The sinking of a superyacht during a storm off Sicily last week that took the life of British tech entrepreneur Mike Lynch brings to light his legacy, which includes a question of ethics in accounting. That topic was central to federal fraud charges that Lynch faced in relation to the sale of his software company Autonomy to the U.S. tech giant Hewlett Packard. He was acquitted in a San Francisco courtroom earlier this year.
Lynch was known as the “British Bill Gates” and was the founder and CEO of Autonomy. But following the company’s acquisition by HP in 2011 for $11.1 billion, HP would accuse Lynch and other corporate executives of cooking the books. Lynch was acquitted in June but his former CFO Sushovan Hussain was earlier sent to jail for five years, and in July, he was banned from accounting until 2038.
Hussain was found guilty of 16 counts of fraud in 2018. Back-dated contracts, round-trips, and channel stuffing are at least three of the fraudulent accounting practices that sent him to prison for five years. But what do these practices entail?
Using back-dated contracts happens when the perpetrator changes the date of a contract to make it seem like the sale happened in an earlier accounting period, John M. Veitch, dean for the School of Business and Management at Notre Dame de Namur University, told Fortune.
“For instance, say a company may have missed its revenue targets by $1 million for Q4 2023,” he explained. “It could take a sales contract for $1 million signed on Jan. 15, 2024, change the date to Dec. 24, 2023, and then recognize that $1 million as revenue for Q4 2023,” he said. Essentially back-dating a contract improperly pulls sales from a later period back into an earlier period to increase the earlier period's revenues, Veitch said.
In the legal battle, HP argued that Lynch and his allies, Autonomy’s former vice president for finance Stephen Chamberlain, who was also acquitted, as well as Hussain, had used accounting tricks to inflate Autonomy’s value before its sale.
Meanwhile, channel stuffing, in general, occurs when a company attempts to inflate or artificially increase its sales figures by pushing through more products than it's capable of selling to meet expectations, Shane Goodwin, associate dean, and a finance professor at the Cox School of Business at Southern Methodist University, told Fortune. “It’s manipulating the financials to reflect something that is really not true,” he said.
In Autonomy's case the round-tripping “appears to be a little more complex,” Veitch said. What was sold was hardware but it booked these sales as software contracts instead, he said. “The rationale was that hardware sales have low-profit margins, while software contracts tend to have much higher profit margins,” Veitch explained. So, HP would value software sales more highly than hardware sales.
“I can't find details but I imagine that Autonomy bought the hardware back in a later period as hardware, not as a software contract,” he said. “This is the only ‘sophisticated’ piece to the accounting fraud I can find in the public record.”
Ethical guidelines
In general, the boundaries and ethical guidelines for accounting are always set by the company’s board, said Goodwin, who also serves as chair of the audit committees on the boards of Principal Private Credit Fund and Principal Real Asset Fund.
Boards collaborate with leadership, starting with the CEO, then the CFO and audit teams, he said. “We also work closely with the outside auditors to make sure we're understanding everything that's going on with the company from an audit perspective,” Goodwin said.
“In my experience, large-scale use of channel stuffing, back-dating contracts, and round-tripping within a company is almost always sanctioned by those at or near the top because of the pressure to meet goals and the resulting benefits—receive bonuses or maximize stock grant value,” Veitch said.
And in the case of Autonomy, it's questionable whether the company actually wanted to prevent the fraudulent practices, according to Veitch. “I'll simply note that HP was looking to buy Autonomy during this period, and the higher the revenue and revenue growth Autonomy demonstrated, the higher the price HP would pay,” he said. “Members of the Autonomy management team undoubtedly had shares of Autonomy and were hoping for the highest possible price.” It seems the management team incentives “were not aligned with preventing this from happening at all,” he said.
Regarding Lynch, the prosecution's argument was that he had knowledge and understanding of the fraud being committed, Veitch explained. But he argued that he wasn't involved in accounting and contract matters (claiming he couldn't understand the financial projection spreadsheets) and only marketing and technical issues. As Lynch was acquitted in June of the fraud charges, “the jury did not find the prosecution's argument compelling,” Veitch said.
