Xerox Corporation (Xerox), once a star in the technology sector of the economy, found itself engulfed in an accounting scandal alleging that it was too aggressive in recognizing equipment revenue.1 The complaint filed by the Securities and Exchange Commission (SEC) alleged that Xerox used a variety of accounting manipulations over the period 1997 through 2000 to meetWall Street expectations and disguise its true operating performance. The SEC alleged that between 1997 and 2000 Xerox overstated revenues by $3 billion and pre-tax earnings by $1.5 billion. Also engulfed in this scandal was KPMG, Xerox’s auditor, whose actions were also investigated by the SEC for its possible involvement with the alleged accounting manipulations.
Xerox, a Stamford, Connecticut-based company, described itself as “the document company.” At that time, Xerox focused on developing, manufacturing, marketing, servicing, and financing a complete range of document processing products and services to enhance its customers’ productivity. It sold and leased document imaging products, services, and supplies to customers in the United States and 130 other countries. In 2000, Xerox had reported revenues of $18.7 billion (restated) and employed approximately 92,000 people worldwide. Xerox’s stock trades on the New York and Chicago Stock Exchanges.
Fundamental changes have affected the document industry. The industry has steadily transitioned from black and white to color capable devices, from light-lens and analog technology to digital technology, from stand alone to network-connected devices, and from paper to electronic documents. Xerox’s product revenues for 1997 through 1999 are shown on the next page.
Intense price competition from its overseas rivals during the late 1990s compounded the problems stemming from a changing business environment. Foreign competitors became more sophisticated and beat Xerox to the market with advanced color and digital copying technology.The intense competition and changing business environment made it difficult for Xerox to generate increased revenues and earnings in the late 1990s. Unfortunately, several factors put pressure on Xerox to report continued revenue and earnings growth during this challenging period. The investment climate of the 1990s created high expectations for companies to report revenue and earnings growth. Companies that failed to meet Wall Street’s earnings projections by even a penny often found themselves punished with significant declines in stock price. Xerox management also felt pressure to maintain its strong credit rating so it could continue to internally finance the majority of its customers’ sales, by gaining access to the necessary credit markets. Finally, Xerox’s compensation system put pressure on management to report revenue and earnings growth. Compensation of senior management was directly linked to Xerox’s ability to report increasing revenues and earnings. In 1998, management announced a restructuring program to address the emerging business challenges Xerox faced. Chairman and chief executive office (CEO) Paul A. Allaire, noted: The markets we serve are growing strongly and transitioning rapidly to digital technologies. In the digital world, profitable revenue growth can only be assured by continuous significant productivity improvements in all operations and functions worldwide and we are determined to deliver these improvements. This restructuring is an important and integral part of implementing our strategy and ensuring that we maintain our leadership in the digital world. The continued adverse currency and pricing climate underscores the importance of continuous and, in certain areas, dramatic productivity improvements. This repositioning will strengthen us financially and enable strong cash generation.We have strong business momentum.We have exciting market opportunities and excellent customer acceptance of our broad product line.These initiatives will underpin the consistent delivery of double-digit revenue growth and mid- to high-teens earnings-per-share growth.This restructuring is another step in our sustained strategy to lead the digital document world and provide superior customer and shareholder value (Form 8-K, Xerox Corporation, April 8, 1998). Chief operating officer (COO), G. Richard Thoman, noted: Xerox has accomplished what few other companies have — foreseen, adapted to and led a major transformation in its market. As our markets and customer needs continue to change, Xerox will continue to anticipate and lead. We are focused on being the best in class in the digital world in all respects. To enhance our competitive position, we must be competitive in terms of the cost of our products and infrastructure, the speed of our response to the marketplace, the service we provide our customers and the breadth and depth of our distribution channels (Form 8-K, Xerox Corporation, April 8, 1998). Selected financial information from Xerox’s 1997 through 2000 financial statements is presented on the opposing page (before restatement).
