Xerox Corporation Case Analysis External Auditing University of Technology, Jamaica Mr. M. Smith November 02, 2020 Question 1 Question 2 (15 marks) 2-3 pages (a) What’s the auditor responsibility for detecting material fraud in the financial statements and what type of factors should the auditor consider when assessing the likelihood of material misstatements due to fraud? (7 marks) The auditor responsibility for detecting material fraud in the financial statements includes several terms; Material Versus Immaterial Misstatement- material combined with uncorrected errors misstatement are usually considered fraud within the financial statement. Because it will likely change/ influence decision making of financial users. Auditors are responsible to assure that the materiality threshold has been satisfied. And most importantly it is difficult and human impossible to find all errors in fraud. Reasonable Assurance- this is measuring how certain the auditor is at the end of this study/audit. The financial statements must be free from material misstatement, because the auditing standard assurance is high, but not absolute. This method shows that the auditor is an insurer or guarantor of the correctness of the financial statement. Therefore, an audit that is conducted according to the auditing standards may fail to detect fraud. Errors Versus Fraud- errors or fraud can be misstatement material or immaterial. But an error is unintentional misstatement of the financial statement. This can happen where an error is a mistake in extending price times quantity on sales invoice and overlooking older raw materials in determining the lower cost. While fraud is intentionally done. This can happen where financial reporting is intentional overstatement of sales on the balance sheet to increase earning. Professional Skepticism- the purpose of the auditing standards is to provide reasonable assurance of detecting fraud both material errors and fraud in the financial statement. In order to accomplish this the auditor must plan to perform with professional skepticism in all aspects of engagement. Professional skepticism is an attitude that includes questioning the mind and critical assessment of audit evidence. Auditors consider aspects of the evidence not saying they must think that management is being dishonest, but they must think that dishonesty must be considered. They must not think the manager cannot be questioned. (b) What is the most appropriate accounting authority that KPMG should have insisted Xerox adhered to, when accounting for leases? Explain - cite at least two references in the case to support your answer. (8 marks The most appropriate accounting authority that KPMG should have used when accounting for lease at Xerox according to Generally Accepted Accounting Principles (GAAP) Xerox should have immediately recognized revenues from the sale of the product but spread out the servicing the financing revenue throughout the whole week. According to the case these are some supporting points that were made; “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. Generally accepted accounting principles (GAAP) allows most of the fair market value of a lease to be recognized immediately if the lease meets the requirements for a sales-type lease”. And “xerox elected to recognize the revenue from lease price increases and extensions immediately instead of recognizing the revenue over the remaining lives of the leases. GAAP requires that increases in the price or length of a lease be recognized over the remaining life of the lease”. Question 3 (20 marks) (2-4 pages) a) Identify and describe three major inherent business risks that were applicable to Xerox? When the company is exposed to factors that lead to failure or lower the company profit, it is known as business risks. The three major inherent business risks identified in Xerox case study are: Acceleration of lease revenue recognition from bundled leases, acceleration of lease revenue from lease price increase and extensions and increase in the residual values of leased equipment. The acceleration lease revenue recognition the bundled leases that would show the auditors if there were any changes in the lease terms. Xerox used the exploiting accounting opportunities in the beginning to implement the method of deriving the revenue of the equipment sales leases from the estimated fair value of financing and services. The fair value reduction of financing states the financing must produce the maximum of 15% return on the equity of the finance operations. The margin normalization, same as return of equity (ROE) was the top adjustment Xerox made near the end of reporting periods. Allocation of the revenue and sales were booked by the operating units that did not use the margin normalization. Evaluation of the other incomes, auditors could have to examine the interest of income and to research the reason why it wasn’t being recognized into the year it did earn. Failure in disclosure of transactions would need to be looked into to differentiate the past cash flow sales to the current cash flow sales and to ensure that they were being recorded in Xerox financial statements. The acceleration lease revenue would result in extension and price increase that was used to accelerate the recognition of revenue from accounting that was not conforming to GAAP. From 1997 to 1999, there was an increase in equipment in Xerox and pre-tax earnings to close the gap for items between the expected financial performance and the actual financial performance. The company Xerox knew that the practices violated GAAP. The external auditor informed Xerox of the accounting prices increasing and the lease extension violation but, the company didn’t comply with the GAAP advice. They merely reduced the price amount that was recognized. The increase of residual values lease for equipment have been prohibited with the increasing the estimated residual value after it is first established. The company Xerox knew that increasing the residual value of the equipment was reckless and a violated action to GAAP. This has contributed to the material misstatement in the financial results in various public filing in Xerox annual reports and the second and third quarters report over the period of years. b) What are three main audit procedures that KPMG should have executed when conducting control and substantive testing of Xeror’s financial statement? Explain The procedures that the auditors used are methods to acquire the evidence and tests for audit assertions to form the basis for the honest opinions from the financial statements of the company. The three main audit procedures that KPMG should have executed when conducting control and substantive testing of