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U.S. Securities and Exchange Commission









Civil Action No.
    02-272789 (DLC)



The Securities and Exchange Commission ("the Commission") alleges for its Complaint as follows:

1. From at least 1997 through 2000, Xerox Corporation ("Xerox") defrauded investors. In a scheme directed and approved by its senior management, Xerox disguised its true operating performance by using undisclosed accounting maneuvers -- most of which were improper -- that accelerated the recognition of equipment revenue by over $3 billion and increased earnings by approximately $1.5 billion.

2. Relying on what it called "one-time actions," "one-offs," "accounting opportunities" and "accounting tricks" to achieve earnings targets that it otherwise could not have met, Xerox falsely portrayed itself as a business meeting its competitive challenges and increasing its earnings every quarter. Many of these accounting actions violated the established standards of generally accepted accounting principles ("GAAP"). All of them should have been disclosed to investors in a timely fashion because, singly and collectively, they constituted a significant departure from Xerox's past accounting practices and misled investors about the quality of the earnings being reported. The accounting actions improved Xerox's earnings, revenues and margins in each quarter and year during 1997 through 2000, and allowed Xerox to meet or exceed Wall Street expectations in virtually every reporting period from 1997 through 1999.

3. In the face of intense competition and a market demanding stellar earnings performance, Xerox grew progressively dependent on these accounting actions to "close the gap" between its actual operating and financial results and the numbers it wished to and did report to the investing public. By 1998, nearly three out of every ten dollars of Xerox's annual reported pre-tax earnings and up to 37 percent of its reported quarterly pre-tax earnings came from undisclosed changes to its historic accounting practices and estimates.

4. Xerox employed a wide range of tools to enhance its revenue and earnings picture, using them as required to meet Wall Street earnings expectations. Xerox knowingly or recklessly increased revenues and earnings by accelerating the recognition of revenues through mostly non-GAAP accounting actions, overstated its earnings by using so-called "cookie jar" reserves and interest income from tax refunds, disguised loans as asset sales, and otherwise manipulated its accounting in violation of GAAP. Xerox separately tracked these accounting actions to quantify their impact on the financial results reported to the public as compared to the company's underlying operating results, but knowingly or recklessly failed to disclose that its underlying financial performance was dramatically different from what it reported to investors.

5. The most significant and pervasive of these accounting actions were used to pull forward and recognize immediately revenues from leases of Xerox equipment that, under Xerox's historical accounting practices, would have been recognized in future years. As a result, Xerox portrayed its business and growth as far more robust in 1997-99 than it in fact was. Moreover, by accelerating future revenues and profits into the present, Xerox made the prospect of achieving future expectations even more difficult and increased the company's vulnerability to future business downturns. As it happened, underlying sales and business conditions worsened in 1999 and later periods, and Xerox's prior-year accounting actions began to negatively affect its reported results. Xerox could no longer rely in lean times on deferred financing and service revenue from its leases because some of that revenue already had been recognized as income to make the company's financial statements more robust in earlier years.

6. The Commission requests that Xerox be enjoined from further violations of the antifraud and other provisions of the federal securities laws as alleged herein, that it be required to restate its financial results for the periods 1997 through 2000, that it pay a monetary penalty, and that its Board of Directors appoint a special committee of outside directors that shall retain a qualified consultant, not unacceptable to the Commission, to review the company's internal accounting controls and policies.


7. Xerox was a leading technological innovator for most of the last half of the 20th century. But by the late 1990s, the company was confronting intense product and price competition from its overseas rivals. As a result, increasing revenues and earnings became more difficult. This difficulty was apparent from the underlying operating results visible to Xerox before the company implemented top-side adjustments and other accounting actions.

8. The investment climate of the 1990s added to pressures on Xerox. Companies that failed to meet Wall Street's earnings estimates by even a penny often were punished by significant declines in stock price. In addition, compensation of Xerox senior management depended significantly on their ability to meet increasing revenue and earnings targets.

9. 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 through the use of 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.

10. 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.

11. 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.)

"One-Off" Accounting Actions
Gross and Net Impact on Pre-Tax Earnings
(In Millions)







    $ 455   $ 720   $ 569   $ 459   $ 2,203  
  Margin Normalization 55   168   202   192   617  
84   87   131   7   309 *
  Residual Value Increases 36   45   15   0   96  
  PAS Transactions   -     -     400   -     400  
  Cushion Reserve Releases 120   139   214   23   496 **
  ACT Interest Income 41





  Total Gross Impact $ 791

  $ 1,258

  $ 1,543

  $ 686

  $ 4,278

  Total Net Impact   $ 405   $ 656   $ 511   $ (55)   $ 1,517  
* This gross amount does not reflect the reversal of $89 million made during the second half of 1999.
** Included in the gross amounts are the effects of improperly timed reserve releases of $78 million which affected only interim periods within a fiscal year.

