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Xerox Corporation’s Audit Failure

Introduction

Xerox is a multinational American corporation that was founded in 1906, and that sells document products and services in both digital and print forms. It has appeared severally on the list of Fortune 500 companies, and it operates in more than 180 countries across the world. Xerox is among the many US companies that have been involved in financial accounting scandals in the last few decades. In 2001, a financial scandal erupted in the company involving the overstatement of more revenue by more than $2 billion (Markham 223). This came after the WorldCom and Enron scandals that had a severe financial effect on the US economy. The company applied a method commonly referred to as cookie-jar accounting that allowed them to be perceived as performing financially better than they really were. The accounting department account for revenue that had not been earned, thus violating the revenue recognition principle. Xerox’s audit scandal originated from their violation of accepted reporting standards that involved the inclusion of future revenues in current statements, thus inflating their earnings and falsely surpassing the expectations of shareholders.

Company Background

As mentioned earlier, Xerox is a multinational company that manufactures and sells document technology products and services, as well as office equipment such as printers and scanners. It operates in more than 180 countries across the globe, it is headquartered in Connecticut, USA, and it employs more than 130,000 workers (Butala and Khan 81). Between 1997 and 2001, the company experienced several corporate governance challenges; one of them was an audit failure. According to the generally accepted accounting principles (GAAP), organizations have a responsibility to present accurate and up-to-date information to the public regarding their financial performance (Duska et al. 55). The availability of an organization’s financial information to the public should be a deterrent against engaging in financial fraud. However, this did not deter Xerox from manipulating their financial statements in order to attract potential investors. Xerox overstated its revenues by more than $2 billion for a period of five years, between 1997 and 2000 (Meade 37). The company had been audited by KPMG for 30 years, and it was highly unlikely that such a respected corporate auditor would allow financial fraud to occur in a multinational corporation. However, they withheld vital information that could have avoided the scandal and preserved their integrity as an international auditor.

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The Audit Failure

SEC faulted the company for wrongly stating the date when the revenue was recognized. In their restatement, Xerox only changed the year of the revenue recognition, later announcing that the problem arose from its faulty calculations (Pham). In the restatement, the revenue was reduced from $6.4 billion to the actual value, $4.5 billion (Markham 224). In addition, the pretax income for the aforementioned period was decreased by $1.4 billion. According to the SEC, one of the deceptive accounting schemes applied by the corporation was reporting leases as sales, instead of stating the revenue earned over the period of the lease contract (Meade 37). This trick had worked in their favor for several years because it had enabled them to attract more investors and surpass the expectations of shareholders.

The SEC alleged that Xerox had relied heavily on specific accounting practices to manipulate its earnings and income from the sale of equipment. In that regard, they violated GAAP and overstated their earnings from office equipment that had been leased. The misleading earnings were included in quarterly and annual statements that were sent out to investors and shared with the public (Meade 37). This unethical revenue recognition method inflated earnings beyond the actual value. According to GAAP, the revenue earned from a “sales type lease” should be included in financial statements, based on the product’s value, and spread throughout the life of the lease (Duska et al. 56). Xerox violated this principle by recognizing the value of products and accounting for the cost of maintaining the leased products at the time the contract was signed (Markham 223). In that regard, the firm included revenue from new leases immediately in its statements, thus creating a misleading image of high financial performance. The calculations were also deceptive as they ignored prevailing economic conditions, thus establishing unfair product values. The adoption of these new accounting methods was clandestine, and they were not announced to the public as required by law.

Discovery of the Scandal

The audit scandal started to unravel in May 2000 after the company announced that it had discovered accounting irregularities at its subsidiary in Mexico. This announcement exposed the company’s problems to the public, and as a result, the SEC launched an investigation into the matter (Butala and Khan 83). During that same period, the company’s audit committee hired Akin, Gump, Strauss, Hauer, & Feld to conduct an investigation into the issue (Butala and Khan 83). The firm was, however, instructed to only audit the operations of the Mexican subsidiary. This was a clear indication that the company’s management was aware of the situation because the auditor found indications of unethical accounting practices in other Xerox divisions. The corporation’s lawyers maintained that the company’s CEO would investigate the existence of malpractices in the other areas.

In 2001, Xerox made a public announcement stating that its auditor, KPMG LLP, had certified its financial statements and ruled them accurate and in accordance with financial regulations. The problems in Mexico had caught the attention of the SEC, and they started to investigate subsidiaries elsewhere outside of Mexico (Butala and Khan 81). The following year, the company provided restatements of their financial accounts that revealed the reallocation of revenue of more than $2 billion (Pham). KPMG had not discovered the financial manipulation strategy that was aimed at presenting a deceptive image of positive financial performance to shareholders. In the same year, the US Securities and Exchange Commission accused Xerox of manipulating their financial statements between 1997 and 2000.

According to the law, KPMG had the responsibility of ensuring that all the information presented in the company’s financial statements was accurate and free from any fraudulent manipulation. However, they failed to discover the overstated profits. In previous occurrences, the auditor had informed Xerox regarding the issue, even though the company did not do anything to mitigate the situation (Butala and Khan 84). In this situation, KPMG did not report the issue to the SEC as required by law. Auditors have the moral responsibility to prevent unethical financial practices in organizations by reporting cases of fraud to the SEC in order to protect the interests of shareholders (Duska et al. 59). However, because of the decision to condone unethical financial practices, KPMG violated the codes of GAAP and helped Xerox violate corporate governance regulations. By applying cookie-jar accounting, the corporation was able to downplay their losses and present them to be less than their actual value (Duska et al. 87). This practice is opposed by the government and regulatory agencies because it misleads investors with regard to the performance of the organization.

