Abstract
The case of The Lernout & Hauspie Speech Products (L&H) provides a negative example to illustrate the importance of corporate governance, ethics and audit responsibility. Although it happened in Belgium, it still reminds us, as accounting professionals, to consider whether the current regulatory framework in Australia is robust enough to prevent such a situation. This report will analyse the circumstances lead to the failure of L&H primarily. Fraudulent, unethical accounting practices and poor corporate governance are the main reasons for bankruptcy, which include side agreement and factoring unpaid receivables to banks in the Korean division, undisclosed related party transactions and providing misleading information to KPMG. Based on the demonstration of current regulation policies in Australia, such as Corporation Act, ASX Corporate Governance Principles, AASB, and professional accounting institutions, the report will elaborate ethical education to senior managers as an appropriate improvement to the Australian Governance framework.
Contents
2.1 Engage in fraudulent accounting practices. 3
2.2 Business (accounting) practices. 4
2.4 Enhance corporate governance. 5
2 Part B: Regulations and Profession Framework in Australia. 6
3.1 Regulations and Profession Framework in Australia. 6
1. Introduction
In Belgium, Lernout & Hauspie Speech Products (L&H) had been considered one of the most promising high technology companies. The company was started in 1987 by Jo Lernout and Pol Hauspie and successfully struggled through its early years. Belgium's National pride and the aspiration to convert Flanders, Belgium's Dutch-speaking region into Silicon Valley were the two factors that helped L&H fight the battle. The company declared bankruptcy in October 2001 after the discovery of a massive accounting fraud. The purpose of this report is to highlight the fraudulent practises mentioned in the case that led to the failure of L&H. The report also analyses the Corporate Governance framework of Australia that would have some oversight on the events that occurred in the company. The analyses will be conducted to find out whether Australia's Regulatory framework is strong enough to overcome the challenges posed by such an event. At the end of this report, some suggestions will be given related to the regulations.
2. Part A: L & H Analysis
2.1 Engage in fraudulent accounting practices
L&H Speech Products is a company which produces speech technology software, which are high-technology products of inventory, thus prone to obsolescence. Under the pressure of Wall Street Journal expectations and competitive software developing industry, L&H was very keen to meet the desired earning targets as well as management incentives; this made L&H susceptible to accounting fraud in order to mislead investors.
With the acquisition of Dictaphone, investors were finally able to get a clearer view of L&H's financial results as the company was then obliged to file detailed accounts with the SEC in 1998. The fact that L&H was listed on the Belgium stock exchange, where the reporting and listing rules are much less stringent than in United States, also made the company prone to engage in fraudulent accounting practices as the chances of being detected were minimal.
The organisational factors identified as likely contributors to L&H's fraudulent accounting include its weak control environment as it was clearly indicated by the case facts that L&H internal controls were insufficient to detect the improper license revenues recognition which amounted to nearly $160 million in its South Korea division; rapid growth buoyed by related-parties deals and a spate of fresh acquisitions; inadequate or inconsistent profitability as showed in the L&H's sales in South Korea which soared from only $90,000 in 1999 to $58,932,000 in 2000 after the acquisition of Bumil Information & Communication Co in September 1999; management placing undue emphasis on meeting sales targets due to performance-based bonuses. In combination, all the organisational factors together made L&H prone to engage in fraudulent financial reporting (Brennan & McGrath, 2007).
The fact that the founders of the company were able to replace the company's CEO single-handedly whenever they wanted was clearly an indication of too much power being concentrated in the hands of two persons. This enabled them to override controls and direct others to commit or conceal the fraud, therefore made the company prone to fraudulent accounting practices as there were no other employees was dare to challenge the misconducts of the powerful top level executives for fear of losing their jobs.
2.2 Business (accounting) practices
Fraudulent accounting practices – Side agreements and factoring unpaid receivables to banks.
