Xerox Revenue Recognition and Audit Failures: Tomorrow’s Lease Revenue in Today’s Results

Xerox paid a $10 million civil penalty to settle the Securities and Exchange Commission’s revenue recognition case over allegedly accelerated equipment revenue and inflated earnings. The SEC alleged that the actions moved more than $3 billion of equipment revenue into earlier periods and increased pretax earnings by approximately $1.5 billion from 1997 through 2000. If you work with lease allocations, quarterly adjustments or audit questions, you may recognize how reported growth can depart from the business underneath it. We see a penalty dwarfed by the earnings the SEC said Xerox added on paper.

This account follows the Stamford, Connecticut company’s lease accounting, the internal explanations and the separate proceedings involving its executives and alleged audit failures at KPMG. The broader pattern of revenue recognition and premature sales includes several ways of borrowing from a later period. At Xerox, the SEC’s case centered on which part of a customer’s lease payment counted as equipment revenue and when investors were told about the accounting changes.

Xerox’s Lease Had Three Different Revenue Streams

Xerox’s customer leases combined equipment, service and financing, each with a different recognition timetable. The SEC’s account of its issuer complaint explains that Xerox had to recognize the equipment component at the beginning of the lease, while recognizing service and financing revenue over the lease’s life. Xerox called the equipment the “box.”

That distinction put considerable weight on the allocation. A dollar assigned to servicing the copier belonged across the service period. A dollar assigned to the copier itself could enter revenue immediately. The SEC alleged that Xerox shifted more of the lease into the equipment component to improve current results at the expense of future periods. For a lease-accounting analyst, the allocation workpaper connects the customer’s bargain to the earnings announcement.

Return on Equity Moved Financing Revenue

The SEC alleged that Xerox’s return on equity method shifted revenue historically allocated to financing into equipment revenue. Financing income that otherwise belonged over the lease term could then appear at its beginning. The question for someone who knew the model was what justified changing the financing allocation and whether the underlying business supported that change.

Margin Normalization Moved Service Revenue

Margin normalization did the same kind of work on the service component, according to the SEC’s issuer complaint. It shifted revenue historically allocated to servicing into equipment revenue. The agency alleged that the two methods violated generally accepted accounting principles and increased equipment revenue by $2.8 billion and pretax earnings by $660 million over the same period.

The complaint also alleged that Xerox failed to disclose its use of, and changes to, these methods and estimates. A customer could still be paying for years of service while the public accounts attributed more revenue to equipment delivered at the outset. In the SEC’s account, the service revenue arrived before the service.

A 2019 paper, Accounting Fraud: A Literature Review in Risk Governance and Control: Financial Markets & Institutions, describes how timing, reclassification and presentation can combine to distort a company’s financial picture. Xerox’s alleged allocation methods make that mechanism tangible. The important movement was between components of the same customer arrangement, which is why understanding the contract matters as much as reading the total revenue line.

Reserve Releases and Lease Sales Also Helped Make the Quarter

The SEC’s issuer complaint described approximately $1 billion of additional accounting actions used to improve operating results. These included improper use of excess reserves, recognition of a gain from a one-time event and other lease-accounting adjustments. The agency alleged that Xerox concealed these actions as well as using accounting treatments that violated the applicable standards.

The SEC separately alleged that Xerox failed to disclose the effect of approximately $400 million in lease sales on its 1999 results. According to the complaint, those transactions added $182 million in pretax profit by recognizing income immediately that otherwise would have arrived in future periods. Xerox had previously made similar transactions in smaller amounts, but the SEC said the scale of these sales was different.

The separate executive complaint also alleged premature recognition of revenue from negotiated price increases and retroactive increases to equipment residual values, meaning the estimated value left at the end of a lease. Those practices put the timing of a customer’s price change and the estimate of a copier’s remaining value into the earnings calculation. A person maintaining those schedules could explain which assumption changed and who approved it.

That creates another comparison for the person handling the lease portfolio. An allocation change moves revenue between components of a lease. A lease sale can change when future income enters reported results. The lease-sale files, reserve schedules and quarterly adjustments explain different contributions to the same earnings number.

What Xerox’s Executives Knew About the Adjustments

The SEC alleged that senior executives tracked the difference between operational results and the results Xerox reported publicly. Its account of the executive complaint describes internal reports, memoranda, emails and meetings addressing that difference. In the agency’s account, headquarters accounting adjustments repeatedly filled the gap between the business’s earnings and management’s targets. The issuer complaint alleged that accounting actions generated 37% of Xerox’s reported pretax profit in the fourth quarters of both 1998 and 1999.

One email makes the purpose unusually clear. The release quotes the chief financial officer asking about a potential accounting action in September 1997:

In August 1998, according to the SEC, Xerox’s controller told the company’s president that Europe’s operational growth was 2%, while growth likely to be reported was closer to 10% after headquarters adjustments. The agency also alleged that the chief financial officer told executives in November 1999 that, after stripping away accounting actions and certain other items, Xerox was essentially a no-growth company from 1998 to 1999.

