GROUP ASSIGNMENT:

Audit Case of
Xerox Corporation (Case 4.5)

By Group Accounting Class - Auditing:

Amellia Samantha / 008201500036
Jersey Purba / 008201500057
Samuel Alexander / 008201500028
Stephanie Angelica / 008201500095
Batch 2015
Auditing Seminar Subject
Lecturer: Gatot Imam Nugroho

President University
Jalan Ki Hajar Dewantara, Cikarang,
West Java - Indonesia
(021) 89109762

May 2018
 Case 4.5 Xerox Corporation
Evaluating Risk of Financial Statement Fraud

I. Summary
General
Xerox Corporation is an American global corporation that sells print and digital
document solutions, and document technology products in more than 160 countries. In 2000,
Xerox had reported of s18.7 billion (restated) and employed around the Stock Exchanges
revenues. 92,000 people worldwide. Xerox's stock trades on the York and Chicago steadily
Fundamental changes have affected the industry document. The industry has transitioned
from black and white to colour-capable devices, from light-lens and analogue technology to
digital technology, from stand alone to network connected devices, and from paper to
electronic documents.
However, intense price competition from its overseas rivals during the late 1990s
compounded the problems stemming from a changing business environment, where foreign
competitors became more sophisticated and beat Xerox to the market with advanced colour
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.
In 2000, it is revealed that over the past five years (1995-200) Xerox has improperly
classified over $6 billion in revenue, leading to an overstatement of earnings by nearly $2
billion.
The announcement of Xerox is not entirely new. The Securities and Exchange
Commission (SEC) began an investigation that ended in April of this year. The SEC had
charged the producer of copiers and related services with accounting manipulations. It was
estimated at the time, however, that the amount involved was about half that which is now
stated, or about $3 billion. A settlement was eventually reached that included a $10 million
fine, as well as an agreement to conduct a further audit. It was this audit that produced the $6
billion figure.
There were two basic manipulations that formed the basis for the SEC investigation.
The first was the so-called “cookie jar” method. This involved improperly storing revenue off
the balance sheet and then releasing the stored funds at strategic times in order to boost
lagging earnings for a particular quarter. This is a widely used manipulation. Earlier this year
Microsoft settled an investigation by the SEC into similar practices at the software giant.
The second method—and what accounted for the larger part of the fraudulent
earnings—was the acceleration of revenue from short-term equipment rentals, which were
improperly classified as long-term leases. The difference was significant because according
to the Generally Accepted Accounting Principles (GAAP)—the standards by which a
company’s books are supposed to be measured—the entire value of a long-term lease can be
included as revenue in the first year of the agreement. The value of a rental, on the other
hand, is spread out over the duration of the contract.

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 The effect of the manipulation was that Xerox could count as earnings what
essentially future revenue was. This boosted short-term profits and allowed the company to
meet profit expectations in 1997, 1998 and 1999, though it had the effect of reducing
earnings during the past two years. In 1998 Xerox reported a pretax income of $579 million,
while it should have reported a loss of $13 million. On the other hand, the $137 million loss
for 2001 will become a $365 million gain after the manipulation is reversed. The $1.9 billion
total that will now be subtracted from revenue reported from 1997-2001 will be added to
future reports.
Several factors that put Xerox into pressure:
1. The investment climate of the 1990s created high expectations for companies to report
revenue and earnings growth.
2. Companies that failed to meet Wall Street's earnings projections by even penny often
found themselves punished with significant declines in stock price.
3. Xerox management also felt pressure to maintain its strong credit rating so could
continue to internally finance the majority of its customers' sales, by gaining access to
the necessary credit markets.
4. 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.
Accounting Manipulation
1. Acceleration of Lease Revenue Recognition from 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. 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.
2. Acceleration of Lease Revenue from Lease Price Increases and Extensions
Xerox elected recognize the revenues from lease price increases and extensions
immediately instead of recognizing the revenues over the remaining lives of the leases.
3. Increases in the Residual Values of Leased Equipment.
Cost of sales for leased equipment is derived by taking the cost equipment and
subtracting the expected residual value of the leased equipment at the time the lease is
signed. Periodically Xerox would increase the residual value of previously recorded
leased equipment.
4. 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 Xerox packaged and sold these lease revenue streams to
investors to allow immediate revenue recognition.

