewlett says two accounting firms failed to catch what it now says were ruses.

On a conference call on Tuesday, John F. Schultz, H.P.’s general counsel, said Autonomy kept opaque books. “Critical documents were missing from the obvious places and it required that we look in every nook and cranny,” he said.

It’s possible that the company was looking at Autonomy through somewhat rose-colored glasses at the time of the acquisition, putting its desire for growth above the need for thorough due diligence. Autonomy cost $ 11.1 billion. Hewlett said Tuesday that it took a charge of more than $ 5 billion related to the accounting trouble, though it’s not clear exactly how the company arrived at that amount.

Despite everything, Hewlett’s chief executive, Meg Whitman, said that Autonomy would still play an important role at her company.

“This will be a growth engine for H.P.,” she said, then added, “Perhaps not as big a growth engine as we originally anticipated.”


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