Sometimes big companies engage in transactions that make you wonder what on earth they were thinking. Hewlett-Packard’s 2011 acquisition of the British software company Autonomy certainly falls in that category. Even at the time, news of the acquisition contributed to a 20% drop in HP’s share price. And last fall HP wrote down the value of the acquired company by $8.8 billion, blaming $5 billion of the writedown on improper accounting.
Right now, regulators are investigating whether Autonomy actually engaged in improper accounting. But what’s interesting is that almost no one raised a red flag at the time. KPMG, the big accounting firm, was helping HP with its due diligence by inspecting Autonomy’s books. The accountants apparently gave the company a clean financial bill of health, even though there had been rumors of accounting improprieties.
It’s all an astonishing story — except that similar things happen on a lesser scale all the time. Investors and lenders find themselves misled by companies’ financials. Acquirers pay too much for a target company because they have misread or misinterpreted the books. Sometimes the problem is outright fraud. More often it’s a problem related to what we call the Art of Finance.
The idea of finance as an art sometimes puzzles people. Financial reporting is about numbers, they assume, and numbers are either accurate or they are not. Financial numbers, though, are different. Many of the entries on a company’s income statement and balance sheet reflect estimates, assumptions, and procedural rules. Companies can treat these estimates, assumptions, and rules very differently, and so can wind up with wholly different accounting numbers for similar sets of transactions.
For example, imagine that two companies are launching new lines of medical imaging equipment, complete with maintenance and service contracts. One company might decide that most of its costs are incurred in manufacturing and so will “recognize” most of the revenue from a sale — that is, record the revenue on its books — as soon as the equipment is delivered. The other might want to allow for major costs on the service end, and so will wait until the service contract expires to record much of the revenue. Result: the two companies’ books would look quite different, even though their business was very similar. As long as both companies are consistent, it is all quite legal.
Autonomy, by many reports, engaged in “aggressive” accounting, which means that it used the estimates, assumptions, and rules to make its books look as good as possible. HP and KPMG were remiss in not tracking down exactly how aggressive its procedures were. But Autonomy is hardly alone in this practice; many companies treat their financial statements in this way. Former Sunbeam CEO “Chainsaw” Al Dunlap was even said to view his finance department as a profit center. By manipulating the books, the company could polish up its results until they glistened.
When you look at a company’s books, you’re really looking at the integrity of the executive team responsible for them. You would want to check out their past practices and reputations, and you would want to sit down and go over the estimates, assumptions, and rules in great detail. But HP was so eager to get the transaction done that it failed to examine the financials with sufficient care.
Why so? According to a recent Wall Street Journal article, then-CEO Leo Apotheker was the deal’s chief advocate, and lobbied the board hard to approve it. The late Peter Drucker may have the best explanation. “I will tell you a secret,” said Drucker: “Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work — dealmaking is romantic, sexy. That’s why you have deals that make no sense.”
Apotheker is long gone from HP. But the company, unfortunately, is paying a steep price — $8.8 billion in writeoffs — for this senseless deal.
Originally published on Harvard Business Review Blog.