Fernandez, Hisham

BSAc - 2B
EXTAUD

CASE 2
Xerox Corporation
Evaluating Risk of Financial Statement Fraud

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.

- Office printers, copiers, fax machines, scanners, multifunction machines, servers,

workstations, portable computers, and storage devices are among the goods
produced by Hewlett Packard Corporation (HP). Office printers, production printers,
print controllers and servers, office copiers, fax machines, scanners, and
multifunction devices are among the goods produced by Xerox Corporation. In the
copier and print production space, Xerox offers a larger selection of goods than HP
does. Selected HP financial data for the years 1997 to 2000 is as follows (and is
comparable to the Xerox financial data supplied in the case materials):
 The financial success of Xerox was not as impressive as HP's from 1997 to 2000.
Compared to HP, Xerox had lower margins and turnovers (based on un-restated
numbers). Xerox's return on equity was under pressure because of the reduced
margins and turnovers. In contrast to HP's positive cash flow throughout the reporting
period of 1997 to 2000, Xerox was also unable to produce a positive cash flow from
its activities. A significant difference between reported earnings and operational cash
flows is a sign that earnings have been artificially manipulated, hence the difference
between Xerox's reported earnings and its operating cash flows should have worried
the financial community about Xerox's "quality of earnings." The aforementioned data
implies that Xerox struggled to adapt its products and feature sets to the evolving
business landscape in the document sector. Significant commercial problems were
being presented to Xerox by the escalating competition from outside as well as the
industry's move to network-connected color printing equipment, digital technologies,
and electronic documents.

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] In order to reasonably assure that the financial statements are free of substantial
misrepresentation, whether the consequence of error or fraud, auditors are needed to design
and carry out audit engagements. The difference between mistakes and fraud is whether the
false statement was made on purpose or accidentally. Unintentional misstatements are
called errors, and intended ones are called frauds. By assessing the likelihood of fraud and
increasing audit testing when there is a higher likelihood of fraud, the auditor provides a
reasonable level of assurance that frauds resulting in material misstatements will be
discovered.

[b] Financial reporting fraud or asset theft can also result in false statements. Fraudulent
financial reporting is the term used to describe financial statement errors or omissions that
are meant to mislead users. Misappropriation of assets is the term used to describe thefts of
entity assets listed in the financial accounts.

[c] When assessing the likelihood fraud the auditor should consider:
- Management’s incentives (are there industry conditions or operating characteristics
putting pressure on management to perpetuate a fraud?)
- Management’s opportunity (are there significant accounts requiring subjective
estimates,
is the control environment weak, are controls inadequate?)
- Management’s attitude (is or has management exhibited questionable behavior in the
past?)

[d] Factors that existed during the 1997 through 2000 audits of Xerox that created an
environment conducive to fraud include:
- Changing business environment for document processing products (transition to
color
documents, digital technology, network connected devices, and electronic documents),
- Increasing competition from foreign competitors,
- Investment climate of the 1990s for public companies to continuously report
revenues
and earning growth,
- Need for Xerox to maintain high credit rating to obtain the funds necessary to
internally
finance customer purchases,
- Linkage of senior management compensation to increasing revenues and earnings,
- Negative operating cash flows.
- Complexity and subjectivity of accounting related to lease transactions.
- Management’s use of aggressive accounting practices to increase revenues and
earnings,
- Senior management’s view of accounting manipulations as accounting opportunities,
- Senior management’s disregard for accounting concerns raised by non-senior
managers

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.

Incentive conditions that existed at the time the alleged fraud occurred were:
- Investment climate of the 1990s for public companies to continuously report
revenues and
earning growth,
- Need for Xerox to maintain a high credit rating to obtain the capital necessary to
internally
finance customer purchases,
- Linkage of senior management compensation to increasing revenues and earnings,
- Negative operating cash flows.

An opportunity condition that existed at the time the alleged fraud occurred was:
- Senior management’s ability to direct and change the accounting methods without
audit
committee or board of director oversight,
- Complexity and subjectivity of accounting related to lease transactions.

Attitude conditions that existed at the time the alleged fraud occurred were:
- Senior management’s view of accounting manipulations as accounting opportunities.
- Senior management’s disregard for accounting concerns raised by non-senior
managers.

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

a) Service Revenue, Sales Revenue, Finance Receivables, and Finance Revenue.

b) The auditor might examine historical Xerox practices and those of other companies in the
industry regarding bundled lease allocations and contrast them with the current practice. If
there is a change in practice, the auditor should assess whether there is a change in
estimation or in principle and decide what kind of disclosure would be required to ensure that
readers of financial statements are not misled. In order to assess the appropriateness of the
bundled lease allocations, the auditor can also think about examining previous non-bundled
sales of equipment and services.

ƒ Acceleration of Lease Revenue from Lease Price Increases and Extensions.

a) Sales Revenue and Finance Receivables.

b) The auditor might examine Xerox's prior practices regarding modifications to lease terms
and contrast them with the present practice. If there is a change in practice, the auditor
should assess whether there is a change in estimation or in principle and decide what kind of
disclosure would be required to ensure that readers of financial statements are not mislead.
To find any potential managerial bias in the assumptions, another technique would be to
retrospectively review past year assumptions. In order to find appropriate accounting
methods, the auditor might also go over accounting literature.