The desired turnaround did not materialize in 1999.The worsening business environment had a negative affect on 1999 results. Revenues and earnings (before the restructuring charge) were down. Management’s letter to shareholders in the 1999 annual report stated: Our 1999 results were clearly a major disappointment. A number of factors contributed, some largely beyond our control.And the changes we’re making to exploit the opportunities in the digital marketplace are taking longer and proving more disruptive than we anticipated.We remain confident, however, that these changes are the right ones to spur growth, reduce costs and improve shareholder value. We also saw intensifying pressure in the marketplace in 1999, as our competitors announced new products and attractive pricing. We’re prepared to beat back this challenge and mount our own challenge from a position of strength (1999 Xerox Annual Report). ACCOUNTING MANIPULATIONS UNRAVELED The SEC initiated an investigation in June 2000 when Xerox notified that agency of potential accounting irregularities occurring in its Mexico unit. After completing its investigation, the SEC alleged that Xerox used several accounting manipulations to inflate earnings from 1997 through 1999 including: Acceleration of Lease Revenue Recognition from Bundled Leases. The majority of Xerox’s equipment sales revenues were generated from long-term lease agreements where customers paid a single negotiated monthly fee in return for equipment, service, supplies and financing (called bundled leases). Xerox accelerated the lease revenue recognition by allocating a higher portion of the lease payment to the equipment, instead of the service or financing activity. Generally accepted accounting principles (GAAP) allow most of the fair market value of a leased product to be recognized as revenue immediately if the lease meets the requirements for a sales-type lease. Non-equipment revenues such as service and financing are required to be recognized over the term of the lease. By reallocating revenues from the finance and service activities to the equipment, Xerox was able to recognize greater revenues in the current reporting period instead of deferring revenue recognition to future periods. The approach Xerox used to allocate a higher portion of the lease payment from the finance activity to equipment was called “return on equity.” With this approach Xerox argued that its finance operation should obtain approximately a 15 percent return on equity. By periodically changing the assumptions used to calculate the return on equity, Xerox was able to reduce the interest rates used to discount the leases thereby increasing the allocation of the lease payment to equipment (and thus increasing the equipment sales revenue). The approach Xerox used to allocate a higher portion of the lease payment from services to equipment was called “margin normalization.” With this approach Xerox allocated a higher portion of the lease payment to equipment in foreign countries where the equipment gross margins would otherwise be below gross margins reported in the United States due to foreign competition in those overseas markets. In essence, Xerox adjusted the lease payment allocations for bundled leases in foreign countries to achieve service and equipment margins consistent with those reported in the United States where competition was not as fierce. Acceleration of Lease Revenue from Lease Price Increases and Extensions. In some countries Xerox regularly renegotiated the terms of lease contracts. Xerox elected to recognize the revenues from lease price increases and extensions immediately instead of recognizing the revenues over the remaining lives of the leases. GAAP requires that increases in the price or length of a lease be recognized over the remaining life of the lease. Increases in the Residual Values of Leased Equipment. Cost of sales for leased equipment is derived by taking the equipment cost and subtracting the expected residual value of the leased equipment at the time the lease is signed. Periodically Xerox would increase the expected residual value of previously recorded leased equipment. The write-up of the residual value was reflected as a reduction to cost of sales in the period the residual value was increased. GAAP does not allow upward adjustment of estimated residual values after lease inception. Acceleration of Revenues from Portfolio Asset Strategy Transactions. Xerox was having difficulty using sales-type lease agreements in Brazil, so it switched to rental contracts. Because revenues from these rental contracts could not be recognized immediately, Xerox packaged and sold these lease revenue streams to investors to allow immediate revenue recognition. No disclosure of the change in business approach was made in any of Xerox’s reports filed with the SEC. Manipulation of Reserves. GAAP requires the establishment of reserves for identifiable, probable, and estimable loss contingencies. Xerox established an acquisition reserve for unknown business risks and then recorded unrelated business expenses to the reserve account to inflate earnings. In other words, Xerox debited the reserve account for unrelated business expenses thereby reducing operating expenses and increasing net income. Additionally, Xerox tracked reserve accounts to identify excess reserves that could be used to inflate earnings in future periods as needed using similar techniques. Manipulation of Other Incomes. Xerox successfully resolved a tax dispute that required the Internal Revenue Service to refund taxes along with paying interest on the disputed amounts. Instead of recognizing the interest income during the periods 1995 and 1996, when the tax dispute was finalized and the interest was due, Xerox elected to recognize most of the interest income during the periods 1997 through 2000. Failure to Disclose Factoring Transactions. Analysts were raising concerns about Xerox’s cash position. The accounting manipulations discussed above did nothing to improve Xerox’s cash position. In an effort to improve its cash position, Xerox sold future cash streams from receivables to local banks for immediate cash (factoring transactions). No disclosure of these factoring transactions was made in any of the reports Xerox filed with the SEC. Senior management allegedly directed or approved the above accounting manipulations frequently under protest from field managers who believed the actions distorted their operational results. Senior management viewed these accounting manipulations as “accounting opportunities.” KPMG, Xerox’s outside auditor, also questioned the appropriateness of many of the accounting manipulations used by Xerox. Discussions between KPMG personnel and senior management did not persuade management to change its accounting practices. Eventually KPMG allowed Xerox to continue using the questionable practices (with minor exceptions). The SEC noted in its complaint that: Xerox’s reliance on these accounting actions was so important to the company that when the engagement partner for the outside auditor [KPMG] challenged several of Xerox’s non-GAAP accounting practices, Xerox’s senior management told the audit firm that they wanted a new engagement partner assigned to its account.The audit firm complied (Compliant: Securities and Exchange Commission v. Xerox Corporation, Civil Action No. 02-272789). The aggregate impact of the previously listed accounting manipulations was to increase pretax earnings from 1997 to 1999 by the following amounts:
Xerox’s accounting manipulations enabled the company to meet Wall Street earnings expectations during the 1997 through 1999 reporting periods.Without the accounting manipulations, Xerox would have failed to meet Wall Street earnings expectations for 11 of 12 quarters from 1997 through 1999. Unfortunately, the prior years accounting manipulations and a deteriorating business environment caught up with Xerox in 2000. Xerox could no longer hide its declining business performance. There were not enough revenue inflating adjustments that could be made in 2000 to offset the lost revenues due to premature recognition in preceding years. During the 1997 through 1999 reporting periods, Xerox publicly announced that it was an “earnings success story” and that it expected revenue and earnings growth to continue each quarter and year.The reported revenue and earnings growth allowed senior management to receive over $5 million in performance-based compensation and over $30 million in profits from the sale of stock. The SEC complaint also noted that Xerox did not properly disclose policies and risks associated with some of its unusual leasing practices and that it did not maintain adequate accounting controls at its Mexico unit. Xerox Mexico, pressured to meet financial targets established by corporate headquarters, relaxed its credit standards and leased equipment to high risk customers. This practice improved short-term earnings but quickly resulted in a large pool of uncollectible receivables. Xerox Mexico also improperly handled transactions with third-party resellers and government agencies to inflate earnings. EPILOGUE Xerox’s stock, which traded at over $60 per share prior to the announcement of the accounting problems, dropped to less than $5 per share in 2000 after the questionable accounting practices were made public. In April 2002, Xerox reached an agreement to settle its lawsuit with the SEC. Under the Consent Decree, Xerox agreed to restate its 1997 through 2000 financial statements. Xerox also agreed to pay a $10 million fine and create a committee of outside directors to review the company’s material accounting controls and policies. In June 2003, six senior executives of Xerox agreed to pay over $22 million to settle their lawsuit with the SEC related to the alleged fraud. The six executives were Paul A. Allaire, chairman and CEO; Barry B. Romeril, chief financial officer (CFO); G. Richard Thoman, president and COO; Philip D. Fishback, controller; and two other financial executives: Daniel S. Marchibroda and Gregory B.Tayler. Because the executives were not found guilty Xerox agreed to pay all but $3 million of the fines. All of these executives resigned their positions at Xerox. PricewaterhouseCoopers replaced KPMG as Xerox’s auditor on October 4, 2001. In April 2005, KPMG agreed to pay $22 million to the SEC to settle its lawsuit with the SEC in connection with the alleged fraud. KPMG also agreed to undertake reforms designed to improve its audit practice. In October of 2005 and February of 2006, four former KPMG partners involved with the Xerox engagement during the alleged fraud period each agreed to pay civil penalties from $100,000 to $150,000 and agreed to suspensions from practice before the SEC with rights to reapply from within one to three years. A fifth KPMG partner agreed to be censured by the SEC. The alleged inappropriate accounting manipulations used in Xerox’s financial statements resulted in multiple class action lawsuits against Xerox, management, and KPMG. In March 2008, Xerox agreed to pay $670 million and KPMG agreed to pay $80 million to settle a shareholder lawsuit related to the alleged fraud.2 REQUIRED  Professional standards outline the auditor’s consideration of material misstatements due to errors and fraud. (a) What responsibility does an auditor have to detect material misstatements due to errors and fraud? (b) What two main categories of fraud affect financial reporting? (c) What types of factors should auditors consider when assessing the likelihood of material misstatements due to fraud? (d) Which factors existed during the 1997 through 2000 audits of Xerox that created an environment conducive for fraud?  Three conditions are often present when fraud exists. First, management or employees have an incentive or are under pressure, which provides them a reason to commit the fraud act. Second, circumstances exist – for example, absent or ineffective internal controls or the ability for management to override controls – that provide an opportunity for the fraud to be perpetrated. Third, those involved are able to rationalize the fraud as being consistent with their personal code of ethics. Some individuals possess an attitude, character, or set of ethical values that allows them to knowingly commit a fraudulent act. Using hindsight, identify factors present at Xerox that are indicative of each of the three fraud conditions: incentives, opportunities, and attitudes.  