Xerox Accounting Fraud - Essay Example

Running Head: XEROX ACCOUNTING FRAUD Xerox Accounting Fraud of the of the Xerox Accounting Fraud For fifteen years, from 1975 to 1992, Xerox Corporation's stock traded between about $5 and $14 per share. Looking at a long-term chart, one would think that it was a $10 a share stock. In late 1986, Paul Allaire became a director and in 1990, CEO. Like most CEOs of large companies, Allaire was well respected. He was a member of the Business Roundtable and Business Council and was on the board of directors of other companies including J.P. Morgan, Lucent Technologies, Sara Lee, Smith Kline, and Priceline.com. Xerox's stock continued to trade in the same range until around 1994, at which time the price began to rise along with the general rise in the stock market. In 1997, approximately five years before Allaire's scheduled retirement, Xerox stock began to outperform the market. The stock reached a high of $63.69 on May 3, 1999 (see Figure 1). This was just one month after Allaire stepped aside as CEO and became Chairman, and Rick Thoman, with the support of Allaire, became CEO. Figure 1: Xerox (XRX) Stock Price History The 1999 Proxy Statement disclosed that Allaire had realized approximately $8.3 million on sales of stock from options in 1998. It also disclosed that he still owned approximately $57 million of exercisable options and $21 million of not yet exercisable options. For each 10 percent increase in the stock price, Allaire would make approximately $17.8 million, or for each $1 increase in share price he would make a little more than $3 million. Thoman's option position was less vested, but he had more upside over the longer run: For each 10 percent rise in stock price he would make approximately $27 million, or for each $1 increase in share price, he would make over $4 million. Both individuals clearly had a significant vested interest in the stock price. Just one week prior to the shareholder meeting in May 1999, Xerox officials told Wall Street analysts that Xerox shares were undervalued given the company's "consistent earnings growth" of "12 percent or better in 16 of the past 17 quarters," and that the company's goal would continue to be to "consistently deliver earnings growth of mid to high teens." In effect, the predicted growth bar was raised, and some wondered how profits could grow at three times the rate of revenues. Revenue growth was predicted to be 5 percent for the quarter although year-to-year revenue growth for the first quarter was zero. Investors Grow Uneasy By July investors were getting suspicious. In retrospect, they had good reason. The stock had fallen more than 10 percent when Xerox reported that it was in line with its targets for second- quarter growth of 13 percent in "core earnings." The company also noted that revenue had grown at only 2.5 percent and that "mid to high teens" earnings per share growth would be hard to achieve for the balance of the year. On receipt of that news, the stock traded down 8.2 percent to close just below $51. The company tried to adjust the spin to emphasize future opportunities, noting that it was transforming itself from a copier company to a copier services company and that it expected the services component to account for 50 percent of total revenue (up from 15 percent) within eight to ten years. Research analysts supported the company story. Eight out of eleven continued to rank Xerox a strong buy. By mid-September 1999, Xerox was forced to lower expectations again when the CFO noted that revenue growth would fall below 5 percent. A strong U.S. dollar and economic weakness were blamed-although with the stock down about 30 percent from the high four months earlier, several analysts expressed doubt that Xerox's problems were limited to foreign sales. Within a week Xerox announced the acquisition of Tektronix's color printing and imaging business for $950 million, saying that it expected that market to grow at 23 percent for the next three years. Thoman said, "This is really about growth." (DJI, 1999) Again the analysts supported the company, noting that Xerox's problems were little more than a paper jam and that the Tektronix deal would catapult Xerox from number six to number two in the color printing and imaging business. In October 1999, the company warned that third-quarter earnings would not meet expectations and that they would, in fact, decline more than 18 percent. The stock promptly traded down 25 percent to $30. The company again blamed weakness in foreign sales. Two months later, the company warned it would miss fourth-quarter earnings expectations by 40 percent, and Thoman declined to give guidance for 2000.( Keith, 2002) The stock traded down to under $25. Within a few more days it hit $20. With the stock trading at about one-third the price of its high, some analysts lowered their ratings to a "hold," while one retained the "strong buy" rating and predicted the stock would hit $41 within eighteen months. The stock continued to decline throughout 2000 and closed at $4.69 on December 5, 2000, at which time there were ten "hold" recommendations and one "sell" recommendation on the stock. During the course of the year, as the price declined despite every effort by the company to hold it up, Allaire sold stock, which he had acquired from options, for more than $8.5 million. In early 2000, the company announced a joint investigation with their auditors, KPMG, into accounting irregularities in Mexico. The investigation was headed by Thomas Theobald, chairman of the audit committee. In May Thoman retired as CEO, and Allaire was reappointed to replace him and given a two-year contract. At the same time the Board appointed Anne Mulcahy as President and COO. She had been with Xerox for twenty-five years, most recently as EVP of Xerox and President of General Market Operations. By October 2000, Mulcahy had learned more about Xerox than she had bargained for. To her credit she proclaimed Xerox's business model to be "unsustainable," and the company's stock fell 25 percent in one day. She has said, in retrospect, that such a pronouncement taught her a "painful lesson" about disclosure.