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 meet Wall 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, describes itself as “the document company.” Xerox focuses on developing, manufacturing, marketing, servicing, and financing a complete range of document processing products and services to enhance its customers’ productivity. It sells and leases 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).............

REQUIRED

[1] Financial information was provided for Xerox for the period 1997 through 2000. Go to the SEC web site (www.sec.gov) and obtain financial information for Hewlett Packard Company for the same reporting periods. How are Xerox’s and Hewlett Packard’s businesses similar and dissimilar? Using the financial information, perform some basic ratio analyses for the two companies. How do the two companies financial performance compare? Explain your answers.
[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?
[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.
[4] KPMG has publicly stated that the main accounting issues raised in the Xerox case do not involve fraud, as suggested by the SEC, rather they involve differences in judgment.3

(a) Which of the questionable accounting manipulations used by Xerox involved estimates?

(b) Based on AU 342, Auditing Accounting Estimates, describe the auditor’s responsibilities for examining management-generated estimates.
[5] Some will argue that KPMG inappropriately subordinated its judgments to Xerox preferences. How could accounting firms ensure that auditors do not subordinate their judgments to client preferences on other audit engagements?
[6] 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.
[7] 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 accountingfor general reserves, contingency reserves, rainy day reserves, or cookie jar reserves. Accounting for so-called restructurings has become an artform. 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?
[8] In 2002 Andersen was convicted for one felony count of obstructing justice related to its involvement with the Enron Corporation scandal (this conviction was later overturned by the United States Supreme Court). Read the “Enron Corporation and Andersen, LLP” case included in this casebook,

(a) 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?
[9] On April 19, 2005, KPMG agreed to pay $22 million to the SEC to settle its lawsuit with the SEC in connection with the alleged fraud. Go to the SEC’s web site to read about the settlement of this lawsuit with the SEC (try, “http:// www.sec.govews/press/2005-59.htm”). Do you agree or disagree with the findings? Explain your answer.
[10]A2002 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.4

(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?

Transcribed Image Text:

Digital products Light-lens copiers Paper, Other products, currency Total revenues 1999 $ 10.2 5.8 3.2 $19.2 1998 (in billions) $8.6 7.4 3.4 $19.4 1997 $ 6.3 8.3 3.5 $18.1