CASE STUDY: XEROX CORPORATION (Evaluating Risk of Financial Statement

Fraud)

SUMMARY:

Xerox, a Connecticut-based company focused on developing, manufacturing,

marketing, servicing, and financing a complete range of document processing products
and services to enhance its customers’ productivity in the United States and 130 other
countries. In 2000, Xerox had reported revenue of $18.7 billion (restated) and employed
approximately 92,000 people worldwide. The company brought about fundamental
changes that have affected the document industry. The industry transitioned from black
and white 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.

The intense competition and changing business environment made it difficult for Xerox
to generate increased revenues and earnings in the late 1990s due to foreign
competitors becoming more sophisticated and beat Xerox to the market with advanced
color and digital copying technology. Furthermore, several factors put pressure on
Xerox to report continued revenue and earnings growth during this challenging period.
One, is Wall Street’s high expectation. Two, is to maintain a strong credit rating. And
finally, the compensation system.

In June 2000, the SEC initiated an investigation on Xerox and later revealed that the
company allegedly overstated revenues by $3 billion and pre-taxed earnings by $1.5
billion using a variety of accounting manipulations over the period of 1997 through 2000
to meet Wall Street expectations and disguise its true operating performance. These
accounting manipulations include:

● Acceleration of Lease Revenue Recognition from Bundled Leases.

● Acceleration of Lease Revenue from Lease Price Increases and Extensions
● Increases in the Residual Values of Leased Equipment.
● Acceleration of Revenues from Portfolio Asset Strategy Transactions.
● Manipulation of Reserves.
● Manipulation of Other Incomes.
● Failure to Disclose Factoring Transactions.

Senior management allegedly directed or approved the above accounting manipulations

frequently under protest from field managers who believed the actions distorted their
operational results. Xerox's outside auditor, KPMG, also questioned the
appropriateness of many of its practices. Discussions between KPMG personnel and
senior management did not persuade management to change its accounting practices.
Eventually KPMG allowed Xerox to continue using questionable practices with minor
exceptions.

Xerox's accounting manipulations enabled the company to meet Wall Street earnings
expectations during the 1997 through 1999 reporting periods; without it, the company
would have found itself punished with significant declines in stock price. Unfortunately,
Xerox could no longer hide its declining business performance in 2000. There were not
enough revenue inflating adjustments that could be made in 2000 to offset the lost
revenues due to premature recognition.

Xerox's stock dropped from over $60 per share to less than $5 per share in 2000 after
the accounting problems were made public. Xerox reached an agreement to settle its
lawsuit with the SEC in April 2002. In June 2003, six senior executives of Xerox agreed
to pay over $22 million to settle their lawsuit. The executives were found not guilty, so
Xerox agreed to pay all but $3 million of the fines and later they all resigned.

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 and 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 agreed
to pay civil penalties from $100,000 to $150,000 and agreed to suspensions from
practice before the SEC.

The alleged inappropriate accounting manipulations used in Xerox's financial

statements resulted in multiple class action lawsuits. Xerox agreed to pay $670 million,
and KPMG agreed to pay $80 million to settle a shareholder lawsuit related to the
alleged fraud.
REQUIRED:

1. 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 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

Xerox Corporation is one of the top brand companies that sells and manufactures digital
prints and provides supplies with digital production as a major operation. On the other
hand, Hewlett-Packard Company also provides comparable products and products that
are not marketed by Xerox, such as personal computers and digital cameras. Both
businesses share the same business environment. However, Xerox Corporation was
getting progressively worse with regards to financial performance from 1997 to 2000
due to its attempt to obtain a Wall Street earnings projection by rushing the recognition
of revenue that should have been recorded in the future year. Xerox Corporation's
liquidity ratio shows that the company had the capability to make a profit during 2000
with a 2.083 current ratio over 1.53 of HP's, which indicates that they had the ability to
pay short-term liabilities. Though both companies have declining net sales, which trails
the profit margin, HP was more likely to keep up its sales than Xerox. Xerox net sales
went down for two consecutive years, hitting an undesirable level. In terms of debt
ratio, Xerox Corporation had higher debt, especially in the year 2000. That went up to
0.829 compared to 0.26 for HP, which means that they will highly face a long-term debt.
Furthermore, HP’s debt ratio has gone up from 1997 to 2000 which also illustrates that
Xerox wasn’t the only one having it worse. From 1997 to 2000, both companies' asset
liquidity increased noticeably, and both used stockholders' equity to generate revenue.

2. 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?

(a) Auditors maintain a responsibility to provide reasonable assurance that financial

statements are free of material misstatement due to fraud or errors. The auditors must
maintain an attitude of professional skepticism throughout an audit, while maintaining
independence in appearance and in fact. As to these responsibilities, An Auditor's
should (1) gather information needed to identify risks of material misstatement due to
fraud, (2) assess these risks after taking into account an evaluation of the entity’s
programs and controls and (3) respond to the results.