ƒ Increases in the Residual Values of Leased Equipment

a) Cost of Sales.

b) The auditor might compare the current practice to earlier procedures used by Xerox in
relation to changes in residual values of leased equipment. Whenever there is a change in
practice, the auditor should assess whether there is a change in estimation or in principle
and decide what kind of disclosure would be required to ensure that the financial statements
are not misleading. In order to find appropriate accounting methods, the auditor might also
go over accounting literature.

ƒ Acceleration of Revenues from Portfolio Asset Strategy Transactions

a) Sales Revenue, Rental Revenue, Equipment on Operating Leases, and Cost of Sales.

b) To find appropriate accounting procedures for the new business practice, the auditor
might examine the accounting literature. To make sure the financial statements are not
deceptive, the auditor could also go through the management disclosures that are included
with the financial statements.

ƒ Manipulation of Reserves

a) Selling, General, and Administrative Expenses, Cost of Sales, or Cost of Services and
Other Liabilities.

b) The auditor could review journal entries recorded in reserve accounts to evaluate the
appropriateness of the adjustment.

Moreover, the auditor might conduct a retrospective evaluation of the expenses incurred in
connection with different reserve accounts to assess the reasonableness of management
judgments and assumptions.

ƒ Manipulation of Other Incomes.

a) Interest (Other) Income and Interest Receivable.

b) The auditor could review the documentation supporting the interest income from tax
refunds due Xerox to ascertain the periods covered.

ƒ Failure to Disclose Factoring Transactions

a) Finance Receivables or Accounts Receivable.

b) The auditor may check the cash receipts journal for significant or unusual transactions,
consult with management, and examine any relevant supporting records for any transactions
noticed. The auditor might also write to financial institutions doing business with Xerox and
ask them questions about factoring receivables.

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 “hotspots” 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?

- Accounting reserves are established for expenses expected to be incurred in

the future as a result of past business activities. Accounting reserves are an
example of an accounting estimate and thus the auditor is responsible for
evaluating the reasonableness of accounting estimates made by
management in the context of the financial statements taken as a whole (see
AU Section 342). The auditor needs to obtain reasonable assurance that the
accounting reserve amount is reasonable and that its presentation and
disclosure is appropriate. The reasonableness of the accounting reserve
amount can be evaluated by one or a combination of the following
approaches:

ƒ Review and test the process used by management to develop the accounting
reserve amount,

ƒ Develop an independent expectation of the accounting reserve amount to

corroborate the reasonableness of management’s estimate,
 ƒ Review subsequent events or transactions occurring prior to completion of
fieldwork. Note that AU Section 316 requires auditors to perform a retrospective
review of actual expenses incurred related to reserve accounts to evaluate whether
management judgments and assumptions are reasonable.

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?

- The answers provided by the students to this question may lead to an engaging
"in-class" discussion. Both Enron and Xerox were huge publicly listed firms that were
obliged to restate their financial accounts because of substantial accounting
practices. According to reports, Xerox overstated its earnings by $1.5 billion, while
Enron overstated its earnings by $0.5 billion. Although Enron's accounting fraud
focused on its accounting for investment transactions, Xerox's accounting fraud
focused on its accounting for lease transactions, notably its estimations of lease
revenues (specifically its accounting for Special Purpose Entities). The stock prices
of both firms experienced large drops after the restatement announcement. In
contrast to Enron, whose stock value dropped from over $100 per share to under $10
per share, Xerox's stock value dropped from over $60 per share to less than $5 per
share. Due to the alleged accounting fraud, Enron was ultimately forced to file for
bankruptcy protection. Investors and workers who had big retirement savings
invested in Enron shares suffered enormous losses as a result of the company's
collapse.
- Why did Enron eventually collapse due to the alleged fraud yet Xerox did not is an
intriguing topic. Both businesses had substantial financial commitments financing
them, and their fundamental business activities were facing serious difficulties. Their
primary area of distinction is their core business. In contrast to Xerox, which
produced copiers and printing equipment, Enron was primarily a speculative energy
and commodity trading corporation at the time of the restatement. In the end, Enron
stopped producing and selling tangible goods. Instead, Enron served as a service
provider that connected producers and purchasers.. Buyers and sellers were no
longer interested in using Enron’s services when the integrity of management was
brought into question, causing its business to basically disappear overnight. Xerox on
the other hand, was still perceived to produce quality products it could sell to its
customers.
- Andersen was far more effected by Enron's restatement of its financial accounts than
was KPMG by Xerox's restatement of its financial statements. Andersen's
involvement in several high-profile fraud cases (including Waste Management, Global
Crossing, Sunbeam, Qwest Communications, and Enron) contributed to its rapid
decline in the eyes of the investment world and the federal government. More
significantly, Andersen was obliged to stop performing audits of public corporations
as a result of his criminal conviction for document falsification while under SEC
investigation. In the end, Andersen's services were meaningless due to the public's
lack of faith. KPMG fortunately, has not been involved in as many high profile fraud
cases. Nevertheless, the demise of Andersen has brought about a significant
re-evaluation and re-structuring of all public accounting firms to prevent similar
situations in the future.