Strategic Auditing: Xerox Corporation - Case Study Example

Xerox Corporation Case Analysis I. Case study question The background of the company Xerox Corporation was established in 1906 in Rochester, New York, and registered under the name of Haloid Photographic Company (Ellis, 2006:41). The company was first established to engage in the business of manufacturing photographic papers. The process of manufacturing photographic papers was very expensive and inefficient, and thus it s only the government institutions or large companies that held photographic copiers. To address his challenge, Chester Carlson invented and patented the first xerographic imaging system in 1938, which made the production of digital images much fast and efficient (Hiltzik, 1999:22). Consequently, the manufacture of photographic paper became less expensive and widespread, as many companies joined the field that was previously dominated by Haloid Photographic Company (Markham, 2006:12). This caused the business to become very slow for Haloid, forcing the company to issue its first public stock on the in 1936 (Rhodes & Streeter, 1999:44). Using the funds obtained from the public offer of stocks, Haloid Photographic Company acquired the patented rights to the xerographic imaging system developed by Chester Carlson in 1946, and obtained license to develop the invention into a commercialized product (Mullin, Bensley & Friedman, 1991:72). In order to brand the company commensurately with the new acquired xerography product, the company changed its name to Haloid Xerox in 1958, which was then later changed into simply Xerox, in 1961, giving rise to the company as it is known today (Smith & Alexander,1999:21). Following its success with the new xerography technology business, the company moved its headquarters from Rochester New York in 1969, to establish its new headquarters in Stamford, Connecticut, with 150 employees at the time (Owen, 2004:36). The nature of its business The nature of business of Xerox Corporation is the production and sale of a variety of office equipment, which includes the black-white and color printers, photocopiers and digital press printing systems (Stim, 2006:388). Nevertheless, the single most popular product that has been manufactured and sold by Xerox Corporation, which brought the company into prominence is the Xerox 914 plain paper photocopier that was produced in 1959 (Ellis, 2006:42). Following the introduction of this product into the market, the company was able to raise its revenue generation capacity immensely, hitting an annual revenue generation of $60 million in 1961, which then increased many folds, and saw the company reach the $500 million in revenue by 1965 (Owen, 2004:33). In addition, the company also engages in a related line of business where it offers consultancy and other related services on the digital production of photographic papers and xerography equipments. The consultancy service line of the Xerox Corporation generates income for the company through offering smart document management service strategies and innovative document management solutions to other businesses (Hiltzik, 1999:29). Further, the company is also involved in the research, development and sale of digital and computing items and related products, with the notable inventions of the Xerox Corporation researchers being the invention of the computer mouse for desktop computing (Mullin, Bensley & Friedman, 1991:77).The last line of business that generates income for Xerox Corporation is the offering of associated supplies, software and support systems to the businesses and offices applying huge document production and storage (Markham, 2006:58). The nature of fraud committed by the company and how it was discovered The nature of the fraud committed by Xerox Corporation was the alteration of the Generally Accepted Accounting Principle provisions of historical cost principle, which requires that a company reports the value of its assets such as property and equipment in terms of the value of their historical cost (Jessup & Nance, 2011:156). Instead, Xerox Corporation altered the accounting methods, such that from 1997 to 2000, the value of the equipments held by the company was no longer accounted for on the basis of the true historical cost, but rather on the basis of the present value (Brooks, 2007:19). The other fraud committed by Xerox Corporation was the use of the Return on Equity Method (ROE) manipulation, through applying “topside” accounting, which entails the doctoring of the value of the leases that the company held on equipments (Jessup & Nance, 2011:157). The doctoring entailed allocating a higher value in the periods immediately following the lease, while reducing the value of the lease in the course of its lifetime (Burg, 1994:24). Margin Normalization Method fraud is the other form of fraud that was committed by Xerox Corporation, where the company increased its revenue margins in countries where the margins were lower than the USA and allocated the increased margins to the current financial periods, as opposed to waiting for the actual realization of the high margins in the future periods (DeVries & Kiger, 2004:16). The discovery of the fraud first occurred into full light in 1998, when KPMG, the external auditor of Xerox Corporation realized that the manipulations done on normalization of margins, though previously noted, were become more apparent. The Securities Exchange Commission discovered the fraud in the course of assessing other security matters at Xerox (Seipp, Kinsella &. Lindberg, 2011:229). This forced Xerox to go public in a letter attached to the 2000 financial report, with the claim that certain accounting irregularities had been discovered (Ferrara, LaMeau & Gale, 2012:61). Consequently, the SEC launched investigations, and unearthed the fraud. The name and background of the external auditor of Xerox KPMG was the external auditor of the Xerox Corporation (Jessup & Nance, 2011:156). KPMG is one of the largest accounting firms operating globally, currently ranked as the third largest global accounting firm, with its headquarters in Amstelveen, Netherlands (KPMG, 2002:75). The audit firm was established in 1979, under the name of KMG having merged with three different firms from Netherlands, USA, UK and Germany, meant to establish a strong European accountancy firm (KPMG, n.d., 13). However, the accountancy firm was to change into KPMG in 1987, after the KMG merged with Peat Marwick accounting firm from London, UK, in one of the historical accountancy mergers globally (KPMG, 1995:4). KPMG offers three lines of services associated with financial reporting, name accountancy, tax and financial advisory services (KPMG, 2007:23). The business line of KPMG has also been expanded in the recent decade to involve the provision of financial legal services, as well as financial assurance services. The company currently operates in over 820 different locations, situated in 159 different countries globally (KPMG, n.d.: 12). Nevertheless, while the company had been growing constantly since its inception in the late 1970s, its major growth and branding as a global accounting giant came in the 1990s (Vault, 1998:56). The company was able to promote its diversified lines of business and thus managed to grow by 11.1% in 1997 and later increasing its revenues by 15.6% in 1998 (Seipp, Kinsella &. Lindberg, 2011:228). The consequences of the fraud case to Xerox The consequences of the fraud case to Xerox is that the company was overburdened with an extended legal suit that had to run starting 2000 to 2002, in which SEC charged Xerox with numerous accounts of defrauding the shareholders in full knowledge (Seipp, Kinsella &. Lindberg, 2011:27). As a result, Xerox suffered from huge fines that the court imposed on it, with the SEC fining the company $10 million, which was the largest fine ever charged on a firm by the account of SEC claims (Countryman, 2003:n.p.). However, Xerox never admitted or denied the charges on which the SEC was making a claim of defrauding its shareholders. Therefore, the stocks of Xerox, which were listed in the New York stock market were affected very much, where the stock prices of the shares reduced by a large margin over the course of the legal tussle and also in the wake of the fraud discovery and claims, changing from $30 to the lowest of $3.75 in the course of the legal tussle (Tharp, 2001:n.p.). The other consequence of the fraud on Xerox is that it had to lose a substantial amount of money in paying for the legal fees and disgorgement of its management executives, while also making a reimbursement for the total sum of money that the executives paid as a result of the legal claim, other than for the $3 million charged to individual executives, which is not refundable under the regulations of SEC (Norris, 2003:n.p.). The other major consequence is that Xerox had to lose a substantial number of top management executives who were identified as being responsible for the fraud discovered (CNN Money, 2002:n.p.). Therefore, Xerox had to fire thirteen top executives who were mentioned as culpable in the defrauding case, which then means management disorganization and also a loss of essential workforce experience for the company. Xerox has also incurred huge debts, since it has already used over $7 billion in the process of firing over 9,000 of its employees (Tharp, 2001:n.p.). The consequences of the fraud case to Xerox’s audit firm KPMG was also not spared in the wake of the fraud claim that caught up both the firm and the client company (Ferrara, LaMeau & Gale, 2012:51). SEC held, in its clam against the external audit firm, that KPMG and its partners knew about the accounting irregularities that were committed by Xerox in the course of the three year period running between 1997 and 2000 (Fichtner & Simpson, 2011:89). KPMG first suffered the expense that comes with the settlement of legal claims, since the company was charged with several accounts of fraud and irregularities, as the external auditor of Xerox. Secondly, in regard to revenues, KPMG suffered huge revenue loses, since it was first required to surrender a total of $9.8 million that it had received from Xerox in the course of the three year period between 1997 and 2000 as settlement for the legal fees (Seipp, Kinsella &. Lindberg, 2011:222). Additionally, KPMG lost more revenues through being required to pay for a fine of $2.675 million as part of the interest in the $9.8 million it forfeited to SEC. worse still, KPMG had to suffer more income losses through being required to pay for a fine of $10 million civil penalty for failing to adhere to the required GAAP accounting standards for auditors (Doyle, 2008:45). KPMG also suffered the consequence of the fraud, owing to the fact that its five partners in the accounting audit of the Xerox financial statements were charged between $100,000 and $150,000 each (Butala & Khan, 2008:n.p.). The last of the consequences faced by KPMG following the fraud is that it was required to institute different policy auditing