Published on February 3, 2009
The Xerox Corporation Fraud Case (2002)
By Vrij Ghose – 06C275 Neha Bhargava – 06C277 Xerox Corporation is a global document management company which manufactures and sells a range of color and black-and-white printers, multifunction systems, photo copiers, digital production printing presses, and related consulting services and supplies. Xerox is headquartered in Norwalk, Connecticut, though its largest population of employees is based in and around Rochester, New York, the area in which the company was founded. History … The Xerox 914 was the first one-piece plain paper photocopier, and sold in the thousands. Xerox was founded in 1906 in Rochester, New York as quot;The Haloid Companyquot;, which originally manufactured photographic paper and equipment. The company subsequently changed its name to quot;Haloid Xeroxquot; in 1958 and then simply quot;Xeroxquot; in 1961. The company came to prominence in 1959 with the introduction of the first
plain paper photocopier using the process of xerography (electrophotography) developed by Chester Carlson, the Xerox 914. The 914 was so popular that by the end of 1961, Xerox had almost $60 million in revenue. By 1965, revenues leaped to over $500 million. Before releasing the 914, Xerox had also introduced the first xerographic printer, the quot;Copyfloquot; in 1955. The company expanded substantially throughout the 1960s, making millionaires of some long-suffering investors who had nursed the company through the slow research and development phase of the product. In 1960, the quot;Wilson Center for Research and Technologyquot; was opened in Webster, New York, a research facility for xerography. In 1961, the company changed its name to quot;Xerox Corporationquot;. Xerox common stock (XRX) was listed on the New York Stock Exchange in 1961 and on the Chicago Stock Exchange in 1990. In 1963, Xerox introduced the Xerox 813, the first desktop plain-paper copier, bringing Carlson's vision of a copier that could fit on anyone's office desk into a reality. Ten years later in 1973, a color copier followed. The laser printer was invented in 1969 by Xerox researcher Gary Starkweather by modifying a Xerox copier. This development resulted in the first commercially available laser printer, the Xerox 9700, being launched in 1977. Laser printing eventually became a multi billion dollar business for Xerox. In 1970, under company president Charles Peter McColough, Xerox opened the Xerox PARC (Xerox Palo Alto Research Center) research facility. The facility developed many modern computing technologies such as the mouse and the graphical user interface (GUI). From these inventions, Xerox PARC created the Xerox Alto in 1973, a small minicomputer similar to a modern workstation or personal computer. This machine can be considered the first true personal computer, given its versatile combination of a cathode-ray-type screen, mouse-type pointing device, and a QWERTY-type alphanumeric keyboard. But the Alto was never commercially sold, as Xerox itself could not see the sales potential of it. In 1979, several Apple Computer employees, including Steve Jobs, visited Xerox PARC, interested in seeing their developments. Jobs and the others saw the commercial potential of the GUI and mouse, and began development of the Apple Lisa, which Apple introduced in 1983.
The Xerox Alto workstation was developed at Xerox PARC In the mid 1980s, Apple considered buying Xerox; however, a deal was never reached. Apple instead bought rights to the Alto GUI and adapted it into to a more affordable personal computer, aimed towards the business and education markets. The Apple Macintosh was released in 1984, and was the first personal computer to popularize the GUI and mouse amongst the public. The company was revived in the 1980s and 1990s, through improvement in quality design and realignment of its product line. Xerox worked to turn its product into a service, providing a complete quot;document servicequot; to companies including supply, maintenance, configuration, and user support. To reinforce this image, the company introduced a corporate signature, quot;The Document Companyquot; above its main logo and introduced a red quot;digital Xquot;. The quot;digital Xquot; symbolized the transition of documents between the paper and digital worlds. Although Xerox is a global brand, it maintains a joint venture, Fuji Xerox, with Japanese photographic firm Fuji Photo Film Co. to develop, produce and sell in the Asia-Pacific region. Fuji Photo Film Co. is currently the majority stakeholder, with 75% of the shareholding. Xerox India, formerly Modi Xerox, is Xerox's Indian subsidiary derived from a joint venture formed between Dr. Bhupendra Kumar Modi and Rank Xerox in 1983. Xerox obtained a majority stake in 1999 and aims to buy out the remaining shareholders. Xerox now sponsors the Factory Ducati Team in the World Superbike Championship, under the name of the quot;Xerox Ducatiquot;.
