The acquisition of Autonomy by Hewlett-Packard (HP) for the amount of $11.1bn was written down by $8.8bn in 2012 (Hurley and Hurley 2013). Until now, both entities have been engaged in a lawsuit to determine who was to blame for the write down. Using the given measurement models in the assignment briefing, this report analyzes HP’s and Autonomy’s financial statements in terms of revenue recognition and inventory valuation.
In revenue recognition, Autonomy has been accused of recognising revenue upfront, which is not normal practice for US GAAP, while for inventory valuation, HP could have neglected the accounting methods that were permitted for Autonomy such as FIFO. This accounting method causes a company to show a higher profit margin, which aided in inflating Autonomy’s valuation.
After evaluating the measurement models, accounting standards will be viewed in both institutional and social contexts. This segment will explore how the national culture drives society’s perceptions, which influences the regulations and laws in a country. Consequently, the established regulations would affect accounting standards in the United Kingdom (UK) and the United States (US). Each country will be identified in terms of whether it is principles-based (UK) or rules-based (US).
Before concluding the report, recommendations on the discussed measurement models will be made. This segment also offers a critical analysis of the convergence project between IASB and FASB and the future of both accounting standards: whether there should be a monopoly or co-existence.
Evaluation of Revenue Recognition Policy
It has been identified that the differences in revenue recognition policies adopted by HP and Autonomy was one of the major causes of the merger scandal. The following are the allegations made by HP that Autonomy misrepresented its revenue:
Based on the above statements, the revenue recognition policies of US GAAP and IFRS will be analysed with the focus primarily on software revenue recognition.
Revenue recognition policy – US GAAP and IFRS
The diverse standards of revenue recognition used the US GAAP and IFRS revolve around the timing and fair value when recording revenue in a company’s financial statements (Hurley and Hurley 2013). Revenue recognition is only considered when there is an exchange transaction; this signifies that revenue should not be recognised until the exchange transaction has occurred (PWC 2012). This circumstance also implies that ownership and risk of a good should have been transferred to the buyer in order to recognise the revenue. However, as the US GAAP is rules-based, its revenue recognition policy has extensive industry-specific guidance, unlike the IFRS, which offers more flexibility (PWC 2012).
Software revenue recognition
An example of highly specialised guidance is the software revenue recognition, which is a major contributing factor to the scandal between HP and Autonomy (Shapiro 2013). Software companies like HP and Autonomy commonly bundle their products and services under a single contract (Morningstar 2015). The products and services include the software licence, installation, training services, and post-contract customer support (Morningstar 2015).
Under US GAAP, companies are required to utilise vendor-specific objective evidence (VSOE) of fair value for each product and service to recognise partial revenue before the contract is fulfilled (Grant Thornton 2011). If the fair value were not established, the company would have to defer recognising all revenue until the last element of the contract was delivered (Grant Thornton 2011). To establish VSOE for the selling price of each product, HP uses the price charged for a deliverable when sold separately; its alternative option is to utilise third party evidence (TPE) of the selling price by evaluating similar standalone sales to similarly situated customers in the past (HP 2013). Unlike IFRS, US GAAP requires VSOE to be used in all circumstances it is available and resort to TPE as an alternative only when deemed necessary.
For IFRS, Autonomy is also required to establish separate fair value for each product and service in a single contract if it aims to recognise partial revenue before the contract is fulfilled (Sam, Smith and Strickland 2014). However, VSOE’s concept of fair value does not exist in IFRS (PWC 2012). IFRS acknowledges that fair value of an item is recognised by the price that is charged when it is sold separately from a contract, akin to US GAAP (Sam, Smith and Strickland 2014). Yet, if the standalone value of the product and service is not available, cost plus a reasonable margin and residual methods are alternative options (Srivastava 2014). The different accounting methods illustrate the poor comparability between HP and Autonomy, which caused the misinterpretations from both entities.