(b) Two main categories of fraud that affect financial reporting are (1) misstatements
arising from fraudulent financial reporting and (2) misstatements arising from
misappropriation of assets. In which, Misstatements arising from fraudulent financial
reporting are intentional misstatements or omissions of amounts or disclosures in
financial statements to deceive financial statement users. Fraudulent financial reporting
may involve acts such as the following: (1) Manipulation, falsification, or alteration of
accounting records or supporting documents from which financial statements are
prepared (2) Misrepresentation in, or intentional omission from, the financial statements
of events, transactions, or other significant information (3) Intentional misapplication of
accounting principles relating to amounts, classification, manner of presentation, or
disclosure. Misstatements arising from misappropriation of assets (sometimes referred
to as defalcation) involve the theft of an entity's assets where the effect of the theft
causes the financial statements not to be presented in conformity with generally
accepted accounting principles. Misappropriation can be accomplished in various ways,
including embezzling receipts, stealing assets, or causing an entity to pay for goods or
services not received. Misappropriation of assets may be accompanied by false or
misleading records or documents and may involve one or more individuals among
management, employees, or third parties.

(c) Auditors should consider the actions, behavior, and how their managers
communicate and treat them, and basically, it is the code of ethics of their managers.
Second, auditors should consider the environment of the business to be able to have an
efficacious corporation. And lastly, auditors should also consider the internal controls of
the business to be able to have an efficient and reliable corporation. These three factors
should be considered when assessing the likelihood of material misstatement due to
fraud.

(d) The factor that existed from 1999 to 2000 in Xerox Company was the competition
towards their competitors, which is basically normal or part of the business industry.
Second, pressure to maintain the company's ratings and expectations of their clients. In
a business industry lapses, and drawbacks are always present, but the only thing that a
business should portray is to keep on fighting and improving. And lastly, it is hard to
maintain the revenue and income growth of the company.

3. 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.
The Fraud Triangle is visibly present in Xerox company's case. To narrow down the
fraudulent acts inside the company, we decided to generally use the whole company
and summarize the fraud triangle.

Incentive- Xerox's financial needs. The pressure and their aim for the company to meet
wall street expectations is coming up short, thus they see the easiest way possible to
catch up to the intense price competition, is to commit fraud. Ofcourse, any company
that commits fraud basically needs money and for the company to be wealthy. Xerox
was basically pressured into committing fraud, when they saw how vulnerable they were
when their company was slowing down, and other companies inside their market had
better digitized products.

Opportunity- "Senior management viewed these accounting manipulations as

“accounting opportunities.”" all of the manipulations that Xerox pulled off, was an
opportunity. The lack of Internal and External Control, made them see these
manipulations as an opportunity to lift up the company's stock prices. The Company
was in denial that their products are not good enough for the rising digital world, as
other big companies made their move on upgrading their products to colorized printing,
This gave them the opportunity to manipulate their books.

Rationalization/Attitude- "Without the accounting manipulations, Xerox would have

failed to meet Wall Street earnings expectations for 11 of 12 quarters from 1997 through
1999." The Company felt that it is okay to commit fraud because they want to meet Wall
Street earnings expectations, the mindset that the company gave was to reach these
expectations so that the company's stock prices will go up, giving their company hope in
staying on top of the market.

4. 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.
Acceleration of Lease Revenue Recognition from Bundled Leases
● Xerox manipulated the lease payment by recognizing revenue in the current
reporting period instead of deferring revenue recognition to future periods. To do
so, Xerox reallocates revenues from finance and service activities to the
equipment. This action increased the revenue account on the financial
statements and also increased the net income for the current reporting period,
hence reducing the net income for the future periods. KPMG should have
scrutinized the leases to verify the accuracy and to see whether there were
manipulations done. Additionally, KPMG should have also questioned the
reallocation of revenues.

Acceleration of Lease Revenue from Lease Price Increases and Extensions

● Instead of recognizing the lease price increases and extensions over the
remaining life of the lease, which is the proper way of doing so, Xerox
immediately recognized it, resulting in the increase of revenue account on the
financial statements, which will also increase the net income for the current
period. The immediate recognition of lease price should have been corrected if
KPMG thoroughly checked the terms of lease contracts that were renegotiated.

Increases in the Residual Values of Leased Equipment

● By periodically increasing the expected residual value of previously recorded
leases equipment, the cost of sale will consequently reduce. When the cost of
sales decreases, the net sales and net income for the period increase. To assess
the appropriateness of the practices, KPMG should have checked if there were
upward adjustments of estimated residual values, especially since this action
was prohibited by GAAP.

Acceleration of Revenues from Portfolio Asset Strategy Transactions

● Since the revenues from rental contracts could not be recognized immediately,
Xerox resorted to selling these rental contracts to investors, for them to be able
to immediately recognize money from the sale. This increases the revenue
account on the financial statements. Furthermore, in regards to this transaction,
KPMG should have checked or made sure that these said rental contracts were
really in Xerox's possession. KPMG should have also taken notice of the
concealment of the change in business approach from the SEC.