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 5. Manipulation of Reserves.
Xerox established an acquisition reserve for unknown business risks and then recorded
unrelated business expenses to the reserve account to inflate earnings.
6.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.
7. Failure to Disclose Factoring Transactions.
In an effort to improve its cash position, Xerox sold future cash streams from
receivables to local banks for immediate cash (factoring transactions).
Epilogue
Xerox's stock, which traded at over $ 60 per share prior to the announcement of the
accounting problems, dropped to less than $ 5 per in 2000 after the questionable accounting
practices were made public.In April 2002, xerox reached an agreement to settle its lawsuit
with the SEC.
PricewaterhouseCoopers replaced KPMG as Xerox's auditor on October 4, 2001. In
April 2005, KPMG agreed to pay $ 22 mi on the SEC in connection with the alleged fraud.
KPMG also agreed to undertake reforms designed to improve its audit In October 2005 and
February of 2006, four former KPMG partners involved with the Xerox engagement during
the fraud periods agreed to pay civil penalties from $ 100,000 to and agreed to suspensions
from practice before the SEC with right to reapply from within one to three years. A fifth
KPMG partner agreed to be censured by the SEC.
II. Learning Objectives
 Describe the auditor’s responsibility to detect material misstatements due to
fraud

From the case of Xerox, KPMG as the auditor need to improve their audit
practice and do their responsibility. Those describes in SAS:
SAS no. 99 describes a process in which the auditor (1) gathers information needed
to identify risks of material misstatement due to fraud, (2) assesses these risks
after taking into account an evaluation of the entity’s programs and controls and
(3) responds to the results.

SAS no. 99 significantly expands the number of information sources for

identifying risks of fraud. It provides guidance on obtaining information from:

1. Management and others within the organization.

2. Analytical procedures.
3. Consideration of fraud risk factors.
4. Other sources.

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 Many of the queries related to these matters should be submitted to personnel
outside of management or the accounting department. For example, you may
wish to use inquiries to
a. Identify the presence of the fraud triangle characteristics.
b. Understand the policies, procedures and controls for recording journal entries or
other adjustments.
c. Identify circumstances under which management has or may override internal
controls.
d. Understand policies and procedures related to revenue recognition.
e. Understand the business rationale for significant unusual transactions.

 Recognize risk factors suggesting the presence of fraud

From the case of Xerox, we can see that risk factors suggesting the presence of
fraud is the fraud triangle (pressure, opportunity, and rationalization).
1. Pressure: this case shows that Xerox faced a lot of pressure, and one of them is to
meet Wall Street's earnings projections.
2. Opportunity: KPMG as their external auditor did not persuade them to change their
wrong accounting practice.
3. Rationalization: Senior Xerox management said that their accounting manipulation as
“accounting opportunity”

 Describe auditor responsibilities for assessing the reasonableness of

management’s estimates
The auditor's objective when evaluating accounting estimates is to obtain
sufficient appropriate evidential matter to provide reasonable assurance that—
1. All accounting estimates that could be material to the financial statements have been
developed.
2. Those accounting estimates are reasonable in the circumstances.
3. The accounting estimates are presented in conformity with applicable accounting
principles and are properly disclosed.
Determining that the accounting estimate is presented in conformity with
applicable accounting principles and that disclosure is adequate.
The risk of material misstatement of accounting estimates normally varies
with the complexity and subjectivity associated with the process, the availability and
reliability of relevant data, the number and significance of assumptions that are made,
and the degree of uncertainty associated with the assumptions

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 Describe processes that can be used by audit firm to reduce the likelihood that
auditors will subordinate their judgement to client preferences.

The likelihood that auditors will subordinate their judgement to client

preferences is basically can be caused from many factors. Some of them which are:
1. Lack of auditor's ability or understanding of the client's business
2. Auditor lack of scepticism
3. Auditor is not independent (example: client offer a high fee to clear up the
audit findings) & auditor ethics
4. There’s no control of audit activity from the audit firm to their auditors.
From some example above, the audit firm can do several things to maintain their
audit quality by creating:
1. Leadership and culture of a firm.
2. The skills and personal traits of audit partners and professional staff.
3. The effectiveness of a firm’s audit process, methodologies, policies and tools.
4. The reliability and usefulness of audit reporting.
5. The business and regulatory environment in which the CPA firm and their
clients operate.
6. Independence and ethics.
7. Engagement performance, professional scepticism and judgement.
8. Quality control and consultation.

