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This case study will perform ratio analysis on Xerox financial statements, highlight auditors' responsibility for detecting fraud and errors, identify factors present at Xerox that were indicative of frauds existence, and how could accounting firms ensure that auditors do not subordinate their judgments to client preferences on other audit engagement, and lastly indicating how financial statements were affected, because of accounting manipulation.
This case study is about Xerox corp. who misstated their financial statements using illegitimate accounting methods. According to CNN money, Xerox between the periods of 1997-2000, accelerated their lease recognition revenue by more than $3 billion and increased its pre-tax earnings by about $1.5 billion. This case also focuses on how KPMG, Xerox's outside auditor, permitted Xerox to manipulate its accounting practices and also failed to exercise due care, lack of professional scepticism and adhere to GAAP.
(a) How are Xerox's and Hewlett Packard's business similar and dissimilar?
Xerox Corporation is one of the global brand companies, which is selling and manufacturing different ranges of colour printers and photocopies, as well as providing related consulting services and supplies to their customers. Major competitor of Xerox Corporation is Hewlett Packard Company (HP), which provides similar product lines and business strategic as Xerox Corporation. The different between Xerox Corporation and HP is that HP provides products such as computer, scanners, digital cameras, calculators, PDAs and other. However, Xerox is just focusing on digital production printing
(b) Using the financial information, perform some basic ratio analyses for the two companies. However does the two companies financial performance compare?
Short-term Liquidity Ratio:
Hewlett Packard Company
Xerox Corporation had an increasing trend in liquidity ratio which may improve the ability to make profit during 2000. The data indicated that Xerox Corporation had a much higher ability for paying short-term liability and collected cash from credit customers than Hewlett Packard.
Hewlett Packard Company
Both Xerox Corporation and Hewlett Packard Company experienced an obvious decrease in terms of net sales which brings major profit to business. However, Hewlett Packard had more power to keep higher earning per dollars of sales than Xerox Corporation.
Return of Equity (ROE)
The trend of Xerox Corporation while negative has not ensured the figure has dropped to an unsatisfactory level. It does show, however, that the return to shareholder is less in 2000 than that in 1997. Xerox Corporation's ROE was lower than Hewlett Packard Company's ROE which indicated that the former has collected much more money than the later from shareholder.
Return of Assets (ROA)
There had been dramatic increase and decreases in the ability of both Xerox Corporation and Hewlett Packard Company. The ratio of Hewlett Packard Company indicated that its assets could be used more efficiently to earn profit, and its shareholders could earn more from their investment.
Financial Leverage Ratio:
Hewlett Packard Company
Xerox Corporation has been aggressive in financing its growth with debt during 1997-2000. This could result in fluctuating earnings as a result of the additional interest expense. However, Hewlett Packard Company had got a stable trend in financial leverage ratio, which may indicate that the company has a stronger financial interest in the business than Xerox Corporation.
There is a rising debt ratio of both of the companies during 1997-2000. However, Xerox Corporation still had a higher debt ratio of 0.829 in 2000, which illustrates that Xerox Corporation is more likely confront tension on paying interest and their long-term debt. In addition, because debt ratio increased more quickly in Hewlett Packard Company then it decreased in Xerox Corporation, it is possible that Hewlett Packard Company have a higher business's obligations in the future.
Capital Turnover Ratios:
Hewlett Packard Company
Sales to Assets
Net Worth Sales
There is a growth in assets liquidity and sales to assets ratios in both companies. And this means both companies use its stockholders' equity to generate revenue better from 1997 to 2000. Merely, less in assets liquidity ratio, Xerox Corporation does not necessarily indicate it had worse performance than Hewlett Packard Company.
(a) What responsibility does an auditor have to detect material misstatements due to errors and fraud?
Auditors spend a great portion of their time planning and performing auditing to detect the unintentional mistakes made by management and employees in financial reports. (Arens,Best, Shailer,Fiedler,Elder and Beasley. 2010). Auditors detect errors because of such things as mistakes in calculation, omissions, misunderstanding and misapplication of accounting standards, and incorrect summarisations and descriptions.
