Agency Theory and the Internal Audit - Case Study Example

Strategy audit case study Contents Answer 4 Background of the company 4 Nature of business 4 Nature of fraud committed and way it was discovered 5 Name and background of the external auditor of Xerox 5 Consequences of fraud case to Xerox 6 Consequences of fraud case to Xerox’s audit firm 6 Answer 2 7 Responsibility of external auditors 7 Fraud factors that external auditors should consider 8 Factors during 1997 through 2000 audits of Xerox conductive for fraud 9 Answer 3 10 Factors indicative of incentive/pressure 10 Factors indicative of opportunities 11 Factors indicative of rationalization 11 Answer 4 13 Responsibility of external auditors 13 The red flags that were present during the audit of Xerox Corporation 14 References 17 Answer 1 Background of the company Xerox is an American multinational firm that manufactures and sells a range of colour and black and white printers, multifunction system, photocopier system, digital production printing process, consulting services and supplies. The headquarters of Xerox are in Norwalk, Connecticut. Over the years Xerox has been the leading manufacturer of photocopy instruments. Xerox had annual sales figure of $18.7 billion in 2000. In the year 2000 Xerox had 92,500 employees worldwide and was ranked 86th amongst the Fortune 500 companies globally. Researchers at Xerox have invented several patents over the years to cover a wide variety of products. However, the company did not approve of those researches and subsequently these were sold to other companies such as Apple and Microsoft who used these technologies and inventions successfully in order to extend their duopoly positions in the market. Nature of business Xerox is considered as the world’s leading enterprise in the field of business process and document management solutions. The company is engaged in providing services, technology and expertise to help their customers that range from small business to global corporate so that they can focus on their core business and can operate more effectively (Xerox, 2013). The document management market in which Xerox is a leading player and has several sub systems like document systems, software’s, solutions and services that the customers of Xerox has relied upon for years to run their business effectively and is estimated at roughly $100 billion. Nature of fraud committed and way it was discovered In the 1990s Xerox faced increased competition from its competitors which decreased its sales figure of the photocopier machines and the revenue that it generated out of it. The lowering of revenues would ideally lead to lowering of the expected returns that the norm. However the failure on the company’s part to meet the expected return by the analyst can have a negative impact on the stock price of any company. The company managers were determined as to not let this happen. So Xerox resorted to several accounting manipulations in order to meet the expected earnings that were projected by analysts in every quarter of 1997-2000 (Kaplan, 2001). It is also noted that if Xerox would not have been party to the manipulations then it would have missed the deadline in 11 out of the 12 quarters. The fraud was uncovered by security and exchange commission who was in the course of reviewing other security matters at Xerox (Tharp, 2001). The SEC formally filed the complaint after investing for two years into the accounting practices employed by the company. Name and background of the external auditor of Xerox The auditing job and the role of the external auditor at Xerox were taken up by KPMG. KPMG is one of the big 4 accounting firms in the world and had been engaged in the audit of Xerox for the last 40 years. KPMG is one of the largest professional service companies in the world. It forms part of the big 4 accounting firms. The other firms included in the list are Delloite, E&Y and PWC. KPMG was formed by the merger of two firms that is KMG and Peat Marwick. KPMG is registered as a Swiss company and is located in Amstelveen, Netherlands. KPMG has its offices in almost every country across the globe and employs 162,000 people. Consequences of fraud case to Xerox As a consequence of the accounting fraud Xerox was required to pay to the SEC $10 million as fine and restate the company earnings for the period of fraud. It should be however be noted that Xerox neither agreed to nor denied the accusations that were brought against the company (CNN Money.com, 2002). Xerox also agreed to the condition imposed by SEC that required it to have a committee that would be appointed by the board of directors in order to review the company’s material internal accounting controls and policies (Pratley and Treanor, 2002). The six executives of Xerox that were involved in the fraud were collectively required to pay $3 million in civil penalties, surrender nearly $14.4 million in stock profit and bonuses and $5 million in interest. Two of the executives namely Fishbach and Marchibroda were required to relinquish $177,000 in deferred bonus and interest. A permanent ban was also imposed by SEC against Romeril, and a five year ban against Allaire and Fishbach and three year ban against Thoman. Tayler was also suspended for three years and after 3 years and he was given the right to apply for reinstatement after 3 years. Consequences of fraud case to Xerox’s audit firm In settlement of the fraud committed by the audit firm KPMG in relation to the Xerox case KPMG had to forfeit to SEC the total audit fees that it had received from XEROX during 1997-2000 for doing the audit