It was the differences of software revenue recognition between US GAAP and IFRS that prompted HP to accuse Autonomy of booking licensing revenue upfront before deals were closed, inflating its revenue (Reuters 2012). The difference in timing when recognising revenue was associated with the disparity in calculation of fair value of each product.
Evaluation of Differences Permitted in Inventory Valuation (LIFO v FIFO)
Both US GAAP and IFRS define inventories as the following:
Though US GAAP and IFRS generally includes direct costs of getting inventories ready for sale, the differences can be summarised as shown below:
Table 1: Differences in costs of inventory (IAS 2015)
A major difference between the accounting standards is that US GAAP has more options for valuating the inventory such as First in First out (FIFO), Last in First out (LIFO), and the weighted-average method, whereas IFRS restricts LIFO (Fosbre, Fosbre and Kraft 2010). The variance in the number of options allows US GAAP-compliant companies to reduce its income tax. This circumstance is existent with the assumption that over the long- or even short-term, prices of goods will rise (Jeffers, Mengyu and Askew 2010).
Consequently, FIFO would mean that companies gain a larger profit margin, which would be perceived to be attractive by investors. Yet, LIFO causes the costs of goods to be higher, which reduces net income (Satin and Lin 2009). This circumstance would benefit the company by exposing it to a lower tax rate (Haflich 2014). HP is an example of an American company applying such practices. Diagram 1 is a snapshot of HP’s accounting methods for inventory.
Diagram 1: HP’s inventory valuation (HP 2013)
In the case of Autonomy, FIFO may have contributed to inflating its valuation (Jeffers, Mengyu and Askew 2010). As inventory is part of a company’s current asset, HP could have viewed Autonomy’s net asset as a positive result and neglected the differences in accounting methods for inventory valuation (Haflich 2014). With the lack of similarities in inventory valuation between US GAAP and IFRS, it is perplexing that HP had overlooked this element. If HP had noticed the difference in its inventory valuation, the company may have been able to detect the distinction in revenue recognition as well. This is because sales revenue of a company is strongly associated with its inventory (Satin and Lin 2009).
Discussion of the Influence of the Institutional Context
Comparison between the US and UK regulatory environments
In the US, the Financial Accounting Standards Board (FASB) is responsible for any changes to the financial reporting standards used at the corporate level (FASB 2015). Established in 1973, FASB has issued over 100 Financial Accounting Standards (FAS) pronouncements with the assistance of the Financial Accounting Standards Advisory Councils (FASAC) (FASB 2015). FASAC plays an important role in advising FASB on issues that may influence the GAAP rules by communicating representative views from diverse groups of individuals that would be affected by FASB’s influence: chief executive officers, senior partners of public accounting firms, senior members of academic and analyst communities, and so on (Walker 2004). The enforcement of these standards the responsibility of the Securities and Exchange Commission (SEC), which was established after the stock market crash in 1929 to restore public confidence in the US Stock Exchange (Hodges and Mellet 2012). Its enforcement of rules and regulations aid with protecting investors, maintaining fair and efficient markets, and facilitating capital formation (SEC 2015).
Due to cultural factors in the US (discussed under Social Context), a rules-based approach regulates the US financial sector in its adopting, implementing and enforcing of rules and regulations (Zapranis and Tsinaslanidis 2012). Thus, it is common to witness financial and political figures being prosecuted and jailed for any misconduct that infringe the law because of the stringent regulations (Peytcheva, Wright and Majoor 2014). However, the UK’s accounting standards are directed by a principles-based approach. Regulated by the IFRS that is implemented by the International Accounting Standards Board (IASB), accounting standards in the UK are enforced by the Financial Conduct Authority (FCA) (IAS 2015). Because the IFRS is recognised as a global accounting standard, the UK’s accounting practices are based on reasonable judgement whereby companies can select accounting methods for their financial statements (Dennis 2008).
