Professional Documents
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Audit Case of
Xerox Corporation (Case 4.5)
President University
Jalan Ki Hajar Dewantara, Cikarang,
West Java - Indonesia
(021) 89109762
May 2018
Case 4.5 Xerox Corporation
Evaluating Risk of Financial Statement Fraud
I. Summary
General
Xerox Corporation is an American global corporation that sells print and digital
document solutions, and document technology products in more than 160 countries. In 2000,
Xerox had reported of s18.7 billion (restated) and employed around the Stock Exchanges
revenues. 92,000 people worldwide. Xerox's stock trades on the York and Chicago steadily
Fundamental changes have affected the industry document. The industry has transitioned
from black and white to colour-capable devices, from light-lens and analogue technology to
digital technology, from stand alone to network connected devices, and from paper to
electronic documents.
However, intense price competition from its overseas rivals during the late 1990s
compounded the problems stemming from a changing business environment, where foreign
competitors became more sophisticated and beat Xerox to the market with advanced colour
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.
In 2000, it is revealed that over the past five years (1995-200) Xerox has improperly
classified over $6 billion in revenue, leading to an overstatement of earnings by nearly $2
billion.
The announcement of Xerox is not entirely new. The Securities and Exchange
Commission (SEC) began an investigation that ended in April of this year. The SEC had
charged the producer of copiers and related services with accounting manipulations. It was
estimated at the time, however, that the amount involved was about half that which is now
stated, or about $3 billion. A settlement was eventually reached that included a $10 million
fine, as well as an agreement to conduct a further audit. It was this audit that produced the $6
billion figure.
There were two basic manipulations that formed the basis for the SEC investigation.
The first was the so-called “cookie jar” method. This involved improperly storing revenue off
the balance sheet and then releasing the stored funds at strategic times in order to boost
lagging earnings for a particular quarter. This is a widely used manipulation. Earlier this year
Microsoft settled an investigation by the SEC into similar practices at the software giant.
The second method—and what accounted for the larger part of the fraudulent
earnings—was the acceleration of revenue from short-term equipment rentals, which were
improperly classified as long-term leases. The difference was significant because according
to the Generally Accepted Accounting Principles (GAAP)—the standards by which a
company’s books are supposed to be measured—the entire value of a long-term lease can be
included as revenue in the first year of the agreement. The value of a rental, on the other
hand, is spread out over the duration of the contract.
1|Xerox Corporation
The effect of the manipulation was that Xerox could count as earnings what
essentially future revenue was. This boosted short-term profits and allowed the company to
meet profit expectations in 1997, 1998 and 1999, though it had the effect of reducing
earnings during the past two years. In 1998 Xerox reported a pretax income of $579 million,
while it should have reported a loss of $13 million. On the other hand, the $137 million loss
for 2001 will become a $365 million gain after the manipulation is reversed. The $1.9 billion
total that will now be subtracted from revenue reported from 1997-2001 will be added to
future reports.
Several factors that put Xerox into pressure:
1. The investment climate of the 1990s created high expectations for companies to report
revenue and earnings growth.
2. Companies that failed to meet Wall Street's earnings projections by even penny often
found themselves punished with significant declines in stock price.
3. Xerox management also felt pressure to maintain its strong credit rating so could
continue to internally finance the majority of its customers' sales, by gaining access to
the necessary credit markets.
4. 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.
Accounting Manipulation
1. Acceleration of Lease Revenue Recognition from 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. 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.
2. Acceleration of Lease Revenue from Lease Price Increases and Extensions
Xerox elected recognize the revenues from lease price increases and extensions
immediately instead of recognizing the revenues over the remaining lives of the leases.
3. Increases in the Residual Values of Leased Equipment.
Cost of sales for leased equipment is derived by taking the cost equipment and
subtracting the expected residual value of the leased equipment at the time the lease is
signed. Periodically Xerox would increase the residual value of previously recorded
leased equipment.
4. 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 Xerox packaged and sold these lease revenue streams to
investors to allow immediate revenue recognition.
2|Xerox Corporation
5. Manipulation of Reserves.
Xerox established an acquisition reserve for unknown business risks and then recorded
unrelated business expenses to the reserve account to inflate earnings.
