Assignment in Ethics: Earnings Management

Company’s Background
The company was founded in 1906 as the Haloid Company, a manufacturer and distributor of
photographic paper. In 1947 the firm obtained the commercial rights to xerography, an imaging
process invented by Chester Carlson. Renamed the Haloid Xerox Company in 1958, the company
introduced the 914 xerographic copier in 1959. The process, which made photographic copies onto
plain, uncoated paper, had been known for some time, but this was its first commercial application.
The product brought so much success and name recognition that the company has waged a continuing
campaign to prevent the trademark Xerox from becoming a generic term. The company changed its
name to Xerox Corporation in 1961.

After the success of its first copier, Xerox expanded into other information products and
publishing businesses and founded PARC, a research lab in Palo Alto, California, in 1970. While
remaining a major reprographics manufacturer, the company went on to develop word-
processing machines in 1974, laser printers in 1977, and Ethernet, an office communications network,
in 1979. Xerox sold its publishing firms in 1985. The company’s product lines included copiers, printers,
digital print production presses, and the software and systems support required for document
production. In the 1990s Xerox developed digital photocopiers.

Situation/Fraudulent Scheme, Actions Taken, Implication

Xerox took steps to address the competitive challenges to its business, but it also succumbed to Wall
Street pressures by using undisclosed accounting actions, most of which were improper, that hid the
effect that these challenges had on its business. Xerox increased its equipment revenue and earnings
through the improper acceleration of revenue, and additionally inflated its earnings using reserves and
miscellaneous other accounting actions. Xerox failed to disclose the impact these accounting actions
had on revenues and earnings. Accordingly, Xerox misled investors as to the company's true operating
results.
Initially, Xerox resorted to these accounting actions to add only a penny or two to quarterly earnings to
meet Wall Street estimates. Xerox executives called this process "closing the gap" between true
operating results and expected results. However, as Xerox found it increasingly difficult to meet
quarterly analyst estimates based on revenues as the company had historically accounted for them,
reliance on "one-offs" became more pronounced, accounting for a growing percentage of reported
earnings.

The table below illustrates the sum of the quarterly gross impacts on pre-tax earnings from the one-
offs Xerox used to close the gap in its earnings targets each year during 1997-2000. This table also
shows the annual net impact of these accounting actions on pre-tax earnings, which reflects the
reduced earnings in these years from Xerox's prior actions that had pulled forward revenues from
these periods, as well as the reversal of certain transactions made during 1999. (The hyphens in the
table indicate accounting actions that are not the subject of this action.)
The one-offs were responsible for 4 percent of Xerox's quarterly earnings in early 1997 and between 17
percent and 37 percent of quarterly earnings in 1998 and 1999. Similarly, the impact of accounting
actions on Xerox's annual earnings went from 19 percent in 1997 to 29 percent in 1998, and
constituted 25 percent of 1999 pre-tax earnings. The charts
below detail the impact of accounting actions on Xerox's
earnings in each quarter and year from 1997-1999. The blue
portion of each bar represents earnings as historically
calculated by Xerox. The yellow portion is the additional before
tax earnings that resulted from undisclosed changes in
accounting, including the use of methodologies that did not
comply with GAAP. (The total amounts reflected in the two
charts below and in the charts on pages eight and nine exclude
the restructuring and asset impairment charges Xerox recorded
in the second quarter of 1998.)

  Had Xerox reported its revenues and earnings consistent

with its accounting in earlier years, Xerox would have failed to eet Wall Street earnings-per-share
expectations in 11 of 12 quarters in 1997-1999. The chart below illustrates how "one-offs" "closed
the gap" between earnings measured in accordance with GAAP and Xerox's historical accounting
practices and estimates, and earnings compared with non-GAAP and new accounting practices and
estimates designed to meet the company's earnings' targets and Wall Street's expectations.

Use of "one-offs" distorted the economic reality of Xerox's business and the investing
public's perception of its business. Because they were never told otherwise, investors could only
assume that Xerox was recording earnings and revenues in a manner consistent with prior practice
and GAAP, and its results were the product of improved business performance rather than
accounting maneuvers. Because of the number of undisclosed changes in Xerox's accounting and
the manipulation of its earnings, the investing public had an inaccurate picture of Xerox's financial
results and performance in absolute terms as well as relative to earlier, comparable periods.

 Xerox's senior management was informed of the most material of these accounting actions
and the fact that they were taken for the purpose of what the company called "closing the gap" to
meet performance targets. These accounting actions were directed or approved by senior Xerox
management, sometimes over protests from managers in the field who knew the actions distorted
their operational results.

 Xerox repeatedly told investors, directly and through meetings with analysts, that Xerox
was an earnings success story and expected that its performance would continue improving each
quarter and year with higher revenues and earnings. Moreover, during 1997 through 2000, senior
Xerox management reaped over $5 million in performance-based compensation and over $30
million in profits from the sale of stock. Xerox's reliance on accounting actions was so important to
the company that when the engagement partner for the outside auditor challenged several of
Xerox's non-GAAP accounting practices, Xerox's senior management told the audit firm that they
wanted a new engagement partner assigned to its account. The audit firm complied.

Sources: https://www.sec.gov/litigation/complaints/complr17465.htm
https://www.britannica.com/topic/Xerox-Corporation