The auditing standards recognise that it is more difficult to detect fraud and errors because management, or the employees perpetrating the fraud, attempt to conceal the fraud. (Arens,Best, Shailer,Fiedler,Elder and Beasley. 2010) one important thing to assess fraud is to keep in mind fraud has two characteristics: the pressure and incentive to get a desired financial gain, and the perceived opportunity to commit the fraud.
(b) What two main categories of fraud affect financial reporting?
Fraudulent financial reporting
This is an intentional misstatement or omission of amounts with the intention to deceive users. The fraud involves management's deliberate actions to meet earning objectives and shifting revenue and expenses to reduce fluctuations. Companies often overstate profit and assets or omit liabilities and expenses or they deliberately understate profit in an attempt to reduce profit taxes.
Misappropriation of assets
This is theft of an entity's assets involving employees and others internal to the organisation. The misappropriation of assets is generally perpetrated at lower level of the organisation hierarchy. Sometimes, top management in involved in the theft because of its greater authority and control over organisation assets.
(c) What types of factors should auditors consider when assessing the likelihood of material misstatements due to fraud?
Incentives/pressure, opportunities and attitudes are three conditions of fraud (Arens,Best, Shailer,Fiedler,Elder and Beasley. 2010). In assessing the fraud risks, auditors should sceptically consider the following:
Information the auditors obtained through communication about their knowledge of the company and its industry.
Inquires of management about their view of the risk of fraud and about existing programs and controls to address specific fraud risks.
Specific risk factors, such as incentives or pressures to perpetrate fraud, opportunity to carry out fraud or attitudes used to justify a fraudulent action.
Analytical procedures results obtained during planning
Information gained from other procedures as well as corporate governance and other control factors.
Which factors existed during the 1997 though 2000 audits of Xerox that created an environment conducive for fraud?
Xerox's action to accelerate the lease revenue recognition. For example, it allocates a bigger portion of the lease payment to the equipment instead of service or financing activity or periodically change the assumptions used to calculate the return on equity.
Xerox elects to recognize the revenue from lease price immediately instead of recognizing the revenue over the life of the leases.
Xerox write-up the residual value of some leased equipments.
Xerox switched from sales-type lease agreements to rental contracts, and there is no disclosure of the change.
Xerox established an acquisition reserve for unknown business risks and recorded unrelated expenses to the reserve accounting.
The interest income recognition had been implemented since 1997, but had not been done for the previous years.
Identify factors present at Xerox that are indicative of each of the three fraud conditions: Incentives, Opportunities, and attitudes.
Incentives/ Pressure: -
A common motivation for companies to manipulate financial reports is a decline in the company's financial prospects. As Xerox corp. was facing a market which was growing strongly and transitioning rapidly to digital technologies that created pressure on the company to quickly respond to these new changes. In 1990's, companies were facing pressures from investors that whichever failed to meet the estimated earnings by even a small amount will face significant decline in stock pricing.
Xerox corp. succumbed to the pressures of Wall Street and competitive market by adopting several accounting manipulations like acceleration of lease revenue recognition, cookie jar reverses and Non Generally accepted accounting practices (GAAP), to inflate earnings from 1997 to 1999. From 1997, Xerox corp. was undergoing few changes which were taking longer to show profitable growth revenue, improve shareholder value and reduce costs than what Xerox has expected, motivated to perform accounting irregularities. Also, incentives available for performance and profits tempted senior management to perform accounting practices that will inflate earnings and in return, they will receive big incentives.
Circumstances provide opportunities for management or employees to commit fraud. Through its activities, management provides clear signals to employees about the importance of internal control. Xerox reflected weak internal control due to accounting manipulation activities and management had the ability to override the control, because of these reasons committing fraud was feasible in Xerox.
Xerox management used to allocate a greater portion of the lease payment of bundled lease to equipment in foreign countries because foreign management were obliged to report same gross margin as in United States. This situation created circumstances and because management had the ability to override the control, that provided opportunities for management to commit fraud.
