It is undeniable that human civilization needs an established set of rules and norms in order to function properly. Unfortunately, the will to break these rules is inherent in all of us, especially if we stand to gain something. This disturbing human quality resonates in every facet of our lives, and especially in accounting. On numerous occasions, large companies have released misleading financial statements, effectively allowing them to deceive Wall Street investors. In 2002, the S.E.C (Securities and Exchange Commission) discovered that the Xerox Corporation had been recording earnings on their income statements that weren’t attributed to a specific accounting period, thus violating the revenue recognition principle. In order to carry out this scheme, Xerox made use of two dishonest accounting practices: Cookie Jar Accounting and the improper recording of long-term leases.
Before delving into an analysis of Xerox’s dishonest accounting practices, it is first important to understand the accounting principle that the corporation has violated. The G.A.A.P stipulates that all companies must operate under the accrual basis of accounting, where a company must record revenues and expenses when they are incurred, regardless of when economic considerations actually change hands. This method of accounting allows for more accurate financial statements, ultimately giving external parties a better idea of a company’s performance (“Investopedia: Accrual Accounting”, n.d). That being said, the revenue recognition principle dictates that revenues must be recorded when money is earned, irrespective of when payment is actually received (Larson, 2010, p. 32). For instance, if a company were to provide services on credit, it would be able to record revenue as soon as the job was carried out. Conversely, if a company were to receive advance payment for services to provide in the future, it would not be able to record those revenues until the services were fully executed. The revenue recognition principle sets precedent for all of corporate accounting—which Xerox chose to ignore when it falsified its earnings.
Wall Street investors are constantly scrutinizing large corporations; they put them under immense pressure to reach earnings objectives. If these objectives are not met, the corporation’s public image suffers, and its share value is likely to drop. If Xerox were unable to meet its objectives, the company would have difficulty financing debt—leading to eventual bankruptcy (Kay, 2002, par.8). So when sales began to decline due to competition overseas, top executives decided to manipulate company books in order to protect their interests (Seipp, Kinsella, Lindberg, 2011, p.220). It is important to recognize this scandal is not associated to one particular transaction, but rather to repeated false recording of earnings over an extended period of time. These transactions involved the manipulation financial statements without attracting unwanted attention from financial regulation agencies. Prior to the release of financial statements by major corporations, Wall Street releases a “first call consensus”, an estimate of a company’s earnings (or losses) per share. Xerox calculated an earnings amount that would only slightly surpass its first call consensus—allowing them to slip under the radar (Seipp, Kinsella, Lindberg, 2011, p.220). For instance, in 1997 when the company’s expected earnings were set at 1.99 per share, and Xerox released earnings of 2.02 a share. However, actual earnings were at 1.65 per share (Kay, 2002, par.12). The adoption this disingenuous tactic was unlikely to raise any suspicion, which is what they got away with it at first. Even when it came to the internal auditing of the firms accounts, there was foul play. KPMG was the firm responsible for Xerox’s accounts during the time of the scandal, and were also investigated by the S.E.C. When the head auditor of the firm started raising questions about Xerox’s accounting practices, he was immediately replaced (Kay, 2002, par.15).
With a more concrete understanding of the nature of these transactions, let us further examine how this scandal itself was carried out. In simple terms, the Xerox accounting scandal involved the statement of future revenue as present earnings in order to meet profit expectations (Kay, 2002, par. 6). First and foremost, it is crucial to recognize that Xerox did not create false earnings; it instead chose to record its revenues at times where it would be most beneficial to the firm (Kay, 2002, par.7). When Xerox overstated its earnings after first call consensus, it simply recorded past or even future revenues in order to compensate for financial losses. Needless to say, this is clearly a violation of the revenue recognition principle, and a dishonest way to operate a business.