reforms, among them instituting a ‘whistle blowing’ policy against firms that are conducting financial accounting and reporting irregularities (Seipp, Kinsella &. Lindberg, 2011:228). II. Case study question 2 The responsibility of external auditors relating to the detection of material misstatements It is the responsibility of the external auditors to investigate any changes related to the methods of accounting for assets, especially in relation to the change of the accounting method for the assets from the historical costing method to any other method (Seipp, Kinsella &. Lindberg, 2011:28). Thus, the external auditor has the responsibility to investigate any material change arising from the change of the accounting for asset value, and report on such outcomes of the investigations appropriately. The other responsibility held by the external auditor is that of disclosing any material misrepresentation of the value of a firm as recognized in the course of auditing the firm’s financial statement (Holdman, 1984:76). In this case, KPMG was aware that Xerox was overstating its revenues through applying misleading accounting methods, but did not disclose on this accounting irregularity (Holtfreter, 2008:47). It is the responsibility of the external auditor not to assist, aid or abet any violations of the required accounting standards or any other laws that guide the accounting of a company’s financial statements, for example the SEC regulations (Seipp, Kinsella &. Lindberg, 2011:28). It is also the responsibility of the external auditor to report the accounting irregularities conducted by a firm to the relevant audit committee of the firm, as well as to the relevant authorities such as the SEC (Kasidi, Chaturvedi & Singh, 2010:407). The fraud factors that external auditors should consider when assessing the likelihood of material misstatements due to fraud The nature of the fraud that the external auditors should check while assessing the likelihood of material misstatement due to fraud include the change in any method of accounting for revenues or expenses for the client company. KPMG was responsible for checking the change in the method of accounting for revenues arising from the equipment leases as one of the possible area of fraud committed by Xerox (Koku & Qureshi, 2012:312). The other nature of the fraud that the external auditor should check is the accuracy of the record keeping of all transactions conducted by a firm within a given financial period. KPMG ought to have monitored the accuracy of recorded transactions of the equipment leases, where it would have noted the irregularity of overpricing that Xerox was applying on the equipment leases. The external auditor should also assess the additional notes, disclosures and information attached to the financial statements, which are meant to make the financial statements not misleading (Seipp, Kinsella &. Lindberg, 2011:228). KPMG should have assessed the additional notes and information, and realized that the change in the method of accounting for equipment lease revenues had been changed, and that such change was irregular, thus contributing to fraud (Jessup & Nance, 2011:156). Factors existed during the 1997 through 2000 audits of Xerox that created an environment conductive for fraud The friendly and cordial relationship that existed between KPMG and Xerox is a major factor that accounted for the favorable environment that encouraged fraud (Lipman, 2012:55). This is because, KPMG had acted as an external auditor for Xerox for many years prior to this period, such that the business relationship between the two firms had turned into a more cordial and informal relationship. This made KPMG reluctant to be keen in evaluating the books of account of Xerox, or even reporting the irregularities it identified in the financial reporting of the company, allowing departures and manipulations of GAAP requirements by Xerox (Jessup & Nance, 2011:156). The other factor that accounted for a favorable environment for fraud during this period is the highly competitive season in the industry that Xerox served (Seipp, Kinsella &. Lindberg, 2011:227). The high competition that the company was experiencing, most especially from companies in Japan saw the revenues of Xerox start to reduce at a higher margin rate, creating a favorable condition for the company to engage in fraud, in order to represent the financial and revenue situation of the company as still appealing (Jessup & Nance, 2011:156). III. Case study question 3 Factors present at Xerox Corporation that are indicative of incentive/pressure The high competitiveness of the industry market where Xerox operates is a factor that contributed to the pressure that caused the company to engage in fraud (Rendell, 2006:2). The high competition in the industry developed in the 1990s, causing the company to feel the pressure of sustaining its revenue earning capacity that was dwindling. After realizing that the initial revenue generation capacity would not be realized and recognizing the need to keep the pleasant traditional financial status of the company, extreme pressure developed that caused the company to engage in financial irregularities that constituted the fraud (Seipp, Kinsella &. Lindberg, 2011:228). The other factor that generated internal pressure for the company is formulation of the benchmarking goals. The benchmarking goals for the Xerox Corporation during this period were made based on the lead competitors as benchmarks (Jessup & Nance, 2011:156). This developed internal pressure