Xerox’s financial statements are: Confirmation, Analytical Review and Recalculation. Confirmation is the process of inquiry that acquires the information presented or existing situation straight from the mediator. It’s frequently used to link the relation amongst accounting balances in the company and the elements without being restricted. Confirmation requests could be designed to find out if there are modifications that were created to the agreement. In the case, if there were any changes then the current details are required. Auditor used this process to gather evidence about the missing action for certain situations. Example, an undisclosed absence would influence revenue recognition. When the auditor was conducting the quarter or annual audit report for the company, he or she should have inquired about the financial statement report to find out the incorrect information presented. Analytical Review is the procedure that consists of the evaluations of the financial statement information which form the study of the relationships between non-financial data and the financial data. It’s the procedure to investigate the identified inconsistent of the relevant information from the predicted amounts. The auditor should have done an analytical review when he or she notices the red flag, to notify the organization of the fraudulent activity and to run more tests on the balances. Recalculation is the checking for mathematical efficiency on the financial statements. Xerox saw that price for equipment increased and it did not add to the figures of the company financial report. The external auditor would recalculation the values to find out the errors. The auditor would have to recheck and review all the receipts, sales order and purchases order both hard and soft copy for verification. c) Justify whether KPMG should have carried out more or less analytical procedures and test of details of balances during the financial statement audit of Xerox. KPMG should have carried out more analytical procedures and run multiple tests on Xerox Company accounting balances. Seeing that the company was operating illegal activities with a lot of red flags, the auditor should have done more tests of balancing with auditing the financial statement reports. There was an increase of prices for equipment that wasn’t shown on the report, there were leasing agreements that brought the company into risks. If the auditor had run more tests of details of the balances, it would have come to a conclusion that the business is operating fraudulent activities from the beginning. Xerox has to now implement proper internal control procedures in the business to run its operation legal and in the right manner. The proper internal control procedure will limit one person having more than one responsibility and Xerox Company will operate more effectively. Question 4 (27 marks) (a) Identify four fraud factors present at Xerox and were indicative of each of the three conditions/stages of the fraud triangle. Fraud factors are those circumstances that enable individuals or employees to commit fraud. The fraud triangle consists of three specific elements. These elements are: Rationalization, Opportunity and Pressure/Motivation. Rationalization is when an individual tries to justify their wrongdoings. Pressure is where there are circumstances which drive an individual to commit fraud. These circumstances can either be internal, which is likely to be some form of pressure or external which is likely to be some form of incentives factors. Pressure stems from trying to reach targets that are impossible. Opportunity is where someone sees a flaw in the system and uses that as a way to try and commit a fraud. Opportunity is not easily detected but with the proper implementation of procedures and controls it can be minimized. Four fraud factors (red flags) that existed at Xerox and were expressive of the three elements of the fraud triangle are: Under the opportunity element it is evident that the accounting controls were not properly maintained therefore it was easy for persons to tamper with documents. The weakness could be very minor and it will still present an opportunity to commit fraud. In the case they mentioned that “Xerox did not maintain adequate control in its Mexico unit” therefore it was easy for them to interfere with the system. Lack of proper internal control created a path for numerous amounts of malicious acts and manipulations to take place. Under the Pressure/motivation element Xerox was pressured to meet financial targets from competitors and investors. Evidently, they were pressured to meet Wall Street’s expectations; they were pressured to maintain strong credit pairings and also they were pressured to report revenue and earnings growth. It was also said that their competitors introduced new products and attractive pricing. This too could pose as pressure to perform or to get resources in order to compete with competitors and be the leading company. Rationalization is evident in the case where it said senior management saw manipulations as “accounting opportunities'' therefore they frequently approved or directed the manipulations. They didn’t see it as a wrong-doing but rather an opportunity to portray the company in a way that is a misrepresentation of what it really is. KPMG allowed the practices to take place even though they were questionable. The rationalization factor may very well be the major reasons why the fraud occurred for many years since the senior management had already found a way to justify the actions to make it seem as if what they were doing is acceptable when it is in fact not acceptable. (b) Identify five questionable accounting manipulations/irregularities outlined in the case, Five questionable accounting manipulation/irregularities that were outlined in the case are: · Acceleration of: o lease revenue recognition from bundled leases o lease revenue from lease price increases and extension (i) · Manipulation of other income · Failure to Disclose factoring transactions · Increase in residual value of leased equipment. Indicate the affected financial statement accounts affected for each manipulation For each manipulation there is a financial statement that is affected. The manipulation “acceleration of lease revenue recognition from bundled leases” affects the financial statements account revenue (sales) which will therefore affect business’s net income and is present in the income statement. The manipulation “acceleration of lease revenue from lease price increases and extension” affects the business’s sales revenue and also its net income. The manipulation “increase in residual value of leased equipment” affects the business’s cost of goods sold account which