A Glass or Two of Red Helps Square the Numbers

(Bloomberg Opinion) -- The U.K. arm of Deloitte got a record fine from Britain’s accounting watchdog in September. With the full judgement against the firm laid bare last week, you can see why. If there was ever proof that auditors can get too close to their clients, it’s the accounting giant’s handling of former U.K. technology darling Autonomy Corp.

Deloitte LLP wrongly gave a clean bill of health to Autonomy's accounts for 2009 and 2010. These financial statements misleadingly suggested revenue from shifting hardware came from software, while related costs were inappropriately classified as sales and marketing expenses, the U.K.’s Financial Reporting Council argued. That helped sustain the impression that Autonomy was a fast-growing, high-margin “pure software” business — a perception that was critical to its stock-market rating. The group was subsequently acquired by HP Inc., which later took a jumbo impairment charge and alleged Autonomy had committed fraud.

Emails included in the judgement reveal that Deloitte’s Autonomy team was conscious there was a problem with their client’s desired approach to revenue and cost recognition as it worked on 2009’s third-quarter numbers. One of the auditors, trying to rationalize the methodology, noted: “This is where I begin to struggle.” But the lead partner ultimately accepted it just before a meeting of Autonomy’s audit committee. 

“The decision to approve the allocation bears all the hallmarks of having been made in a hurry under client pressure,” said the independent tribunal that heard the case. “Deloitte had been anxiously considering the allocation of the hardware purchase costs for at least ten days and time was running out.”

This has been a drawn out investigation focused on Deloitte. It went on for so long partly because the firm would not settle. Deloitte says its audit practices and processes have evolved significantly since the work for Autonomy was performed, and that it’s continuing to invest in its controls. Two partners also sanctioned say that they believe that at all times they acted professionally, diligently and in good faith and they disagree with the tribunal’s findings.

Sadly, the dynamics exposed here are familiar and enduring. Autonomy was under pressure to meet investors’ expectations for revenue and gross margin expansion. In turn, its auditor was under pressure to approve an aggressive accounting methodology. These forces were magnified by the size and status of the client, a member of the FTSE-100 index and the lynchpin of Deloitte’s Cambridge office.

The tribunal concluded a key failure was a loss of “objectivity.” Small wonder. The Deloitte partner leading the Autonomy work sent his client an email from his wife’s account saying that “after a glass or two of red wine” and a plate of her “medieval pasta” he’d drafted an explanation of the proposed accounting treatment himself, for Autonomy to work on. “This needs to come form [sic] you to us,” it went on. Clearly this is not how an auditor should be telling a client to provide supporting evidence for their accounting.

The individual fines levied here of 500,000 pounds ($675,550) and 250,000 pounds are clearly some deterrent to misconduct. But Deloitte’s 15 million-pound penalty will be easily swallowed. The “Big Four” are essentially too big to fail. Financially they can only be hit so hard, while their dominance means that reputational hits won’t turn off their revenue.

The case points to other remedies. Better promotion of “speak-up” channels is one. An audit team member whose concerns are disregarded by their seniors should feel able, and duty bound, to go over their heads. Anonymous phone lines are a requirement of the U.K. accounting industry’s governance code and audit firms’ non-executive directors are obliged to ensure they’re effective. Annual disclosure of the usage statistics would focus minds.

The debacle meanwhile strengthens the case for having a smaller, challenger firm come in alongside a Big Four auditor. That was recently proposed by the U.K.’s top trustbuster to help stimulate competition. It would support objectivity too.

And auditors might find it easier to stay detached from their clients if they dealt more regularly with the end user of the accounts — the investors. Former banker Donald Brydon’s recent review of the sector identified an “under engagement” with the auditing process by institutional shareholders. So long as that continues, don’t be surprised if auditors see their clients, not investors, as the boss.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.