 Identify audit procedures that could have been performed to assess the
appropriateness of questionable accounting manipulation used by Xerox.

Audit procedures that auditor can do to assess manipulation, for instance, audit
procedure for lease revenue due to bundled leases are:
a) Affected Accounts: Sales Revenue Finance Revenue, Service Revenue, and
Finance Receivables
b) Audit process: The auditor may consider practices industry associated with bundled
lease allocations. Based on the observation of the auditors, the non-bundled
transactions could also be considered by auditor while evaluation process.

Another way that can be taken is journal entry testing. Because committing
material financial statement fraud often requires adjustments to the company's
financial records, auditors will test the company's journal entries for any signs of
manipulation.

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III. 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.
Answer:

HP is a leading global provider of computing and imaging solutions and

services for business and home and is focused on the opportunities of the internet and
the emergence of next-generation appliances, e-services, and infrastructure. HP’s
major business segments include imaging and printing systems, computing systems,
and IT services.Xerox is known as “the document company” and a leader in the
global document market. It focuses on selling equipment providing document
solutions including hardware, services, and software that enhances productivity and
knowledge sharing. Xerox’s activities include developing, manufacturing, marketing,
servicing, and financing a complete range of document processing products, solutions,
and services designed to make organizations around the world more productive. The
companies are similar in the fact that both provide services and equipment to
businesses and home users to help store, manage, and share information. The
companies are different first because HP is more focused on sharing the information
electronically, while Xerox is more focused on paper documents and printing. Second,
HP tends to market its products to households and small to medium sized businesses,
while Xerox tends to market its products to larger companies

2. Professional standards outline the auditor's consideration of material

misstatements due to errors and fraud. (a) What does an auditor have to detect
material misstatements due to errors and fraud? (b) What are the major
categories of fraud affecting financial reporting? (c) What kind of factors should
the auditors consider assessing the likelihood of material misstatements due to
fraud? (d) which factors during the 1997 through 2000 audits of ted Xerox that
created an environment conducive for fraud?
Answer:

a. Responsibility of an auditor to detect the material misstatement due to fraud

and error
Auditor should plan and make audit engagements to give reasonable assurance
about the financial statement disclosures are free of misstatement.

b. Two main categories of fraud affect financial reporting

The two categories are misappropriation of assets and fraudulent act. Theft of
company asset is termed as misappropriation of asset while intentional financial
statement misstatement is fraudulent act.

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c. Factors to assess the likelihood of material misstatement due to fraud
 Management’s incentives
 Management’s attitude
 Management’s opportunity

d. Factors during the 1997 through 2000 audits of ted Xerox that created an
environment conducive for fraud
First of all, there were fundamental changes in the document industry. They
were in a transition from black and white to color, from light-lens and analog to
digital technology, from stand alone to network connected devices, and from paper to
electronic documents. Second, there was an intense price competition from overseas
rivals. Foreign competitors became more sophisticated and beat Xerox to the market
with advanced color and digital copying technology. Third, the investment climate of
the 1990s created high pressures for companies to report revenue and earnings
growth. Failure to meet this growth was punished by declines in stock price. Xerox
also had to maintain a strong credit rating to finance a majority of its customer’s sales.
Nsext, Xerox’s compensation plan put pressure on management to report revenue and
earnings growth, and management compensation was directly linked to Xerox’s
ability to report increasing revenues and earnings. Finally, there were a lot of
opportunities to manipulate accounting transactions to put Xerox in a better financial
position.

3. Three conditions are often present when fraud exists. Using hindsight, identify
factors present at Xerox that are indicative of each of the three fraud conditions:
incentives, opportunities, and attitudes.
Answer:

Incentives/Pressures:
 Intensive price competition from foreign competitors.
 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 1900s.
 The investment climate created high expectations for companies to report
revenue and earnings growth.
 The compensation of senior management was directly related to reported
revenue and earnings growth.
 Wanted to maintain strong credit rating so they could continue to finance the
majority of its customer’s sales.
 Customer’s needs continued to change and demanded a higher quality of
service and product.
 Wanted to meet the Wall Street earnings expectations during the 1997 through
1999 periods.