Its Current array of products… Xerox today manufactures and sells a wide variety of office and production equipment including LCD Monitors, photo copiers, Xerox Phaser printers, multifunction printers, large-volume digital printers as well as workflow software under the brand strategy of FreeFlow. Xerox also sells scanners and digital presses. On 29 May 2008, xerox launched XEROX iGen 4 digital press. It also produces fax machines, professional printers, black and white copiers, and several other products.In addition, Xerox produces many printing and office supplies Xerox logo 1971–2008 designed by Chermayeff & Geismar. Although Xerox is a global brand, it maintains a joint venture, Fuji Xerox, with Japanese photographic firm Fuji Photo Film Co. to develop, produce and sell in the Asia-Pacific region. Fuji Photo Film Co. is currently the majority stakeholder, with 75% of the shareholding. Xerox India, formerly Modi Xerox, is Xerox's Indian subsidiary derived from a joint venture formed between Dr. Bhupendra Kumar Modi and Rank Xerox in 1983. Xerox obtained a majority stake in 1999 and aims to buy out the remaining shareholders. Xerox now sponsors the Factory Ducati Team in the World Superbike Championship, under the name of the quot;Xerox Ducatiquot;. The Xerox trademark… The word quot;xeroxquot; is commonly used as a synonym for quot;photocopyquot; (both as a noun and a verb) in many areas; for example,quot;I xeroxed the document and placed it on your desk.quot; or quot;Please make a xeroxed copy of the articles and hand them out a week before the examquot;. T hough both are common, the company does not condone such uses of its trademark, and is particularly concerned about the ongoing use of Xerox as a verb as this places the trademark in danger of being declared a generic word by the courts. The
company is engaged in an ongoing advertising and media campaign to convince the public that Xerox should not be used as a verb. To this end, the company has written to publications that have used Xerox as a verb, and has also purchased print advertisements declaring that quot;you cannot 'xerox' a document, but you can copy it on a Xerox Brand copying machinequot;. Xerox Corporation continues to protect its trademark diligently in most if not all trademark categories. Despite their efforts, many dictionaries continue to mention the use of quot;xeroxquot; as a verb, including the Oxford English Dictionary. In India, Parle Agro's quot;Kaccha Mango Bitequot; candy ran a tagline claiming quot;Kacche Aam Ka Xeroxquot; which means quot;Xerox of the raw mangoquot;. The tag was later modiified to quot;Kacche Aam Ka Copyquot;, which means quot;Copy of the Raw Mango.quot; In 2008, Xerox changed its logo to a red sphere with a white X with three grey stripes. The change is meant to reflect less on the photo copying duties Xerox has carried out and instead to refocus on document management and solutions across the world for companies
Fact File….. Xerox Corporation Type Public (NYSE: XRX) Founded Rochester, New York, USA (1906) Norwalk, Connecticut, USA Offices in Rochester, New Headquarters York Fortune 500 Ranked 145th Document Services Industry Computer Peripherals
Digital Imaging Products Printers Market cap $9.85 billion (2008) Revenue ▲$17.2 billion USD (2007) Employees 57,400 (2007) Website www.xerox.com The Founders… The KPMG network was formed in 1987 when Peat Marwick International and Klynveld Main Goerdeler merged along with their respective member firms. There were four key figures in the formation of KPMG. They are the founding members of the present organization. Klynveld Piet Klynveld founded the accounting firm Klynveld Kraayenhof & Co in Amsterdam in 1917. Peat William Barclay Peat founded the accounting firm Peat & Co in London. Marwick James Marwick established the accounting firm Marwick, Mitchell & Co in New York City in 1897. Goerdeler Dr. Reinhard Goerdeler was the first president of the International Federation of Accountants and a chairman of KPMG. He is credited with laying the foundations of the Klynveld Main Goerdeler merger
About them… KPMG firms are some of the world’s leading providers of audit, tax and advisory services. They have 135,000 people operating in over 140 countries. KPMG was established in India in September 1993, and has rapidly built a significant competitive presence in the country. The firm operates from its offices in Mumbai, Pune, Delhi, Kolkata, Chennai, Bangalore and Hyderabad, and offers its clients a full range of services, including financial and business advisory, tax and regulatory, and risk advisory services. In India, KPMG has a client base of over 2000 companies. The firm's global approach to service delivery help provide value-added services to clients. The firm serves leading information technology companies and has a strong presence in the financial services sector in India while serving a number of market leaders in other industry segments. Their practice is organized around our Audit, Tax and Advisory practices.