for the company to keep up with the competitors, yet the markets environment were not favorable for generating revenues that would match the benchmarks. This pressure caused Xerox Corporation to engage in fraud. Factors present at Xerox Corporation that are indicative of opportunities The major factor present in Xerox that is indicative of opportunities is the Wall Street great emphasis on the company to reach certain goals, failure to which the company would face severe degradation of status consequences (Seipp, Kinsella &. Lindberg, 2011:228). This being the case, Xerox Corporation saw an opportunity in the demand for improved performance to continue seeking for ways to sustain a presentable financial situation through manipulating the financial statements, even when the actual financial situation of the company was not presentable. The lax of the KPMG as the external auditor was another opportunity that presented itself for Xerox to manipulate its financial statements and project to reflect an appealing financial performance than was actually the case (SEC.gov, 2002:n.p.). The financial misstatements and modifications of the revenue generation stream of Xerox was an opportunity created by the lack of strictness of KPMG in auditing and questioning the irregularities of the company. Thus, Xerox took this opportunity and capitalized on it, until it had managed to increase its equipment revenues by $3 billion, while also inflating the pre-tax earnings by $1.5 billion for the three year period running between 1997 and 2000 (Jessup & Nance, 2011:156). Factors present at Xerox Corporation that are indicative of rationalization The major factor that is indicative of rationalization at Xerox Corporation is the margin normalization, which was a strategy applied to increase the revenue performance of the company outside of the USA, with the only problem being that the expected revenues in the future were reported as if they were already earned revenues of the current period (Jessup & Nance, 2011:157). The margin normalization was applied on the basis of the argument that the market values were reported slightly higher than the actual values thus distorting the revenue allocations, such that Xerox corporation was not changing the financial statements, but just adjusting the market rates to represent the true values (Stuart & Stuart, 2004:46). The other aspect of rationalization identifiable in the Xerox corporation case is that the company argued for its inability to accurately determine the true value of equipment leases (Jessup & Nance, 2011:157). This argument is rational, since the future values of the leases are not definite, but instead of applying the right method of estimating the future value, Xerox turned into manipulating the values to present a favorable financial position. IV. Case study question 4 The responsibility of external auditors to the different internal control components The external auditors are responsible for internal control components such as the margin normalization methods, where the external auditors are supposed to inspect the methods to ascertain their accuracy and their ability to reflect the true and fair value (Seipp, Kinsella &. Lindberg, 2011:226). KPMG failed to ascertain this method and its accuracy, resulting in the fraud that occurred in Xerox Corporation. The external auditor is also responsible for controlling the ROE measures within the client company, such that the assumptions applied to measure the ROE reflect the required GAAP standards, and thus estimate the value of the assets with the highest possible level of precision (Wong, 2007:17). Lease term extensions and lease contract price increases are the other internal control components that the external auditors are responsible for. The GAAP requires that any lease term extensions or the increment in the price of the lease contract should be recognized for the remaining term of the contract, but instead, Xerox recognized such increments and extensions immediately, while KPMG did not apply control to adjust this anomaly (Seipp, Kinsella &. Lindberg, 2011:225). The red flags that was present during the audit of Xerox Corporation that may have suggested weaknesses in Xerox’s internal control system The first red flag that would have suggested a weakness in Xerox’s internal control system is the instant change of the method of accounting for the value of the equipments of the company from the historical costing method to the present costing method (Jessup & Nance, 2011:156). The sudden change would have definitely indicated that something is wrong with the Xerox’s internal control system, since such changes are not supposed to occur suddenly, and neither should such changes be effected without the correct procedures of approval and disclosures (Stuart & Stuart, 2004:48). The second red flag that should have indicated a weakness in the internal control system of Xerox Corporation is the fact that the company was just meeting and exceeding its target revenues for each quarter, despite the high competitiveness and unfavorable market environments that stood for revenue earnings reduction (SEC.gov, 2002:n.p.). Further, the depletion of the Xerox Corporation’s reserves is yet another red flag that would have indicated a weakness in the internal control, since the company was withdrawing its reserves in piecemeal, and then releasing such reserves as incomes earned during certain financial periods (Seipp, Kinsella &. Lindberg, 2011:220). 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