that amounted to $9.8 million (SEC, 2003). Additionally KPMG had to pay interest charges of $ 2.675 million on the audit fees that were forfeited. Additionally KPMG had to pay civil penalties that amounted to $10 million. In addition to the above penalties KPMG was additional required to install reforms that would prevent such violations from occurring in future. The five KPMG partners were also heavily fined by KPMG. The partners were additionally prevented from appearing before SEC for certain terms. In addition to paying fines to the SEC, XEROX and KPMG also settled a case with the investors that were filed by the investors by paying them $670 million and $80 million in fines. Lastly KPMG was removed from being the Auditor and PWC was made the auditor of Xerox. Answer 2 Responsibility of external auditors The company’s financial statement needs to be validated and the external auditors play a key role in validating the financial statements of the firm (Burke, Guy, and Tatum, 2008). External auditor and their audit of the firm and its accounting and financial statements lends credibility to the statements. Investors or lenders often look out for audited statements before they decide to invest in a company (Basu, 2006). If the auditor fails to deliver its job correctly and correctly point out the accounting malfunctions then it has a poor reflection on the credibility of both the company and its audit firm (Gray and Manson, 2007). Various accounting standards and guides are released by professional bodies that reflect the role and scope of work of an external auditor so as to prevent any account fraud from occurring. Some of the responsibilities of the external auditors are as follows. Providing opinion of financial statements External auditors are responsible for going through the financial statements and providing reasonable assurance to the investors and lenders that the firm has not resorted to any material mismanagement in preparing the financial statements and has complied with the accounting rules and norms in preparing the financial statements (Porter, ‎ Hatherly ‎ and Simon, 2008). External auditors give solutions to the problem although some of them issue advices to the management. External auditors are however not responsible to the lenders that the financial statements are absolutely free from any errors. They are only required to provide reasonable assurance. Understanding entity and its environment Accounting is based on the understanding that the numbers in the financial statements do not arise out of vacuum but are a function of the environment in which the company operates. External auditor has to perform periodic risk assessment of the firms’ external environment in order to understand the risk factors that exist in the business (KPMG, 2011). The external auditor is required to analyze electronic accounting system and the performance of other companies in the sector to analyze whether the particular company is not doing any data manipulations. Fraud factors that external auditors should consider When an auditor conducts audit on a firm in accordance with GAAS, it is responsible for ensuring that the financial statements as a whole are free from material misstatement, whether it is caused by fraud and error. Due to the fact that inherent limitations of audit that exists it may be the case that some of the material mismanagements may not actually be detected by the external audit even though the audit has been properly planned and performed according to the requirements of GAAS (Aicpa, 2014). The risk of not being able to detect the misstatement increases in case of error fraud than in case of error. This is due to the fact that fraud may involve schemes that has been designed sophisticatedly and carefully in order to conceal the fraud. Such attempts to conceal may be even more difficult to detect if they are accompanied by collusions (Journal of accountancy, 2003). Collusion may cause the auditor to believe that the evidence of the audit is good when in fact it is false and misrepresentation. Whether the auditor will be able to detect the fraud or not depends on factors like how skill full the perpetuator is? How frequently the manipulation is done? What is the degree of collusion? What is the relative size of the amounts involved? The auditor may identify opportunities where fraud may occur however it may fail to identify whether the maladjustments are a result of fraud or error. Factors during 1997 through 2000 audits of Xerox conductive for fraud In the 1990s Xerox faced lowering of sales of its photocopier machine due to competitors from Japan such as Cannon. This would result in turn in lowering of the expected returns of the company which in turn would have a negative impact on the company’s stock price. However this would have a negative impact on the company’s stock prices. The company did not want that its stock prices should reduce. So the company resorted to a no. of accounting manipulations to keep the expected returns in the levels that the analysts expected (Kay, 2002). Some of the methods that the company used to boost its expected results were The company over a period of time designed a cookie jar of reserves that were released in the income side as to meet the quarterly projections of the analysts regarding the expected returns. The funds in the cookie jar were released from time to time so as to meet the gap in between the actual results and the expectation of the analysts. Figure 1Accounting fraud used by the company (SEC, 2002) The above figure shows the amount of fund that the company inse4rted