Manipulation of Reserves
● Xerox had established reserve accounts where they put unrelated business
expenses, thereby decreasing the operating expenses and increasing the net
income. On the other hand, to check the appropriateness of the practice, KPMG
should have examined Xerox's financial statements to the recorded list of
 expenses to see if the figures being reported are accurate or in the correct value.
Additionally, KPMG should have compared the documents of the reserve
account and the portion of retained earnings if they matched.

Manipulation of Other Incomes

● Xerox recognized most of the interest income received from the Internal Revenue
Service during the periods 1997 through 2000 instead of recognizing them during
the periods 1995 and 1996. This would affect the net income and the retained
earnings balance for those years. The KPMG should have verified or checked
the documentation if the interest income received was allocated or recognized to
the correct periods.

Failure to Disclose Factoring Transactions

● For Xerox to improve its cash position, the company sold future cash streams
from receivables to the local banks for immediate cash. This would result in the
increase of cash balance for the current period, but this would also decrease the
accounts receivable balance as well as the net income for the future periods. The
KPMG could have verified if the amount from the sale that was being recognized
was really its correct value. They also could have contacted the local banks to
confirm it. Additionally, as there was no disclosure of these factoring transactions
in any of the reports Xerox filed with the SEC, the KPMG should have made sure
that the changes were reported to the SEC.

5. 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?

● From the definition of Accounting Reserves, we define it as “profits that have

been appropriated for a particular purpose.”, which means that this profit was
generated by the company and kept as reserve for other purposes. It is a good
way of storing funds for a certain purpose, but it must comply with the full
credibility and relevant to the transactions made in the period. Auditors are
responsible for evaluating on how reasonable the purpose of the accounting
reserves are, it should comply with having a purpose in keeping the financial
statements of the company credible as possible. Auditors are also responsible for
checking on both of the objective and subjective factors that may arise within the
management’s plans on the said accounting reserves. Since fraud may arise
from the funds that are kept from reserves, auditors must see to it that there are
no fraudulent financial statements from the company. Auditors can test the
accounting reserves by giving audit evidence that supports that the reserves are
fraud-free. There are three ways on how auditors can test the reasonableness of
these accounting reserves. They must test procedures on how the company has
generated the fund for accounting reserves so that they are updated to the step-
by-step process. Second, develop evidence from independence to develop
expectation of the amount allocated for the accounting reserve so that there is a
basis of credibility from the company’s financial information and from the
auditor’s. Lastly, the auditors must examine the transactions that happened
throughout the dates wherein the profits were generated for the accounting
reserves to determine if these transactions were legal, and that creates audit
evidence that is reliable and relevant.

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). (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?

(a) Both Enron Corporation and Xerox Corporation encountered accounting

manipulations in their financial statements. Enron's earnings were overstated by 0.5
billion while in Xerox’s earnings it was overstated by 1.5 billion. The accounting
manipulation in Xerox Corporation was centered in lease transactions accounting while
in Enron Corporation problems was centered in investment transactions accounting. In
both corporations, with their restatement announcement it resulted in declining their
share prices.

(b) When the issues became public both corporation’s share prices dropped. The stock
value of Xerox Corporation dropped from $60 per share to less than $5 per share. While
in Enron’s share prices it jumped down to $10 per share from $100 per share. When all
these accounting manipulation issues became public both corporation’s manipulated
financial statements resulted in multiple lawsuits against their corporations.

(c) Enron Corporation was known to be the biggest company of all time. It was widely
known all over the world and has the high-class reputation that they have maintained
before. Enron Corporation paved the way for energy services. Meanwhile, Xerox
Corporation had the same status before with Enron and Xerox also paved the way for
the technology sector of the economy. But, with their small similarities, financial or
business sectors reacted differently towards their wrongdoings. Enron Corporation left a
big impact in the corporate world because they have created a scheme that was
approved by the SEC. But, Xerox Corporation only engaged in misstatements of
financial statements. As Enron Corporation became a large contributor to the rise of
stock price, it had also largely contributed to the fall of the stock market. Basically,
Enron Corporation created an impact to the economy and this resulted in ceasing their
operations. On the other hand, Xerox Corporation, despite the accounting fraud they’ve
engaged in, they were still able to rise from it and one of the factors of it was because
they were producing products that helped them rebuild their company.

(d) During their time, KPMG’s situation was somehow similar to Andersen LLP because
both auditing companies engaged in fraudulent activities. They tolerated the
misstatements and wrongdoings of their clients. But, if you observe closely, the scandal
that Enron brought to Andersen created such a big effect on Andersen that they had to
cease their operations. They also broke a law which is obstruction of justice that
became a factor in ceasing their operations. On the other hand, in KPMG’s situation,
only four former partners were involved in the fraud and they were able to settle their
lawsuits.