Consequences of the Audit Failure

The audit failure had severe consequences on both the company, the shareholders, the senior executives involved in the scandal, and the accounting profession. Xerox did not admit or deny any wrongdoing with regard to the SEC’s accusation. However, they agreed to pay a $10 million civil fine and restate their financial results for the years in contention (Markham 224). The corporate governance scandal tarnished the image of the corporation as it was highly unlikely that they would recover from the situation. After the crisis, Anne Mulcahy was appointed the new CEO and given the responsibility of transforming the company into an ethical organization. Despite the opinions of critics who described the firm as a lost cause, she was able to rebuild it into a company that has been described as one of the most ethical organizations in recent years. In order to achieve this feat, the new CEO replaced the accounting team that was involved in the scandal. Several changes occurred within the organization: aggressive cost-cutting measures, the desktop division was dismantled due to poor performance, and the outsourcing of employees was adopted as a turnaround strategy (Butala and Khan 85). Furthermore, the prices of certain products were revised downward in order to increase purchases and gain a competitive advantage. In that regard, the recovery process was faster than earlier anticipated.

Several senior executives had been accused of engaging in the fraudulent financial scandal. In 2002, six of them, CEO Paul A. Allaire, CFO Barry D. Romeril, Philip Fishbach, Daniel Marchibroda, Gregory Tayler, and Richard Thoman settled with the SEC by agreeing to pay $22 million in fines and interest, and to return any ill-gotten funds (Markham 224). The deal excluded denying or agreeing to the accusations leveled against them by SEC. They were accused of abetting a fraudulent scheme that was aimed at improving the company’s image on Wall Street and improve its stock price (Markham 224). Another effect of the scandal was the dismissal of KPMG as the company’s auditor and the hiring of Pricewaterhouse Coopers LLP. The stock value of Xerox was also affected immensely by the crisis. After the announcement of the scandal by the SEC, its share price dropped by approximately 90% (Markham 224). The SEC accused Allaire and Thoman of creating a corporate culture that encouraged accounting manipulation in order to meet short-term earnings targets.

The accounting profession changed immensely owing to the outcomes of the scandal. An important change that occurred was the enactment of the Sarbanes-Oxley (SOX) Act of 2002 (Duska et al. 76). The legislation aims to protect investors and the public from unethical financial reporting. It introduced reforms to existing securities regulations and introduced fines for violators of the law. Moreover, it introduced more stringent rules and regulations for auditors, accountants, and organizational executives (Duska et al. 77). It focuses on four main areas: corporate responsibility, accounting regulation, amplified criminal punishment, and new protections.

How the Auditors Could Have Fixed the Problem

Investigations revealed that KPMG had earlier discovered the use of aggressive accounting measures within the company and warned the management about their consequences. However, the senior executives ignored the warning and carried on with their unethical practices. First, they should have offered advice to the management on how to mitigate the problem. Safran, one of KPMG auditors, revealed that one of the main causes of overstating revenue was because the task of adjusting accounts was given to top managers. Therefore, it was easy for them to manipulate the accounting methods and statements. Second, the auditors should have reported the matter to the SEC as required by law. During the fraud lawsuit, the SEC claimed that KPMG failed to report the matter because they did not want to destroy a relationship with one of their prime partners. So, they disregarded the unethical practices taking place in the organization because of financial gains. Third, the auditor should have maintained full independence from the firm in order to be able to act ethically and objectively. According to the SEC, KPMG lied that they had applied professional auditing standards while they had not in order to maintain the lucrative partnership. It was clear that senior executives were influencing their professional decisions.

Conclusion

In the last five decades, many companies have been sued by the SEC for engaging in unethical accounting practices. The Xerox auditing scandal is an example of the application deceptive accounting practices in order to manipulate financial performance and the shareholders. The company engaged in these practices between 1997 and 2000 by manipulating its financial accounts, which resulted in a higher stock price and more investments. KPMG should have adhered to GAAP, as well as its own code of conduct with regard to financial auditing procedures and exposed the unethical activities. The scandal had severe consequences: Xerox and its senior executives paid millions of dollars in fines, accountants involved in the fraud were dismissed, and the stock value of the firm dipped significantly. Moreover, a new law, the Sarbanes-Oxley (SOX) Act of 2002 was enacted to increase regulation of corporations, accountants, and auditors.

Works Cited

Butala, Amy, and Zafar Khan. “Accounting Fraud at Xerox Corporation: Ethical Considerations.” Journal of Leadership, Accountability and Ethics, vol. 16, no. 5, 2019, pp. 81-89.

Duska, Ronald, Duska, Brenda, and Kenneth Kury. Accounting Ethics, 3rd ed. Wiley Blackwell 2018.

Markham, Jerry K. A Financial History of Modern US Corporate Scandals: From Enron to Reform. Routledge, 2015.

Meade, David. Fraud Prevention. eBooklt.com, 2013.

Pham, Alex. Xerox Adds to Scandals with Huge Restatement. Los Angeles Times, 2002.

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