Audit of Fraud & Fraud Detection Techniques RTI, Nagpur
Case Study (2.1)- Xerox Corporation ( Based on material circulated by ICAI)
Xerox’s main source earnings came from lease payments that recognized deferred revenue over a period of time- sales type leases and equipment sales. The company frequently entered into longer-term sales-type equipment leases and service arrangements promising “ total satisfaction guaranteed” throughout the lease term. However, the company expected the equipment conveyed at the beginning of the lease to become economically unusable to the customer many months before the end of the lease term, Under these arrangements, the company was contractually required to incur the expenses of any extraordinary refurbishment or machine replacement. There were no disclosures of the material risks and associated costs of such a business practice in the financial statements.
Xerox Corporation resorted to a series of changes in accounting practices between 1997 and 2000 that resulted in a significant impact on the financial statements of the company.
Xerox made the following changes in revenue accountal of lease and equipment income:
Revenue Recognition
· The company reallocated lease payments revenues to the copier by reallocating expenses from finance and services to the equipment altering the future cash flow stream whereby equipment income increased and lease income declined.
· In order to effect this re-allocation, the company used two parameters namely return on equity and margin normalization. Since 1995, the company justified reductions in its estimate of the fair value of financing by claiming that the financing should produce no more than 15% return on the equity of its finance operations. This standard was based on approximated average of handful of finance companies whose businesses were wholly unrelated to either Xerox or the manufacturing of photocopiers. This practice was also not in accordance with US GAAP.
Return on equity
· While retaining its revenue assumption for determining finance component of its sales type leases, the company, between 1997 and 2000 continually depressed its estimate of the fair value of financing that increased its reported equipment revenues. This was achieved through expanding the coverage of ROE to new geographic areas and strategically timed changes in the factors and assumptions used to calculate the lease interest rate that would produce a15%.
· This resulted in pulling forward $2.2 billion in equipment revenue and $301 million in earnings- none of which resulted from the sale of a single additional copier or other Xerox product.
· The method of revenue recognition, the changes and the formula adopted were not disclosed to the investors.
Margin Normalisation
· As a result of growing price competition, margins on Xerox equipment declined especially outside the US, while service margins remained stable. Instead of acknowledging reduced equipment margins, Xerox reallocated anticipated leasing revenue around the world using an accounting action –margin normalization so that the margins on equipment would approximate more closely with those in the U.S. This margin normalization used to derive equipment revenue for sales type leases did not comply with US GAAP.
· It is noteworthy that the company regularly and at will changed the formula for calculating anticipated revenue reallocated from service to the equipment but not significantly to beat Wall Street estimates. This resulted in addition to equipment revenues pulled forward during 1997 through 2000 for $617 million. The pre-tax earnings amounted to $358million.
Price increases and extensions to leases
· The company caused price increases and unilateral extensions of leases that resulted in approx $300 million being pulled forward and $200 million in pre-tax earnings. The accounting method employed for such revenue recognition did not conform with GAAP.
· As per GAAP, at the inception of a lease, the lessor must establish an estimated fair value of the equipment at the end of the lease and once established, the value cannot be increased for any reason. However, from 1997 to 1999, Xerox made upward revisions retroactively to net residual values on machines in Brazil, Europe, U.S. Argentina and Mexico units. These write-ups credited to cost of sales were often recorded close to the end of quarterly reporting periods.
· The company switched over to rental contracts business as opposed to sales type leases in Brazil, being unsustainable. The company then entered into portfolio asset strategy- that allowed sale of revenue streams to investors and immediate revenue recognition. This pulled forward $400million in profit before taxes.
Issues
The Securities and Exchange Commission of U.S.A. filed a complaint against Xerox Corporation for defrauding the investors. What were the grounds for fraud and how the fraud was perpetrated?
Suggested Solution to Case Study 2.1
One of the critical areas affecting true and fair view of the financial statements is the method of revenue recognition. Any changes, that too repeated changes, over a very short period of time, in accounting changes without a justifiable need calls for a serious enquiry.
As per the generally accepted accounting standards and the international accounting norms, only those items of revenue should be recognized that have accrued and pertain to the current accounting period. Thus, revenue that is yet to be earned or accrued cannot affect the current year’s earnings. Similarly, allocation of expenses would have to follow this principle- as between future incomes yet to be earned and those that have already accrued.
Against this standard, the company’s following actions are motivated and of dubious nature,
· Shifting of future lease payments to those of equipment sales not only boosted up immediate sales that were based on fiction but also reduced or negatively affected the future periods. The investors or the shareholders had no way of knowing that the company’s profits resulted from accounting changes rather than improved operational performance in view of the fact this fact was not disclosed in-spite of their material impact.
· In order to sustain unjustified revenue acceleration, the company adopted unusual method of estimating fair value of services financing and also depressed the finance component without justification so as to report heightened equipment sales. The company did no testing to determine whether its arbitrary ROE methodology resulted in economically realistic financial reporting based on the fair market value of the equipment or prevailing finance rates in different markets. The basis of the rates determined was not disclosed to the investors. All this was achieved while not a single additional copier was actually sold.
· The practice of approximating margins around the world with those in the U.S. is an unusual business practice and did not comply with GAAP. The revenue thus earned from margin normalization only on account of anticipated leasing revenue was pulled forward with no basis on reality.
· The unilateral extensions of leases by the company and the arbitrary upward adjustments of the residual value of the equipment and the fact these were carried out towards the end of quarterly period of reporting supports the conclusion that the intention was to build up and mislead investor expectations.
· The incorporation of future income streams as current cash inflows is wholly improper and affected the future viability of the company. Non-disclosure by the company about such a material fact thus amounted to material misstatement and amounted to fraudulent financial reporting.
· The company also failed to disclose the risks associated with unusual leasing practices whereby the company was contractually expected to replace the machine in case the machine became unusable.
It is evident that the company deliberately did not disclose material facts responsible for huge reported earnings and resorted to unusual accounting treatment and business practices with the sole object of projecting a false picture of the financial health of the company to deceive unsuspecting investors considering the fact that the company faced increasing competition with declining margins around the world.
The Complaint by the U.S.SEC thus charged that the company, defrauded the investors through irregular accounting actions and deliberate non-disclosure of material facts impacting upon the reported earnings.
Case Study 2.1 4