1. Companies move in new directions bringing uncertainty to the forefront. What tactics and tools exist so auditors can better analyze decisions so that the SEC or other agencies do not impose fines and actions such as those imposed on Xerox?
2. Provide examples of lessons that can be learned from the Xerox Corporation case study in order to handle the risk that can be applied to 2022 and beyond. What level and type of auditors or other professionals should be in place as companies move into new emerging areas?

CASE 4.5 Xerox Corporation Evaluating Risk of Financial Statement Fraud MARK S. BEASLEY . FRANK A. BUCKLESS . STEVEN M. GLOVER . DOUGLAS F. PRAWITT LEARNING OBJECTIVES After completing and discussing this case you should be able to [1] Describe the auditor's responsibility to detect [4] Describe processes that can be used by audit material misstatements due to fraud firms to reduce the likelihood that auditors will (2] Recognize risk factors suggesting the presence of subordinate their judgments to client preferences fraud Identify audit procedures that could have been (3] Describe auditor responsibilities for assessing performed to assess the appropriateness of ques- the reasonableness of management's estimates tionable accounting manipulations used by Xerox INTRODUCTION 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.' 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, described itself as "the document company." At that time, Xerox focused on developing, manufacturing, marketing, servicing, and financing a complete range of document processing products and services to enhance its customers' productivity. It sold and leased 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. The background information about this case was primarily obtained from 8-K's and 10-K's filed by Xerox with the Securities and Exchange Commission and Accounting and Auditing Enforcement Release Nos. 1542, 1796, 2135, 2333, 2379 issued by the Securities and Exchange Commission The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph. D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of am administrative situation. 2015 Pearson Education, Inc. 121Section 4: Accounting Fraud and Auditor Legal Liability 1999 1998 1997 (in billions) Digital products $ 10.2 $ 8.6 $ 6.3 Light-lens copiers 5.8 7.4 8.3 Paper, Other products, currency 3.2 3.4 35 Total revenues $ 19.2 $ 19.4 $ 18.1 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 (Source: Form 8-K, April 8, 1998). Chief operating officer (COO), G. Richard Thoman, noted: Xerox has accomplished what few other companies have - foreseen, adapted to and led a major transformation in its market. As our markets and customer needs continue to change, Xerox will continue to anticipate and lead. We are focused on being the best in class in the digital world in all respects. To enhance our competitive position, we must be competitive in terms of the cost of our products and infrastructure, the speed of our response to the marketplace, the service we provide our customers and the breadth and depth of our distribution channels (Source: Form 8-K filed with SEC). Selected financial information from Xerox's 1997 through 2000 financial statements is presented on the opposing page ( before restatement). 122 @2015 Pearson Education, Inc.Case 4.5: Xerox Corporation For the Year Ended December 31 2000 1999 1998 1997 (in millions) Revenues $ 18,632 $ 19,228 $ 19,447 $ 18,144 Cost and expenses (excluding income taxes) 19,188 17,192 18,684 16,003 Income/(loss) from continuing operations (384) 1.424 585 1,452 Net income (loss) (384) 1,424 395 1.452 Cash flows from operating activities (827) 1.224 (1,165) 472 As of December 31 2000 1999 1998 1997 Assets (in millions) Cash $ 1,741 S 126 79 75 Accounts receivable, net 2.281 2.622 2,671 2.145 Finance receivables, net 5,141 5,115 5,22 4.599 Inventory 1.930 2.961 3.269 2.792 Other current assets 2,001 1,161 1,236 1,155 Total current assets 13.094 11,985 12.475 10.766 Finance receivables 8,035 8.203 9,093 7,754 Land, building, and equipment, net 2,495 2,456 2,366 2.377 Investments in affiliates 1.362 1.615 1.456 1,332 Goodwill, net 1,639 1,724 1,731 1.375 Other assets 3.062 1,701 1.233 1,103 Investment in discontinued operations 1.130 1,670 3.025 Total assets $ 29.687 $ 28.814 $ 30.024 $ 27.732 Liabilities and Equity Short-term and current portion of long-term debt $ 2,693 $ 3.957 4,104 $ 3.707 Accounts payable 1.033 1.016 948 776 Accrued compensation and benefit costs 662 630 722 811 Unearned income 250 186 210 205 Other current liabilities 1,648 2.161 2,523 2.193 Total current liabilities 6.286 7.950 8,507 7.692 Long-term debt 15,40 10.994 10,867 8,779 Postretirement medical benefits 1,197 1,133 1,092 1.079 Deferred taxes and other liabilities 1,933 2.263 2,71 2.469 Discontinued operations, liabilities, policyholders" deposits and other 428 911 1,693 Deferred ESOP benefits 221) (299) (370) (434) Minorities' interests in equity subsidiaries 141 127 124 127 Obligation for equity put options Company-obligated, mandatorily redeemable preferred securities of subsidiary trust holding solely subordinated debentures of the Company 538 638 638 637 Preferred stock 647 669 687 705 Common shareholders' equity 3,630 4,911 4,857 4,985 Total liabilities and equity $ 29.687 3 28.814 $ 30,024 $ 27,732 2015 Pearson Education, Inc. 123Section 4: Accounting Fraud and Auditor Legal Liability The desired turnaround did not materialize in 1999. The worsening business environment had a negative affect on 1999 results. Revenues and earnings (before the restructuring charge) were down. Management's letter to shareholders in the 1999 annual report stated Our 1999 results were clearly a major disappointment. A number of factors contributed, some largely beyond our control. And the changes we're making to exploit the opportunities in the digital marketplace are taking longer and proving more disruptive than we anticipated. We remain confident, however, that these changes are the right ones to spur growth, reduce costs and improve shareholder value. We also saw intensifying pressure in the marketplace in 1999, as our competitors announced new products and attractive pricing. We're prepared to beat back this challenge and mount our own challenge from a position of strength (Source: 1999 Xerox Annual Report). ACCOUNTING MANIPULATIONS UNRAVELED The SEC initiated an investigation in June 2000 when Xerox notified that agency of potential accounting irregularities occurring in its Mexico unit. After completing its investigation, the SEC alleged that Xerox used several accounting manipulations to inflate earnings from 1997 