ACCOUNTING FRAUD AT XEROX Research on Accounting Fraud at Xerox Company Ahu Atay

ACCOUNTING FRAUD AT XEROX 2 Abstract This analysis will examine the Xerox accounting fraud scandal, its caus es and effects, and the need for best practices in business ethics, corporate go vernance and oversight. Xerox utilized creative accounting techniques to misrepres ent its assets and liabilities, deceiving investors and inflating its stock. The scandal was staggering in its scope and scale: chairman and CEO Allaire and oth ers enriched themselves to the tune of millions at stockholders expense (Mills, 2 003, pp. 21, 30). The Xerox scandal demonstrates the need for accountability and ethics in corporate governance and finance: Xeroxs central problem was its inept , short-sighted and unethical senior executives.

ACCOUNTING FRAUD AT XEROX 3 Xerox Corporation is a global document management company which manufactures and sells a range of color and black-and-white printers, multifunction systems, pho to copiers, digital production printing presses, and related consulting services and supplies. Xerox established itself as the purveyor of its xerography machin es, establishing the company name in the common lexicon. Its Palo Alto Research Center (PARC) invented such hallmarks of digital age technology as the personal c omputer, graphical user interface [mouse], Ethernet, and laser printer (Daft, 2009 , p. 4). But the high profit margins of Xeroxs copiers blinded management to the potential of this technological cornucopiawhich 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, Xeroxs fortunes seemed to be improving. Under the leadership of chairman and CEO Paul A llaire (since 1990), Xeroxs stock began to increase. However, the change was illu sory: Xerox was using creative accounting techniques to mislead investors about its true worth. Allaire and others in Xeroxs top management were unloading their fraudulently-inflated stocks and pocketing millions, all while closing the gap betwe en target and actual performance (Lowenstein, 2004, pp. 74-75). That gap continu ed to grow when in 2000 Xerox continued to lose ground to Canon and suffered a lo ss (p. 76). Then came the revelation of accounting irregularities in Mexico.

ACCOUNTING FRAUD AT XEROX 4 The Securities and Exchange Commission (SEC) began to investigate and filed suit against Xerox in US District Court for the Southern District of New York. 1 The complaint alleged that Xerox, using a host of undisclosed accounting actions, which were oft en referred to as accounting opportunities and one-offs, distorted earnings and misl ed investors There were two basic manipulations that formed the basis for the SE C investigation. The first was the so-called cookie jar method. This involved impr operly 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 methodand what accounted for the larger part of the fraudulent earningswas the acceleration of revenue from shortterm equipment rentals, which were improperly classified as long-term leases. Th e difference was significant because according to the Generally Accepted Account ing Principles (GAAP)the standards by which a companys books are supposed to be me asuredthe entire value of a longterm lease can be included as revenue in the firs t 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 th e markets expectations and actual operating results from 1997 to 2000, as shown i n the below chart SEC created chart used to illustrate the impact of these accoun ting actions when compared to Wall Street estimates. Paul Berger, Associate Direc tor of Enforcement for the SEC stated in this press release, Xerox s senior manag ement orchestrated a four-year scheme to disguise the company s true operating p erformance, and Charles D. Niemeier, Chief Accountant for the Division of Enforce ment, added, "Xerox employed a wide variety of undisclosed and often improper to p-side accounting

ACCOUNTING FRAUD AT XEROX 5 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 denyi ng the SEC allegations Xerox agreed to pay the $10 million penalty -- the bigges t fine the SEC had ever levied for accounting fraud -- and to restate the compan ys 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 account ing controls and policies. In 2005, KPMG agreed to pay $22.5 million to settle S EC charges related to its audits of Xerox from 1997 through 2000. Under that arr angement, 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

ACCOUNTING FRAUD AT XEROX 6 the largest payment ever made to the SEC by an audit firm.2 The Securities and E xchange Commission also charged six former senior executives of Xerox Corporatio n, including its former chief executive officers, Paul A. Allaire and G. Richard Thoman, and its former chief financial officer, Barry D. Romeril, with securiti es 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 interes t without admitting or denying the SEC s allegations. 1 These are the general pa rticulars of the case. The lengths to which Xerox went to misrepresent its finan cial situation, however, beg questions like ; What led Xeroxs senior executives t o such an unethical (and risky) course of action? , and The Boards contribution t o the scandal- how could they have not known? . The Xerox scandal may have grabb ed the attention of the financial media and Wall Street, but the seeds for Xeroxs failure were sown decades before. As seen, Xerox developed many technologies in the digital ageand then failed to take advantage of them. According to Daft (200 9), while Xerox was plodding along selling copy machines, younger, smaller, and h ungrier companies were developing PARC technologies into tremendous money-making products and services (p. 4). Not only did Xerox fail to capitalize on new techn ologies, by 1982 its copier market share had fallen from 95 to 13 percentwhen 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).

