Question: Xerox Corporation (Xerox), once a star in
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.
BACKGROUND
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.
![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.
BACKGROUND
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
[1] 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?
[2] 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.
[3] 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.
[4] 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?
[5] 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.
[6] 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?
[7] 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.
[8] 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.
[9] 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.
[10] 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.
[11] 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.
[12] 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?
[13] 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.](../images/xerox-corporation-xerox-once-a-star-in-the-technology-sector-273858-1.jpg)
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).
![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.
BACKGROUND
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
[1] 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?
[2] 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.
[3] 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.
[4] 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?
[5] 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.
[6] 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?
[7] 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.
[8] 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.
[9] 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.
[10] 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.
[11] 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.
[12] 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?
[13] 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.](../images/xerox-corporation-xerox-once-a-star-in-the-technology-sector-273858-2.jpg)
![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.
BACKGROUND
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
[1] 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?
[2] 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.
[3] 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.
[4] 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?
[5] 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.
[6] 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?
[7] 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.
[8] 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.
[9] 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.
[10] 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.
[11] 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.
[12] 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?
[13] 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.](../images/xerox-corporation-xerox-once-a-star-in-the-technology-sector-273858-3.jpg)
![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.
BACKGROUND
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
[1] 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?
[2] 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.
[3] 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.
[4] 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?
[5] 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.
[6] 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?
[7] 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.
[8] 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.
[9] 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.
[10] 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.
[11] 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.
[12] 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?
[13] 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.](../images/xerox-corporation-xerox-once-a-star-in-the-technology-sector-273858-4.jpg)
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 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.
BACKGROUND
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
[1] 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?
[2] 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.
[3] 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.
[4] 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?
[5] 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.
[6] 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?
[7] 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.
[8] 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.
[9] 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.
[10] 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.
[11] 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.
[12] 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?
[13] 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.](../images/xerox-corporation-xerox-once-a-star-in-the-technology-sector-273858-5.jpg)
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
[1] 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?
[2] 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.
[3] 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.
[4] 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.â€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?
[5] 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.
[6] 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?
[7] 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.htmâ€). Do you agree or disagree with the findings? Explain your answer.
[8] 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.
[9] 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.
[10] 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.
[11] 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.
[12] 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?
[13] 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.
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> A person with asthma took measurements by blowing into a peak-flow meter on seven consecutive days. 429 425 471 422 432 444 454 Display the data in a dot diagram.
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> A major West Coast power company surveyed 50 customers who were asked to respond to the statement, "People should rely mainly on themselves to solve problems caused by power outages" with one of the following responses. 1. Definitely agree. 2. Somewhat
> Twelve bicycles are available for use at the student union. Use Table 1, to select 4 of them for you and three of your friends to ride today.
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> It was 9:30 A.M. on a Monday morning when the call came through. “Hi Dr. Mitchell, do you have a minute?” “Sure,” the professor replied. “I am one of your former students, but if you don’t mind, I would prefer to remain anonymous. I think it is best for
> Nathan recently interviewed with one of the accounting firms in the city where he wants to live. The firm agreed to cover the expense of a rental car that he used to travel from his university to the firm’s office. The rental car agency required that Nat
> Brent Dorsey graduated six months ago with a master’s degree in accounting. Immediately after graduation, Brent began working with a large accounting firm in Portland, Oregon. He is now on his second audit engagement—a company called Northwest Steel Prod
