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The Xerox Corporation Fraud Case (2002) Xerox Corporation is a global document management company which manufactures and

sells a range of color and black-and-white printers, multifunction systems, photo copiers, digital production printing presses, and related consulting services and supplies. Xerox is headquartered in Norwalk, Connecticut, though its largest population of employees is based in and around Rochester, New York, the area in which the company was founded. The Founders« The KPMG network was formed in 1987 when Peat Marwick International and Klynveld Main Goerdeler merged along with their respective member firms. There were four key figures in the formation of KPMG. They are the founding members of the present organization. Piet Klynveld founded the accounting firm Klynveld Kraayenhof & Co in Amsterdam in 1917. William Barclay Peat founded the accounting firm Peat & Co in London. James Marwick established the accounting firm Marwick, Mitchell & Co in New York City in 1897. Dr. Reinhard Goerdeler was the first president of the International Federation of Accountants and a chairman of KPMG. He is credited with laying the foundations of the Klynveld Main Goerdeler merger Facts: KPMG firms are some of the world¶s leading providers of audit, tax and advisory services. They have 135,000 people operating in over 140 countries. KPMG was established in India in September 1993, and has rapidly built a significant competitive presence in the country. The firm operates from its offices in Mumbai, Pune, Delhi, Kolkata, Chennai, Bangalore and Hyderabad, and offers its clients a full range of services, including financial and business advisory, tax and regulatory, and risk advisory services. The firm's global approach to service delivery help provide value-added services to clients. The firm serves leading information technology companies and has a strong presence in the financial services sector in India while serving a number of market leaders in other industry segments. Their practice is organized around our Audit, Tax and Advisory practices. The KPMG ± Xerox Fraud Case In one of the latest scandals involving a prominent American corporation, Xerox revealed in 2002 that over the five years prior to 2002 it had improperly classified over $6 billion in revenue, leading to an overstatement of earnings by nearly $2 billion. The announcement of Xerox is not entirely new. The Securities and Exchange Commission (SEC) began an investigation that ended in April of that year. The SEC had charged the producer of copiers and related services with accounting manipulations. It was estimated at the time, however, that the amount involved was about half that which is now

A settlement was eventually reached that included a $10 million fine. on the other hand. 1998 and 1999.9 billion total that will now be subtracted from revenue reported from 1997-2001 will be added to future reports. It was this audit that produced the $6 billion figure. The first was the so-called ³cookie jar´ method.stated. This is a widely used manipulation. To the same end. whose astronomical incomes are bound up with stock options. On the other hand. The $1. but also has financial consequences for top executives. WorldCom improperly capitalized about $4 billion in ordinary expenses in order to allow the company to deduct the expense over a period of decades rather than writing it off all at once. though it had the effect of reducing earnings during the past two years. In 1998 Xerox reported a pretax income of $579 million. The SEC investigation noted that ³compensation of Xerox senior management depended significantly on their ability to meet [earnings] targets. their share values will drop. while it should have reported a loss of $13 million. Rather it spread its income out in a fraudulent manner. Why carry out these manipulations when the extra money earned in one year would have to be subtracted from future years? This was necessary because corporations are under enormous pressure from Wall Street investors to keep up short-term earnings. which not only threatens companies heavily reliant on share values to finance debt. which were improperly classified as long-term leases. as well as an agreement to conduct a further audit. The effect of the manipulation was that Xerox could count as earnings what was essentially future revenue. Thus. There were two basic manipulations that formed the basis for the SEC investigation.. This involved improperly storing revenue off the balance sheet and then releasing the stored funds at strategic times in order to boost lagging earnings for a particular quarter. Both these methods serve to boost short-term profits. The difference was significant because according to the Generally Accepted Accounting Principles (GAAP)²the standards by which a company¶s books are supposed to be measured²the entire value of a long-term lease can be included as revenue in the first year of the agreement. or about $3 billion. is spread out over the duration of the contract. unlike some of the other scandals that have emerged over the past several months. The value of a rental. the $137 million loss for 2001 will become a $365 million gain after the manipulation is reversed. This boosted short-term profits and allowed the company to meet profit expectations in 1997. Xerox has not been accused of falsely creating unearned income.´ Because of the . Otherwise. The second method²and what accounted for the larger part of the fraudulent earnings²was the acceleration of revenue from short-term equipment rentals.