Of the nearly $160 million in sales revenue from L&H Korean unit between 1999 and 2000, 70% of them were fictitious. The revenues were fraudulent for two reasons: firstly, side agreements were being entered into between L&H and customers which excused them from paying their overdue bills (Intal & Thuy Do, 2002). Secondly, L&H-Korea had been involved in factoring unpaid receivables resulting from some of those fraudulent sales to banks, along with side letters which gave the banks right to take back the money if the L&H Korea's customers defaulted, and so the factoring agreements were in fact were loans.
Unethical accounting practices – Undisclosed related-party sales transactions
Dictation Consortium was an undisclosed related-party of L&H. Dictation Consortium was established by L&H with the initial purpose of allowing L&H to falsely claim revenue from its own R&D costs. L&H had improperly recorded the R&D costs which amounted to $26.6 million in 1996 and 1997 as revenue before the projects were able to produce any saleable products, and hence was inconsistent to the recognition of revenue under US GAAP – which demands that revenue be recognised only when it is earned (Intal et al., 2002).
Acceptable accounting practise – Acquisition of Dictation Consortium
Dictation Consortium had few assets and a significant portion of the purchase price represented goodwill, which could be amortised over 7 years. Given that the acquisition of Dictation Consortium was a legal one, it was an acceptable accounting practise, which L&H could utilise to shield its bottom line resulting from goodwill amortisation.
When the Korea scandal broke out, L&H commissioned KPMG to do a midyear audit. KPMG gave the company clean options in 1998 and 1999. After the fraud revealed, it claimed that its auditors have been fooled by L&H. This claim is believable because the top managers of L&H gave and even influenced others to give false information.
After the Korea scandal was reported, Mr. Bastiaens visited customers who interviewed for The Wall Street Journal. Then, they denied their former arguments that L&H had excessively reported their business with it. In addition, L&H factored unpaid receivables to banks to obtain cash in advance. Then pay them itself if the bank couldn't collect money from its customers. When auditors questioned why L&H was not collecting more of its overdue bills from customers, L & H asked customers to transfer their contracts to third parties, who then took out bank loan to 'pay'. This meant that in effect, L&H was paying itself, and the asked the third party to refuse KPMG's audit. These activities made L&H look as if it had collected money from customers when in fact it had not.
Generally, an external auditor's duty is to report his or her opinions on whether the company's financial report is in accordance with an identified financial reporting framework and gives a 'true and fair' view. The auditor prepares the Audit Report based on the information which is given by the clients (Leung, P., 2009, p. 182). In this case, L&H provided false information, and make a feint of running very well. When KPMG questioned about its overdue bills, L&H used schemes to cover the fraud. These made the discovery of fraud much more difficult. From the very outset, KPMG conducted the audit based on the fake information. It was hard for KPMG to access real information, and was consequently fooled by L & H.
2.4 Enhance corporate governance
To prevent fraudulent behaviours from taking place, companies need to enhance corporate governance. This can be achieved, such as setting up audit committee as well as other sub-committees. Actually, after Enron and WorldCom collapsed, many countries set up new regulation to enhance the corporate governance. For example, the US developed SOX in 2002. In this law, it states that a majority of the board of directors must be independent directors. A compensation committee of the board and a nominating/corporate governance committee of the board must be comprised entirely of independent directors (Sarbanes- Oxley Act, 2002). In Australia, there are similar rules, in ASX principles of good corporate governance, the majority of the board should be independent, and companies should establish an audit committee with independent auditors, to focus on issues relevant to the integrity of the company's financial reporting (ASX, 2007). If companies follow these regulations, the possibility of frauds occurring may be lower.
Considering how the fraud committed by Enron and WorldCom were discovered, another efficient mechanism is to set up whistleblower policies. Companies should encourage employees to speak out about problems in the company, since employees may notice problems better and earlier than external auditors may.
2 Part B: Regulations and Profession Framework in Australia
3.1 Regulations and Profession Framework in Australia
Since 2001, there are several regulatory and professional frameworks related to accounting and corporate governance that have been developed or changed in Australian.