> Banking regulators announced in early 2015 a greater focus on evaluating ethical culture as part of their regulatory examination of a bank’s health. In a February 2015 speech, Thomas Baxter, Executive Vice President and General Counsel
> On November 15, 2004, the Securities and Exchange Commission (SEC) filed an enforcement action in the Northern Illinois U.S. District Court against Hollinger Inc., a Toronto-based company, and its former Chairman and CEO, Conrad Black, and the company’s
> Murchison Technologies, Inc. recently developed a patient-billing software system that it markets to physicians and dentists. Jim Archer and Janice Johnson founded the company in Austin, Texas five years ago after working at IBM for more than 15 years. J
> Scott glanced up at the clock on his office wall. It read 2:30 P.M. He had scheduled a 3:00 P.M. meeting with George “Hang-ten” Baldwin, chief executive officer of Surfer Dude Duds, Inc. Surfer Dude specialized in selling clothing and accessories popular
> Spencer and Loveland, LLP is a medium-sized, regional accounting firm based in the western part of the United States. A new client of the firm, K&K, Inc., which manufactures a variety of picture frames, recently contracted with Spencer and Loveland t
> Auto Parts, Inc. (“the Company”) manufactures automobile subassemblies marketed primarily to the large U.S. automakers. The publicly held Company’s unaudited financial statements for the year ended December 31, 2018, reflect total assets of $56 million,
> The information below relates to the audit of EyeMax Corporation, a client with a calendar year-end. EyeMax has debt agreements associated with publicly traded bonds that require audited financial statements. The company is currently, and historically ha
> The Runners Shop (TRS) was a family-owned business founded 17 years ago by Robert and Andrea Johnson. In July of 2018, TRS found itself experiencing a severe cash shortage that forced it to file for bankruptcy protection. Prior to shutting down its opera
> Southeast Shoe Distributor (SSD) is a closely-owned business that was founded 10 years ago by Stewart Green and Paul Williams. SSD is a distributor that purchases and resells men’s, women’s, and childrenâ€&#
> Southeast Shoe Distributor (SSD) is a closely owned business founded 10 years ago by Stewart Green and Paul Williams. SSD is a distributor that purchases and resells men’s, women’s, and children’s sho
> Southeast Shoe Distributor (SSD) is a closely owned business that was founded 10 years ago by Stewart Green and Paul Williams. SSD is a distributor that purchases and sells men’s, women’s, and childrenâ€
> After being in business for only two years, Your 1040 Return.com has quickly become a leading provider of online income tax preparation and filing services for individual taxpayers. Steven Chicago founded the company after a business idea came to him whi
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> RedPack Beer Company is a privately-held micro brewery located in Raleigh, North Carolina. Bank loan covenants require that RedPack submit audited financial statements annually to the bank. Specifically, the bank covenants contain revenue and liquidity m
> Your audit firm, Garrett and Schulzke LLP, is engaged to perform the annual audit of Hooplah, Inc., for the year ending December 31, 2017. Hooplah is a privately-held company that sells electronics components to companies that manufacture various applian
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> You couldn’t be more excited about being on your first financial statement audit as you launch into your new professional accounting career. Having recently graduated with a Master of Accountancy degree, you are thrilled to be employing all the skills ac
> Henrico Retail, Inc. is a first year audit client. The audit partner obtained the following description of the sales system after recently meeting with client personnel at the corporate office. DESCRIPTION OF THE SALES SYSTEM Henrico’s sales system is IT
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> Asher Farms, Inc. is a fully-integrated poultry processing company engaged in the production, processing, marketing and distribution of fresh and frozen chicken products.Asher Farms sells ice pack, chill pack and frozen chicken, in whole, cut-up and bone
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> On January 24, 2008, Société Générale, France’s second largest bank announced the largest trading loss in history, a staggering 4.9 billion Euro ($7.2 billion U.S.), which it blamed on a single rogue trader. The trader, Jérôme Kerviel, worked at what Soc
> Large public companies in the U.S. are required by law to engage an auditor to perform an “integrated audit” involving both a traditional financial statement audit and an audit of internal control over financial reporting. PCAOB Audit Standard No. 2201,
> You are the new information technology (IT) audit specialist at the accounting firm of Townsend and Townsend, LLP. One of the audit partners, Harold Mobley, asked you to evaluate the effectiveness of general and application IT-related controls for a pote
> St. James Clothiers is a high-end clothing store located in a small Tennessee town. St. James has only one store, which is located in the shopping district by the town square. St. James enjoys the reputation of being the place to buy nice clothing in the
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> Apple Inc. (Apple) is a worldwide provider of innovative technology products and services. Apple’s products and services include iPhone®, iPad®, Mac®, iPod®, Apple Watch®, Apple TV®, a portfolio of consumer and professional software applications, iOS, ma
> Tina is an audit manager with a national public accounting firm and one of her clients is Simply Steam, Co. Simply Steam provides industrial and domestic carpet steam-cleaning services. This is the first time Simply Steam has been audited. Thus, Tina doe
> John C. Koss started his first company, J.C. Koss Hospital Television Rental Company, in 1953, based in Milwaukee, Wisconsin, but John had greater ambitions. Eventually he partnered with Martin Lange, an engineer, and by 1958 the two had founded Koss Ele
> In December 1995, the flamboyant entrepreneur, Michael “Mickey” Monus, formerly president and chief operating officer (COO) of the deep-discount retail chain Phar-Mor, Inc., was sentenced to 19 years and seven months in prison. Monus was convicted for th
> Waste Management, Inc.’s Form 10-K filed with the Securities and Exchange Commission (SEC) on March 28, 1997 described the company at that time as a leading international provider of waste management services. According to disclosures i
> One can only imagine the high expectations of investors when the boards of directors of CUC International, Inc. (CUC) and HFS, Inc. (HFS) agreed to merge in May 1997 to form Cendant Corporation. The $14 billion stock merger of HFS and CUC, considered a m
> Enron Corporation entered 2001 as the seventh largest public company in the United States, only to later exit the year as the largest company to ever declare bankruptcy to that point in U.S. history. Investors who lost millions and lawmakers seeking to p
> Don’t ever tell yourself, “that won’t happen to me.” Just ask Cynthia Cooper, former Vice President of Internal Audit at WorldCom. Cynthia Cooper was a typical accounting student as an undergrad at Mississippi State University. Raised in Clinton, Mississ
> The accounting firm of Barnes and Fischer, LLP, is a medium-sized, national CPA firm. The partnership, formed in 1954, now has over 4,000 professionals on the payroll. The firm mainly provides auditing and tax services, but it has recently had success bu
> In what ways can leaders create ethical organizations?