The HP and Autonomy Case in an Institutional Context
In relation to the Revenue Recognition Model discussed above, the influence of the US institutions has produced extensive guidelines for American companies to abide by, thereby causing Autonomy’s revenue recognition practice to be in breach of US accounting standards (Collins, Pasewark and Riley 2012). Autonomy was accused of inflating its revenue as it recognised partial revenue of a single contract by using a different method (cost plus a reasonable margin or residual) to estimate a single product’s fair value rather than VSOE (Hurley and Hurley 2013).
Yet, from HP’s perspective, Autonomy should have utilised VSOE of selling price as its first option. However, in the UK, the Serious Fraud Office (SFO) has closed its investigation into Autonomy because it deemed there was insufficient evidence for a realistic prospect of conviction. This casts doubt on HP’s accusations (Financial Times 2015). In the US, HP’s writedown of $8.8 billion on Autonomy’s acquisition has garnered interest regarding the capabilities of its accounts department and auditor in that they overlooked the differences in accounting standards (Financial Times 2015).
Hence, other regulators such as The Public Company Accounting Oversight Board (PCAOB) that was created by the Sarbanes-Oxley Act of 2002 and the American Institute of Certified Public Accountants (AICPA) also play important roles in monitoring audit companies’ actions (IAS 2015). These entities aim to protect investors and further the public interest in the preparation of informative, fair, and independent audit reports (Nagy 2014). Unlike FASB, these entities process and review the registration of accounting firms through the establishment of quality control (expertise of auditors and accountants) and ethical standards (independence of auditors and accountants) regulations (Spillane 2015).
For example, Ernst & Young (HP’s auditor) signed off on HP’s 2014 annual results that included materials (goodwill and amortizable intangible assets) of the acquisition of Autonomy without identifying any misleading information until a whistleblower emerged (Forbes 2012). This circumstance questions the expertise of auditors in the Big Four firms. Nonetheless, the role of audit firms is not to detect fraud but to consult and provide an opinion on companies’ financial statements (Christensen, Olson and Omer 2015).
Discussion of the Influence of the Social Context
Hofstede’s cultural dimensions
As previously stated under Institutional Context, the differences and similarities of the US and the UK regulatory environment are strongly influenced by the countries’ cultures (McGillivary and Fung 2013). Diagram 2 below is an illustration of both countries’ culture through Hofstede’s cultural dimensions.
Diagram 2: US and UK cultural comparisons (Hofstede 2015)
As observed in Diagram 2, Americans tend to be slightly more individualistic than British people. This signifies that Americans are more inclined to maintaining their self-interest than the harmony of a group of individuals, with a higher possibility of manipulation in companies’ financial statements by individuals with authority (Hofstede 2015). Moreover, the cultural understanding of masculinity in both countries prompts individuals to prioritise achievement and success and encourage competition. Thus, in the case between HP and Autonomy, the British chief executive officer (Mike Lynch) may have concentrated on meeting sales targets by exploiting weaknesses in the UK’s accounting standards, which aided in inflating the company’s valuation (Cieslewicz 2014). Though the UK has similar levels of individualism and masculinity as the US, it is more orientated on the long-term. Hence, British people would not get involved in excessive fraudulent activities that focus on short-term profits unless deemed necessary, such as in Autonomy’s case (Kolesnik 2013).
Further, the large differences in the levels of uncertainty avoidance between the UK and the US distinguish the accounting standards in both countries (Kolesnik 2013). American’s rule-based approach in accounting standards demonstrates the rigid regulatory system that penalises individuals who violate the law, without any consideration for the motivation of the actions, as illustrated in the HP and Autonomy case (Stander, Buys and Oberholzer 2013).
