Question

Audit Sampling and Accounts Receivable

Question 1 KPMG was the auditor for Xerox Corporation between 1997 and 2000. During this time, approximately $6 billion of revenue was improperly classified and earnings were overstated by approximately $2 billion. When the fraudulent conduct was exposed, Xerox restated its financial statements and replaced KPMG as its auditor. KPMG paid $22.5 million to settle a lawsuit against the firm by regulators.

Research this accounting fraud on the Internet for further details on what occurred.

Required: Suppose that you are part of Xerox Corporation’s audit team hired to complete 1997 to 2000 financial statement audits.

Do the following:

a) Identify a piece of audit evidence that you would have used during your audit and discuss why you would or would not have relied on this evidence. Provide at least three arguments to support why this evidence would or would not have been relied on.

Answer 1

Background

The Xerox Corporation was under intense pressure from the shareholders to maintain and elevate its performance. The underlying business model of the company was under threat and needed a fix, so as to continue to be a sustainable and profitable business. Instead blanket of some accounting tricks was put on poor performance.

During the time, KPMG was the statutory auditor of the corporation, tasked with ensuring and reporting to the shareholders that the accounts drawn up were free from any material misstatement and fraud. Instead the firm turned a blind eye to all the creative accounting.

Fraud

To keep up with the expectations of the Wall Street, Xerox Corp. was to enhance its performance by one way or the other. It did this by a number of ways:

a. Cookie Jar Accounting: Cookie Jar Accounting is a method in which reserves are treated as a jar and these reserves are used whenever the operating performance of the company falls short of its expectations. Extraordinary one time expenses were written of against these reserves, avoiding a hit on the Profit & Loss.

b. Acceleration of Lease Income: As per Generally Accepted Accounting Principles, income from leases was to be recognized over the lease term, except for lease relating to equipment which could be recognized immediately. The company offered a bundled lease wherein along with the equipment, other services and financing was also done. The company did not bifurcate between the leases and recognized all of such lease rentals as income immediately.

c. Enhancing Residual Value of Leased Assets: As per Generally Accepted Accounting Principles (GAAP), the residual value of the asset leased cannot be revised upwards after inception of the lease. The company regularly employed the practice of increasing the residual value of the leased assets.

d. Late recognition of income: The other income gained by the company in a tax dispute in years prior to 1997 was recognized only in 1997. This is against GAAP. This was done so as to even out the deteriorating performance of the company during 1997 to 2001, when this accounting fraud was in motion.

e. Disclosure of Factoring Transactions: The company had meagre cash balance vis-a-vis its asset base. To cover this up, the company sold its receivable and realized cash against it. However this was not disclosed as a part of the report on financial statements. The source of cash is of vital importance.

Evaluating Audit Evidence

1. Cookie Jar Accounting: An evidence in this area could have been gathered by checking the ledger of reserves whereby the firm could have figured out what were reserves made up of and why the reserves have decreased during the year. If there were expenses which were written off against the same the reason for the same and whether the same should have been charge to Profit & Loss. A defense could be argued from the company’s side that only extraordinary and irregular expenses were written off against the reserves. However the same is not sustainable referring to GAAP.

2. Acceleration of Lease Income: The firm could have looked into the composition of the leases and why were the leases sold in bundle. Moreover, can the lease rentals be broken down in to equipment sales and rentals for other services and financing. The firm would have referred to the treatment given in the GAAP for leases and come to the conclusion that the company was clearly trying to recognize the income quite in advance.

3. Enhancing Residual Value of Leased Assets: The firm could have inquired about the frequent revisions in the residual values of the leased assets. Moreover, only upward revaluations would easily answer the doubts. The fact that the same is not permissible by GAAP, the company’s probable defense that it revalue the assets to reflect fair value bears no significance.

4. Late recognition of income: There was no practical reason for recognizing incomes of earlier years during 1997-98. An income is recognized when it is measurable and there is a reasonable certainty of receiving it. The only defense company has for this is inability to show certainty. Only on this ground would the auditor not qualify the audit report. The firm of auditors would have obtained a copy of the proceedings of the tax dispute to establish certainty over receiving the same and act accordingly.   
5. Disclosure of Factoring Transactions: The most important element of a business is the cash flows of the entity. The sales result in profits which ultimately bears cash to the firm. The realization of sales in to cash is the single most important thing in a business. The lack of conversion of profit to cash reflects poor collection system of the business, inflated sales figures, etc. The same was the case with Xerox Corp. Since sales were inflated, it were not going to result in cash ultimately. Nevertheless an adequate level of cash was to be maintained. For this reason factoring of receivables was done. The firm of auditors would have analyzed the balance sheet that one current asset has been converted in to another current asset i.e., receivables were converted in to cash. A false impression was passed on that receivables have been collected regularly since no disclosure was given.