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Opportunities:
 Xerox was able to manipulate foreign gross margins in order to have margins
consistent with those reported in the United States.
 Senior Xerox management directed or approved the accounting manipulations
that were under protest from field managers.
 KPMG allowed Xerox to continue using the questionable practices (with
minor exceptions).
 Xerox didn’t properly disclose policies and risks associated with some of its
unusual leasing practices.

Rationalization:
The attitude conditions which exist in Xerox: Senior managements sight of
accounting manipulations like accounting opportunities

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.

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

estimates?
A lot of the accounting manipulations that were involved with the inflated
earnings were due to non-GAAP accounting practices. There were a couple areas that
did involve the usage of estimates. They used estimates when they manipulated their
reserves. GAAP requires the establishment of reserves for identifiable, probable, and
estimable loss contingencies. Xerox established a reserve for unknown business risks
and then recorded unrelated business expenses to inflate earnings. Therefore, Xerox
debited the reserve account for unrelated business expenses to reduce operating
expenses and inflate earnings. Another area we felt estimates were used was when
Xerox failed to disclose factoring transactions. In an effort for Xerox to improve their
cash position, they sold future cash streams from receivables to local banks for
immediate cash.Also Xerox’s accounting manipulation with their acceleration of lease
revenue recognition from bundled leases involved the use of estimates. Xerox
accelerated the lease revenue recognition by allocating a higher portion of the lease
payment to the equipment, instead of a service or finance activity. With estimating the
amount of the portion they assigned to the equipment, Xerox was able to recognize
revenue immediately instead of deferring the recognition to future periods.Xerox also
used estimates with their acceleration of lease revenue from lease price increases and
extensions. Xerox regularly renegotiated the terms of lease contracts by using
estimates on higher costs. They then recognized the revenues immediately instead of
over the life of the lease.

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b) Based on AU 342, Auditing Accounting Estimates, describe the auditor’s
responsibilities for examining management-generated estimates.

According to AU 342, 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. As estimates are based on subjective as well as
objective factors, it may be difficult for management to establish controls over them.
Even when management’s estimation process involves competent personnel using
relevant and reliable data, there is potential for bias in the subjective factors.

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?
Answer:

Although KPMG questioned the appropriateness of many accounting

manipulations used by Xerox, they did not persuade management to change its
accounting practices. Xerox even persuaded KPMG to change the engagement partner
assigned to the account. To prevent this from occurring in the future, auditing firms
need to stand firm as a team together against companies that want to manipulate
earnings. KPMG wanted to keep the account so badly that they went against the
judgment of the lead partner. Firms could also have a committee established to solve
questions on accounting manipulations so thateveryone agrees and stands behind the
decision. Management could enforce this by setting a tone at the top that encourages
others to not back down to pushy clients. With the partners behind this decision, it
would create a company culture of preventing accounting manipulations.

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.

 Acceleration of Lease Revenue Recognition from Bundled Leases

Here, Xerox manipulated the lease payment to recognize revenue now. 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. This increased the revenue account on
the financial statements, which would increase net income in this period at the
expense of decreasing net income in future periods. The auditors could have caught
this manipulation by taking a closer look at the leases to assess the accuracy of their
valuation. They could have compared Xerox’s allocation of the lease bundle to the
four areas to other companies’ allocation to see if they were similar. KPMG could
have also asked for an explanation to Xerox as to why they allocated such a large
amount of the bundled leases to equipment instead of service, supplies and financing.

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 Acceleration of Lease Revenue from Lease Price Increases and Extensions
Xerox renegotiated the price of the lease, and recognized any increase in price as
revenue immediately. Since this is supposed to be recognized over the life of the
lease, this increased the revenue account on the financial statements which once again
increased net income. KPMG could have caught this by checking the lease
renegotiations for accuracy. Any increase in their price should have been recognized
over the remaining life of the lease.