ACCOUNTING FRAUD AT XEROX 7 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 Xeroxs superb company cult ure was offset by poor decision-making at the top that stopped its success. The SEC investigation noted that compensation of Xerox senior management depended sig nificantly on their ability to meet [earnings] targets. Because of the accounting manipulations, top Xerox executives were able to cash in on stock options value d 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 an d acted ethically in their financial reporting.Xerox Corp. did have and Audit co mmittee, and the companys independent auditors were at the time of the scandal KP MG, LLP. Indeed, Xerox was guilty of a considerable number of accounting tricks that involved manipulating period reporting: according to Mills (2003) the SEC a lso charged Xerox with improperly recognizing revenues from its leasing operation s because Xerox booked lease payments for future services or supplies up front, an d with attempting to increase short-term results by overstating the value of futu re payments from leases originated in developing countries (p. 21). It also faile d to write off mounting bad debts, another example of attempting to paint a rosier picture of the companys finances through fraudulent means in order to increase i nvestor confidence (p. 21). This is a well-known accounting trick, using cookie j ar 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).

ACCOUNTING FRAUD AT XEROX 8 Mills (2003) explained that executives are able to fraudulently manipulate their accounting statements because accountants, banks, brokers, and attorneys all ben efit from helping CEOs do this (p. 27). Xeroxs deception was enabled by these inte rests; indeed, the SEC charged Xeroxs accounting firm, KPMG, with auditing Xerox too meekly KPMG was at least a partial intervention point: it did finally balk at Xe roxs accounting tricks in 2001and Xerox fired KPMG (Lowenstein, 2004, p. 77). One of the major factors impeding Xeroxs feasibility to change was its organizational culture: according to Lowenstein (2004), by the time that Binghams investigation revealed the corruption at the heart of Xerox, Xeroxs culture had declined to th e point that directors were culturally disinclined to question management (p. 76). It was actually in the directors interests, by this point, not to question manage ment: directors such as George Mitchell and Vernon Jordan were there for the $75, 000 stipend, in return for which management got wellknown, and dependably suppor tive, directors (p. 77). These men lacked the timeMitchell sat on seven boards, Jo rdan on twelvelet alone the desire or motivation to hold management accountable u nder ethical guidelines of corporate governance (p. 77). Ethics must start with the companys leadership team and permeate the companys culture.. In 2001, Anne Mul cahy became CEO and proceeded to systematically overhaul Xerox, cutting costs an d closing money-losing operations, including the division she had previously head ed (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

ACCOUNTING FRAUD AT XEROX 9 cut research and development and customer contact (p. 5). Her ethical, forward-thi nking leadership made the difference: Xeroxs fortunes rebounded with new products and services and growth in new sectors. In 2007 sales rose to more than $17 bill ion (p. 5). Mulcahy regained the trust of employees and then customers and investo rs 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 thi s 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 th at society constantly and consistently chooses integrity over personal gain scan dals such as this and others will reproduce and multiply. Thus, Xeroxs story demo nstrates the need for morally informed businesses in a flourishing democracy on both sides of the coin: Mulcahys success was the creation of an organizational cu lture built on a foundation of ethics and accountability, precisely the kind of culture that Xerox lacked under Allaire. Mulcahy also redesigned Xeroxs business model and overhauled its cost structure .

ACCOUNTING FRAUD AT XEROX 10 References Daft, R. L. (2009). Organization theory and design (10th ed.). Mason, OH: SouthWestern 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.

ACCOUNTING FRAUD AT XEROX 11 Upper Saddle River, NJ: Financial Times Prentice Hall. 1 April 11, 2002; Niemeie r, C., Berger, P., Xerox Settles SEC Enforcement Action Charging Company With Fra ud Securities & Exchange Commission, Washington, D.C. www.sec.gov 2 January 29, 2 003, Press Release, Securities & Exchange Commission, Washington, D.C., SEC Charg es KPMG and Four KPMG Partners With Fraud in Connection With Audits of Xerox Retr ieved from http://www.sec.gov/news/press/2003-16.htm October 2003