ACCOUNTING FRAUD AT XEROX

Research on Accounting Fraud at Xerox Company

Ahu Atay
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Abstract

This analysis will examine the Xerox accounting fraud scandal, its causes and effects, and the

need for best practices in business ethics, corporate governance and oversight. Xerox utilized

‘creative accounting’ techniques to misrepresent its assets and liabilities, deceiving investors and

inflating its stock. The scandal was staggering in its scope and scale: chairman and CEO Allaire

and others enriched themselves to the tune of millions at stockholders’ expense (Mills, 2003, pp.

21, 30). The Xerox scandal demonstrates the need for accountability and ethics in corporate

governance and finance: Xerox’s central problem was its inept, short-sighted and unethical

senior executives.
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Xerox Corporation is a global document management company which manufactures and

sells a range of color and black-and-white printers, multifunction systems, photo copiers, digital

production printing presses, and related consulting services and supplies. Xerox established itself

as the purveyor of its xerography machines, establishing the company name in the common

lexicon. Its Palo Alto Research Center (PARC) invented such hallmarks of digital age

technology as “the personal computer, graphical user interface [mouse], Ethernet, and laser

printer…” (Daft, 2009, p. 4). But the high profit margins of Xerox’s copiers blinded management

to the potential of this technological cornucopia—which other companies rushed to exploit. By

1982, Xerox was facing drastically-reduced market shares as companies such as Canon began

out-competing it in the copier sector (p. 4).

But by 1997, Xerox’s fortunes seemed to be improving. Under the leadership of chairman

and CEO Paul Allaire (since 1990), Xerox’s stock began to increase. However, the change was

illusory: Xerox was using creative accounting techniques to mislead investors about its true

worth. Allaire and others in Xerox’s top management were unloading their fraudulently-inflated

stocks and pocketing millions, all while “’closing the gap’” between target and actual

performance (Lowenstein, 2004, pp. 74-75). That gap continued to grow when in 2000 Xerox

“continued to lose ground to Canon and suffered a loss” (p. 76). Then came the revelation of

’accounting irregularities’ in Mexico.

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The Securities and Exchange Commission (SEC) began to investigate and filed suit
1
against Xerox in US District Court for the Southern District of New York. The complaint

alleged that Xerox, using a host of undisclosed accounting “actions,” which were often referred

to as “accounting opportunities” and “one-offs,” distorted earnings and misled investors 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. 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.

In an official release to the press the SEC explains these “accounting actions” were

employed by Xerox to “close the gap” between the market’s expectations and actual operating

results from 1997 to 2000, as shown in the below chart SEC created chart used to illustrate the

impact of these “accounting actions” when compared to Wall Street estimates. Paul Berger,

Associate Director of Enforcement for the SEC stated in this press release, “Xerox's senior

management orchestrated a four-year scheme to disguise the company's true operating

performance,” and Charles D. Niemeier, Chief Accountant for the Division of Enforcement,

added, "Xerox employed a wide variety of undisclosed and often improper top-side accounting
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actions to manage the quality of its reported earnings. As a result, the company created the

illusion that its operating results were substantially better than they really were.".

In response to the SEC complaint, Xerox consented and without admitting or denying the

SEC allegations Xerox agreed to pay the $10 million penalty -- the biggest fine the SEC had

ever levied for accounting fraud -- and to restate the company’s financial results for 1997, 1998,

1999 and 2000. Additionally, the SEC release stated that Xerox had agreed to have its board of

directors appoint a committee composed entirely of outside directors to review the company's

material accounting controls and policies. In 2005, KPMG agreed to pay $22.5 million to settle

SEC charges related to its audits of Xerox from 1997 through 2000. Under that arrangement, the

firm agreed to relinquish the $9.8 million in fees it received for auditing Xerox's books during

that time, and pay $2.7 million in interest and a $10 million civil penalty. The total package was
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the largest payment ever made to the SEC by an audit firm.2 The Securities and Exchange

Commission also charged six former senior executives of Xerox Corporation, including its

former chief executive officers, Paul A. Allaire and G. Richard Thoman, and its former chief

financial officer, Barry D. Romeril, with securities fraud and aiding and abetting Xerox's

violations of the reporting, books and records and internal control provisions of the federal

securities laws. The six defendants agreed to pay over $22 million in penalties, disgorgement and

interest without admitting or denying the SEC's allegations. 1

These are the general particulars of the case. The lengths to which Xerox went to

misrepresent its financial situation, however, beg questions like ; What led Xerox’s senior

executives to such an unethical (and risky) course of action? , and The Board’s contribution to

the scandal- how could they have not known? .

The Xerox scandal may have grabbed the

attention of the financial media and Wall Street, but the

seeds for Xerox’s failure were sown decades before. As

seen, Xerox developed many technologies in the digital

age—and then failed to take advantage of them.