The regulation of corporate governance is a mix of legal regulation and self- regulation (Lipton & Herzberg, 2008, p.289). The main regulatory elements are:
1. Corporations Act. It deals with a wide variety of corporate governance issues. These include
² directors' duties,
² shareholders' meetings, rights and remedies,
² the continuous and periodic disclosure obligations,
² the requirement for, and regulation of, auditors
² the regulation of takeovers
Legal regulation prescribes minimum standards which, if breached, may result in civil and, in the worst cases, criminal liability. However, legal regulation alone is insufficient in promoting good corporate governance practice.
For listed companies this is best achieved by self-regulation and disclosure of corporate governance practices to the market under the ASX Listing Rules (Lipton & Herzberg, 2008, p.290).
The focus of corporate governance is largely on the role and function of the board of directors. A board's functions fall into two distinct and separate categories: supervisory and strategic. The separation of these roles has led to several recommended corporate governance practices such as separation of the roles of chair and CEO, the appointment of independent directors and the use of board committees- especially in the areas where management may act in its own interests and not in the interests of shareholders (Lipton & Herzberg, 2008, p. 290).
2. ASX corporate governance listing rules.
ASX Listing Rule 4.10.3 requires the annual reports of listed companies to disclose the extent to which they have followed the recommendations in the ASX Corporate Governance Council's Corporate Governance Principles and Recommendations. This corporate governance disclosure requirement has been operative since 2003 (ASX, 2010).
Compliance with the Corporate Governance Principles and Recommendations is not compulsory. While it is recognised that listed companies are different from one another and have varying needs depending on their size, complexity and other considerations, there is an obligation to explain to investors why they may have adopted an alternative approach if they have departed from the Recommendations. According to the ASX, this approach puts emphasis on disclosure rather than compliance with prescribed practices, thereby allowing for greater flexibility and adaptation to changes as corporate governance principles evolve (Lipton & Herzberg, 2008, p.291).
3. There are some other regulations in Australia.
The AASB is a set of "rules of the road" that govern the way in which financial statements are prepared so that different financial statements are comparable (Locke, p. xvi). Members of CPA Australia, The Institute of Chartered Accountants in Australia and the National Institute of Accountants have a professional obligation to take all reasonable steps within their power to ensure that entities with which they are involved comply with Accounting Standards in preparing their general purpose financial reports (ASX, 2010).
Auditors must follow the AUASB, the standards by which audits were performed were scrutinised. Auditing as a professional service should not only provide assurance for the credibility of the financial statements but also enhance the integrity of financial information and its usefulness in decision making by management and other users (Leung et al, 2009, p. 7).
AUASB Standards establish requirements and provide explanatory guidance on the responsibilities of the auditor and the assurance practitioner, as appropriate, in audit and assurance engagements (AUASB, 2010).
Ideally, the regulation is established to prevent people from crime. But in fact, some people will risks to get what they want, both in daily life and business affairs. For example, both China and US still have capital punishment, but that really cannot stop crime. Recently, the regulations cover almost every step in companies' day-to-day operations in Australia. Regardless of position within the company- managers, employees, accountants or the auditors all must follow the specific regulations. For example, according to Corporation Act, managers should be responsible for their decisions and their decision can not harm for the company. If managers cannot comply with the law, they will be fined or even go to the prison. The same is true for accountants and auditors. However, these regulations cannot really stop the scandals. In 2008, ABC Learning Centre fell into receivership in 2008 because of fraud (Morrison, 2008). All these facts indicate that, sometimes the regulations cannot stop crime when people have strong intention to commit a crime. So, Australian current regulations and professional frameworks is not robust enough to prevent such a situation like L & H occurring in Australia.
In L & H case, the management created fake customers to increase the revenue of the company and engaged in other fraudulent activities as well. These behaviours are forbidden under current Australia regulation. But this does not mean the regulations can prevent frauds from occurring. The regulations can only remind management that what they do or what they want to do is wrong, and may be punished by the laws. But management may have their own ideas, such as they will be punished only if they are detected. So they still do the so-called wrong thing if they really want to do that.