Xerox has been writing-up the residual value of previously recorded leased equipment which reflected a decrease in the cost of sales in the period the residual value was increased. This accounting procedure violated standards under GAAP. This manipulation took place because of weak internal control in Xerox.
The management is in the environment that imposes sufficient pressure that causes them to rationalise committing a dishonest act. Rational behaviour was seen in Xerox Mexico operation who was facing difficulties in achieving financial targets set by corporate headquarters. This pressurised environment stimulated rational behaviour on decisions like not properly disclosing policies and also some unusual leasing practices which inflated earnings of Xerox Mexico for short terms.
Management's integrity and ethical values are important considerations in internal controls. Xerox has shown accounting irregularities by accelerating lease revenue from lease price increases and extensions which did not comply with GAAP. Xerox also failed to disclose the change in business approach in Brazil where they switched to rental contracts from sale-type agreements. This approaches in business shows that Xerox management was itself engaged in unethical activities which affected management's integrity and promoted unethical sets of values and rationalism in making decisions.
Which of the questionable accounting manipulations used by Xerox involved estimates?
According to AU 342, Estimates are based on the subjective as well as objective and as a result, judgement is required to estimate an amount at the date of the financial statement.
Xerox accelerated lease revenue recognition from bundled lease is one of the two estimates used by management. The questionable practices involve estimation of higher portion of lease payment to equipment despite of bundled lease. By allocating in this manner, Xerox was able to recognise greater revenue immediately for the rather then, deferring revenue over the term of the lease which complies with GAAP. According to GAAP, in a bundled lease which includes equipment, services, supplies and financing, Xerox should have allocated appropriate portion of revenue for non equipment revenue that means, deferring revenue over the term of the lease. Xerox justified their estimation about allocating less revenue for finance, saying that finance operation should achieve approximately 15% return on equity (ROE) and also changed the assumptions to calculate lease interest rate that would produce a 15 percent ROE, as a result increasing revenue for current financial period. The rational behaviour was experienced in making estimation because management's judgement and assumptions were taken in a biased way for a reason that future revenue could be adjusted over the period and also, the pressures and incentives motivated management in Xerox to act in a biased way.
Another accounting estimation used by Xerox was increasing the residual values of leased equipment. Xerox used estimation in increasing the residual value of the previously recorded lease equipment. Because of this type of estimation which decreases cost of sales for the current period, and increases the residual value, thus increases profit for the current period. GAAP under FAS 13 amended by FAS 23 prohibits upward adjustment of estimated residual values after lease commencement.
(b) Based on AU342, Auditing Accounting Estimates, describe the auditor's responsibilities for examining management-generated estimates?
AU 342 Auditing accounting estimates states that, the auditor should identify the reasonableness of accounting estimates made by management in the relation of the financial statements. As estimates are based on subjective as well as objective factors, the auditors should determine management's internal control. Auditor should also consider management's qualification, competency and skills in making estimation. Auditor is required to review prior year's financial statement to detect any changes in the management's judgement and assumptions that might reflect a bias view. The auditor should consider, during planning and performing procedures which will assess accounting estimates, with an attitude of professional scepticism, both the subjective and objective factors.
How could accounting firms ensure that auditors do not subordinate their judgements to client preferences on other audit engagements?
First of all we should notice that all the actions from KPMG are irregularities. Because it against several auditor objectives and responsibilities. From ASA 200 requires "that an audit should to provide reasonable assurance of detecting material misstatements in the financial report arising from fraud or error." (Arens,Best, Shailer,Fiedler,Elder and Beasley. 2010) And the primary objective of the audit is to express an opinion on the financial statements. Auditor should disclosing or declaring any impairment to independence or objectivity that may exist. Which KPMG personnel questioned the appropriateness manipulations but they did not persuade management to change accounting practices. Auditors must avoid making misleading or false statements that tend to injure or discredit the audited company's reputation. To avoidance all those impropriety mistake, the auditor should work independence and take responsibilities. Auditor independence is auditor's own judgment to audit the finance report without other influences, no matter exterior or interior. Auditor's independence is most basal and important to the finance report. If auditor didn't do their work independence, their report information may not be credible, and also the finance information will cheat to the shareholder and clients, finally it will get loss. To avoid this happen, auditors should do their work independent in both fact and appearance. However, there is many facts influence auditor's independence judgment.
