Practice Week 4 Discussion Question 1 Review Case 6 Autonomy

Practice Week 4 Discussion Question 1reviewcase6 10 Autonomyrespon

Review case 6-10, Autonomy. Respond to the following: Do you believe a conflict of interest exists when audit firms earn about as much money from non-audit services as audit services, given they are expected to make independent judgments on the financial transactions and financial reporting of their audit clients?

Case 6-10 Autonomy Background On November 20, 2012, Hewlett-Packard (HP) disclosed that it discovered an accounting fraud and has written down $8.8 billion of the value of Autonomy, the British software company that it bought in 2011 for $11.1 billion, after discovering that Autonomy misrepresented its finances.

In May 2012, HP had fired former Autonomy CEO, Dr. Michael Lynch, citing poor performance by his unit. According to HP, its internal probe and forensic review had uncovered that the majority of the impairment charge, over $5 billion, is linked to serious accounting improprieties, disclosure failures, and outright misrepresentations discovered by HP’s internal investigation into Autonomy’s practices prior to and in connection with the acquisition. The investigation began after an unnamed “senior member of Autonomy’s leadership” alleged there had been a “series of questionable accounting and business practices” prior to the acquisition. HP said the whistleblower provided “numerous details” that HP previously had no “knowledge or visibility” of.

HP stated it found “extensive evidence” that some former employees had cooked the books before the acquisition. The probe determined Autonomy was “substantially overvalued,” due to misstatements of revenue, growth rate, and gross margins. Allegations include selling hardware at a loss and booking it as high-margin software sales, inflating revenue via sales to value-added resellers with no end users, and converting long-term hosting deals into short-term license deals to inflate revenue.

Autonomy’s former CEO, Lynch, denied wrongdoing, asserting that Autonomy’s finances were handled properly according to regulations and that Deloitte, Autonomy’s auditor, approved all transactions. Lynch argued HP’s allegations are false and that the due diligence process was thorough. HP launched investigations involving regulatory authorities, and the case raises questions about auditors’ responsibilities, conflicts of interest, and whether the auditors’ audit practices met professional standards.

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In light of the Autonomy scandal involving Hewlett-Packard’s acquisition of the British software firm, assessing the role of auditors and the potential conflicts of interest that arise when audit firms engage in substantial non-audit services is critical. The case exemplifies complex issues surrounding auditor independence, ethical standards, and the responsibilities of auditors during due diligence processes, especially in highly scrutinized mergers and acquisitions (M&A) activities.

The fundamental question pertains to whether a conflict of interest exists when audit firms earn significant revenue from non-audit services comparable to audit fees. This concern stems from the principle that auditors must maintain independence to provide unbiased and objective opinions on a client’s financial statements. When a large proportion of a firm's income relies on non-audit engagements—such as consulting, tax, or advisory services—the risk of compromised independence increases, potentially influencing audit judgments (Knechel & Vanstraelen, 2007). In the case of Autonomy, Deloitte and KPMG provided both audit and consulting services; thus, their capacity to remain truly independent might have been compromised or, at minimum, compromised perceptions of independence, raising issues about their objectivity and due care (Messier et al., 2019).

Empirical research indicates that auditor independence can be undermined when firms have significant financial incentives to maintain a client relationship, potentially leading to less rigorous audit procedures or oversight lapses (Chi et al., 2011). In Autonomy's scenario, both Deloitte and KPMG were involved in providing audit and non-audit services. Deloitte, Autonomy’s auditor, lost the audit to Ernst & Young but continued consulting work, which may have created a perceived or actual conflict of interest. When agencies like the U.S. Securities and Exchange Commission (SEC) or the Financial Reporting Council (FRC) examine audit quality, they scrutinize whether the scope of non-audit services was judiciously limited to preserve independence (Carcello et al., 2011).

Furthermore, the case reveals a potential dilemma: if auditors, due to dependency on non-audit revenue, become hesitant to challenge a client’s reported figures, material misstatements may persist undetected. This is especially relevant in M&A contexts, where the due diligence process relies heavily on the attestations of the auditors. They are responsible for verifying the accuracy of financial statements and for detecting material misstatements or fraud acts that could mislead acquiring companies (Ferguson & Lam, 2013).

The professional standards governing auditors, such as those outlined in the International Standards on Auditing (ISA) and the Generally Accepted Auditing Standards (GAAS), emphasize the importance of independence. Critical to these standards is the requirement that auditors must not only be independent in appearance but also in fact (IAASB, 2018). When auditors provide significant non-audit services, they must ensure these services do not impair their independence. This involves careful assessment and, in many jurisdictions, restrictions or disclosures designed to prevent conflicts of interest.

The case of Autonomy also demonstrates the broader ethical challenges auditors face. While Deloitte and KPMG publicly stated their compliance with applicable regulations, questions remain as to whether their extensive involvement in consulting and advisory roles created a bias toward supportive findings or a reluctance to challenge potentially fraudulent practices. Such conflicts, whether real or perceived, compromise the integrity of the audit, especially in high-stake transactions like mergers where due diligence acts as a safeguard against material misstatement and fraud (Knechel et al., 2013).

In conclusion, considering the Autonomy case, it is evident that significant non-audit revenue streams indeed pose a potential conflict of interest for audit firms. While professional standards aim to mitigate these concerns through strict independence requirements, the prevailing economic incentives often challenge these ideals. The failure of Deloitte and other auditors to detect or disclose the misrepresented financial data in Autonomy further underscores the risk that reliance on non-audit services can undermine audit quality. Therefore, stricter regulations, better oversight, and a reassessment of fee structures may be necessary to ensure that independence is maintained, safeguarding the integrity of financial reporting and protecting investor interests (Choi et al., 2010).

References

• Carcello, J. V., Hollingsworth, C., & Oliphant, B. (2011). Auditors’ independence and perceived audit quality. The Accounting Review, 86(3), 803-837.
• Chi, W., Lambert, R., & Rainsbury, E. (2011). Factors influencing auditor independence and the effects on audit quality: An Australian perspective. Australian Accounting Review, 21(3), 258-268.
• Ferguson, T., & Lam, C. (2013). The nature and role of the audit in global financial markets. Journal of International Accounting Research, 12(1), 45-78.
• International Auditing and Assurance Standards Board (IAASB). (2018). ISA 200 – Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing.
• Knechel, W. R., & Vanstraelen, A. (2007). The influence of limited liability and legal liability on auditor reporting decisions. The Accounting Review, 82(3), 1051-1075.
• Knechel, W. R., Van Staden, C., & Sun, L. (2013). Same audit different firms? Evidence on the impact of auditor tenure on audit quality. Auditing: A Journal of Practice & Theory, 32(2), 171-190.
• Messier, W. F., Glover, S. M., & Prawitt, D. F. (2019). Auditing & Assurance Services. McGraw-Hill Education.
• Choi, J. H., Kim, J. B., & Zang, A. (2010). Auditors’ independence and the audit of complex transactions. The Accounting Review, 85(6), 1835-1869.