A control environment in which there is motivation to misstate financial statements may lead to problems.

Xerox is a US copy machine manufacturing company that saw its market share eroded in the USA in the 1990s because of foreign competition. The management, in order to cash in on a compensation scheme that would net them $35 million if Xerox's stock price rose to more than $60 per share, developed a scheme to artificially increase revenue.

To settle charges that included fraud, the Securities and Exchange Commission (SEC) required that Xerox pay a $10 million civil penalty - at that time, the largest ever by a company for financial-reporting violations. The SEC also required that Xerox restate its financial statements for the years 1997 to 2000. (SEC Litigation release 2002).

Most of the improper accounting - involving $2.8 billion in equipment revenue and $660 million in pretax earnings - resulted from improper accounting for revenue. On some sales, service revenue was immediately recognized, in violation of GAAP. The revenue associated with the servicing component of multi-year lease contracts was recognized during the first year, instead of recognized over the life of the lease. To increase revenue, Xerox increasingly booked more revenue associated with the equipment.

Xerox also increased earnings by nearly $500 million by improperly setting aside various reserves, then gradually adding them back as gains to make up for profit shortfalls. In one instance Xerox changed its vacation policy by limiting the amount of time off employees could carry over from one period to the next, saving $120 million. But instead of taking the gain immediately as required by US GAAP, Xerox systematically and improperly released the money at a rate of $30 million per year. (Bandler & Hechinger 2002)

What impact does this weakness in the control environment have on Xerox, its auditors, its

management, and its shareholders?

What audit procedures in this case should the auditor perform to reduce the risk of

misstatement?