12. 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.)

13. 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.

14. The same information is shown below measured annually.

15. 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.

16. 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.

17. 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.

18. 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.

19. The practices summarized above and detailed below constitute an unlawful scheme by Xerox to defraud investors through undisclosed accounting practices and other material transactions, some of which the company knew or should have known violated GAAP. Xerox failed to tell investors that these actions were the reason Xerox met or exceeded consensus earnings estimates quarter after quarter.


20. The Commission brings this action pursuant to Section 20(b) of the Securities Act of 1933 ("Securities Act") [15 U.S.C. §§ 77t(b)] and Section 21(d) of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. §§ 78u(d)].

21. This Court has jurisdiction over this action pursuant to Sections 20(b) and 22(a) of the Securities Act [15 U.S.C. §§ 77t(b) and 77v(a)] and Sections 21(d) and 27 of the Exchange Act [15 U.S.C. §§ 78u(d) and 78aa].

22. The defendant, directly and indirectly, has engaged in, and unless restrained and enjoined by this Court will continue to engage in, transactions, acts, practices, and courses of business that violate Section 17(a) of the Securities Act [15 U.S.C. §77q(a)] and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. §§ 78j(b), 78m(a), 78m(b)(2)(A) and 78m(b)(2)(B)] and Rules 10b-5, 12b-20, 13a-1, 13a-13 and 13b2-1 thereunder [17 C.F.R. §§240.10b-5, 240.12b-20, 240.13a-1, 240.13a-13 and 240.13b2-1].


23. Xerox is a Stamford, Connecticut-based company incorporated in New York which manufactures, sells and leases document imaging products, services and supplies in the United States and 130 other countries. In 2000, Xerox employed approximately 92,500 people worldwide, 50,000 of them in the United States. For the year ended December 31, 2000, Xerox reported revenues of $18.7 billion and a loss of $257 million. Xerox is a public company whose securities are registered with the Commission pursuant to Section 12(b) of the Exchange Act and it is required to file periodic reports with the Commission pursuant to Section 13 of the Act. Its securities are listed on the New York and Chicago Stock Exchanges and also are traded on the Boston, Cincinnati, Pacific Coast, Philadelphia, London and Switzerland exchanges. Throughout the relevant time period, Xerox's stock was covered by Wall Street analysts who routinely issued quarterly and annual earnings estimates.


24. Xerox sells copiers and other office equipment outright to its customers for cash, but more frequently enters into long-term lease agreements in which customers pay a single negotiated monthly fee in return for the equipment, service, supplies and financing. Xerox refers to these arrangements as bundled leases and the monthly payment as "Total Cost of Ownership" ("TCO"). Although the popularity of bundled leases versus outright cash sales varies somewhat from country to country, Xerox has successfully promoted the leasing concept since the early 1980s so that, beginning at least in the early 1990s, bundled lease transactions constituted the majority of its sales revenue.

25. Although Xerox had resorted to a variety of accounting actions on a more modest scale as early as 1995, these tools grew more central and more material to the company's financial reporting strategy during the period 1997-2000. In 1997, Xerox substantially departed from its historical accounting methods to improperly manage its earnings, accelerate recognition of equipment revenue and earnings growth, and meet Wall Street analyst expectations. Part of this departure involved looking for undisclosed ways to realize immediately revenue that Xerox previously had deferred recognizing. Chief among them was reallocation of TCO leasing revenue to the copier or other high-cost equipment (known internally as "the box"). Under GAAP, most of the fair market value of a leased product can be recognized as revenue immediately if certain requirements are met, while non-equipment revenues such as service and financing are recognized over the term of the lease. By shifting and reallocating revenues from finance and service to the box, Xerox shifted revenues and earnings from future periods knowing that such reallocations would negatively affect those future periods.

26. The fraudulent scheme incorporated other accounting actions to "close the gap" between Xerox's actual underlying earnings and its internal targets and those of Wall Street analysts. Certain of these activities clearly violated GAAP, including the use of excess or "cushion" reserves to boost earnings and the use of loans disguised as sales of receivables to improve cash flow from operations. These actions had a material impact on the financial statements and, like the other "one-offs," undermined the comparability of prior and current reporting periods.