Fact File… Type Swiss Cooperative 1987; merger of Peat Marwick International and Founded Klynveld Main Goerdeler Headquarters New York, NY (global) Tim Flynn (Chairman and CEO) John B. Harrison, Chairman KPMG Asia Pacific Key people Region Ben van der Veer, Chairman KPMG Europe, Middle East and Africa Region Industry Professional services Audit Services Tax Advisory Revenue ▲$22.7 billion USD (2008) Employees 136,896+
Website www.kpmg.com The KPMG – Xerox Fraud Case In one of the latest scandals involving a prominent American corporation, Xerox revealed in 2002 that over the five years prior to 2002 it had improperly classified over $6 billion in revenue, leading to an overstatement of earnings by nearly $2 billion. The announcement of Xerox is not entirely new. The Securities and Exchange Commission (SEC) began an investigation that ended in April of that year. The SEC had charged the producer of copiers and related services with accounting manipulations. It was estimated at the time, however, that the amount involved was about half that which is now stated, or about $3 billion. A settlement was eventually reached that included a $10 million fine, as well as an agreement to conduct a further audit. It was this audit that produced the $6 billion figure.
There were two basic manipulations that formed the basis for the SEC investigation. The first was the so-called “cookie jar” method. This involved improperly 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 method—and what accounted for the larger part of the fraudulent earnings—was the acceleration of revenue from short-term equipment rentals, which were improperly classified as long-term leases. The difference was significant because according to the Generally Accepted Accounting Principles (GAAP)—the standards by which a company’s books are supposed to be measured—the entire value of a long-term lease can be included as revenue in the first year of the agreement. The value of a rental, on the other hand, is spread out over the duration of the contract. The effect of the manipulation was that Xerox could count as earnings what was essentially future revenue. This boosted short-term profits and allowed the company to meet profit expectations in 1997, 1998 and 1999, though it had the effect of reducing earnings during the past two years. In 1998 Xerox reported a pretax income
of $579 million, while it should have reported a loss of $13 million. On the other hand, the $137 million loss for 2001 will become a $365 million gain after the manipulation is reversed. The $1.9 billion total that will now be subtracted from revenue reported from 1997-2001 will be added to future reports. Thus, unlike some of the other scandals that have emerged over the past several months, Xerox has not been accused of falsely creating unearned income. Rather it spread its income out in a fraudulent manner. To the same end, WorldCom improperly capitalized about $4 billion in ordinary expenses in order to allow the company to deduct the expense over a period of decades rather than writing it off all at once. Both these methods serve to boost short-term profits. Why carry out these manipulations when the extra money earned in one year would have to be subtracted from future years?
This was necessary because corporations are under enormous pressure from Wall Street investors to keep up short-term earnings. Otherwise, their share values will drop, which not only threatens companies heavily reliant on share values to finance debt, but also has financial consequences for top executives, whose astronomical incomes are bound up with stock options. The SEC investigation noted that “compensation of Xerox senior management depended significantly on their ability to meet [earnings] targets.” Because of the accounting manipulations, top Xerox executives were able to cash in on stock options valued at an estimated $35 million. Xerox stock rose to a peak of $60 a share in mid-1999, when the company was carrying out the accounting fraud. It has since declined sharply and is now trading at about $7.
Confronted with declining revenue during the late 1990s that should have led to lower than expected earnings reports—thereby reflecting the true nature of the company’s deepening problems—Xerox decided to cook the books. This was done quite methodically. Internal documents have recorded discussions among top officials at Xerox concerning ways to manipulate accounting to allow the company to meet Wall Street expectations. Executives apparently calculated the exact amount that would have to be altered in order to allow the company to just meet or slightly exceed “first call consensus” expectations on Wall Street, which are determined prior to a company’s release of earnings data. In 1997, for example, expected earnings were at $1.99 a share, while reported earnings were $2.02. Actual earnings, correcting for the accounting manipulations, were at $1.65. Using its earlier underestimate of $3 billion in improperly classified revenue, the SEC calculated these actual earnings. In 1998, expected and reported earnings were both at $2.33 while actual earnings were only $1.72 a share. In 1999, reported earnings beat expected earnings by one cent, while actual earnings fell short by almost 50 cents. This is a striking example of a company fitting earnings to expectations in order to prevent a run on stock. It is, however, a fairly common practice. Many companies, like General Electric for example, always seem to come out just barely ahead of expectations. Indeed, recent studies have found the distribution of reported earnings of major companies around expectations was skewed to the positive side. That is, it is more likely for a company to beat than to fall short of expectations, suggesting that there are many companies that have been following the same accounting practices as Xerox. Like the WorldCom fraud, Xerox’s manipulation should have been easy to detect if there was anyone interested in looking. As former SEC chief accountant Lynn Turner noted, “These numbers have gotten so large that it’s akin to auditors driving past Mt. Everest and saying they never saw it.... Corporate America has somehow gotten into the mindset that this is OK.” Xerox’s auditor during the period in question was KPMG, one of the “big four” accounting firms that dominate the profession. KPMG was fired in October and replaced by PricewaterhouseCoopers. KPMG was also part of the SEC investigation that began last year. The evidence suggests that the auditing firm knew what was going on and decided to allow it to continue. An internal document obtained by the SEC contained a statement by a KPMG official acknowledging that Xerox’s schemes constituted “half-baked revenue recognition.” When the KPMG auditor in charge of the Xerox account began to raise some concerns about the company’s improper techniques, he was replaced with someone else.