To sum up, the effectiveness of the regulation is highly dependent on whether people choose to comply with it, but not the regulation itself.
People are more likely to take risks if the benefit is enticing. So, regulations should focus on how to solve the problem of "risk". Let people aware the risk, so that they would not like taking the risk. On one hand, the regulators can increase the penalty for the crime. But in fact, even the death penalty cannot stop people committing a crime. So it needs to figure out in another way. The regulation should let people obey the regulation voluntary. This can be called as "ethical education". For example, in the army, the soldiers' mission is following the command. So, in the economic market, the regulators should do the same thing as the army. That is to say, the first mission of the manager is following the laws. If this theory becomes a culture in the economic market, the manager will follow the rules voluntarily, possibly leading to a decrease in white-collar crime. According to Low, Davey and Hooper (2005), teaching people how to run a business or some theories in accounting is important, but to tell people to do the business in a moral way is more important. As a previous president of the United States of America, Theodore Roosevelt states: "To educate a person in mind and not in morals is to educate a menace to society".
3 Conclusion
Under the intense competition in IT industry and high expectation to be listed on stock exchange by investors as well as the management incentives of performance-based bonus, L&H committed fraudulent accounting practices. It overstated its accounting profit in South Korea division by side agreements and factoring unpaid receivables to banks, undisclosed related-party sales transactions and acquisition of Dictation Consortium. The audit partner KPMG was fooled by L&H's intentional scheme that covered its overdue bills by referring them to third parties and KPMG audited L&H's financial report based on the misleading information. The L&H case demonstrates that corporate governance is important to prevent fraudulent behaviours, such as establishing audit committee and having independent directors. Another way is to set up whistleblower policies which allow employees to detect fraud and speak out about the problem. To enhance the understanding of corporate governance, the second part in this report outlines the regulations and professional framework in Australia, examines their roles and provides some recommendations. Major regulatory and professional frameworks that related to the L&H in Australia were the Corporation Act, ASX Corporate Governance Principles and Recommendations, AASB, CPA, CA and AUASB. Despite a series of regulatory and professional frameworks in Australia to prevent fraudulent behaviour like L&H's, it is not enough. And how to make the users follow the regulations and principles is important, so implements such as "ethical education" need to be done.
4 References
ASX (2010) Corporate Governance, Retrieved from http://www.asx.com.au/about/corporate_governance/index.htm
AASB, (2010) Pronouncements, Retrieved from http://www.aasb.com.au/Pronouncements.aspx
AUASB, (2010) Standards and Guidance, Retrieved from http://www.auasb.gov.au/Standards-and-Guidance.aspx
Brennan, N.M. & McGrath, M. (2007). Financial Statement Fraud: Some Lessons From US and European Case Studies. Australian Accounting Review, 17(2), 49-61. Retrieved from Proquest database.
Intal, T. & Thuy Do, L.(2002). Financial Statement Fraud: Recognition of Revenue and the Auditor's Responsibility for Detecting Financial statement Fraud. Unpublished doctoral dissertation, Goteborg University, Gothenburg, Sweden.
Locke, C., 2008, Financial Reporting Handbook 2008, 2008 edition, John Wiley & Sons Australia, NSW
Lipton, P & Herzberg, (2008), Understanding Company Law, 14th edition, Thomson, NSW
Lowa, M.,, Davey. H, and Hooper, K (2005) Accounting scandals, ethical dilemmas and educational challenges, Critical Perspectives on Accounting 19 (2008) 222–254
Leung, P., Coram, P., Cooper B., and Richardson, P (2009) Modern Auditing and Assurance Services, 4th edn, John Wiley and Sons Australia, Australia
Morrison. K, (2008) Major Australian child care corporation at risk of bankruptcy, Retrieved from http://www.wsws.org/articles/2008/sep2008/abcl-s30.shtml
Sarbanes- Oxley Act of 2002
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