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Xerox, Inc.Edward Seipp, Sean Kinsella, and Deborah L. LindbergABSTRACT: This audit case examines an interesting real-life instance of financialstatement manipulation by a client 共Xerox, Inc.兲 and the related audit failure by the auditfirm 共KPMG兲. The facts of this case are drawn from several SEC Accounting Enforce-ment and Administrative Proceedings Releases. Learning objectives specific to thiscase include an increased awareness of the importance of reserves, including whentheir use is appropriate or inappropriate; better understanding of the role of a concurringpartner; improved perception of when departures from GAAP are improper; a height-ened awareness of the importance of professional skepticism; the identification of auditrisk factors; exposure to International Financial Reporting Standards 共IFRS兲; and iden-tification of illegal acts by a client’s management.Keywords: Xerox; KPMG; accounting reserves; concurring partner; capital leases; au-dit quality; professional skepticism.We have determined that certain accounting practices including some that involve complex ac-counting issues, which we had previously believed to comply with generally accepted accountingprinciples 共GAAP兲, in fact, misapplied GAAP. In addition, we have made period adjustments tocertain previously recorded charges for errors and irregularities resulting from the accounting issuesin Mexico. The impact is a cumulative reduction of common Shareholders’ Equity and Consoli-dated Tangible Net Worth of $137 and $76 million, respectively. Amendments to revenue in each ofthe three years 1998–2000, were insignificant. 共Xerox 2001a兲INTRODUCTIONThe above statement appeared in a letter sent to shareholders along with Xerox Inc.’s共hereafter referred to as Xerox兲 2000 Annual Report. In reality, when the dust had finallysettled, it was determined that the errors and irregularities encompassed far more thanaccounting issues in Mexico. In July 2002, Xerox issued a restatement that resulted in a decreaseof revenues of over $3.8 billion and a decrease in pretax earnings of $1.2 billion for the period1997–2000 共SEC 2002a兲.1These errors and irregularities ultimately cost Xerox, six Xerox execu-tives, Xerox’s independent auditors, and five partners of the auditing firm nearly $800 million inpenalties, interest, and settlement of a class action shareholders’ lawsuit.Edward Seipp is an Instructional Assistant Professor at Illinois State University, Sean Kinsella is President ofKinsella Farms, and Deborah L. Lindberg is a Professor at Illinois State University.Editor’s note: Accepted by Kent St. Pierre.1The material presented in this case was drawn from several SEC accounting and auditing enforcement releases, litiga-tion releases, and administrative proceedings; since some of the information from these sources is overlapping, refer-ences provided in the text of this case will be to the primary source where the information was located.ISSUES IN ACCOUNTING EDUCATION American Accounting AssociationVol. 26, No. 1 DOI: 10.2308/iace.2011.26.1.2192011pp. 219–240Published Online: February 2011219MAKING THE NUMBERS LOOK GOODXerox is the leading manufacturer of photocopy equipment in the world. Over the years,Xerox developed many new products and became known for its high-quality products. In its 2000Annual Report, Xerox reported annual sales of $18.7 billion. Xerox was ranked 87th in theFortune 500 and had 92,500 employees worldwide 共CNNMoney.com 2000兲. Xerox, like manytechnology companies, faced significant competition from overseas, especially in Japan, in the late1990s. They faced competition in the copy machine business from the likes of Canon, Minolta,and Ricoh. Because of the increased competition, Xerox was confronted with declining revenues,which should have led to lower than expected earnings 共SEC 2005a兲.Failing to meet the investment community’s expectations can have a dramatic negative impacton the price of the company’s stock. It appears that Xerox’s senior management was obsessed withmeeting quarterly earnings expectations 共SEC 2002a兲. According to complaints filed by the SEC in2000, Paul Allaire and G. Richard Thoman 共each of whom were the CEO during portions of theperiod investigated by the SEC兲, and Barry Romeril, the CFO, set a negative “tone at the top”共SEC 2003a兲. This tone measured the success of Xerox by the company’s ability to meet analysts’expectations. This meant meeting quarterly earnings targets estimated by stock analysts and re-ported by First Call, a service that reports a consensus earnings projection based on estimatesprepared by various analysts 共SEC 2005a兲.Xerox, as shown in Figure 1, met or exceeded First Call’s estimated quarterly earnings inevery quarter for the period 1997–1999. As is also shown in the chart, if Xerox had not resortedto various accounting devices 共i.e., manipulation schemes兲, the company would have missed thequarterly estimates in 11 of the 12 quarters. Senior management knew about these schemes, andkept track of each of these manipulations to quantify their impact on the corporate financialresults.The manipulation schemes initially added only a penny or two to the quarterly earnings pershare. At their worst, however, these schemes added 30 cents per share to the fourth quarter of1998 earnings per share, and 61 cents to the 1998 annual earnings per share. In the fourth quarterof 1998, 36 percent of the earnings per share came from the accounting devices. Managementreferred to the process of manipulating the quarterly earnings per share as “closing the gap”共SEC 2005a兲.Cookie Jar ReservesOver the years, Xerox developed a “cookie jar” of financial reserves that were released intoincome, as needed, to meet quarterly expectations. During the period 1997–1999, Romeril, PhilipFishbach, Xerox’s corporate Controller, and Daniel Marchibroda, the Assistant Controller whoreported to Fishbach, released $415 million of reserves held in the cookie jar to “close the gap”between actual results and analysts’ expectations 共SEC 2003a兲. Gregory Tayler, who served invarious capacities of Xerox management during this time, participated in the release of $100million of these reserves. Exhibit 1 summarizes the key personnel involved in this case for bothXerox and KPMG.Reserves were tracked on schedules prepared by employees in Fishbach’s office. Marchibrodaand Fishbach reviewed these


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UI ACCT 592 - Xerox Inc Case for Students

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