6.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.
7. Failure to Disclose Factoring Transactions.
In an effort to improve its cash position, Xerox sold future cash streams from
receivables to local banks for immediate cash (factoring transactions).
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 in 2000 after the questionable accounting
practices were made public.In April 2002, xerox reached an agreement to settle its lawsuit
with the SEC.
PricewaterhouseCoopers replaced KPMG as Xerox's auditor on October 4, 2001. In
April 2005, KPMG agreed to pay $ 22 mi on the SEC in connection with the alleged fraud.
KPMG also agreed to undertake reforms designed to improve its audit In October 2005 and
February of 2006, four former KPMG partners involved with the Xerox engagement during
the fraud periods agreed to pay civil penalties from $ 100,000 to and agreed to suspensions
from practice before the SEC with right to reapply from within one to three years. A fifth
KPMG partner agreed to be censured by the SEC.
II. Learning Objectives
Describe the auditor’s responsibility to detect material misstatements due to
fraud
From the case of Xerox, KPMG as the auditor need to improve their audit
practice and do their responsibility. Those describes in SAS:
SAS no. 99 describes a process in which the auditor (1) gathers information needed
to identify risks of material misstatement due to fraud, (2) assesses these risks
after taking into account an evaluation of the entity’s programs and controls and
(3) responds to the results.
3|Xerox Corporation
Many of the queries related to these matters should be submitted to personnel
outside of management or the accounting department. For example, you may
wish to use inquiries to
a. Identify the presence of the fraud triangle characteristics.
b. Understand the policies, procedures and controls for recording journal entries or
other adjustments.
c. Identify circumstances under which management has or may override internal
controls.
d. Understand policies and procedures related to revenue recognition.
e. Understand the business rationale for significant unusual transactions.
4|Xerox Corporation
Describe processes that can be used by audit firm to reduce the likelihood that
auditors will subordinate their judgement to client preferences.
Identify audit procedures that could have been performed to assess the
appropriateness of questionable accounting manipulation used by Xerox.
Audit procedures that auditor can do to assess manipulation, for instance, audit
procedure for lease revenue due to bundled leases are:
a) Affected Accounts: Sales Revenue Finance Revenue, Service Revenue, and
Finance Receivables
b) Audit process: The auditor may consider practices industry associated with bundled
lease allocations. Based on the observation of the auditors, the non-bundled
transactions could also be considered by auditor while evaluation process.
Another way that can be taken is journal entry testing. Because committing
material financial statement fraud often requires adjustments to the company's
financial records, auditors will test the company's journal entries for any signs of
manipulation.
5|Xerox Corporation
III. Required
1. Financial information was provided for Xerox for the period 1997 through
2000. Go to the SEC web site (www.sec.gov) and obtain financial information for
Hewlett Packard Company for the same reporting periods. How are Xerox’s and
Hewlett Packard’s businesses similar and dissimilar? Using the financial
information, perform some basic ratio analyses for the two companies. How do
the two companies financial performance compare? Explain your answers.
Answer:
6|Xerox Corporation
c. Factors to assess the likelihood of material misstatement due to fraud
Management’s incentives
Management’s attitude
Management’s opportunity
d. Factors during the 1997 through 2000 audits of ted Xerox that created an
environment conducive for fraud
First of all, there were fundamental changes in the document industry. They
were in a transition from black and white to color, from light-lens and analog to
digital technology, from stand alone to network connected devices, and from paper to
electronic documents. Second, there was an intense price competition from overseas
rivals. Foreign competitors became more sophisticated and beat Xerox to the market
with advanced color and digital copying technology. Third, the investment climate of
the 1990s created high pressures for companies to report revenue and earnings
growth. Failure to meet this growth was punished by declines in stock price. Xerox
also had to maintain a strong credit rating to finance a majority of its customer’s sales.
Nsext, Xerox’s compensation plan put pressure on management to report revenue and
earnings growth, and management compensation was directly linked to Xerox’s
ability to report increasing revenues and earnings. Finally, there were a lot of
opportunities to manipulate accounting transactions to put Xerox in a better financial
position.