Indeed. one of the ³big four´ accounting firms that dominate the profession. for example. Xerox stock rose to a peak of $60 a share in mid-1999. while actual earnings fell short by almost 50 cents. it is more likely for a company to beat than to fall short of expectations. Actual earnings. It is. correcting for the accounting manipulations. Internal documents have recorded discussions among top officials at Xerox concerning ways to manipulate accounting to allow the company to meet Wall Street expectations.99 a share.. reported earnings beat expected earnings by one cent. In 1998. the SEC calculated these actual earnings. This is a striking example of a company fitting earnings to expectations in order to prevent a run on stock. This was done quite methodically. In 1997. KPMG was fired in October and replaced by PricewaterhouseCoopers. like General Electric for example. That is. expected earnings were at $1.72 a share. It has since declined sharply and is now trading at about $7. In 1999.´ When the KPMG auditor in charge of the Xerox account began to .accounting manipulations. The evidence suggests that the auditing firm knew what was going on and decided to allow it to continue. which are determined prior to a company¶s release of earnings data.. recent studies have found the distribution of reported earnings of major companies around expectations was skewed to the positive side. Executives apparently calculated the exact amount that would have to be altered in order to allow the company to just meet or slightly exceed ³first call consensus´ expectations on Wall Street. suggesting that there are many companies that have been following the same accounting practices as Xerox. were at $1. a fairly common practice.02. An internal document obtained by the SEC contained a statement by a KPMG official acknowledging that Xerox¶s schemes constituted ³half-baked revenue recognition. when the company was carrying out the accounting fraud. Everest and saying they never saw it. KPMG was also part of the SEC investigation that began last year. Using its earlier underestimate of $3 billion in improperly classified revenue. Like the WorldCom fraud. Xerox¶s manipulation should have been easy to detect if there was anyone interested in looking.´ Xerox¶s auditor during the period in question was KPMG.. Confronted with declining revenue during the late 1990s that should have led to lower than expected earnings reports²thereby reflecting the true nature of the company¶s deepening problems²Xerox decided to cook the books. expected and reported earnings were both at $2. top Xerox executives were able to cash in on stock options valued at an estimated $35 million.65.33 while actual earnings were only $1. As former SEC chief accountant Lynn Turner noted. Many companies. always seem to come out just barely ahead of expectations. Corporate America has somehow gotten into the mindset that this is OK. however. while reported earnings were $2. ³These numbers have gotten so large that it¶s akin to auditors driving past Mt.

It also approved the books of the collapsed Belgian software company Lernout & Hauspie Speech Products NV. many of the practices used failed to comply with GAAP. Pitt. in April. For example. According to SEC¶s complaint. Such a discussion. It managed to renegotiate its credit earlier this month. On the other hand. in late 2000. The Xerox case has focused attention on the role of the SEC and its chairman. the SEC considered filing civil charges against top executives at both KPMG and Xerox. Because of its protracted crisis. Xerox used a return on equity allocation method that involved calculating the estimated fair value of the equipment as the portion of the lease payments remaining after subtracting the estimated fair value of the services and financing components. but at higher interest rates. Earlier this year. Moreover. a former lawyer for the big accounting firms including KPMG. met with KPMG¶s new chairman. As the estimated fair value of services and financing declined. The accounting firm is currently facing lawsuits from shareholders charging the company with failing to audit Xerox properly. having failed to raise any flags while the fraud was being carried out. it may have been unable to meet its obligations. In an attempt to cut back on costs. forcing it into bankruptcy. . if it took place. the accounting violations committed by Xerox are ‡ Accelerating leasing revenue Xerox allegedly repeatedly changed the way it accounted for lease revenue but failed to disclose that the associated gains were the result of accounting changes rather than improved operating performance. Xerox has been forced to sell off some of its assets. The SEC.. which recently acknowledged that it inflated its income by more than $1 billion over a two-year period. Xerox has laid off thousands of workers in the past two years and may well make further retrenchments in the future.´ Pitt denied that the two discussed Xerox at all during the meeting. as Xerox¶s troubles grew more severe. in the capital markets. If the company had failed to renegotiate its credit line. appears complicit in the scandal. the equipment sales revenue that was recognized immediately increased. which has admitted to fabricating 70 percent of sales at its largest unit. KPMG is also under scrutiny for its role in approving the books of the drug store chain Rite Aid. the company¶s CEO Anne Mulchay received a pay package in 2001 that could be worth as much as $25 million. would be a serious violation of norms of independence. This almost happened once before.raise some concerns about the company¶s improper techniques. Xerox was also accused of accelerating the recognition of revenues by immediately recognizing as the revenue price increases and extensions of existing lease rather than recognizing the increases over the remaining life of the lease. he was replaced with someone else. O¶Kelly issued a statement declaring he told Pitt at this meeting that any SEC action against KPMG would be ³unfounded´ and ³would pose serious disruption . Gene O¶Kelly. Harvey Pitt..