Earlier this year, the SEC considered filing civil charges against top executives at both KPMG and Xerox. The accounting firm is currently facing lawsuits from shareholders charging the company with failing to audit Xerox properly. KPMG is also under scrutiny for its role in approving the books of the drug store chain Rite Aid, which recently acknowledged that it inflated its income by more than $1 billion over a two-year period. It also approved the books of the collapsed Belgian software company Lernout & Hauspie Speech Products NV, which has admitted to fabricating 70 percent of sales at its largest unit. The Xerox case has focused attention on the role of the SEC and its chairman, Harvey Pitt. Pitt, a former lawyer for the big accounting firms including KPMG, met with KPMG’s new chairman, Gene O’Kelly, in April. O’Kelly issued a statement declaring he told Pitt at this meeting that any SEC action against KPMG would be “unfounded” and “would pose serious disruption ... in the capital markets.” Pitt denied that the two discussed Xerox at all during the meeting. Such a discussion, if it took place, would be a serious violation of norms of independence. The SEC, having failed to raise any flags while the fraud was being carried out, appears complicit in the scandal. Because of its protracted crisis, Xerox has been forced to sell off some of its assets. It managed to renegotiate its credit earlier this month, but at higher interest rates. If the company had failed to renegotiate its credit line, it may have been unable to meet its obligations, forcing it into bankruptcy. This almost happened once before, in late 2000. In an attempt to cut back on costs, Xerox has laid off thousands of workers in the past two years and may well make further retrenchments in the future. On the other hand, as Xerox’s troubles grew more severe, the company’s CEO Anne Mulchay received a pay package in 2001 that could be worth as much as $25 million. According to SEC’s complaint, the accounting violations committed by Xerox are
• Accelerating leasing revenue — Xerox allegedly repeatedly changed the way it accounted for lease revenue but failed to disclose that the associated gains were the result of accounting changes rather than improved operating performance. Moreover, many of the practices used failed to comply with GAAP. For example, Xerox used a return on equity allocation method that involved calculating the estimated fair value of the equipment as the portion of the lease payments remaining after subtracting the estimated fair value of the services and financing components. As the estimated fair value of services and financing declined, the equipment sales revenue that was recognized immediately increased. Xerox was also accused of accelerating the recognition of revenues by immediately recognizing as the revenue price increases and extensions of existing lease rather than recognizing the increases over the remaining life of the lease. • Improper increases in residual values of leased equipment — Xerox allegedly adjusted the estimated residual value of leased equipment (that is, its remaining value at the end of the lease term) after the inception of the lease in violation of GAAP. SEC
alleges that this write-up in the residual value of equipment was used to credit the cost of sales, were recorded close to the end of quarterly reporting periods as “a gap-closing measure to help Xerox meet or exceed internal and external earnings and revenue expectations.” • Acceleration of revenues from portfolio asset strategy transactions— Selling investors the revenue streams from portfolios of its leases that otherwise would not have allowed for immediate revenue recognition. SEC alleges that Xerox used these transactions to recognize revenue that would have otherwise been recognized in future periods and failed to disclose this practice. • Fraudulent manipulation of reserves and other income— Xerox allegedly increased its earnings by releasing excess reserves that were originally established for some other purpose into income in violation of GAAP. Xerox also allegedly systematically released a gain associated with the successful resolution of a dispute with the Internal Revenue Service to improperly increase earnings from 1997 through 2000. Although GAAP required that the entire gain be recognized upon the completion of all legal contingencies in 1995 and 1996, Xerox used most of it to meet its earnings targets. • Failure to disclose factoring transactions— Xerox allegedly failed to disclose factoring transactions that allowed it to report a positive year end cash balance, instead of a negative one. This factoring involved Xerox selling its receivables at a discount in order to realize instant cash instead of a future stream of cash. According to SEC complaint, analysts looked to Xerox to increase its liquidity and called for stronger end-of year cash balances in 1999. Unable to generate cash, Xerox management instructed its largest operating units to explore the possibility of engaging in factoring transactions with local banks. These transactions materially affected Xerox’s 1999 operating cash flows but these transactions were not disclosed in its 1999 financial statements. In some of the factoring transactions involved buy-back agreements in which Xerox would reacquire the receivables after the end of the year. By accounting for these transactions as true sales, Xerox violated GAAP. Not only did Xerox fail to disclose the agreements, it failed to reverse them in the next year.
