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Deloitte's Autonomy auditor 'lost objectivity' when looking at Brit software firm's disputed books, says regulator

FRRP's full report will be uncomfortable reading for ex-CEO Mike Lynch

The Financial Reporting Review Panel has said the senior Deloitte auditor who signed off Autonomy's accounts engaged in "word smithing" to help the British software firm hide its hardware sales from the market.

Former Deloitte accountants Richard Knights and Nigel Mercer were both found to have committed professional misconduct, as the FRRP announced last year. Today brings the publication of its detailed report, or judgment, into what amounted to a trial held last year by the accounting profession's private regulatory court.

The report comes after the FRRP announced its sanctions against Mercer, Knights and Deloitte in September 2020: a £15m fine for the firm; a £500k fine for Knights and a £250k fine for Mercer. Both men have now retired from accounting.

While the FRRP report has no direct bearing on the High Court case brought by Hewlett Packard Enterprise against former Autonomy CEO Mike Lynch and CFO Sushovan Hussain, the pair's defence throughout that amounted to "Deloitte signed them off so our accounts were OK." Neither will enjoy reading the full FRRP report.

Hard talk over hardware

Knights was a senior partner at Deloitte's Cambridge office while Mercer was on the audit team. Both were closely involved in the auditing of Autonomy's accounts during the critical 2009-2011 period, after which Autonomy was bought by Hewlett Packard (as was) for $11bn. Shortly after that buyout, HP wrote down Autonomy's value by $8.8bn and cried that it had been defrauded.

Knights and "to a lesser extent" Mercer were involved in Deloitte's failure to detect that Autonomy's accounts were false, with the duo having failed to challenge internal Autonomy accounting practices, the FRRP found.

The report said they'd failed to make it clear to Autonomy that its sales of hardware (both pure enterprise hardware and appliances with pre-installed software) should have been broken out separately in the published accounts.

Autonomy instead told the world it had a "pure software model" as far as its business was concerned.

A 2009 statement made on a part of Autonomy’s website titled "The Investors' Question Board" said:

Historically, companies that have achieved these [revenue] levels often diversify into hardware or other areas, which has a big impact on operating margin. For Autonomy, it's hard to see what other areas could be valuable enough to warrant such a large departure from the pure software model.

In addition the panel said: "Both Mr Knights and Mr Mercer knew that the hardware sales would be of great interest to the market... That is also why Mr Knights engaged in 'word smithing' to facilitate the non-disclosure."

Instead of issuing an unqualified audit opinion that the accounts were OK, Knights and Mercer should have "refused to sign" until Autonomy corrected "the misleading statements" in its directors' reports.

Gone native

Autonomy was, as the FRRP stated in today's detailed report, "the only FTSE 100 company audited from Deloitte's Cambridge office".

Knights was the Deloitte "engagement partner" for Autonomy overseeing the commercial relationship between the two companies. He had a special interest in keeping Autonomy's board sweet during the quarterly and year-end audits, as became clear during the FRRP hearings last year. In a 2010 email seen by the panel, he told his Deloitte bosses "we have set ourselves a target of increasing revenues to this FTSE company by >20%".

The engagement partner, found the FRRP, "yielded to client pressure when accepting the hardware cost allocation" suggested by Autonomy for its 2009 reported revenues – and even "searched for ways for Autonomy to avoid being frank with users of the financial results when proposing wording for the Q2 10 press release."

Mercer, meanwhile, half-heartedly tried to tell Autonomy that investors "would expect appropriate explanation to be given" of its hardware sales but the FRRP ruled that at most he had made a "suggestion" rather than doing the right thing.

Neither man was dishonest, the FRRP went on to state, but it did say that Knights had "lost his objectivity", which is a key part of being a financial auditor.

After the FRRP announced its findings last year he remained insufficiently apologetic, as the panel found: "We are left with the impression that Mr Knights may not even now accept that he did anything wrong. That would be consistent with the fact that he and the other Respondents fought this case on every issue to the very end."

"At most," it continued, "Mr Knights made suggestions to Autonomy as to what it should consider doing and said that there may be a requirement to disclose. The statement 'we are totally comfortable with the numbers as reported to the Audit Committee and in the release' (email of 4 November 2009) and the tone and substance of his email to [Autonomy] of 25 January 2010 clearly show that Mr Knights was not in fact pressing Autonomy to disclose the hardware sales."

Mercer's misconduct, meanwhile, was found to be "significantly less serious than that of Mr Knights."

The pair and Deloitte were also found to have committed misconduct over Autonomy's transactions with its resellers, which, HPE alleged in the High Court, were a cash carousel designed to pump up revenues through a web of fake deals. It was alleged in court that selected resellers creamed 10 per cent off these fake contra deals.

This is more proof that we were defrauded, says HPE

Knights and Mercer's spokeswoman referred The Register to a statement they gave when the FRRP first announced its findings against them. This said: "We are disappointed that the Tribunal has criticised our conduct and certain judgements we made in 2009 to 2011. At all times we believe we acted professionally, diligently and in good faith and we disagree with the findings. We are grateful for the full and unwavering support of Deloitte in this matter."

Deloitte also repeated its statement from September, saying: "Our audit practices and processes have evolved significantly since this work was performed over a decade ago and we continue to transform our audit by investing in firm-wide controls, technology and processes. We remain committed to playing our role in delivering change that embraces audit quality, improves choice and restores trust in the profession."

HPE, perhaps unsurprisingly, was quietly joyous about today's report, telling The Register: "HPE welcomes the publication of the Financial Reporting Council report. The findings from the report confirm our view that Autonomy misrepresented its financial performance through a series of calculated sham transactions and the deliberate failure to disclose its substantial hardware reselling business."

Mike Lynch, former CEO of Autonomy, declined to comment. The Register is unable to reach former CFO Sushovan Hussain because he is in prison in the US, serving a five-year sentence for fraudulently misrepresenting Autonomy's accounts.

The FRRP investigation was triggered by Autonomy whistleblower Brent Hogenson, formerly its US CFO.

Hogenson said he tried warning Lynch in 2010 that something was wrong with Autonomy's accounting after one of his juniors spotted irregularities. He was demoted and fired for his troubles. Lynch later described Hogenson in the High Court as having tried to blackmail Autonomy for a payoff after the man tried and failed to cover up his own incompetent accounting.

The High Court has yet to hand down judgment in the case against Lynch and Hussain.

In a few weeks Lynch faces the start of a US extradition attempt, which could end with him standing trial on criminal charges on the far side of the Atlantic. The Register will be covering the extradition proceedings. ®

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