Being UK based, Autonomy has more options for obtaining desired results through different accounting methods for revenue recognition. Though accounting practices that are based on an individual’s judgement can be questionable, it is a practice commonly adopted by qualified accountants and auditors when preparing companies’ financial statements. They make assumptions and professional judgements when selecting an accounting method to adopt (Cieslewicz 2014). Therefore, Autonomy could be acquitted from HP’s allegation in the UK as IFRS encourages a flexible approach for companies to achieve true and fair representation in its financial statements (Kanagaretnam, Lim and Lobo 2014).
Recommendations Concerning the Implications of Differences in IFRS and US GAAP
In 2002, the Convergence Project between FASB and IASB was signed in an effort to reduce the divergence between the two accounting standards (Rivera et al. 2014). Although IASB had been able to encourage the incremental adoption of IFRS in many countries, especially in Group of 20 (G20) as shown in Diagram 3, the US remains unyielding to selective criteria such as the flexible approach in revenue recognition that FASB does not endorse (James 2012).
Diagram 3: IFRS Jurisdiction in G20 (IAS 2015)
In 2008, IASB and FASB set a specific set of short-term goals in order to produce common and principle-based standards (Garmong 2012). Diagram 4 demonstrates the set of goals that need to be achieved by IASB and FASB respectively.
Diagram 4: Goals of IASB and FASB (IAS 2015)
Up until now, both entities have made slight progress and had many deliberations on joint projects such as the impairment and revenue recognition phases (Mostafa and Mohamed 2014). As a result, it may be impossible to witness a complete convergence between IASB and FASB in developing a global accounting standard (Gornik-Tomaszewski and McCarthy 2003). However, the monopoly of IASB in accounting standards may be detrimental to the purpose of financial reporting. Without FASB, any flaws in IASB’s accounting standards may not be highlighted (Cohn 2015). Hence, FASB and IASB may need to co-exist in order to constantly discover faults in each accounting standard.
In HP’s and Autonomy’s case, US GAAP has aided with attracting attention to the flexibility of the IFRS, which can significantly inflate a company’s value (Srivastava 2014). Consequently, companies adopting GAAP would be wary when engaging in future merger and acquisition activities with companies under IFRS jurisdiction, which protects investors’ interests. However, the convergence project between IASB and FASB should adopt a more stringent approach like US GAAP as a global accounting standard for revenue recognition policy (Dennis 2008). This is because revenue recognition is one of the primary factors that investors and management teams focus on when valuating a company (Sam, Smith and Strickland 2014). Therefore, comparability is an important feature in revenue recognition.
This case also highlighted the need for increased due diligence on HP’s side in terms of the expertise of accountants and auditors (Zapranis and Tsinaslanidis 2012). With the difference in accounting standards between IFRS and US GAAP, accountants in the UK and US would only be familiar with their respective accounting standards and have little exposure to foreign standards (Kolesnik 2013). Therefore, entities such as AICPA and the Association of Chartered Certified Accountants (ACCA) should cooperate in organising events for accountants from both parties to get involved in conferences and events to share work experiences and varied opinions on IFRS and US GAAP (Collins, Pasewark and Riley 2012).
In summary, the convergence project would still require decades to be completed. However, many conflicting opinions in accounting standards that are rooted in national cultures continue to hinder the project’s progress. HP and Autonomy’s case is merely a reminder of the difference between IFRS and US GAAP (Hurley and Hurley 2013).
Autonomy (2009) Annual Report 2009. [pdf] Available at: Autonomy_Annual_Report_2009.pdf [Accessed 20 June 2015].
Autonomy Accounts (2015) Mike Lynch publishes an open letter to Hewlett Packard. [online] Available at: http://autonomyaccounts.org/ [Accessed 2 June 2015].
Christensen, B. E., Olson, A. J. and Omer, T. C. (2015) “The role of audit firm expertise and knowledge spillover in mitigating earnings management through the tax accounts”. Journal of the American Taxation Association 37 (1), 3-36.
Cieslewicz, J. K. (2014) “Relationships between national economic culture, institutions, and accounting: implications for IFRS”. Critical perspectives on Accounting 25 (6), 511-528.
