​The Case for Due Diligence

Companies may open themselves up to fraud if they don't do their homework about the companies they acquire.

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​Two former executives of U.K.-based Autonomy have been indicted on criminal fraud charges stemming from the software company's 2011 acquisition by Hewlett Packard (HP), CRN.com reports. U.S. prosecutors allege former CEO Mike Lynch and Stephen Chamberlain, former vice president of finance, used fraudulent accounting practices to inflate Autonomy's value. A year after completing the purchase, HP took a $8.8 billion write down of Autonomy's assets and later sold those assets to Micro Focus. Last April, a U.S. federal court jury found former Autonomy CFO Sushovan Hussain guilty of wire and securities fraud. Also, Hewlett Packard Enterprise, which spun off from HP in 2015, has sued Lynch and Hussain in the U.K. Lynch's attorneys claim HP made mistakes in integrating Autonomy's assets that reduced their value.

Lessons Learned

This story illustrates the need for a thorough due diligence process for a major acquisition. Internal auditors can view advice and resources about the due diligence process provided by organizations such as The IIA, the U.S. Securities and Exchange Commission (SEC), and the Association of Certified Fraud Examiners. Two key aspects of the process may have helped reveal the core issues in dispute in this alleged fraud: due diligence risk assessment and the potential impact of differing international accounting standards.

Due Diligence Risk Assessment A thorough risk assessment of the company targeted for acquisition is essential. Furthermore, the SEC and U.S. Department of Justice (DOJ) have issued A Resource Guide to the U.S. Foreign Corrupt Practices Act (the FCPA Guide), which recommends companies conduct pre-acquisition due diligence on merger and acquisition deals. Uncovering fraud after the deal is completed can have damaging consequences for an acquirer. Two key parts of this due diligence are:

  • Assessing the validity, accuracy, and integrity of the financial statements. This assessment should include related internal and external financial reporting, significant estimates and accounting policies, regulatory changes and their impact on financial statements, past and recent findings of internal and external auditors, and staff competency and training.

  • Examining the organization's internal controls, using a risk-based approach. This examination should review internal control procedures and documentation, and analyze gaps in internal control structures and the adequacy of management's corrective action plans. Moreover, it should review related internal and external audit reports and findings on internal control deficiencies, along with remediation strategies. Depending on the results of these reviews in terms of risk, a further internal audit or external audit of internal controls may be warranted.

    According to the DOJ/SEC FCPA Guide, companies do not examine the target company's internal control environment in detail before completing an acquisition. Consequently, internal control weaknesses that may exist are left to be identified during the post-acquisition integration process. These weaknesses may lead to an increase in the risk of fraud.

  • Applying data mining techniques to uncover potential fraud. At a minimum, the acquiring company should obtain as much transactional data as possible from the target company's accounting system. Analyzing this data using a data mining tool can identify potential anomalies in the operation of internal controls and unusual transactions that may be evidence of fraudulent activity.
     

Other aspects of a risk assessment include a review of the target company's compliance and ethics program, its ethical culture, and background checks on key executives and employees.

Financial Accounting Standards In the Autonomy case, there is a potential issue around the differences among financial accounting standards that exist internationally. Lynch has stated that the claims of fraud come down to a dispute over the application of U.K. accounting standards. The U.K. and many other countries use International Financial Reporting Standards (IFRS) as their accounting method. IFRS has some key differences from the Generally Accepted Accounting Principles (GAAP) approach used in the U.S. Lynch and his attorneys argue that differences in interpretation between them could have contributed to the view that Autonomy inflated its value before its acquisition.

A major difference between IFRS and GAAP is the methodology used to assess the accounting process. GAAP focuses on research and is rules-based, whereas IFRS looks at the overall patterns and is based on principles. With an IFRS-based accounting method, potentially different interpretations could result in higher values being included in financial statements in five areas:

  • Inventory reversal. GAAP specifies that if the market value of the asset increases, the amount of the write down cannot be reversed. Under IFRS, however, the amount of the write down can be reversed. In other words, GAAP is cautious of inventory reversal and does not reflect any positive changes in the marketplace.
     
  • Development costs. A company can capitalize its development costs under IFRS, as long as certain criteria are met. This allows a business to leverage depreciation on fixed assets. Under GAAP, development costs must be expensed in the year they occur and are not allowed to be capitalized.
     
  • Intangible assets such as research and development or advertising costs. IFRS accounting takes into account whether an asset will have a future economic benefit as a way of assessing the value. Intangible assets measured under GAAP are recognized at the fair market value only.
     
  • Income statements. Under IFRS, extraordinary or unusual items are included in the income statement and not segregated. Under GAAP, they are separated and shown below the net income portion of the income statement.
     
  • Fixed assets such as property, furniture, and equipment. Companies using GAAP accounting must value these assets using a cost model. This takes into account the historical value of an asset minus any accumulated depreciation. IFRS uses a different model, called the revaluation model, based on the fair value at the current date minus any accumulated depreciation and impairment losses.
Art Stewart
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About the Author

 

 

Art StewartArt Stewart<p>​Art Stewart is an independent management consultant with more than 35 years of experience in internal audit, financial management, performance measurement, governance, and strategic policy planning.​​​</p>https://iaonline.theiia.org/authors/Pages/Art-Stewart.aspx

 

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