27. Despite the material impact of these accounting activities, none was disclosed in Xerox's quarterly and annual financial reports filed with the Commission. Nor were they disclosed in at least seven registration statements that were in effect or were filed with the Commission during 1997-2000, including four offerings that registered nearly $9 billion dollars worth of debt securities.

28. Xerox knew or was reckless in not knowing the impact its accounting actions had on its equipment revenues and earnings. Xerox documented the impact in schedules and lists of "one-offs," year-over-year causal reports and monthly and quarterly performance summaries that were distributed to and discussed by Xerox's financial management. Xerox's operating units also documented the impact of accounting actions on their financial performance, comparing "reported" and "underlying" results. Xerox also regularly received information from its outside auditor quantifying the impact of its accounting actions.

29. Xerox's senior financial management knew or was reckless in not knowing that Xerox's increasing dependence on undisclosed accounting actions to meet revenue and earnings expectations was undermining the company's ability to achieve results in the future and was presenting an inaccurate picture of Xerox's financial performance.

30. For example, in November 1999, Xerox's chief financial officer told senior Xerox management that when accounting actions were stripped away, Xerox had essentially "no growth" through the late 1990s. Xerox's vice chairman conveyed the same conclusion in October 1999 regarding Xerox Europe after reviewing information showing the subsidiary's performance in the late 1990's. The president of Xerox Europe also conveyed the conclusion in October 1999 that Xerox Europe's profit before tax was in steady decline from 1996 to 1999, but that one-time accounting adjustments helped "contain" this declining trend in the reported profit.

31. Despite this knowledge, Xerox routinely painted a false portrait of its financial condition in the periodic reports it filed with the Commission, as well as in quarterly earnings releases, financial reviews, and other financial summaries publicly issued by the company. Xerox also routinely held conference calls with Wall Street analysts to discuss its quarterly financial results in which Xerox falsely portrayed its actual performance. All of these public disclosures were false and misleading because Xerox failed to disclose the material impact that its accounting actions had on its actual financial performance.

32. By failing to disclose fully and accurately the impact and nature of these accounting actions, Xerox knowingly or recklessly deceived shareholders and investors with periodic reports and public statements that contained materially false and misleading statements and omissions regarding the operating results of Xerox.

33. In addition, many of these accounting actions constituted changes in accounting estimates or accounting methods, requiring disclosure under GAAP provisions promulgated as Opinions 20 and 28 of the Accounting Principles Board ("APB"). Xerox regularly made favorable changes in estimates having a materially positive impact on its earnings even though such changes were not supported by any changes in economic or business circumstances. Such changes in estimates included frequent alterations and recalculations intended to maximize short-term gains from leasing revenues. Xerox knew or was reckless in not knowing that such changes should have been disclosed under GAAP, but nonetheless withheld such information from shareholders and investors in its periodic filings. The aggregate impact of such undisclosed changes in estimate on pre-tax earnings from 1997 through 2000 was in excess of $600 million.

34. Xerox's financial reporting was materially misleading as a result of violations of GAAP and the failure to disclose material changes in accounting methods. These violations are described in more detail below.


A. Acceleration of Leasing Revenue to Recognize Revenue Immediately at the Expense of Future Periods

35. From the mid-1990s to the present, Xerox repeatedly and improperly changed the manner in which it accounted for lease revenue. These accounting changes pulled forward nearly $3.1 billion in equipment revenue and pre-tax earnings of $717 million from 1997 through 2000. Xerox never disclosed that these gains were a result of accounting changes rather than improved operational performance. Xerox knew or was reckless in not knowing that such material changes in accounting required disclosure and that the investing public would be misled by its failure to disclose these changes. The failure to disclose these changes made Xerox's financial reports and its public statements that it met Wall Street earnings expectations materially misleading. It also violated GAAP requirements that material changes in accounting methods be disclosed.

36. Financial Accounting Standard ("FAS") 13, an Original Pronouncement of the Financial Accounting Standards Board ("FASB"), sets forth the rules accountants must follow under GAAP in accounting for lease revenue. Under FAS 13, monthly payments due under ordinary leases are recognized only as they become due during the term of the lease. But equipment leases meeting certain criteria are accounted for under FAS 13 as if the lessor has sold the equipment and provided financing for the sale. "Sales-type" lease accounting results in immediate revenue recognition of a large portion of the lease payments representing the equipment sale, with a smaller portion recognized gradually as interest income over the lease term. For these sales-type leases, FAS 13 required Xerox to record the equipment sale at the equipment's fair value.