Several questionable accounting manipulations were identified by the SEC. (a) For each accounting manipulation identified, indicate the financial statement accounts affected. (b) For each accounting manipulation identified, indicate one audit procedure the auditor could have used to assess the appropriateness of the practice.  In its complaint, the SEC indicated that Xerox inappropriately used accounting reserves to inflate earnings. Walter P. Schuetze noted in a 1999 speech: One of the accounting “hot spots” that we are considering this morning is accounting for restructuring charges and restructuring reserves. A better title would be accounting for general reserves, contingency reserves, rainy day reserves, or cookie jar reserves. Accounting for so-called restructurings has become an art form. Some companies like the idea so much that they establish restructuring reserves every year.Why not? Analysts seem to like the idea of recognizing as a liability today, a budget of expenditures planned for the next year or next several years in down-sizing, right-sizing, or improving operations, and portraying that amount as a special, below-the-line charge in the current period’s income statement.This year’s earnings are happily reported in press releases as “before charges.” CNBC analysts and commentators talk about earnings “before charges.”The financial press talks about earnings before “special charges.” (Funny, no one talks about earnings before credits—only charges.) It’s as if special charges aren’t real. Out of sight, out of mind (Speech by SEC Staff: Cookie Jar Reserves, April 22, 1999). What responsibility do auditors have regarding accounting reserves established by company management? How should auditors test the reasonableness of accounting reserves established by company management?  Financial information was provided for Xerox for the period 1997 through 2000. Go to the SEC website (www.sec.gov) and obtain financial information for Hewlett Packard Company for the same reporting periods. How were Xerox’s and Hewlett Packard’s businesses similar and dissimilar during the relevant time periods? Using the financial information, perform some basic ratio analyses for the two companies. How did the two companies financial performance compare? Explain your answers.  In 2002 Andersen was convicted for one felony count of obstructing justice related to its involvement with the Enron Corporation scandal (this conviction was later overturned by the United States Supreme Court). Read the “Enron Corporation and Andersen, LLP” case included in this casebook. (a) Based on your reading of that case and this case, how was Enron Corporation’s situation similar or dissimilar to Xerox’s situation? (b) How did the financial and business sectors react to the two situations when the accounting issues became public? (c) If the financial or business sectors reacted differently, why did they react differently? (d) How was KPMG’s situation similar or dissimilar to Andersen’s situation?  On April 19, 2005, KPMG agreed to pay $22 million to the SEC to settle its lawsuit with the SEC in connection with the alleged fraud. Go to the SEC’s website to read about the settlement of this lawsuit with the SEC (try, “http://www.sec.gov/news/press/2005-59.htm”). Do you agree or disagree with the findings? Explain your answer.  The SEC outlines in Accounting and Auditing Enforcement Release No. 2234 its assessment of the Xerox fraud. Obtain and read a copy of the enforcement release (try http://www.sec.gov/litigation/ admin/34-51574.pdf). Compared to the information presented in this case would your opinion of KPMG’s audit performance change after reading the enforcement release. Explain your answer.  The SEC outlines in Accounting and Auditing Enforcement Release No. 2234 five “undertakings” for KPMG to alter or amend its audit practices. Obtain and read a copy of the enforcement release (try http://www.sec.gov/litigation/admin/34-51574.pdf) and read the five “undertakings.” Based on your reading of the five “undertakings,” which elements of a system of quality control did KPMG have weaknesses? Explain your answer.  A 2002 editorial in BusinessWeek raised issues with compensation received by corporate executives even when the company does not perform well. In 1980 corporate executive compensation was 42 times the average worker compensation while in 2000 it was 531 times the average worker compensation.3 (a) Do you believe executive compensation levels are reasonable? (b) Explain your answer. (c) What type of procedures could corporations establish to help ensure the reasonableness of executive compensation? PROFESSIONAL JUDGMENT QUESTIONS It is recommended that you read the Professional Judgment Introduction found at the beginning of this book prior to responding to the following questions.  KPMG has publicly stated that the main accounting issues raised in the Xerox case do not involve fraud, as suggested by the SEC, rather they involve differences in judgment.4 (a)What is meant by the term professional judgment? (b) Which of the questionable accounting manipulations used by Xerox involved estimates? (c) Refer to professional auditing standards and describe the auditor’s responsibilities for examining management-generated estimates and briegly describe the role of auditor professional judgement in evaluating estimates.  Some will argue that KPMG inappropriately subordinated its judgments to Xerox preferences. What steps could accounting firms take to ensure that auditors do not subordinate their judgments to client preferences on other audit engagements?  The SEC outlines in Accounting and Auditing Enforcement Release No. 2234 KPMG's alleged acts and ommisons (section C. 3.). Obtain and read a copy of the enforcement release (try http://www.sec.gov/ litigation/admin/34-51574.pdf). Based on your reading of the enforcment release and KPMG's five- step judgment process, which of the five-steps might have improved the judgments made by KPMG professionals? Explain your answer.