(Securities and Exchange Commission, 2002) Investors who might have but didn't buy stock that day avoided the pain of future price declines and probably applauded Mulcahy's candor. Had they bought, their investment would have been reduced to half its value relatively quickly. Six months later, more than one year after the beginning of the Mexico investigation, and after having delayed the filing of its 2000 10K in April 2001, the company finally filed on May 31, 2001. That filing disclosed the restatement of consolidated financial statements for two years ended December 31, 1998 and 1999. Net income for 1998 was reduced by $122 million (30.9 percent) and for 1999 by $85 million (6 percent). In total, that came to a $207 million overstatement of income. The company acknowledged that certain accounting errors and irregularities had occurred, and that GAAP had been misapplied. The blame was placed squarely on several senior managers in Mexico who had collaborated to circumvent Xerox's accounting policies and procedures. Thoman, by virtue of his being replaced, was indirectly accused, and the board fired KPMG, which absorbed blame. Not mentioned was the fact that Xerox had complained previously to KPMG about an auditor who was questioning its accounting and requested that the individual be taken off the Xerox account. The SEC Steps In Unlike with other companies that have successfully swept problems away with minor disclosures, the SEC was not satisfied with these adjustments and continued its own investigation, which resulted in the commission filing a civil fraud injunctive action against Xerox in April 2002. The complaint alleged that Xerox had overstated revenues by more than $3 billion and profits by more than $1.5 billion over a four-year period beginning in 1997. This year coincided with the time that Xerox began to outperform the market and Allaire began to accumulate a fortune. The action was finally settled in June 2002 with a second restatement involving the inappropriate booking of $6.4 billion in revenue and overstated pretax profits of $1.4 billion.(Securities and Exchange Commission, 2002) The company was fined $10 million, paid, of course, with shareholders' money. Stephen Cutler, the SEC's director of enforcement said, "Xerox used its accounting to burnish and distort operating results rather than to describe them accurately. As a result, investors were misled and betrayed." Paul R. Berger, associate director of enforcement said, "Xerox's senior management orchestrated a four-year scheme to disguise the company's true operating performance. Senior management had no compunctions about engaging in improper conduct." And Charles D. Neimeier, chief accountant for the division of enforcement added, "Xerox employed a wide variety of undisclosed and often improper top-side accounting actions to manage the quality of its reported earnings. As a result, the company created an illusion that its operating results were substantially better than they really were."(William, 2002) Figure 2, based on a chart prepared by the SEC, shows the impact of the accounting manipulation at Xerox, quarter by quarter, for the years 1997 through 1999. The lowest part of each bar is real EPS. The smaller top component shows manufactured one-off earnings and the partial line near or at the top of each bar pinpoints the consensus analyst's estimates, largely guided by the company. This chart clearly demonstrates earnings manipulation. The SEC learned during its investigation that Xerox CFO Barry Romeril had told senior management in November 1999, "When accounting actions were stripped away, Xerox had essentially 'no growth' throughout the late 1990s." The Aftermath Rich Thoman retired after events caught up with him and he was unable to sustain reported growth. Thomas Theobald (who missed finding about $6 billion of overstated revenues and about $1.4 billion in overstated profits) resigned from the board in July 2002. Paul Allaire has not been prosecuted nor were his profits taken back, although the SEC has notified him that he may be subject to penalties. In 2001 he received a salary of $1.2 million and a bonus of $1.5 million, in total almost $1.5 million more than the previous year. Romeril, the CFO, retired at the end of 2001 and received a $500,000 termination bonus as well as $1,215,000 for each of two years plus 50,000 incentive stock rights, from which he can profit if there is any recovery in share price. These terms, set by the board of directors, were more than his termination agreements required and were paid to "ensure a smooth transition." In his last working year he made less than $700,000. Anne Mulcahy became CEO of Xerox in July 2001, the day after the company announced a $281 million second-quarter loss on a 13 percent decline in revenues. The stock was trading at $8. She became both Chairman and CEO on January 1, 2002, when Allaire retired. Source: U.S. Securities and Exchange Commission news release, "Xerox Settles SEC Enforcement Action Charging Company With Fraud," April 11, 2002. Figure 2: Write-offs Added to Xerox's Earnings-Per-Share Figure 2 shows the impact of Xerox's one-off accounting actions on reported quarterly earnings per share 1997 through 1999. It also compares reported earnings per share with First Call consensus estimates by quarter. The SEC settlement with Xerox occurred about six months after Enron went bankrupt. Although the Xerox case received several days of press coverage, the case was largely ignored by the media. When the settlement was announced, the stock was down 89 percent and was trading at $6.97, down from $63.69 at its high. In early 2003, Corporate Financing Week estimated that the company's pension fund was underfunded by $2.3 billion, which arguably should have been expensed over the period. (Julie, 2003) The primary difference between Enron and Xerox is that Xerox once had a viable business model and did not go bankrupt. To investors that lost money and employees who were fired, that difference is small. References "Xerox to Buy Tektronic Color-Printing Unit for $950 Million," Dow Jones Business News, Dow Jones Interactive, September 22, 1999. Keith H. Hammonds, "The Secret Life of the CEO: Do They Even Know Right from Wrong" Fast Company (December 31, 2002). U.S. Securities and Exchange Commission, "Xerox Settles SEC Enforcement Action Charging Company With Fraud," Litigation Release No. 17465, April 11, 2002. U.S. Securities and Exchange Commission, "Xerox Settles SEC Enforcement Action Charging Company With Fraud," news release, April 11, 2002. William M. Bulkeley, "Ex-Xerox Officials Got Big Bonuses Despite SEC's Accounting Concerns," The Wall Street Journal, April 19, 2002. Julie E. Satow, "Underfunded Pension Plans May Prompt COs to Market," Corporate Financing Week (January 5, 2003). Read More