3. Three conditions are often present when fraud exists. Using hindsight, identify
factors present at Xerox that are indicative of each of the three fraud conditions:
incentives, opportunities, and attitudes.
Answer:
Incentives/Pressures:
Intensive price competition from foreign competitors.
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 1900s.
The investment climate created high expectations for companies to report
revenue and earnings growth.
The compensation of senior management was directly related to reported
revenue and earnings growth.
Wanted to maintain strong credit rating so they could continue to finance the
majority of its customer’s sales.
Customer’s needs continued to change and demanded a higher quality of
service and product.
Wanted to meet the Wall Street earnings expectations during the 1997 through
1999 periods.
7|Xerox Corporation
Opportunities:
Xerox was able to manipulate foreign gross margins in order to have margins
consistent with those reported in the United States.
Senior Xerox management directed or approved the accounting manipulations
that were under protest from field managers.
KPMG allowed Xerox to continue using the questionable practices (with
minor exceptions).
Xerox didn’t properly disclose policies and risks associated with some of its
unusual leasing practices.
Rationalization:
The attitude conditions which exist in Xerox: Senior managements sight of
accounting manipulations like accounting opportunities
4. 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.
8|Xerox Corporation
b) Based on AU 342, Auditing Accounting Estimates, describe the auditor’s
responsibilities for examining management-generated estimates.
9|Xerox Corporation
Acceleration of Lease Revenue from Lease Price Increases and Extensions
Xerox renegotiated the price of the lease, and recognized any increase in price as
revenue immediately. Since this is supposed to be recognized over the life of the
lease, this increased the revenue account on the financial statements which once again
increased net income. KPMG could have caught this by checking the lease
renegotiations for accuracy. Any increase in their price should have been recognized
over the remaining life of the lease.
8. 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) on your
reading of that case and this case, how was Enron Corporation's situation
similar or dissimilar to Xerox's situation? (b) How 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?
a. Enron dissimilar with to Xerox by Both Enron Corporation and Xerox Corporation
were big players and publicity traded companies. Thus, it is mandatory for them to
restate their company’s financials due to massive accounting manipulations. Enron
earnings were apparently overstated by amount of 0.5 billion whereas Xerox earning
10 | X e r o x C o r p o r a t i o n
were seemingly overstated by amount of $1.5 billion. In case of Xerox Corporation,
the basic center of accounting manipulations appear at lease transaction accounting
whereas Enron problems centered with investment transactions accounting.
b. When the accounting matters became public both company share get a major
dropped. Xerox stock value jump downed from $60 per share maximum to $5 per
share minimum whereas Enron stock value crashed from $100 per share maximum to
$10 per share minimum.
c. They react differently because basically of their different core business and
operation’s nature. Both companies were majorly financed with debt and were facing
significant challenges regarding their respective core business operations. While the
restatement process, Enron was mainly a speculative energy as well as commodity
trading company whereas Xerox was dealing with the manufacture of printing devices
and copier equipment’s.
d. KPMG and Andersen are similar because they are charged by SEC, but Andersen
was involved in many high-status fraud cases which drop its credibility. While KPMG
has not caught up in as many high-status fraud cases, so it didn’t go bankrupt like
Arthur Andersen.
9.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. Do you agree or
disagree with the findings?
In short, the SEC charged that KPMG “wilfully aided and abetted” Xerox’s
violations of the federal securities laws. We agree with the SEC’s findings for several
reasons. As stated in the official SEC ruling (http:www.sec.gov/news/press/2005-
59.htm):- “Most of Xerox's topside accounting actions violated generally accepted
accounting principles (GAAP) and all of them inflated and distorted Xerox's
performance but were not disclosed to investors.
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“KPMG's audit partners received many warnings from member firms of KPMG
International in Europe, Brazil, Canada and Japan that methods adopted by Xerox to
“close the gap” between actual and desired results were not based on adequate
evidentiary support.”
We agree with the finding as we find the punishment is harsh enough to give
lesson for KPMG and other public accounting firms to conduct their audit work more
carefully and ethically to protect the public’s interest.
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