According to Daft (2009), “while Xerox was plodding

along selling copy machines, younger, smaller, and hungrier companies were developing PARC

technologies into tremendous money-making products and services” (p. 4). Not only did Xerox

fail to capitalize on new technologies, by 1982 its copier market share had fallen from 95 to 13

percent—when its xerography patents started to expire, Canon and Ricoh were able to sell

copiers “at the cost it took Xerox to make them” (p. 4).
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The irony is that Xerox was once “the envy of the corporate world” for its “dedicated

employees” and a company culture that emphasized “values of fairness and respect… risk taking

and employee involvement…” (Daft, 2009, p. 4). But Xerox’s superb company culture was

offset by poor decision-making at the top that stopped its success. The SEC investigation noted

that “compensation of Xerox senior management depended significantly on their ability to meet

[earnings] targets.” Because of the accounting manipulations, top Xerox executives were able to

cash in on stock options valued at an estimated $35 million.

When it comes to the Board ; the straight forward answer to the question of what could

the Board have done to prevent or mitigate the effects of the scandal is that they could have held

truth above all else and acted ethically in their financial reporting.Xerox Corp. did have and

Audit committee, and the company’s independent auditors were at the time of the scandal

KPMG, LLP.

Indeed, Xerox was guilty of a considerable number of accounting tricks that involved

manipulating period reporting: according to Mills (2003) the SEC also charged Xerox with

“improperly recognizing revenues from its leasing operations…” because Xerox booked lease

payments for future services or supplies up front, and with attempting to increase short-term

results “by overstating the value of future payments from leases originated in developing

countries” (p. 21). It also failed “to write off mounting bad debts,” another example of

attempting to paint a rosier picture of the company’s finances through fraudulent means in order

to increase investor confidence (p. 21). This is a well-known accounting trick, using “cookie jar”

reserve accounts to create the illusion of a smoother “growth path of sales and profits” in order to

increase investor confidence and inflate stock values (pp. 30-31).

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Mills (2003) explained that executives are able to fraudulently manipulate their

accounting statements because “accountants, banks, brokers, and attorneys all benefit from

helping CEOs do this” (p. 27). Xerox’s deception was enabled by these interests; indeed, the

SEC charged Xerox’s accounting firm, KPMG, with auditing Xerox too “’meekly’” KPMG was

at least a partial intervention point: it did finally balk at Xerox’s accounting tricks in 2001—and

Xerox fired KPMG (Lowenstein, 2004, p. 77).

One of the major factors impeding Xerox’s feasibility to change was its organizational

culture: according to Lowenstein (2004), by the time that Bingham’s investigation revealed the

corruption at the heart of Xerox, Xerox’s culture had declined to the point that “directors were

culturally disinclined to question management…” (p. 76). It was actually in the director’s

interests, by this point, not to question management: directors such as George Mitchell and

Vernon Jordan “were there for the $75,000 stipend, in return for which management got well-

known, and dependably supportive, directors” (p. 77). These men lacked the time—Mitchell sat

on seven boards, Jordan on twelve—let alone the desire or motivation to hold management

accountable under ethical guidelines of corporate governance (p. 77).

Ethics must start with the company’s leadership team and permeate the company’s

culture..

In 2001, Anne Mulcahy became CEO and proceeded to systematically overhaul Xerox,

cutting costs and closing “money-losing operations, including the division she had previously

headed” (Daft, 2009, p. 5). She negotiated the scandal personally, communicating “a new

commitment to ethical business practices and corporate social responsibility” (p. 5). Production

was largely outsourced, freeing Xerox to focus on innovation and service. Mulcahy “refused to
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cut… research and development and customer contact” (p. 5). Her ethical, forward-thinking

leadership made the difference: Xerox’s fortunes rebounded with new products and services and

growth in new sectors. In 2007 sales “rose to more than $17 billion…” (p. 5). Mulcahy regained

the trust of employees and then customers and investors

Currently our society rewards those people that produce what is desired, and give little

thought as to how the desired results were produced. Examples of this are everywhere:

consumers purchase goods without giving a thought to the fact that it was produced by child

labors living in developing countries or the toxic waste created during the production of the

product. Until the day comes when that society constantly and consistently chooses integrity

over personal gain scandals such as this and others will reproduce and multiply.

Thus, Xerox’s story demonstrates the need for morally informed businesses in a

flourishing democracy on both sides of the coin: Mulcahy’s success was the creation of an

organizational culture built on a foundation of ethics and accountability, precisely the kind of

culture that Xerox lacked under Allaire. Mulcahy also redesigned Xerox’s business model and

overhauled its cost structure .

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References

Daft, R. L. (2009). Organization theory and design (10th ed.).

Mason, OH: South-Western Cengage Learning.

Lowenstein, R. (2004). Origins of the crash: The great bubble and its undoing.

New York: The Penguin Press.

Mills, D. Q. (2003). Wheel, deal, and steal: Deceptiveaccounting, deceitful CEOs, an ineffective

reforms.
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Upper Saddle River, NJ: Financial Times Prentice Hall.

1 April 11, 2002; Niemeier, C., Berger, P., “Xerox Settles SEC Enforcement Action Charging

Company With Fraud” Securities & Exchange Commission, Washington, D.C.

www.sec.gov

2 January 29, 2003, Press Release, Securities & Exchange Commission, Washington, D.C.,

“SEC

Charges KPMG and Four KPMG Partners With Fraud in Connection With Audits of

Xerox” Retrieved from http://www.sec.gov/news/press/2003-16.htm October 2003