The Xerox accounting scandal was carried out through the use of two illegal accounting practices, the first being “cookie jar accounting”. Cookie jar accounting connotes a company using periods of good financial results to create reserves, hence the term “cookie jar”. Instead of recording these earnings immediately, the company saves them to record on its financial statements at a later time. When the company then faces a period of financial difficulty, it records these “cookie jar earnings” in its books (“Investopedia: Cookie Jar Accounting”, n.d). This method allows companies to smooth out fluctuations in its earnings, thus giving them an image of strong performance. Aside from violating the revenue recognition principle by not recording revenues when they are earned, this practice is malicious and unethical. Firstly, it completely disregards the essential purpose of financial statements. Financial statements are intended to help both internal and external parties evaluate a company’s performance for a given period. In contempt of this, cookie jar accounting gives external parties an idea of a company’s performance over an extended period of time, while tricking them onto believing the statements represent a specific accounting period. Furthermore, this tactic is employed in order to dupe investors into thinking the company’s performance always meets their expectations. This leads investors to give the company a high valuation, which in turn drives up the price of their stock.
The second malicious tactic employed by Xerox was the improper recording of earnings for both short-term equipment rentals and long term-leases. Xerox took advantage of the specific accounting rules regarding the recording of each transaction in order to record revenue when they wanted to. Being a technology company, Xerox sees a lot of revenue from the leasing of expensive equipment such as photocopiers and printers, for instance. In order to deal with accounting for these types of transactions, the G.A.A.P stipulates that the immediate fair value of the lease must be recorded as revenue immediately, where as all subsidiary revenues associated to the lease must be amortised over the lease period (Seipp, Kinsella, Lindberg, 2011, p.223). For instance, if Xerox were to lease a photocopier to an enterprise, it is obliged to report the revenue from the lease immediately, in the accounting period that the lease was issued. However, all ancillary costs such as maintenance, ink and other supplies had to be recognized over the term of the lease (Seipp, Kinsella, Lindberg, 2011, p.223). When Xerox decided to cook the books, it started recording leases in a way that completely violated G.A.A.P requirements. Firstly, Xerox determined the value of all subsidiary costs associated to a lease and combined them with the fair value of the lease itself. The company then set a maximum return on equity (ROE) for the ancillary services, and completely disregarded the ROE used to determine the cost of the monthly lease payment. This created an excess amount of ROE which the company shifted onto the original fair value of the equipment, which of course was to be reported immediately (Seipp, Kinsella, Lindberg, 2011, p.223). This allowed the company to create immediate revenue recognition on goods and services, which had to be recorded during the term of the lease. On the other hand, Xerox also sometimes recorded long-term leases as short term rentals in order to delay the revenue recognition process to its advantage (Kay, 2002, par.5) While the G.A.A.P states that the revenues for long term leases are supposed to be recorded immediately (aside from subsidiary costs), it also specifies that the revenues from short-term equipment rentals are to be spread over the duration of the contract. In spite of this, Xerox sometimes purposely classified long-term leases as short-term rentals in an effort to postpone revenue recording.
In the final analysis, Xerox’s accounting practices for the recording of revenue were not only in clear violation of one of the fundamental principles of the G.A.A.P, but were also completely dishonest as they provided investors with the false idea that the corporation was constantly meeting earnings objectives, thus violating the revenue recognition principle and compromising it’s own financial statements. In order to carry out these fraudulent activities, Xerox made use of cookie jar accounting and the improper recording of revenues from leases and rentals—two malicious accounting practices allowing corporation to manipulate when specific revenues are recorded. After defrauding millions of investors, Xerox was only fined a mere 10 million dollars—a slap on the wrist for such a large corporation.
Investopedia: Accrual Accounting. (n.d). Retrieved from http://www.investopedia.com/terms/a/accrualaccounting.asp
Investopedia: Cookie Jar Accounting. (n.d). Retrieved from http://www.investopedia.com/terms/c/cookiejaraccounting.asp
Kay, Joseph. "World Socialist Web Site." Xerox Restates Billions in Revenue: Yet Another Case of Accounting Fraud -. International Committee of the Fourth International, 1 July 2002. Web. 29 Apr. 2015.
Larson, K. (2010). Accounting; custom copy for Marianopolis College. Montreal: McGraw Hill.
Seipp, E., Kinsella, S., & Lindberg, D. L. (2011). Xerox, Inc. Issues In Accounting Education, 26(1), 219-240. doi:10.2308/iace.2011.26.1.219