37. Xerox, however, claimed it was impracticable to estimate the fair value of its equipment. Instead, Xerox elected to adopt a unique, and undisclosed, approach to allocating the lease payments among the equipment price, the financing income and any service elements included in its bundled lease arrangements. Xerox's method was to derive the estimated fair value of the equipment as the portion of the lease payments remaining after subtracting the estimated fair value of the service and financing components. Under Xerox's method, as deferred revenues attributed to services and financing declined, the equipment sales revenue that was recognized immediately increased. Therefore, every additional dollar Xerox allocated to the "box" meant a dollar more of immediate revenue, but a dollar less that could be recognized in later years.

38. Two accounting actions Xerox used to reallocate revenue to the box were called "ROE" (for "return on equity") and "margin normalization." Beginning in 1997, when Xerox faced greater difficulty meeting earnings expectations, the company used ROE more expansively than it had in years past. It also implemented various forms of margin normalization in Xerox Europe, Brazil and other Latin American subsidiaries in 1997. Also beginning at least in 1997, Xerox improperly recognized price increases it negotiated with existing customers in Brazil and other parts of the world. Beginning that same year, Xerox violated GAAP by retroactively increasing the estimated residual value of equipment.

1. ROE

39. As early as 1995, Xerox began exploiting accounting opportunities by using its method of deriving the equipment revenue for sales-type leases from its estimate of the fair value of services and financing. At that time, Xerox justified reductions in its estimate of the fair value of financing by claiming that the financing should produce no more than a 15 percent return on the equity of its finance operations. Xerox selected this 15 percent rate because it approximated the average return of a handful of finance companies wholly-owned by other public companies but whose businesses were completely unrelated to either Xerox or the manufacturing of copiers. Although those wholly-owned subsidiaries reported returns of from below 6 percent to over 22 percent, suggesting a wide range of performance, Xerox simply chose for its targeted return a rate near the average. This method of deriving the equipment revenue for sales-type leases did not comply with GAAP.

40. From 1995 through 2000, Xerox did not change its assumption of a 15 percent ROE for determining the finance component of its sales-type leases. But between 1997 and 2000, Xerox continually depressed its estimate of the fair value of financing, thereby increasing its reported equipment revenues. It did this by expanding its ROE method to new geographic areas and through strategically timed changes in the factors and assumptions used to calculate the lease interest rate that would produce a 15 percent ROE. For example, Xerox reduced the interest rates to discount its leases in 1998 by 100 basis points or more because it assumed certain income after the minimum lease term. In other periods, Xerox adopted or changed assumptions used to estimate the interest rate required to produce a 15 percent ROE, such as the appropriate effective tax rate, debt-to-equity ratio, administrative cost allocation, and the tax timing benefits. As a result of these continuing changes, more and more income was shifted to the equipment. For example, a 48-month lease recorded at the operational level as generating $15,000 in sales revenue (i.e., revenue attributed to the "box") was increased by the top-side adjustment by 6 percent in 1997 and by 13 percent in 2000.

41. From 1997 through 2000, the application of the ROE method resulted in Xerox pulling forward $2.2 billion in equipment revenue and $301 million in earnings -- none of which resulted from the sale of a single additional copier or other Xerox product. Xerox did no testing to determine if its arbitrary ROE methodology resulted in economically realistic financial reporting based on the fair market value of the equipment or on prevailing equipment finance rates in different markets. Nor were the adoption, changes and expansions of the formula disclosed to investors.

42. In most cases, application of ROE was a "top-side" adjustment directed by corporate headquarters. Operating units allocated lease cash flows to the box, service and finance components according to long-established procedures. Before the financial results were reported publicly, Xerox's regional headquarters, using data supplied by corporate, recalculated these allocations to insure that Xerox's financing operations realized no more than a 15 percent return, regardless of its own capital or administrative costs or the interest rates paid by the customer to lease a copier. Initially, use of the ROE formula was limited to the United States and to Xerox Brazil, where the formula was implemented by at least 1995. As the pressure to meet earnings targets grew, and competition made selling copiers more difficult, ROE was expanded to Xerox Europe in 1998.

