Xerox Corporation, a company based in Stamford, Connecticut, is involved in the production and management of documents in the form of copy machines, fax machines, and commercial printing equipment. In the late 1990s, competition had a negative impact on Xerox sales (among others things, computer printers were replacing copiers to generate print copies). A poorly organized business restructuring also caused administrative problems and billing and sales slowdowns for Xerox. The accounting department at Xerox began being pressured to compensate for the poor sales results with accounting measures. Xerox “assigned accountants numerical goals to produce profits through accounting actions. It just became standard operating procedure that, you know, you look to the accountants to find income.” 14 In April 2002, Xerox settled a case with the SEC, agreeing to pay a $10 million fine and restating its results back to 1997. The restatement showed that it had recorded $6.4 billion of revenue early and had overstated its pretax income by $1.41 billion over the five years, a 36% overstatement. Paul R. Berger, Associate
Director of Enforcement at the SEC, described the actions of Xerox executives in the SEC enforcement notice: “Xerox’s senior management orchestrated a four-year scheme to disguise the company’s true operating performance. Such conduct calls for stiff sanctions, including in this case, the imposition of the largest fine ever obtained by the SEC against a public company in a financial fraud case. The penalty also reflects, in part, a sanction for the company’s lack of full cooperation in the investigation.” 15
The SEC enforcement notice reported that the company had recorded long term leasing agreements for copiers over shorter periods than the leases ran in order to record more revenue during the early years of the leases. The company also had made a one-time sale of accounts receivable to increase operating results but failed to disclose this fact to outsiders. Xerox established a “cookie jar” reserve account that was set up to cover merger costs but instead was used to meet analysts’ quarterly earnings forecasts. From 1997 to 2000, the SEC alleged that senior managers at Xerox were paid more than $5 million on performance-based compensation and made more than $30 million from the sale of company stock. In a related SEC inquiry, notices of possible civil action for fraud were sent to
KPMG, Xerox’s former auditor (that had been fired in 2001), and a number of Xerox executives (both current and former). KPMG responded that it did nothing wrong in its work for Xerox and had, in fact, been fired for forcing Xerox to conduct an independent accounting exam that resulted in an earlier Xerox restatement.
The restatement in 2001 prompted the SEC investigation in 2002. Xerox executives argued that they had relied on the accounting guidance provided by KPMG.
a. Evaluate the revenue recognition policies used by Xerox. As an auditor, would you have approved them?
b. Describe how the audit risk model could have been used in the Xerox audit to consider the performance-based compensation and the decline in sales revenue.
c. How would the auditor evaluate management in this company? Would the auditor be aware of management’s position to “look to the accountants to find income”?