would also be reflected in the company’s net income in the income statement. The manipulation “failure to disclose factoring transactions” would affect the accounts receivable account and the “manipulation of other income” affected the interest account which can also be found in the income statement. (ii) Identify one audit procedure the auditor could have used for each manipulation For each manipulation there are respective audit procedures that the auditor could have considered using in order to to assess the applicability of the practice or action. For the manipulations “acceleration of lease revenue recognition from bundled leases'' and “acceleration of lease revenue from lease price increases and extension” An audit procedure that should have been used by the auditor is an analytical review therefore they could assess the unusual transactions and events that were taking place at Xerox to ensure that they were adhering to the standards that are in place. They could also use the inquiry procedure to get an explanation as to why extensive transactions were taking place. For the manipulation “Failure to disclose factoring transactions'' the auditor could inspect records and documents such as cash receipts so they would be aware of the transactions that were taking place at Xerox . For the manipulation “Increase in residual value of leased equipment.” The auditor could use the re-calculation audit procedure. This would allow them to check how accurate the documents are and to be aware of any increase that took place. By using the re calculation procedure they could evaluate the sustainability of records in the statements at Xerox. “For the Manipulation of other income” the auditor could use inspection of records and documents in order to trace given supporting documents to the transaction records that were present at Xerox. Question 5 (24 marks) 2-4 pages (a) Did KPMG issue the right audit reports? If yes, explain why. If not, state why and the type of reports that should have been issued? (12 marks) KMPG help the managers manipulate the financial statements by issuing unqualified audit reports stating that the company’s reports were consistent with Generally Accepted Accounting Principle (GAAP) when in reality they were not. KPMG did not issue the right audit report as there were several material misstatements in the financial report that was issued, which cause investors and shareholders to justifiably rely on these statements when it was their intent to deceive. According to Price (2016), concluded that “unqualified audit reports are those that are free from material misstatements and are in compliance with GAAP. These are often referred to as clean audit reports and are they type of reports most companies wish to receive.” I believe KMPG this because of pressure from the management of Xerox as well as they had obligations of Wall Street to be met and they felt pressure from their competitors. In my opinion as well as evidence from the case senior management compensation was directly linked to Xerox’s ability to report increasing revenues and earnings which may pressure them to indulge in fraudulent acts as well as the indication of a breakdown in internal controls. Given the facts of the case KPMG should have issued an adverse audit report. This type of report is where the auditor has discovered a high level of material misstatements and is not prepared in accordance with Generally Accepted Accounting Principle (GAAP). As supported with evidence from the case this type of report has a high level of fraud as the information presented will mislead and deceive shareholders and investors. The accounting profession is guided by principles that guide the behavior of professionals of what is generally acceptable and to be responsible in their act in the public interest. These rules, ethical principles and guidelines are termed as code of conduct that accounting professionals should comply with in performing the duties of their client or employer and simply acting in the public interest. Some of the fundamental principles include integrity, objectivity, independence, professional due care among other professional ethics. Integrity a fundamental principle in my opinion accounting professionals should possess which refers to being straightforward, honest, being transparent in all professional and business conduct. Objectivity according to The International Federation of Accountants (2020) refers “to not allowing bias, conflict of interest or undue influence of others to override professional or business judgements.” KMPG was in breach of all these principles as well as not maintaining professional due care which is performing duties with required skill and knowledge providing the client with competent professional service and judgement that are done in accordance with the accounting legislation and principles acceptable in compliance with professional standards. As seen in the case of Xerox there were certain circumstances that threatened compliance to the fundamental principles identified above. A self-interest threat was identified when Xerox senior managers approved the accounting manipulations under protest from field managers who viewed these manipulations as accounting opportunities, which a clear indication of breach of integrity, objectivity and professional due care. There was also a threat to compliance with fundamental principles such as GAAP when Xerox was receiving undue pressure from Wall Street and their exceptions, as well as competitors in the market and so they continued to report revenue and earnings growth and KPMG approved these- non-GAAP accounting practices. It was also seen in the case where threats to integrity, objectivity and professional due care were created when the KPMG personnel challenged several of Xerox non-GAAP accounting principles and the senior manager had a new engagement partner from the firm assigned to its accounts and surprisingly KPMG complied with this. This can be because of conflict of interest where there was some personal gain that may have been attached to preparing and reporting misleading information through the acts of others. A legal case that could have been brought against KPMG is legal liability of Auditors to third parties for reason of negligence causing users to rely on financial statements where the auditor has failed to use due care and has failed to identify the material misstatement. In the case it can be said that KPMG was involved in fraudulent conduct because the misstatements made, they had knowledge of this falsity with the intent to deceive. References Arens, A. Alvin. (2012) Auditing And Assurance Services 14th Ed.An Integrated Approach/ Alvin A. Arens, Randal J. Elder, Mark S. Beasley.