> How do the contemporary theories of leadership relate to earlier foundational theories?
> What are the contingency theories of leadership?
> What are the causes and consequences of abuse of power?
> What power or influence tactics and their contingencies are identified most often?
> How is leadership different from power?
> The authors who suggested that membership in a team makes us smarter found that teams were more rational and quicker at finding solutions to difficult probability problems and reasoning tasks than were individuals. After participation in the study, team
> On the highly functioning teams in which you’ve been a member, what other characteristics might have contributed to success?
> From your experiences in teams, do you agree with the researchers’ findings on the characteristics of smart teams? Why or why not?
> Imagine you are a manager at a national corporation. You have been asked to select employees for a virtual problem-solving team. What types of employees would you include and why?
> Can you think of strategies that can help build trust among virtual team members?
> Recall a time when you felt like you could not trust members on your team. Why did you feel that way? How did that affect the team’s performance?
> What are the relevant points of intellectual and physical abilities to organizational behavior?
> In the cases discussed above, where do you think you would perform better, and why? Justify your answer by taking into account efficiency factors, reward systems, the context, and your individual perceptions.
> What type of group or team are cyclists working for a supervisor for Deliveroo? Justify your answer.
> How should the criterion of “legitimacy” be determined? Explain.
> Is there ever a case in which illegitimate tasks should be tolerated or “rightfully” given? Explain your answer.
> When is work performed by individuals preferred over work performed by teams?
> What are the major job attitudes?
> How do you think employees should respond when given illegitimate tasks? How can an organization monitor the tasks it assigns to employees and ensure that the tasks are legitimate? Explain your answer.
> Do you think it is possible for a reward program to start out rewarding the appropriate behavior at its inception but then begin to reward the wrong thing over time? Why or why not?
> Assuming you could become better at detecting the real emotions of others from facial expressions, do you think it would help your career? Why or why not?
> What are the ethical implications of reading faces for emotional content in the workplace?
> How do you overcome the potential problems of cross-cultural communication?
> What do you think are the best workplace applications for emotion reading technology?
> What type of decision-making framework would you advise the warehouse manager to adopt in order to help him reach an optimal decision? How will your suggestion help?
> Identify the stakeholders who will be influenced by the decision to accept or refuse the frozen meat shipment.
> Does the decision to accept or refuse the frozen meat shipment call for ethical or legal considerations? Why?
> How would you have acted had you been in a similar situation?
> How can organizations create team players?
> In what way could the mine management have provided support to him prior to his wrongful act?
> Does behavior always follow from attitudes?
> What should Sipho have done differently?
> Many organizations already use electronic monitoring of employees, including sifting through website visits and e-mail correspondence, often without the employees’ direct knowledge. In what ways might drone monitoring be better or worse for employees tha
> What is the difference between automatic and controlled processing of persuasive messages?
> How will your organization deal with sabotage or misuse of the drones? The value of an R2D2 drone is $2,500.
> Who should get the drones initially? How can you justify your decision ethically? What restrictions for use should these people be given, and how do you think employees, both those who get drones and those who don’t, will react to this change?
> How might the R2D2 drones influence employee behavior? Do you think they will cause people to act more or less ethically? Why?
> Would you consider the Deliveroo and Uber Eats model a work-group or a work-team environment? Justify your answer based on the characteristics of groups and teams.
> What are the motivational benefits of the specific alternative work arrangements?
> What are the major ways that jobs can be redesigned?
> How do other differentiating characteristics factor into OB?
> How does the job characteristics model motivate individuals?
> What are the physiological, psychological, and behavioral symptoms of stress at work?
> How do employees respond to job satisfaction?
> What are the communication differences between downward, upward, and lateral communication sent through small-group networks and the grapevine?
> What are the potential environmental, organizational, and personal sources of stress at work and the role of individual and cultural differences?
> How can managers create a culture for change?
