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

Company Background • Formed in 1987 by Jo Lernout and Pol Hauspie • Developer 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 2

Truth and Consequences • Multi-pronged strategy that resulted in improper revenue recognition – Recording 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 3

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

Fraud Scheme: Asia Transactions • Asian sales explode in 1999. – Singapore sales: $29, Fraud Scheme: Asia Transactions • Asian sales explode in 1999. – Singapore sales: $29, 000 to $80 mm in one year. – Korea sales: up 100 -fold from 1998. • L&H attributes growth to a local acquisition. – Previous year’s sales were $12 mm. • 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. 5

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

Financial Statement Effects Effect on the Income Statement • Overstatement of revenues • Understatement 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 7

Fraud Detection: How Did Their Plan Unravel? • Acquired two competitors in 2000 – 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 $100 mm 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” 8

What Went Wrong? Related Party Transactions • Was there an arms length agreement between 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 9

Hindsight: Prevention How could the fraud have been prevented? What type of controls would 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. 10

Auditing Procedures • Auditing 101 – Look for DRAMATIC Increases in Revenue. • • 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? • • • 11