Cohn, M. (2015) “IASB, FASB look beyond convergence”. Accounting Today 29 (1), 23.
Collins, D. L., Pasewark, W. R. and Riley, M. E. (2012) “Financial reporting outcomes under rules-based and principles-based accounting standards”. Accounting Horizons 26 (4), 681-705.
Dennis, I. (2008) “A conceptual enquiry into the concept of a ‘principles-based’ accounting standard”. British Accounting Review 40 (3), 260-271.
FASB (2015) Introduction on Financial Accounting Standards Advisory Council. [online] Available at: http://www.fasb.org/fasac/ [Accessed 20 June 2015].
Financial Times (2015) Serious Fraud Office closes Autonomy investigation. [online] Available at: http://www.ft.com/cms/s/0/d1a91f1a-9fd9-11e4-9a74-00144feab7de.html#axzz3eGkrsxgY [Accessed 21 June 2015].
Forbes (2012) Hewlett-Packard’s Autonomy allegations: A material writedown puts all four audit firms on the spot. [online] Available at: http://www.forbes.com/sites/francinemckenna/2012/11/20/hewlett-packards-autonomy-allegations-a-material-writedown-puts-all-four-audit-firms-on-the-spot/ [Accessed 21 June 2015].
Fosbre, A. B., Fosbre, P. B. and Kraft, E. M. (2010) “A roadblock to US adoption of IFRS is LIFO inventory valuation”. Global Journal of Business Research 4 (4), 41-49.
Garmong, S. K. (2012) “The state of major FASB IASB convergence projects”. Financial Executive 28 (7), 24-27.
Gornik-Tomaszewski, S. and McCarthy, I. N. (2003) “Cooperation between FASB and IASB to achieve convergence of accounting standards”. Review of Business 24 (2), 52.
Grant Thornton (2011) Revenue recognition for software companies: Making sense of VSOE, discounts and concessions. [pdf] Available at: http://www.grantthornton.com/staticfiles/GTCom/Technology/Techdashboard/Revenue_recognition_for_software_companies-December-2011.pdf [Accessed 20 June 2015].
Haflich, F. (2014) “If GAAP goes, says higher to taxes and cyclicality”. American Metal Market, 132.
Hodges, R. and Mellet, H. (2012) “The U.K. private finance initiative: An accounting retrospective”. British Accounting Review 44 (4), 235-247.
Hofstede (2015) Countries comparison. [image online] Available at: http://geert-hofstede.com/united-states.html [Accessed 21 June 2015].
HP (2013) Annual Report 2013. [pdf] Available at: http://h30261.www3.hp.com/~/media/Files/H/HP-IR/documents/reports/2014/hpq-annual-report-2013.pdf [Accessed 20 June 2015].
Hurley, P. and Hurley, R. (2013) “HP’s risk in the acquisition of Autonomy a cost of $11 billion to a write-down of $8.8 billion in 1 year”. Academy of Business Journal, 3 (2), 1-23.
IAS (2015) Inventories: Key differences between US GAAP and IFRSs. [online] Available at: http://www.iasplus.com/en-us/standards/ifrs-usgaap/inventories [Accessed 22 June 2015].
IAS (2015) Overview of the structure of the IFRS Foundation and IASB. [online] Available at: http://www.iasplus.com/en/resources/ifrsf [Accessed 21 June 2015].
IAS (2015) Public company accounting oversight board. [online] Available at: http://www.iasplus.com/en-us/resources/other-regs/pcaob [Accessed 21 June 2015].
IAS (2015) Use of IFRS by jurisdiction – G20 domestic listed companies. [online] Available at: http://www.iasplus.com/en-gb/resources/ifrs-topics/use-of-ifrs-g20 [Accessed 21 June 2015].
James, M. L. (2012) “Accounting for revenue and the FASB/IASB convergence project: A case study exploring the new exposure draft”. Journal of the International Academy for Case Studies 18 (4), 19-27.
