Chapter 8: Intercorporate Investments
An Acquisition Debacle for Hewlett Packard
In 2011, Hewlett-Packard (HP) purchased approximately 87% of the share capital (213 million shares) of Autonomy Corporation plc. for US $11.1 billion cash. The purpose of this acquisition was to ensure that HP took the lead in the quickly growing enterprise information management sector. Autonomy's products and solutions complemented HP's existing enterprise offerings and strengthened the company's data analytics, cloud, industry, and workflow management capabilities, so the acquisition made sense from a strategic point of view.
Autonomy HP was to operate as a separate business unit. Dr. Mike Lynch, founder and CEO of Autonomy, would continue to lead Autonomy HP's business and report to HP's Chief Executive Meg Whitman (Hewlett Packard, 2011).
However, trouble quickly brewed and in 2012, accounting "anomalies" were uncovered by HP, giving rise to a massive impairment write-down of the Autonomy HP unit to the tune of an $8.8 billion impairment charge. Compared to the original $11.1 billion purchase price, the impairment represented a whopping 79% drop in the investment's value, a mere one year later.
HP alleged that the owners of Autonomy misrepresented their company's financial position due to what HP referred to as serious accounting improprieties . To make matters worse, all this came at a bad time for HP, given that its fourth quarter financial results were already down 20% in hardware sales and 12% in laptop/desktop sales (Souppouris, 2012).
The question remained; how was it possible to lose 79% of Autonomy HP unit value in less than one year? HP claims to have discovered all kinds of accounting irregularities which were denied by Autonomy's founder and CEO, Mike Lynch. HP claimed that it would have paid half the purchase price, had it known what it later discovered about Autonomy's true profitability and growth.
Consider that software companies like Autonomy do not have much value in hard assets, so the impairment did not relate to a revaluation of assets. Also, Autonomy did not have much in the way of outstanding invoices, so there was no large non-payment of amounts owed to trigger the drop in value and subsequent impairment write-down.
So the impairment charge more likely reflected a reassessment by HP of the future cash flows originally estimated, based on the financials, to be much less than anticipated. This is backed up by Chief Executive Meg Whitman's assertion that Autonomy's real operating profit margin was closer to 30%, and not its reported 40 to 45%.
Whitman accused Autonomy of recording both long-term deals and sales through resellers as fully realized sales. Consider that the booking of revenue is not clear-cut in the software industry because of the differing accounting rules. For example, if Autonomy recorded an extra $20 million of future sales now, without recording the associated additional cost of goods sold, the gross profit percentage would exponentially increase, perhaps by as much as 10 to 15%.
HP also stated that the actual losses of Autonomy's loss-prone hardware division were misclassified as "sales and marketing expenses" in the operating expenses section rather than as cost of goods sold in the gross profit section. Since sales figures were reported as steeply increasing, this would create a more favourable overall growth rate. Since growth is another factor in business valuations, this exponential effect could also have affected the purchase price HP thought it was willing to pay.
Companies can also increase reported net income by inappropriately classifying certain current expenses as investments (assets), which are thereafter amortized over several years. Some analysts suspected that Autonomy misclassified some of its research costs in this way. Moreover, some of Autonomy's growth was generated from acquisitions of other businesses. Takeovers can, for example, give a more favourable impression of growth rates, if pre-acquisition sales are understated. In this light, apparently, some analysts questioned Autonomy's acquisition accounting.
With all the factors discussed above, it is possible that HP could allege and demonstrate that inappropriate reporting and valuation errors led to a discrepancy the size of which it purports. Autonomy HP unit CEO, Mike Lynch, denies all charges of reporting impropriety or error. He said that Autonomy followed international accounting rules.
Until HP's accusations are fully investigated, it will be impossible for stakeholders and others to know what really happened.
(Source: Webb, 2012)
[Note: IFRS refers to the balance sheet as the statement of financial position (SFP) and ASPE continues to use the historically-used term balance sheet (BS). To simplify the terminology, this chapter will refer to this statement as the historically generic term balance sheet .
After completing this chapter, you should be able to:
- Describe intercorporate investments and their role in accounting and business.
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Identify and describe the three types of non-strategic investments.
- Fair value through net income (FVNI) classification and accounting treatment.
- Fair value through OCI (FVOCI) classification and accounting treatment.
- Amortized Cost (AC) classification and accounting treatment.
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Identify and describe the three types of strategic investments.
- Investments in associates classification and accounting treatment.
- Investments in subsidiaries classification and accounting treatment.
- Investments in joint arrangements general overview.
- Explain disclosures requirements for intercorporate investments.
- Identify the issues for stakeholders regarding investment analyses of performance.
- Discuss the similarities and differences between IFRS and ASPE for the three non-strategic investment classifications.
Introduction
Intercorporate investments arise when companies invest in other companies' securities as the Hewlett Packard shares acquisition cover story illustrates. This chapter will focus on explaining how these investments are classified, measured (both initially and subsequently), reported, and analyzed. Canada currently has two IFRS standards in effect: IFRS 9, which was effective January 1, 2018 and ASPE. The purpose of this chapter is to identify the various classifications and accounting treatments permitted by either standard for investments in other companies' debt and equity securities.
Chapter Organization