through 1999 including: " Acceleration of Lease Revenue Recognition from Bundled Leases. The majority of Xerox's equipment sales revenues were generated from long-term lease agreements where customers paid a single negotiated monthly fee in return for equipment, service, supplies and financing (called bundled leases). Xerox accelerated the lease revenue recognition by allocating a higher portion of the lease payment to the equipment, instead of the service or financing activity. Generally accepted accounting principles (GAAP) allow most of the fair market value of a leased product to be recognized as revenue immediately if the lease meets the requirements for a sales-type lease. Non-equipment revenues such as service and financing are required to be recognized over the term of the lease. By reallocating revenues from the finance and service activities to the equipment, Xerox was able to recognize greater revenues in the current reporting period instead of deferring revenue recognition to future periods. The approach Xerox used to allocate a higher portion of the lease payment from the finance activity to equipment was called "return on equity." With this approach Xerox argued that its finance operation should obtain approximately a 15 percent return on equity. By periodically changing the assumptions used to calculate the return on equity, Xerox was able to reduce the interest rates used to discount the leases thereby increasing the allocation of the lease payment to equipment (and thus increasing the equipment sales revenue). The approach Xerox used to allocate a higher portion of the lease payment from services to equipment was called "margin normalization." With this approach Xerox allocated a higher portion of the lease payment to equipment in foreign countries where the equipment gross margins would otherwise be below gross margins reported in the United States due to foreign competition in those overseas markets. In essence, Xerox adjusted the lease payment allocations for bundled leases in foreign countries to achieve service and equipment margins consistent with those reported in the United States where competition was not as fierce. Acceleration of Lease Revenue from Lease Price Increases and Extensions. In some countries Xerox regularly renegotiated the terms of lease contracts. Xerox elected to recognize the revenues from lease price increases and extensions immediately instead of recognizing the revenues over the remaining lives of the leases. GAAP requires that increases in the price or length of a lease be recognized over the remaining life of the lease. Increases in the Residual Values of Leased Equipment. Cost of sales for leased equipment is derived by taking the equipment cost and subtracting the expected residual value of the leased equipment at the time the lease is signed. Periodically Xerox would increase 124 @2015 Pearson Education, Inc.Case 4.5: Xerox Corporation the expected residual value of previously recorded leased equipment. The write-up of the residual value was reflected as a reduction to cost of sales in the period the residual value was increased. GAAP does not allow upward adjustment of estimated residual values after lease inception. " Acceleration of Revenues from Portfolio Asset Strategy Transactions. Xerox was having difficulty using sales-type lease agreements in Brazil, so it switched to rental contracts. Because revenues from these rental contracts could not be recognized immediately, Xerox packaged and sold these lease revenue streams to investors to allow immediate revenue recognition. No disclosure of the change in business approach was made in any of Xerox's reports filed with the SEC. " Manipulation of Reserves. GAAP requires the establishment of reserves for identifiable, probable, and estimable loss contingencies. Xerox established an acquisition reserve for unknown business risks and then recorded unrelated business expenses to the reserve account to inflate earnings. In other words, Xerox debited the reserve account for unrelated business expenses thereby reducing operating expenses and increasing net income. Additionally, Xerox tracked reserve accounts to identify excess reserves that could be used to inflate earnings in future periods as needed using similar techniques. Manipulation of Other Incomes. Xerox successfully resolved a tax dispute that required the Internal Revenue Service to refund taxes along with paying interest on the disputed amounts. Instead of recognizing the interest income during the periods 1995 and 1996, when the tax dispute was finalized and the interest was due, Xerox elected to recognize most of the interest income during the periods 1997 through 2000. " Failure to Disclose Factoring Transactions. Analysts were raising concerns about Xerox's cash position. The accounting manipulations discussed above did nothing to improve Xerox's cash position. In an effort to improve its cash position, Xerox sold future cash streams from receivables to local banks for immediate cash (factoring transactions). No disclosure of these factoring transactions was made in any of the reports Xerox filed with the SEC. Senior management allegedly directed or approved the above accounting manipulations frequently under protest from field managers who believed the actions distorted their operational results. Senior management viewed these accounting manipulations as "accounting opportunities." KPMG, Xerox's outside auditor, also questioned the appropriateness of many of the accounting manipulations used by Xerox. Discussions between KPMG personnel and senior management did not persuade management to change its accounting practices. Eventually KPMG allowed Xerox to continue using the questionable practices (with minor exceptions). The SEC noted in its complaint that: Xerox's reliance on these accounting actions was so important to the company that when the engagement partner for the outside auditor [KPMG] challenged several of Xerox's non-GAAP accounting practices, Xerox's senior management told the audit firm that they wanted a new engagement partner assigned to its account. The audit firm complied (Compliant: Securities and Exchange Commission v. Xerox Corporation, Civil Action No. 02-272789). The aggregate impact of the previously listed accounting manipulations was to increase pretax earnings from 1997 to 1999 by the following amounts: For the Year Ended December 31 1997 1998 1999 2000 Total (in millions) The Total Net Impact to Pretax Earnings $ 405 $ 656 $ 511 $ (55 $ 1,517 Xerox's accounting manipulations enabled the company to meet Wall Street earnings expectations 2015 Pearson Education, Inc. 125