Last month, The US Securities and Exchange Commission (SEC) filed suit against Xerox Corporation in connection with a wide-ranging, four-year scheme to defraud investors.
The SEC’s complaint alleges that from at least 1997 through 2000, Xerox used a variety of what it called ‘accounting actions’ and ‘accounting opportunities’ to meet or exceed Wall Street expectations and disguise its true operating performance from investors.
These actions, most of which violated generally accepted accounting principles (GAAP), accelerated the company’s recognition of equipment revenue by over $3 billion and increased its pre-tax earnings by approximately $1.5 billion.
Xerox agreed to settle the SEC’s complaint by consenting to the entry of an injunction for violations of the antifraud and other provisions of the federal securities laws, restating its financials for the years 1997 to 2000, agreeing to a special review of its accounting controls and paying an unprecedented $10 million penalty.
‘Xerox used its accounting to burnish and distort operating results rather than to describe them accurately,’ said Stephen M. Cutler, the SEC’s Director of Enforcement. ‘For Xerox, the accounting function was just another revenue source and profit opportunity. As a result, investors were misled and betrayed.’
‘Xerox’s senior management orchestrated a four-year scheme to disguise the company’s true operating performance,’ said Paul R. Berger, Associate Director of Enforcement. ‘Such conduct calls for stiff sanctions, including, in this case, the imposition of the largest fine ever obtained by the SEC against a public company in a financial fraud case. The penalty also reflects, in part, a sanction for the company’s lack of full co-operation in the investigation.’
Charles D. Niemeier, Chief Accountant for the Division of Enforcement, added: ‘Xerox employed a wide variety of undisclosed and often improper top-side accounting actions to manage the quality of its reported earnings. As a result, the company created the illusion that its operating results were substantially better than they really were.’
The SEC’s complaint, filed in the US District Court for the Southern District of New York, alleges that Xerox used a host of undisclosed accounting actions in Xerox business units worldwide to manage its reported equipment revenues and profits. These accounting actions, which Xerox called ‘one-time actions,’ ‘one-offs,’ ‘accounting tricks’ and ‘accounting opportunities,’ frequently were approved, implemented and tracked by senior Xerox management. The accounting actions had an enormous impact on Xerox’s reported performance. For example, in the fourth quarters of both 1998 and 1999, accounting actions generated 37% of Xerox’s reported pre-tax profit.
The SEC’s complaint further alleges that by 1998, nearly $3 of every $10 of Xerox’s annual reported pre-tax earnings resulted from undisclosed accounting actions. If not for these accounting actions, Xerox would have fallen short of market expectations, often by a wide margin, in almost every reporting period from 1997 through 1999.
The allegations in the complaint centre around seven different accounting actions used, in Xerox parlance, to ‘close the gap’ between the company’s operating results and the market’s expectations from 1997 through 2000. Many of these actions had the purpose and effect of accelerating Xerox’s recognition of revenue at the expense of future periods. According to the complaint, Xerox fraudulently disguised these actions so that investors remained unaware that the company was meeting earnings expectations only by using accounting maneuvers that could compromise future results.
Many of the accounting actions related to Xerox’s leasing arrangements. Under these arrangements, the revenue stream from Xerox’s customer leases typically had three components: the value of the ‘box,’ a term Xerox used to refer to the equipment, revenue that Xerox received for servicing the equipment over the life of the lease; and financing revenue that Xerox received on loans to its lessees.
Under GAAP, Xerox was required to book revenue from the ‘box’ at the beginning of the lease, but was required to book revenue from servicing and financing over the course of the entire lease. According to the complaint, Xerox relied on accounting actions to justify shifting more lease revenue to the ‘box,’ so that a greater portion of that revenue could be recognized immediately.
The complaint alleges that the two accounting actions with the largest impact on Xerox’s financial statements were methodologies that Xerox called ‘return on equity’ and ‘margin normalization.’ These two methodologies alone boosted Xerox’s equipment revenues by $2.8 billion and its pre-tax earnings by $660 million from 1997 to 2000. While these methodologies were quite complex, the results were straightforward. Xerox used the return-on-equity method to shift revenue to the ‘box’ that the company had historically allocated to financing. And margin normalisation shifted revenue to the ‘box’ that had historically been allocated to servicing.
In violation of GAAP, Xerox failed to disclose these methodologies, and the numerous changes it made to them, to investors, creating the appearance that the company was earning much more from its sales of equipment than it actually was. The complaint alleges that the failure to disclose the changes in accounting methods and estimates was fraudulent.
Xerox also used approximately $1 billion in other one-time accounting actions to artificially improve its operating results. By using these accounting actions and failing to disclose their use, Xerox violated GAAP as well as disclosure requirements. These additional one-time accounting actions included the improper use of ‘cushion’ or ‘cookie jar’ reserves, the improper recognition of the gain from a one-time event, and miscellaneous lease accounting related actions.
In addition, Xerox misled investors by failing to disclose the impact that approximately $400 million in sales of leases had on its 1999 operating results. The effect of these undisclosed sales was to recognise income in one period that otherwise would have been recognised in future periods. Although the company earlier had entered into similar transactions in small amounts, none compared in size or scope to the 1999 sales, which added $182 million in pre-tax profits to Xerox’s 1999 results.
Xerox consented, without admitting or denying the allegations in the complaint, to the entry of an injunction for violations of the antifraud, reporting and recordkeeping provisions of the federal securities laws. In addition, Xerox agreed to pay a $10 million penalty and to restate its financial results for the years 1997 through 2000.
Finally, Xerox agreed to have its board of directors appoint a committee composed entirely of outside directors to review the company’s material accounting controls and policies.