Presentation Transcript

1. Lernout & Hauspie Audible Software, Blind Accounting Chuck Boguslaski Martin Cullen Dean Moore

2. Company Background • Formed in 1987 by Jo Lernout and Pol Hauspie • Developer of speech and language technologies • Early financial struggles, but the company was both fortuitous and creative • Went public on the Nasdaq in late 1995 • Dramatic revenue “growth” and stock appreciation • Acquisition of two large competitors for almost $1 billion in stock • Market Cap valued at $9 billion at the height of popularity

3. Truth and Consequences • Multi-pronged strategy that resulted in improper revenue recognition • Recording fictitious transactions • Sham related party transactions • Written and oral side agreements • Admission of accounting irregularities • Resignation of several key executives • Bankruptcy and sale of assets • Arrest of co-founders and CEO

4. Lernout & Hauspie Closing Stock Price Source: Bigcharts.com

5. Fraud Scheme: Asia Transactions • Asian sales explode in 1999. • Singapore sales: $29,000 to $80mm in one year. • Korea sales: up 100-fold from 1998. • L&H attributes growth to a local acquisition. • Previous year’s sales were $12mm. • How did L&H really do it? • Fictitious transactions with fictitious customers. • Fictitious transactions with existing customers. • Sales subject to oral and written side agreements. • ‘Factoring’ of A/R (e.g., fully secured loans from banks). • Paying down its own receivables via related party transactions.

6. Fraud Scheme: How to Book R&D Expenses As Revenue Influence/ Ownership Mr. Lernout Mr. Hauspie FLV Fund Cash Ownership Ownership Payments (Revenue) Shell Company Lernout&Hauspie NV R&D programming Option to buy and receive R&D rights

7. Financial Statement Effects Effect on the Income Statement • Overstatement of revenues • Understatement of R&D expenses • Overstatement of income Effect on the Balance Sheet • Overstatement of cash and A/R • Amortization of goodwill over 7 years vs. current R&D expense

8. Fraud Detection: How Did Their Plan Unravel? • Acquired two competitors in 2000 • Dictaphone for $504 million in stock • Dragon Systems for $460 million in stock • Dictaphone’s $430 million in debt • Difficult for L&H to service • Where’s the $100mm in Korea? • More detailed financial statements for US regulations • Aug 2000 WSJ article focusing on Asian sales • KPMG mid-year audit • “Korean revenues not supported financially”

9. What Went Wrong? Related Party Transactions • Was there an arms length agreement between L&H and the shell companies? • Mr. Lernout and Mr. Hauspie had substantial control over the shell companies • Implicit agreement to compensate shell company investors through acquisition • Scheme financed through the public investors’ money

10. Hindsight: Prevention How could the fraud have been prevented? What type of controls would have sufficed? • Corporate Governance – Independent Chairperson to control/oversee the influence of “The Belgian Mafia” • Strong Audit Committee – Results released 13 days before the audit committee met to discuss the results.

11. Auditing Procedures • Auditing 101 – Look for DRAMATIC Increases in Revenue. • Korean Revenue Scam – • Examine the receivables to discern likelihood of repayment. • Investigate bonus scheme for Korean managers. • Calculate proportion of sales recorded immediately before Quarterly or Yearly financial periods. • Language Development Companies – what service exactly is L&H providing for this dramatic revenue growth?