Without admitting or denying the allegations of the complaint, Xerox consented to a final judgment that includes a permanent injunction from violating the antifraud, reporting and recordkeeping provisions of the federal securities laws, specifically Section 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 13a-1. 13a-13, 12b-20 and 13b2-1 promulgated there under. In addition, Xerox agreed to restate its financials for the years 1997 through 2000 and pay a $10 million civil penalty. As part of this agreement, Xerox also agreed to have its board of directors review the company’s material internal accounting controls and policies. Burning a hole……The Consequences that followed Xerox Corp. agreed to pay $670 million while KPMG LLP had to pay $80 million, to settle an eight-year-old securities lawsuit filed on behalf of Xerox investors who claimed Xerox committed accounting fraud to meet Wall Street earnings expectations. The case of Carlson v. Xerox Corp., filed on behalf of purchasers of Xerox common stock and bonds from between February 1998 and June 27, was something of a high profile one for the pre-Enron era. In April 2002, Xerox had already agreed to a $10 million fine as part of a settlement with the Securities and Exchange Commission. The fine was the largest ever paid by a company to settle with the SEC at that time. The SEC charged that the copier company schemed to defraud investors during a four-year period by using what it called quot;accounting actionsquot; and quot;accounting opportunitiesquot; to meet or exceed Wall Street expectations and disguise its true operating performance. The commission stated at the time that most of the actions violated generally accepted accounting principles, and thus accelerated the
company's recognition of equipment revenue by more than $3 billion and increasing its pretax earnings by approximately $1.5 billion. In 2005, KPMG agreed to pay $22.5 million to settle SEC charges related to its audits of Xerox from 1997 through 2000. Under that arrangement, 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 the largest payment ever made to the SEC by an audit firm. The Securities and Exchange Commission also charged six former senior executives of Xerox Corporation, including its former chief executive officers, Paul A. Allaire and G. Richard Thoman, and its former chief financial officer, Barry D. Romeril, with securities 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 interest without admitting or denying the SEC's allegations. The SEC intended to have these funds paid into a court account pursuant to the Fair Fund provisions of Section 308(a) of the Sarbanes-Oxley Act of 2002 for ultimate distribution to victims of the alleged fraud. The defendants had each offered to settle by consenting, without admitting or denying the SEC's allegations, to the entry of a final judgment in the civil action that: permanently enjoins each of them from violating Section 10(b) of the • Exchange Act and Rule 10b-5 there under, aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 there under, and (except for Allaire and Thoman) violating Section 13(b)(5) of the Exchange Act and Rule 13b2-1 there under; imposes an officer and director bar against Allaire (5 years), Thoman (3 years) • Romeril (permanent), and Fishbach (5 years); requires each of them to pay civil penalties in the following amounts: $1 • million for Allaire; $750,000 for Thoman; $1 million for Romeril; $100,000 for Fishbach; $75,000 for Marchibroda; and $75,000 for Tayler; requires Fishbach and Marchibroda to relinquish their respective rights to • certain deferred bonuses ($127,035 for Fishbach and $50,228 for Marchibroda) plus accrued interest on these amounts.
requires each of them to pay disgorgement and prejudgment interest thereon in the following • amounts: Allaire: $5,696,678 - disgorgement; $1,938,124 - prejudgment interest; Thoman: $4,668,396 - disgorgement; $1,440,993 - prejudgment interest; Romeril: $2,987,282 - disgorgement; $1,227,688 - prejudgment interest; Fishbach: $666,748 - disgorgement; $289,904 - prejudgment interest; Marchibroda: $273,399 - disgorgement; $88,920 - prejudgment interest; Tayler: $92,603 - disgorgement; $32,397 - prejudgment interest; and; Required Fishbach and Marchibroda to relinquish their respective rights to • certain deferred bonuses ($127,035 for Fishbach and $50,228 for Marchibroda) plus accrued interest on these amounts. In addition, both Romeril and Tayler agreed to the entry by the SEC of an Order pursuant to Rule 102(e) of the SEC's Rules of Practice that suspends each of them (based on the entry of the injunction in the federal court action) from appearing or practicing before the SEC as an accountant. This Order will suspend Romeril permanently and suspend Tayler for three years with a right to apply for reinstatement after the three-year period.
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