into its income so as to boost the EPS from time to time so as to close the gap between analysts projection and actual results. At some time the fraud level was about 36%. Other accounting irregularities that were used by the company included by the company for its fraud are in recognizing the profit from the equipment sales. Answer 3 Factors indicative of incentive/pressure Xerox was one of the big tech companies worldwide. It was one of the fortune 500 companies and was ranked 87th. Its annual sales revenue stood at $18.7 billion as stated in its annual report, 2000. It was facing stringent competition from other major giants like Canon, Minolta and Ricoh, resulting in falling turnover and market share. In order to meet investor’s expectations and maintain its stock value, it engaged itself in some accounting malpractices. It was faced with internal and external pressure. Internally the benchmarks set by various analyst groups that forecast the earning potential of the company and the stockholders expectation of positive returns (Spira and Page, 2003). Its revenue started declining, resulting in lower earnings to investors, which started building pressure on the operational efficacy of the company. Externally it was facing stiff competition from its peers, resulting in falling market share. The chief personnel responsible for such deteriorating conditions were Paul Allaire (CEO), Richard Thoman (CEO) and Barry Romeril (CFO). Xerox’s audit partner KPMG and its partners namely KPMG Tokyo, US and Brazil was aware of its misrepresentations of financial statements and reported their findings of such practices to KPMG UK. The company was also facing pressure from its partner audit firms, who have reported their financial reporting as against the GAAP, and which unnecessarily inflates the revenue figures, resulting in increased pre tax earnings (Adams, 1994). Factors indicative of opportunities There were mainly two key factors that served as avenues for Xerox to manipulate its financial status i.e. external parties vis-a-vis audit firms like KPMG that has wrongly reported the financial position of the company to its benefit. The second key factor was its creation of reserve over the years that helped the company to meet its projected earnings. Such reserves were known as “Cookie Jar Reserves” and charges were made against these reserves when the quarterly earnings fell short of the projection. The audit partners of KPMG, who audited the financial statements of Xerox and reported its activities and approved all its methods of recording and reporting financial items (Griffiths, 2012). The other audit firms of KPMG engaged with Xerox were KPMG Brazil and US. KPMG chief officials in UK acted under professional obligation not to disclose or share any information with other business wings of Xerox. The audit firm’s indifference served as a key avenue for Xerox to evade the accounting principles and engage in financial manipulations (Seipp, Kinsella and Lindberg, 2011) (Blouin, Grein and Rountree, 2007). Factors indicative of rationalization Xerox Corporation devised various ways to artificially build its revenues and pre tax earnings to retain its stock values and meet investor’s expectations. Though such methods used to record financial transactions were completely not illegitimate, but was not recognized by GAAP (Sharma, 2011). Few of the manipulations, which were also called accounting devices were against the GAAP, yet it was approved by external audit firm i.e. KPMG reported Xerox’s accounting devices as rational or pragmatic. It had created arbitrary reserves also known as “Cookie Jar Reserves” which were used to push the revenue and earnings level to the desired or projected level that would help satisfy its investors (Jessup, Nance and Kaufman, 2011). There were mainly three types of reserves i.e. 1. The rank reserve – A reserve created for unknown risks after buying the 20% stake of Rank group Plc in Rank Xerox Ltd. The reserve was valued at $100 million. 2. Vacations pay accrual reserve – Xerox limited the number of leaves that could be carried over to the next year, resulting in creating a balance of $30 million over its additional balance of $41.9 million 3. FAS 106 Reserve – This reserve was created for post retirement benefits and had an excess balance of $40 million (Jessup, Nance and Kaufman, 2011). There were methods Xerox used to rationalize its increase in pre tax earnings, which are as follows: 1. Return on equity and equipment leases – Xerox followed a new method to recognize the revenue generated from leases from service and supplies. Only in case of equipment leases GAAP allowed to recognize the revenue in the same period, but in case of other lease revenues it had to be recognized over the period of lease, but it recognized other lease revenues in that period itself, resulting in an increase of $301 million pre tax revenue. 2. Profit margin normalization – Management at Xerox used this approach when the ROE method did not meet the projections. Under this method, it adjusted the figures to align the profit margin with the future projections. This approach increased its pre tax revenue by $358 million 3. Price increase/ lease term extension – Due to increase in prices and lease period extensions, GAAP recognizes such differentials over the entire lease period, but Xerox recognized the entire amount in the same year. The resulting effect increased the pre tax revenues by $200 million. 