Xerox Corporation (Xerox), once a star in the technology sector of the economy, found itself engulfed in an accounting scandal alleging that it was too aggressive in recognizing equipment revenue.1 The complaint filed by the Securities and Exchange Commission (SEC) alleged that Xerox used a variety of accounting manipulations over the period 1997 through 2000 to meet Wall Street expectations and disguise its true operating performance. The SEC alleged that between 1997 and 2000 Xerox overstated revenues by $3 billion and pre-tax earnings by $1.5 billion. Also engulfed in this scandal was KPMG, Xerox’s auditor, whose actions were also investigated by the SEC for its possible involvement with the alleged accounting manipulations.

REQUIRED

[1] Professional standards outline the auditor’s consideration of material misstatements due to errors and fraud. 

(a) What responsibility does an auditor have to detect material misstatements due to errors and fraud? 

(b) What two main categories of fraud affect financial reporting? 

(c) What types of factors should auditors consider when assessing the likelihood of material misstatements due to fraud? 

(d) Which factors existed during the 1997 through 2000 audits of Xerox that created an environment conducive for fraud? 

[2] Three conditions are often present when fraud exists. First, management or employees have an incentive or are under pressure, which provides them a reason to commit the fraud act. Second, circumstances exist – for example, absent or ineffective internal controls or the ability for management to override controls – that provide an opportunity for the fraud to be perpetrated. Third, those involved are able to rationalize the fraud as being consistent with their personal code of ethics. Some individuals possess an attitude, character, or set of ethical values that allows them to knowingly commit a fraudulent act. Using hindsight, identify factors present at Xerox that are indicative of each of the three fraud conditions: incentives, opportunities, and attitudes. 

[3] Several questionable accounting manipulations were identified by the SEC. 

(a) For each accounting manipulation identified, indicate the 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. 

[4] In its complaint, the SEC indicated that Xerox inappropriately used accounting reserves to inflate earnings. Walter P. Schuetze noted in a 1999 speech: One of the accounting “hot spots” that we are considering this morning is accounting for restructuring charges and restructuring reserves. A better title would be accounting for general reserves, contingency reserves, rainy day reserves, or cookie jar reserves. Accounting for so-called restructurings has become an art form. Some companies like the idea so much that they establish restructuring reserves every year. Why not? Analysts seem to like the idea of recognizing as a liability today, a budget of expenditures planned for the next year or next several years in down-sizing, right-sizing, or improving operations, and portraying that amount as a special, below-the-line charge in the current period’s income statement. This year’s earnings are happily reported in press releases as “before charges.” CNBC analysts and commentators talk about earnings “before charges.” The financial press talks about earnings before “special charges.” (Funny, no one talks about earnings before credits—only charges.) It’s as if special charges aren’t real. Out of sight, out of mind (Speech by SEC Staff: Cookie Jar Reserves, April 22, 1999). What responsibility do auditors have regarding accounting reserves established by company management? How should auditors test the reasonableness of accounting reserves established by company management? 

[5] Financial information was provided for Xerox for the period 1997 through 2000. Go to the SEC website (www.sec.gov) and obtain financial information for Hewlett Packard Company for the same reporting periods. How were Xerox’s and Hewlett Packard’s businesses similar and dissimilar during the relevant time periods? Using the financial information, perform some basic ratio analyses for the two companies. How did the two companies financial performance compare? Explain your answers. 

[6] In 2002 Andersen was convicted for one felony count of obstructing justice related to its involvement with the Enron Corporation scandal (this conviction was later overturned by the United States Supreme Court). Read the “Enron Corporation and Andersen, LLP” case included in this casebook. 

(a) Based on your reading of that case and this case, how was Enron Corporation’s situation similar or dissimilar to Xerox’s situation? 

(b) How did the financial and business sectors react to the two situations when the accounting issues became public? 

(c) If the financial or business sectors reacted differently, why did they react differently? 

(d) How was KPMG’s situation similar or dissimilar to Andersen’s situation? 

[7] On April 19, 2005, KPMG agreed to pay $22 million to the SEC to settle its lawsuit with the SEC in connection with the alleged fraud. Go to the SEC’s website to read about the settlement of this lawsuit with the SEC (try, “http://www.sec.gov/news/press/2005-59.htm”). Do you agree or disagree with the findings? Explain your answer. 

[8] The SEC outlines in Accounting and Auditing Enforcement Release No. 2234 its assessment of the Xerox fraud. Obtain and read a copy of the enforcement release (try http://www.sec.gov/litigation/ admin/34-51574.pdf). Compared to the information presented in this case would your opinion of KPMG’s audit performance change after reading the enforcement release. Explain your answer. 

[9] The SEC outlines in Accounting and Auditing Enforcement Release No. 2234 five “undertakings” for KPMG to alter or amend its audit practices. Obtain and read a copy of the enforcement release (try http://www.sec.gov/litigation/admin/34-51574.pdf) and read the five “undertakings.” Based on your reading of the five “undertakings,” which elements of a system of quality control did KPMG have weaknesses? Explain your answer. 

[10] A 2002 editorial in BusinessWeek raised issues with compensation received by corporate executives even when the company does not perform well. In 1980 corporate executive compensation was 42 times the average worker compensation while in 2000 it was 531 times the average worker compensation.

(a) Do you believe executive compensation levels are reasonable? 

(b) Explain your answer. (c) What type of procedures could corporations establish to help ensure the reasonableness of executive compensation? 

PROFESSIONAL JUDGMENT QUESTIONS 

It is recommended that you read the Professional Judgment Introduction found at the beginning of this book prior to responding to the following questions. 

[11] KPMG has publicly stated that the main accounting issues raised in the Xerox case do not involve fraud, as suggested by the SEC, rather they involve differences in judgment.

(a)What is meant by the term professional judgment? 

(b) Which of the questionable accounting manipulations used by Xerox involved estimates? 

(c) Refer to professional auditing standards and describe the auditor’s responsibilities for examining management-generated estimates and briefly describe the role of auditor professional judgement in evaluating estimates. 

[12] Some will argue that KPMG inappropriately subordinated its judgments to Xerox preferences. What steps could accounting firms take to ensure that auditors do not subordinate their judgments to client preferences on other audit engagements? 

[13] The SEC outlines in Accounting and Auditing Enforcement Release No. 2234 KPMG's alleged acts and omissions (section C. 3.). Obtain and read a copy of the enforcement release (try http://www.sec.gov/ litigation/admin/34-51574.pdf). Based on your reading of the enforcement release and KPMG's five step judgment process, which of the five-steps might have improved the judgments made by KPMG professionals? Explain your answer.