The workpaper may show the adjustment, while the email explains why management wanted it and the forecast shows what it left for the next period. The SEC’s account describes executives possessing precisely that kind of comparison while presenting stronger results to investors.

The Public Reports Carried the Adjusted Results

The SEC alleged that Xerox’s accounting actions reached 12 quarterly reports, four annual reports and seven registration statements covering the period. The complaint concerned the financial picture presented to investors, including people buying debt securities. The alleged adjustments had become part of the company’s public account of its performance.

In the settlement announced on April 11, 2002, Xerox agreed to restate its financial results for 1997 through 2000. It also agreed to a permanent court order barring it from repeating the violations, and to have a committee composed entirely of outside directors review its material accounting controls and policies. For the people working inside those systems, the review concerned how adjustments could enter the accounts and who approved them.

What the SEC Found About KPMG’s Audit Failures

KPMG’s separate proceeding reached the audit work behind Xerox’s reported results. In its April 19, 2005 release, the SEC said KPMG failed to follow auditing standards and allowed unsupported accounting actions. The findings came in an order KPMG agreed to and concerned its audits of Xerox from 1997 through 2000, including its failure to insist that the accounting practices and their effects be disclosed.

The SEC said KPMG audit partners received warnings from member firms in Europe, Brazil, Canada and Japan that Xerox’s methods lacked adequate supporting evidence. The SEC’s order also described warnings from KPMG’s Rochester office that adjustments made outside the normal accounting process were weakening internal controls. According to the order as described by the SEC, KPMG did not demand sufficient evidence that the assumptions reflected business reality.

The agency’s account says KPMG sometimes asked Xerox to test its assumptions, but management ignored those requests and the auditor applied no pressure to obtain the testing. The order found that KPMG also failed to test the assumptions adequately itself, yet issued unqualified audit opinions saying Xerox’s financial reporting complied with accounting standards and fairly represented its financial condition. In the SEC’s account, the questions stayed open. The opinions went out clean.

The order also found that KPMG learned of possible illegal acts but failed to inform Xerox’s board or audit committee before the SEC investigation. According to the SEC, when Xerox complained about the audit engagement partner, KPMG replaced that partner after the audit was completed. For someone on an audit team, the warning, the requested test, the response and the final opinion are distinct parts of the audit work behind the assurance investors receive.

KPMG agreed to pay $22.475 million in the separate civil settlement, including the return of $9.8 million in Xerox audit fees. The SEC also censured the firm and ordered it to stop the violations. The settlement also required channels for audit staff to raise concerns and documentation of engagement-partner changes.

The Executive Settlements and the Investor Distribution

The SEC’s executive action concerned six former senior Xerox executives, including former chief executives, the chief financial officer and senior accounting personnel. They agreed to pay more than $22 million to resolve the agency’s allegations.

The SEC announced an investor distribution totaling $45,867,740. The money came from payments by five Xerox managers and Xerox’s auditors. Xerox’s own penalty went to the U.S. Treasury.

How to Catch Accounting Fraud?

In a case like Xerox’s, the useful evidence connects the lease economics, the accounting adjustment and management’s explanation of the reported result. We work with the person who understands the transaction to trace that connection through the records behind the number. The Xerox proceedings suggest several concrete comparisons:

Under Armour’s Growth Story Also Borrowed From the Future

Under Armour offers a useful parallel in the timing problem. The SEC’s settled action concerned customer orders pulled forward and a growth story that omitted the resulting uncertainty about future revenue. At Xerox, the alleged lease allocations brought future revenue into current equipment results. In both accounts, someone working with the next period’s forecast could understand what the current public number left out.

What Is Whistleblowing in Accounting?

Whistleblowing in accounting can mean explaining how a reported result diverges from the contracts, entries and assumptions behind it. A lease analyst may understand the allocation, a controller may know the adjustment, and an audit team member may know which question went unanswered. We assess that account with you, including questions about your accounting or audit role.

A 2019 working paper hosted by MIT Sloan, Do Corporate Whistleblower Laws Deter Accounting Fraud?, studied firms exposed to state False Claims Acts through state pension-fund ownership. It found lower estimated accounting-fraud risk, with changes in revenue and accrual-related measures helping drive the result. That finding gives a broader reason to take the insider’s knowledge seriously: reporting incentives can affect the accounting choices made before an enforcement action exists.

Eligible SEC whistleblowers can share 10% to 30% of qualifying sanctions collected in an action involving more than $1 million in monetary sanctions. Our experts connect what you know about the accounting to the SEC whistleblower award assessment.

If your information also concerns false claims for government money, we assess that part of the conduct with you. A whistleblower case under the False Claims Act can pay 15% to 30% of what the government recovers.

You Know What Made the Quarter

If you know which lease assumption changed, who approved the adjustment or why an audit question disappeared, talk with our whistleblower experts about the accounting you saw. We build the case around your knowledge of the business, bring in securities fraud whistleblower lawyers who understand revenue recognition and audit failures, and stay beside you throughout the case.