4. Residual value increase – Xerox Corporation has often adjusted the value of the leased equipment, but under GAAP the residual value is to be estimated at the beginning of the lease. Under FAS13 no adjustments are to be made during the life of the lease. The company earned an excess of $43 million as pre tax earnings, using such adjustments (Seipp, Kinsella and Lindberg, 2011). Answer 4 Responsibility of external auditors The external auditors report should be based on facts. It should closely act in accordance with the GAAP and other acts, namely the Exchange Act of 1934 and Securities Act of 1933. It should not approve any reporting of financial items that is not recognized under the statute or guidelines (Tritschler, 2013). If any discrepancies are found it should be brought to the immediate notice of the management and issue a red flag accordingly. It has been observed in the case that Xerox Corporation has evaded various guidelines of GAAP and securities act to increase its pre tax earnings to meet its investors’ expectations and projections of analyst groups (Douglas, Prawitt, Smith and Wood, 2009). It should not be a party to any fraudulent activities or advise or approve financial reporting that would benefit its client company (Roy and Edwards, 2014). It should also honour the company client relationship at all time, and should not be biased. In this case, there were multiple incidents where KPMG had allowed Xerox with such accounting devices and was indifferent to its partner firm’s objections on such accounting practices. It waived any kind of red flags raised by other units (Dauber, 2009). The external auditors in case of Xerox made some reservations, but did not raise any red flags, but gave an indication to carry on the pre existing practices i.e. KPMG UK approved the profit margin normalization approach, which was not recognised by GAAP. It should maintain a cordial company client relationship at all time, without being the beneficiary. They should at all time communicate and correspond with the internal audit team and the management about issues regarding financial reporting, without giving any leverage to either the company or the client (Raghunandan, Dasaratha and Read, 2001). The red flags that were present during the audit of Xerox Corporation Xerox Corporation was engaged in breaching GAAP in reporting its financial transactions. It arbitrarily created reserves to meet the projections of the first call. First call implies the service to contrive reports of earning projections (Swanger and Chewning, 2001). It used various manipulations to report inflated revenues and pre tax figures, to meet the expectations of its investors/ investor sentiment. It used various accounting devices like return on equity and equipment leases, profit margin normalization, lease term extension, increase in residual value and creation of arbitrary reserves known as cookie jars (Knechel and Vanstraelen, 2007). The Securities and Exchange Commission brought a legal suit against Xerox Corporation in the district court of United States on April 11, 2002, owing to the red flags raised in the audit process of its financial reporting (Gupta, 2004). The red flags in the audit process are as follows: 1. No proper source trail of increased pre tax earnings. Pre tax earnings increased to $1.5 billion from 1997 – 2000. 2. Significant increase in sales revenue by over $3 billion. Unacceptable methods were used to inflate the figures, which are not recognized by GAAP. 3. False submission of reports and suppressed facts to Securities and Exchange Commission. 4. Misleading information regarding future projection of earnings from 1997 to 1999. 5. Non disclosure of some leasing practices. 6. Misrepresentation of 1999 financial statement, which shows positive cash balance attributed to accounting devices, which otherwise would have been negative. Securities and Exchange Commission also made some reservations against the chief management personnel and KPMG’s official, owing to non compliance and irregularities in financial reporting. The irregularities of the above mentioned parties are as follows: 1. Non disclosure of impact statement of return on equity and profit margin normalization. 2. Failure to disclose material impact statement of lease extensions, residual value adjustments and price increases. 3. Chief personnel of Xerox responsible for the fraud: Allaire Paul, Romeril Barry, Fishbach Philip, Marchibroda Daniel, Tayler Gregory and Thoman G. Richard. 4. Xerox Corporation’s annual report for the period 1997 to 2000 was found false. KPMG and its audit partners were held responsible for such an act. 5. KPMG stated its satisfaction on Xerox’s financial practices that were fraudulent. 6. KPMG’s Boyle, Safran, Dolanski and Conway were held individually and severally responsible for their acts of filing inaccurate annual and quarterly financial reports of Xerox and non disclosure of items that were specifically required to be reported under GAAP. The Xerox officials were individually and severally fined for their acts. They penalty charges exceeded $20 million and on April 19, 2005 Securities and Exchange Commission asked KPMG to pay more than$10 million as civil penalty and bring about reforms in its audit process and policies. Xerox and KPMG came to a settlement on March 28, 2008, where the former paid $670 million and the latter paid $80 million. 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Audit quality: Association between published reporting errors and audit firm characteristics. New York: Springer Science & Business Media. Xerox, 2013. Business. [online] Available at < http://www.xerox.com/annualreport/2013/assets/xerox-oar-2013-form-10k.pdf > [Accessed 11 March 2015]. Read More