Xerox also allegedly systematically released a gain associated with the successful resolution of a dispute with the Internal Revenue Service to improperly increase earnings from 1997 through 2000. This factoring involved Xerox selling its receivables at a discount in order to realize instant cash instead of a future stream of cash. Without admitting or denying the allegations of the complaint. By accounting for these transactions as true sales. were recorded close to the end of quarterly reporting periods as ³a gap-closing measure to help Xerox meet or exceed internal and external earnings and revenue expectations. Xerox violated GAAP.‡ Improper increases in residual values of leased equipment Xerox allegedly adjusted the estimated residual value of leased equipment (that is. Unable to generate cash. ‡ Failure to disclose factoring transactions Xerox allegedly failed to disclose factoring transactions that allowed it to report a positive year end cash balance.´ ‡ Acceleration of revenues from portfolio asset strategy transactions Selling investors the revenue streams from portfolios of its leases that otherwise would not have allowed for immediate revenue recognition. Not only did Xerox fail to disclose the agreements. SEC alleges that this write-up in the residual value of equipment was used to credit the cost of sales. it failed to reverse them in the next year. 13(a). Xerox consented to a final judgment that includes a permanent injunction from violating the antifraud. ‡ Fraudulent manipulation of reserves and other income Xerox allegedly increased its earnings by releasing excess reserves that were originally established for some other purpose into income in violation of GAAP. Xerox used most of it to meet its earnings targets. 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5. its remaining value at the end of the lease term) after the inception of the lease in violation of GAAP. Xerox management instructed its largest operating units to explore the possibility of engaging in factoring transactions with local banks. These transactions materially affected Xerox¶s 1999 operating cash flows but these transactions were not disclosed in its 1999 financial statements. According to SEC complaint. Although GAAP required that the entire gain be recognized upon the completion of all legal contingencies in 1995 and 1996. 12b-20 and 13b2-1 promulgated there . instead of a negative one. 13a-1. SEC alleges that Xerox used these transactions to recognize revenue that would have otherwise been recognized in future periods and failed to disclose this practice. analysts looked to Xerox to increase its liquidity and called for stronger end-of year cash balances in 1999. 13a-13. specifically Section 17(a) of the Securities Act of 1933 and Sections 10(b). In some of the factoring transactions involved buy-back agreements in which Xerox would reacquire the receivables after the end of the year. reporting and recordkeeping provisions of the federal securities laws.

The SEC intended to have these funds paid into a court account pursuant to the Fair Fund provisions of Section 308(a) of the Sarbanes-Oxley Act of 2002 for ultimate distribution to victims of the alleged fraud. filed on behalf of purchasers of Xerox common stock and bonds from between February 1998 and June 27. As part of this agreement. The Securities and Exchange Commission also charged six former senior executives of Xerox Corporation. In April 2002. The commission stated at the time that most of the actions violated generally accepted accounting principles. The total package was the largest payment ever made to the SEC by an audit firm. KPMG agreed to pay $22. Xerox agreed to restate its financials for the years 1997 through 2000 and pay a $10 million civil penalty. including its former chief executive officers. was something of a high profile one for the pre-Enron era.7 million in interest and a $10 million civil penalty. Paul A. to settle an eight-year-old securities lawsuit filed on behalf of Xerox investors who claimed Xerox committed accounting fraud to meet Wall Street earnings expectations. Allaire and G. Xerox had already agreed to a $10 million fine as part of a settlement with the Securities and Exchange Commission. The six defendants agreed to pay over $22 million in penalties. agreed to pay $670 million while KPMG LLP had to pay $80 million. and its former chief financial officer. and pay $2. Under that arrangement. The SEC charged that the copier company schemed to defraud investors during a four-year period by using what it called \"accounting actions\" and \"accounting opportunities\" to meet or exceed Wall Street expectations and disguise its true operating performance. In 2005. and thus accelerated the company's recognition of equipment revenue by more than $3 billion and increasing its pretax earnings by approximately $1. Xerox Corp.8 million in fees it received for auditing Xerox's books during that time. books and records and internal control provisions of the federal securities laws.under.. the firm agreed to relinquish the $9.5 million to settle SEC charges related to its audits of Xerox from 1997 through 2000. The Consequences that followed Xerox Corp. In addition. . Barry D. with securities fraud and aiding and abetting Xerox's violations of the reporting. The fine was the largest ever paid by a company to settle with the SEC at that time. disgorgement and interest without admitting or denying the SEC's allegations. Richard Thoman. Xerox also agreed to have its board of directors review the company¶s material internal accounting controls and policies.5 billion. The case of Carlson v. Romeril.

Investors were not informed that a material component of Xerox's business results was new and untested improper accounting devices highly subject to manipulation.The Defendants Materially Mislead Investors 32. and they falsely represented that Xerox was recording earnings and revenues in a manner consistent with GAAP. The defendants did not require Xerox to disclose it had changed its methods of accounting in material respects from prior years. the defendants failed to identify material internal control weaknesses. which were supposed to fairly reflect the results of Xerox's business operations. which fairly reflected the results of company operations. Further. Use of these topside accounting devices distorted Xerox's public financial reports. . despite Xerox's claimed inability to reasonably estimate the fair value of its products without resort to unreliable topside estimates.