Xerox Corporation was founded in 1906 in Rochester, New York. Xerox manufactures and sells a wide 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. Barry D. Romeril, Xerox’s chief financial officer (CFO) and Paul Allaire, Xerox’s chairman and corporate executive officer (CEO) were leading Xerox through a difficult period in the late 1990’s. During this time Xerox was faced with tough competition from foreign markets while losing a large portion of their small copier business to desktop printers. During this period, Xerox also lost millions of dollars on their diversification effort into insurance and financial services. In spite of that, Mr. Allaire and Mr. Romeril continued to keep Xerox’s stock prices and earnings high. By the mid-1990s Xerox management had decided they were going to have their accountants come up with creative accounting if they were going to continue to show the Wall Street and their stockholders that they were still able to meet their earnings expectations (SEC Release No. 18174, 2003).
Xerox revealed in 2002 that over the last five years prior to 2002 it had improperly classified over $6 billion in revenue which led to an overstatement of earnings by $2 billion. The Securities and Exchange Commission (SEC) was investigating Xerox and it charged the company with accounting manipulations (SEC Release No. 2002-52, 2002). There were two manipulations that formed the basis for the SEC investigation. The first manipulation 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 method was called the “cookie jar” method. The second manipulation 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 entire value of a long-term lease can be included as revenue in the first year of the agreement. The value of a rental is spread out over the duration of the agreement (SEC Release No. 2002-52, 2002). The SEC investigation noted that “compensation of Xerox senior management depended significantly on their ability to meet targets. Because of the accounting manipulations, top executives were able to cash in on stock options valued at an estimated $35 million. Xerox stock rose to $60 per share when the company was carrying out the accounting fraud (BBC News, 2002).
KPMG, the accounting firm for Xerox Corporation, was also part of the SEC investigation. The auditing firm knew what was going on and decided to allow it to continue. According to the SEC Order, “ In each of the years 1997-2000, KPMG issued audit reports containing unqualified opinions stating that KPMG had applied generally accepted auditing standards (GAAS) to its review of Xerox’s accounting, that Xerox’s financial reporting was consistent with GAAP, and that Xerox’s reported results fairly represented the financial condition of the company. However, the Order found that throughout this period KPMG failed to comply with GAAS and allowed Xerox to utilize accounting actions that did not comply with GAAP, and allowed Xerox to falsify its books and records and failed to maintain adequate internal controls over its accounting.” (SEC Release No. 2005-59, 2005). In June 2002, Xerox restated $6.4 billion of equipment sales from 1997 through 2001 and reduced earnings by $1.4 billion for that period. The company said that of the total restatement, $5.1 billion in revenue was allocated among service, rental, outsourcing, and financing revenue streams over the five years, while $1.9 billion in revenue was recognized in 2002 and beyond (Schneider, 2003). Financial Data, 1997-2000 | | | | | | | | | | Dollars in millions | | | | | | Fiscal Years | | 1997 | 1998 | 1999 | 2000 | | | | | | Reported Revenue | $18,225 | $19,593 | $19,567 | $18,701 | Restated Revenue | 17,457 | 18,777 | 18,995 | 18,751 | Reported net income (loss) | 1,359 | 273 | 1,339 | (257) | Restated net income (loss) | 893 | (167) | 844 | (273) | Source: SEC fillings | | | | | James F Bingham, a 15 year Xerox veteran, and assistant treasurer at Xerox was helping with the creative accounting until he realized that he was helping making the problem bigger. He went to upper management to explain the problem but he was fired and refused to accept a one year settlement with Xerox. He filed a lawsuit against Xerox for being wrongfully terminated for preventing Xerox’s fraudulent activities. The filing of the lawsuit brought him to the attention of the SEC where he was the witness against Xerox.
The SEC charged six executives, including former CFO Barry Romeril and CEO Paul Allaire, with using improper accounting to increase equipment revenue and inflate earnings. In July 2002, the individuals settled the civil suit with a $22 million payment that included penalties and forfeiture of profits. No one was required to admit or deny wrongdoing. Romeril was barred for life from being the director or officer of a public company and from practicing as an accountant before the SEC (SEC Release No. 2002-52, 2002).
In addition, KPMG agreed to settle the SEC’s charges against it and agreed to pay $22.5 million. The final judgment also ordered KPMG to undertake a series of reforms designed to prevent future violations of the securities law. The SEC’s Director of the Division of Enforcement said “This settlement results in significant relief that will serve to deter and prevent future auditor misconduct, and the significant monetary relief will provide a source of future funds which can be distributed to injured Xerox investors.” (SEC Release No. 2003-16, 2003).
Due professional care, due diligence, and professional skepticism would have helped prevent the audit failure. The conduct of KPMG during its audit of Xerox failed to comply with GAAS in gathering sufficient evidence, exercising professional skepticism and enforcing the requirements of GAAP. KPMG allowed the improper accounting and reporting practices to occur year after year, even though various warnings and issues had been brought to the auditors’ attention from various sources. KPMG did not have a reasonable basis for the unqualified opinions that it rendered to Xerox in the years 1997-2000.

References
Accounting panic hits Xerox. (2002, June 28). Retrieved February 17, 2012, from BBC News World Edition: http://news.bbc.co.uk/2/hi/business/2071689.stm
BBC News. (2002, April 11). SEC Charges Xerox with Fraud. Retrieved February 20, 2012, from BBC News: http://news.bbc.co.uk/2/hi/business/1924604.stm
Brooks, L. J. (2007). Business & Professional Ethics for Directors, Executives, & Accountants (4th Edition ed.). Thomson South-western.
Butala, A., & Khan, Z. (2008, June 28). Accounting Fraud at Xerox Corporation. Retrieved from Social Science Reseach Network: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1152770
Pratley, N., & Treanor, J. (2002, June 28). Xerox in $2bn Scandal. Retrieved February 20, 2012, from The Guardian: http://www.guardian.co.uk/business/2002/jun/29/2
Pulliam, S. (2003, January 23). SEC File Civil Action Against KPMG over Xerox. Retrieved February 19, 2012, from The Wall Street Journal: http://sixmile.clemson.edu/306/readings/WSJ_com%20-%20SEC%20Set%20to%20File%20Civil%20Action%20Against%20KPMG%20Over%20Xerox.htm
Schneider, C. (2003, October 24). Xerox: New Lease on Life. Retrieved February 19, 2012, from CFO: http://www.cfo.com/article.cfm/3010599/1/c_3036074
SEC Release No. 18174. (2003, June 5). Executives Agree to Pay Over $22 million in Penalties. Retrieved February 19, 2012, from U.S. Securities and Exchange Commission: http://www.sec.gov/litigation/litreleases/lr18174.htm
SEC Release No. 2002-52. (2002, April 11). Xerox Settles SEC Enforcement Action Charging Company With Fraud. Retrieved February 20, 2012, from U.S. Securities and Exchange Commission: http://www.sec.gov/news/headlines/xeroxsettles.htm
SEC Release No. 2003-16. (2003, January 29). SEC Charges KPMG and Four KPMG Partners with Fraud in Connection with Audits of Xerox. Retrieved February 19, 2012, from U.S. Securities and Exchange Commission: http://www.sec.gov/news/press/2003-16.htm
SEC Release No. 2005-59. (2005, April 19). KPMG Pays $22 Million to Settle SEC Litigation Relating to Xerox Audits. Retrieved February 19, 2012, from U.S. Securities and Exchange Commission: http://www.sec.gov/news/press/2005-59.htm