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 –Singapore sales: $29,000 to $80mm in one year. –Korea sales: up 100-fold from 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 Lernout&Hauspie NV Shell Company FLV Fund Cash Ownership Mr. Lernout Mr. Hauspie Payments (Revenue) R&D programming Option to buy and receive R&D rights Influence/ Ownership Ownership

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?