AUDITING | ING. OLEKSANDRA LEMESHKO BY FABIAN PASCHEN 1 Agenda 1. Introduction 2. Background 3. Accounting Manipulations 4. Question and Answers 2 1. Introduction 3 2. Background 1997 1999 0.35 0.53 4 2. Background 5 3. Accounting Manipulations Acceleration of Lease Revenue Recognition from Bundled Leases Bundled Leases consist of: Equipment, service, supplies & financing GAAP (sales-type lease): - Equipment revenues recognized immediately - Non-equipment revenues recognized over term of the lease àreallocation of revenues from finance and service to equipment Finance activities à equipment: „return on equity“ Service activities à equipment: „margin normalization“ 6 3. Accounting Manipulations Acceleration of Lease Revenue from Lease Price Increase and Extensions Renegotiation of contracts GAAP: increases of price and length recognized over the remaining life of a lease Xerox recognized them immediately. 7 3. Accounting Maipulations Increase in the Residual Values of Leased Equipment Cost of sales for leased equipment = equipment cost – expected residual value GAAP: no upward adjustment of estimated residual value allowed after inception Xerox periodically increased the expected residual value (previously recorded equipment) à reduction of cost of sales 8 3. Accounting Manipulations Acceleration of Revenues from Portfolio Asset Strategy Transactions Difficulties with sales lease agreements in Brazil à rental contracts GAAP: revenues from rental contracts not recognized immediately Xerox sold those contracts to investors à immidiate recognition of revenue Problem: no disclosure of that approach in reports (filed with SEC) 9 3. Accounting Manipulations Manipulation of Reserves GAAP: reserves for identifiable, probable and estimable loss contigencies Xerox: 1. Reserve for unknown business risks established 2. unrelated business expenses recorded and claimed the reserve account à reducing operating expenses à increasing net income 10 3. Accounting Manipulations Manipulation of Other Income Tax dispute: Xerox won a tax dispute in 1996 à taxes and interest payments on disputed amount were refunded GAAP: Recognize the interest income in period the dispute is finalized and interest is due à in Xerox case: 1995 & 1996 Xerox recognized them in the periods 1997-2000. 11 3. Accounting Manipulations Failure to Disclose Factoring Transactions Cash position: Concerns about the very low cash position (1999: $126 millions of cash compared to 28.814 billions of assets) Factoring transactions: Xerox sold future cash flows(receivables) to banks à immediate cash Problem: Again no disclosure in the reports filed with SEC 12 4. Questions 1. Comparison of Hewlett Packard and Xerox in the period 1997-2000. How were Xerox´s and Hewlett Packards businesses similar and disssimilar during the relevant time periods? How did the two companies financial performance compare? Both companies had to challenge the same competition, technology and especially the same changes in that time. 13 4. Questions Revenues (in $): Xerox: Hewlett Packard: 1997 1998 1999 2000 Revenues(in mio) 18,144 19,447 19,228 18,632 Annual growth 7.2% -1.1% -3.1% 1997 1998 1999 2000 Revenues(in mio) 35,465 39,419 42,370 48,782 Annual growth 11.1% 7.5% 15.1% https://www.sec.gov/Archives/edgar/data/47217/000091205701002796/a2032630z10-k.txt 14 4. Questions Net Earnings (in million $): In the year 2000: 1998 1999 2000 Xerox 395 1,424 -384 Hewlett Packard 2,945 3,491 3,697 Assets/Liabilites and Equity Equity-Ratio Cash-ratio Xerox $29,687 (mio) 0.12 0.06 Hewlett Packard $34,009 (mio) 0.41 0.22 15 4. Questions 2. a) What responsibility does an auditor have to detect material misstatements due to error and fraud? -Auditor has to find and disclose all misstatments -Ensure that reports and balance sheets are completly correct and legal represented -Auditors of KPMG haven‘t acted resposibly in that case 16 4. Questions b) What two main categories of fraud affect financial reporting? 1. “Misstatements arising from fraudulent financial reporting” (SAS No. 99.06) à Manipulation, falsification, misrepresentation or omission of records or financial information 2. “Misstatements arising from misappropriation of assets” (SAS No. 99.06) àMisappropriation of assets, for example: stealing assets, company pays for goods or other benefits which are destined for you 17 4. Questions 3. Using hindsight, indentify factors present at Xerox that are indicative of each of the three fraud conditions. 1.Incentive or „under pressure“ à reason to commit fraud 2.Opportunity for a fraud à lack of controls or ineffective controls 3.Ability to rationalize the fraud à depends on the attitude and ethical values of a person (SAS No. 99.07) 18 4. Questions 1. Incentives: Compensation system of senior management linked to presented results Under pressure: Wall Street expectations, strong competition 2. Opportunity for a fraud: lack of controls by KPMG, they were not firm but approving 3. Ability to rationalize the fraud: Senior managers were resolute, called them „Accounting Opportunities 19 4. Questions a) For each accounting manipulation identified, indicate the financial statement accounts affected. Bundled Leases Recognition: àgreater revenues in the profit and loss statementà greater profit/earnings à Bigger position of Equity or profit for shareholders through dividends Price Increases and Extensions through renegotiations: Basically the same 20 4. Questions Increase in Residual Values: à Higher valuation of the assets (equipment) à increase in the asset position land, building and equipment àreduction of cost of salesà increase in the profità increase in equity or shareholders wealth Portfolio Asset Strategy Transactions: Effect of immediate revenues the same (like first two examples) 21 4. Questions Manipulation of Reserves: à First increase of Reserves (reserve for unknown business risk) à Periodically reduction of that account by unrelated business expenses àreduction of operation expenses à increase in net income Manipulation of other Income/tax dispute: àEffect of the interes payments on the other income were delayed à Again effect on the equity (increase was delayed) à Income in the years 1997-2000 again inflated 22 4. Questions Factoring Transactions: - No effect on revenues (asset exchange) à Cash position increasedà financial receivables decreased 23 Sources Case 4.5: „Xerox Corporation: Evaluating Risk of Financial Statement Fraud“ by Mark S. Beasley, Frank A. Buckless, Steven M. Glover, Douglas F. Prawitt (2015 Pearson Education) „Annual report of Hewlett Packard“, published by the Securities and Exchange Comission: https://www.sec.gov/Archives/edgar/data/47217/000091205701002796/a2032630z10-k.txt (Filing date: 25/01/2001) „Consideration of Fraud in a Financial Statement Audit“, AU Section 316, SAS No. 99: http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00316.pdf 24