 Increases in the Residual Values of Leased Equipment

Xerox would increase the expected residual value of the previously recorded
leased equipment, which would reduce the cost of sales for the period. This would
obviously affect the cost of sales on the financial statements, which would lead to an
increase in net sales for the period, and an increase in net income. The auditors could
have checked the residual value of the leases to make sure there were no increases for
the period and used the valuation auditing procedure to assess the validity of any
changes in estimates the firm reported.

7. In its complaint, the SEC indicated that Xerox inappropriately used

accounting reserves to inflate earnings. 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 disclose is appropriate.

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) on your
reading of that case and this case, how was Enron Corporation's situation
similar or dissimilar to Xerox's situation? (b) How 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?

a. Enron dissimilar with to Xerox by Both Enron Corporation and Xerox Corporation
were big players and publicity traded companies. Thus, it is mandatory for them to
restate their company’s financials due to massive accounting manipulations. Enron
earnings were apparently overstated by amount of 0.5 billion whereas Xerox earning

10 | X e r o x C o r p o r a t i o n
were seemingly overstated by amount of $1.5 billion. In case of Xerox Corporation,
the basic center of accounting manipulations appear at lease transaction accounting
whereas Enron problems centered with investment transactions accounting.

b. When the accounting matters became public both company share get a major
dropped. Xerox stock value jump downed from $60 per share maximum to $5 per
share minimum whereas Enron stock value crashed from $100 per share maximum to
$10 per share minimum.

c. They react differently because basically of their different core business and
operation’s nature. Both companies were majorly financed with debt and were facing
significant challenges regarding their respective core business operations. While the
restatement process, Enron was mainly a speculative energy as well as commodity
trading company whereas Xerox was dealing with the manufacture of printing devices
and copier equipment’s.

d. KPMG and Andersen are similar because they are charged by SEC, but Andersen
was involved in many high-status fraud cases which drop its credibility. While KPMG
has not caught up in as many high-status fraud cases, so it didn’t go bankrupt like
Arthur Andersen.

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. Do you agree or
disagree with the findings?

In short, the SEC charged that KPMG “wilfully aided and abetted” Xerox’s
violations of the federal securities laws. We agree with the SEC’s findings for several
reasons. As stated in the official SEC ruling (http:www.sec.gov/news/press/2005-
59.htm):- “Most of Xerox's topside accounting actions violated generally accepted
accounting principles (GAAP) and all of them inflated and distorted Xerox's
performance but were not disclosed to investors.

These undisclosed actions overstated Xerox's true equipment revenues by at

least $3 billion and overstated its true earnings by approximately $1.5 billion during
the four-year period.- “[T]he Order finds that throughout this period KPMG failed to
comply with GAAS and allowed Xerox to utilize accounting actions that did not
comply with GAAP. By doing so, KPMG allowed Xerox to manipulate its accounting
practices to distort the company's financial results, failed to insist that Xerox disclose
those practices and their financial impacts in the company's annual and quarterly
reports, and allowed Xerox to falsify its books and records and to fail to maintain
adequate internal controls over its accounting.- “The Order finds that KPMG was
intimately familiar with the accounting actions Xerox used on a quarterly and annual
basis to increase reported revenues and earnings during 1997-2000.

11 | X e r o x C o r p o r a t i o n
 “KPMG's audit partners received many warnings from member firms of KPMG
International in Europe, Brazil, Canada and Japan that methods adopted by Xerox to
“close the gap” between actual and desired results were not based on adequate
evidentiary support.”

We agree with the finding as we find the punishment is harsh enough to give
lesson for KPMG and other public accounting firms to conduct their audit work more
carefully and ethically to protect the public’s interest.

10. 2002 editorial in BusinessWeek raised issues with compensation received by

corporate [10] 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.
(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?

In our group opinion, the idea of reasonableness of executive compensation

may vary with person to person. Some person may argue that executive compensation
in corporate is reasonable because the industry for corporate executives’ market is
extremely tight and therefore companies may ready to pay high salaries or
compensation to attract such executives with the required skills. In order to ensure the
reasonableness of executive compensation, we think that the gap between executive
and non-executive employee compensation must be reduced to a reasonable point as
the success of the company’s performance is achieved through the hard-work of all
employee. If the compensation gap is too wide, non-executive employee may feel that
it is unfair and subsequently affect the quality of their work negatively.

12 | X e r o x C o r p o r a t i o n