First of all is press. For example, KPMG found Xerox have some accounting problem, and change several of Xerox's accounting practices. But Xerox's senior management told the firm that they wanted a new engagement partner assigned to their account. Under this press, KPMG allowed Xerox to continue using those questionable practices and didn't note those actions. To avoid this press problem, KPMG should report those questionable practices to the higher up manager or shareholders. Because they consider the long profit, and they will give audit an independence environment.
Secondly is fraud, Xerox have many inappropriate finance manipulations like Xerox acquisition reserve for unknown business risk and recoded unrelated business expenses to the reserve account to inflate earnings. Thus cause a great opportunity to take the money from Xerox, even the auditor. To avoid fraud, auditor's must be credible and his independence must be based on an objective and disinterested assessment of the financial statements. . On the other hand, Frank claimed that "Auditor independence helps to ensure quality audits and contributes to financial statement users' reliance on the financial reporting process. An auditor who is independent in fact has the ability to make independent audit decisions even if there is a perceived lack of independence or if the auditor is placed in a potentially compromising position."(2007)
(a) For each accounting manipulation identified, indicate financial statement accounts affected.
(b) For each accounting manipulation identified, indicate one audit procedure the auditor could have used to assess the appropriateness of the practice.
The first questionable accounting manipulation is acceleration of lease revenue recognition from bundled leases. This manipulation will affect revenues account, because Xerox accelerated the lease revenue recognition by allocating a higher portion of the lease payment to the equipment instead of the service or financing activity. By reallocating revenues from the finance and service activity to the equipment, Xerox was able to recognise greater revenues in the current reporting period instead of deferring revenue to the future periods. There are two audit procedures that can suit for this environment. First using internal procedure, recalculation: checking the mathematical accuracy of documents or records. Second using external procedure, confirmation: the process of obtaining a representation from a third party.
Another questionable accounting manipulations performed by Xerox were acceleration of lease revenue from lease price increase & extensions, increase in the residual values of leased equipment and acceleration of revenues from portfolio asset strategy transactions. All these three manipulation will increase revenue account and income statement. The effect of these decisions taken by Xerox will earn revenue in short term, but it will sacrifice the long term profit. To protect company long term profit, auditor should observe all the processes and procedures that are performed. On the other hand auditor should re-performance; it means the auditor's should check the procedures previously performed by entity staff.
For questionable manipulation of reserves. This manipulation will affect equity account. Because Xerox established an acquisition reserve for unknown business risk and unrelated business to the reserve account to inflate earning. It means Xerox put money in equity account to prevent potential risk, but it unrelated to expenses. It easy causes fraud. Auditor can use observation procedure, to looking at processes and procedures being performed or use inquiry procedure, to seeking information from knowledgeable persons.
For questionable manipulation of other income. This manipulation will affect cost and expenses account. Because Xerox elect to recognize most of the interest income during period years. The cost and expenses account will reduce in period years, and meantime make that year's report look better. To appropriateness of this practice, audit should use analytical procedure. Compare the date with similar prior-period date, to keep the report justice.
For questionable failure to disclose factoring transactions. This manipulation will affect revenues account and asset account. From material, we can know Xerox sold future cash from receivable account to local banks for immediate cash. It made Xerox have a strong cash position in the present year, like the revenues account will increase, on the other hand sold receivables to bank must take some lost. The asset account must decrease. It also easy cost fraud. Audits can use inspection of tangible assets and analytical procedures. Inspection of tangible assets can find out the total asset increase or decrease. Xerox company failure to disclose factoring transaction should record in annual report, so use analytical procedure will disclose this problem.