Jeffers, A. E., Mengyu, W. and Askew, S. (2010) “The switch from US GAAP to IFRS – Implications for analysis involving inventories”. Northeast Business and Economics Association, 48-54.
Kanagaretnam, K., Lim, C. Y. and Lobo, G. J. (2014) “Influence of national culture on accounting conservatism and risk-taking in the banking industry”. Accounting Review 89 (3), 1115-1149.
Kolesnik, K. (2013) “The roles of culture in accounting in the light of Hofstede’s, Gray’s and Schwartz’s cultural dimensions theories – a literature review”. E-Finance 9 (3), 33-41.
McGillivary, J. and Fung, H. (2013) “The need for ethical reform in the US financial industry”. International Review of Accounting, Banking and Finance 5 (1), 17-41.
Morningstar (2015) Autonomy Annual Report 2010. [online] Available at: http://quote.morningstar.com/stock-filing/Annual-Report/2010/12/31/t.aspx?t=:AUTNY&ft=&d=02866084e75fb33d806f73103e1058da [Accessed 2 June 2015].
Mostafa, S. H. and Mohamed, T. A. (2014) “A proposed model to address convergence determinants, IFRS & FASB: Measurement and disclosure of revenue recognition”. International Journal of Academic Research 6 (3), 269-285.
Nagy, A. L. (2014) “PCAOB quality control inspection reports and auditor reputation”. Auditing: A Journal of Practice and Theory 33 (3), 87-104.
Peytcheva, M., Wright, A. M. and Majoor, B. (2014) “The impact of principles-based and versus rules-based accounting standards on auditors’ motivations and evidence demands”. Behavioural Research in Accounting 26 (2), 51-72.
PWC (2012) IFRS and US GAAP: similarities and differences. [pdf] Available at: https://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/ifrs-and-us-gaap-similarities-and-differences-2012.pdf [Accessed 20 June 2015].
Reuters (2012) Autonomy founder says HP allegations don’t add up. [online] Available at: http://www.reuters.com/article/2012/11/23/us-hp-results-accounting-idUSBRE8AM0CG20121123 [Accessed 20 June 2015].
Rivera, et al. (2014) “IASB and FASB convergence project: Where are they now?” Global Conference on Business and Finance Proceedings 9 (1), 665-674.
Sam, S., Smith, A. and Strickland, A. (2014) “Differences and similarities between IFRS and GAAP on inventory, revenue recognition and consolidated financial statements”. Journal of Accounting and Finance 14 (2), 120-123.
Satin, D. and Lin, R. (2009) “Is there LIFO after IFRS?” Academy of Accounting and Financial Studies 14 (2), 53-56.
SEC (2015) The role of the SEC. [online] Available at: http://investor.gov/introduction-markets/role-sec [Accessed 21 June 2015].
Shapiro, D. (2013) “The HPQ/AU Scandal: What went wrong?” Journal of Corporate Accounting and Finance 24 (4), 49-53.
Spillane, D. K. (2015) “PCAOB and SEC referrals to the Office of Professional Discipline”. CPA Journal 85 (5), 48-53.
Srivastava, A. (2014) “Selling-price estimates in revenue recognition and the usefulness of financial statements”. Review of Accounting Studies 19 (2), 661-697.
Stander, S., Buys, P. and Oberholzer, M. (2013) “Using the cultural dimension and accounting value classification frameworks to investigate cultural diversity in a multi-national south African-based company”. International Research Journal 11 (3), 301-316.
Walker, R. S. (2004) “The effect of recent US legislation and rule making on corporate compliance and ethic programmes”. International Journal of Disclosure and Governance 1 (2), 138-145.
Zapranis, A. and Tsinaslanidis, P. E. (2012) “Identifying and evaluating horizontal support and resistance levels: an empirical study on US stock markets”. Applied Financial Economics 22 (19), 1571-1585.