43. Top-side adjustments grew larger and larger over this period. Changing factors and other assumptions in the ROE formula produced lower and lower assumed finance, or "discount," rates. Lower discount rates enabled Xerox to account for more and more of the contractual lease payments up front as equipment revenue. But the use of such lower discount rates was unsupported by either objective evidence or economic reality. Neither Xerox management nor its outside auditor ever tested Xerox's claim that the top-side adjustments were necessary to arrive at the actual prevailing equipment finance rates appropriate to the customer. Thus, the effect of the top-side adjustment on any individual lease transaction's interest rate or equipment price was never calculated and compared to market rates or market prices. Nevertheless, the unrealistic discount rates produced by the ROE formula were increasingly apparent in the operational markets in which ROE was used. For example, the discount rates that were applied to leases in the United States fell below Xerox's own incremental borrowing rates.

44. The failure of the ROE method to produce realistic market finance rates was particularly pronounced in Brazil, where Xerox applied its ROE-derived finance rate directly when it recorded the leases in Xerox Brazil's books and records, rather than by a top-side adjustment at Xerox's headquarters. In these cases, market finance rates that framed the actual price and term negotiations with Xerox's lease customers never appeared in Xerox's accounting records. For example, Xerox recorded all its Brazilian leases in early 1997 assuming a finance rate of 8%, then dropped the rate to 7% in the third quarter of 1997, and then reduced the rate again beginning the first quarter of 1998 and continuing through the second quarter of 2000 to no more than 6%. The ROE formula generated rates even as low as 0% in certain periods in 1999. Use of these ROE-derived finance rates produced absurd results by comparison to Xerox's own average local borrowing rate in Brazil, which always exceeded 25% before the final months of 1999. Had Xerox used even its own local borrowing rates as an estimate of prevailing finance rates, the company's equipment revenues reported for Brazil would have been reduced by an estimated total of approximately $757 million during 1997-2000.

2. Margin Normalization

45. Competition for Xerox increased in the 1990s, as foreign manufacturers grew increasingly sophisticated and in some instances beat Xerox to the market with color and digital copying technologies. As a result of growing price competition, margins on Xerox equipment declined, especially outside the United States, while service margins remained stable. Rather than acknowledge that the market was a cause of reduced equipment margins, Xerox reallocated anticipated leasing revenues around the world using an accounting action it referred to as "margin normalization." Xerox used margin normalization so that margins on equipment would more closely approximate those in the United States. This "margin normalization" method, which Xerox used to derive the equipment revenue for sales-type leases, did not comply with GAAP.

46. Margin normalization, like ROE, was a top-side adjustment made by Xerox near the end of reporting periods. Sales and allocation of revenues were initially booked by operating units, which did not use margin normalization. Then, on a consolidated level, management reallocated revenue from service to the box based upon an assumed gross margin differential between service and the box. Xerox even made these reallocations retroactively to transactions that had already been reported in its financial statements. When the methodology was implemented in 1997, management reallocated revenue from service to the box so as to achieve equal gross margins on those two components. By the end of 1999, however, Xerox had changed the methodology so often that its reallocation of revenue resulted in a 17 percentage point gross margin differential between box and service with no economic or business circumstances justifying such changes. Margin normalization, in essence, meant that Xerox recalculated its revenues in Europe, Brazil, Canada, Mexico and Argentina to achieve relative profit margins on the service and box portions of its bundled leases that were identical to those existing in the United States. By doing so, Xerox ignored regional economic or business factors and indirectly derived a profit margin for its equipment sales, in violation of GAAP.

47. Xerox regularly and arbitrarily changed the formula for calculating anticipated revenue reallocated from service to the box to meet -- but not significantly beat -- Wall Street estimates. The total addition to equipment revenues pulled forward during 1997 through 2000 from margin normalization was $617 million. Of that amount, $358 million was pulled forward as pre-tax earnings.

48. Although Xerox's outside auditor ultimately accepted its use, the auditor was so concerned about margin normalization that it internally referred to it as "half-baked revenue recognition" and expressed to Xerox its concern about the frequency with which the methodology was changing.

3. Price Increases and Extensions to Existing Leases

49. Xerox also used accounting that did not conform with GAAP to accelerate the recognition of revenues through price increases and extensions of existing leases. From 1997 through second quarter of 1999, Xerox pulled forward approximately $300 million in equipment revenue, and $200 million in pre-tax earnings, for these items to close the gap between actual and expected financial performance. The net impact on pre-tax earnings for 1997-2000, which reflects the reversal of certain of these adjustments in 1999 and the reversing impact of the adjustments made in earlier periods, was $58 million.

50. In certain regions, principally Brazil, Xerox negotiated or unilaterally imposed price increases and lease extensions on existing lease customers. GAAP, including FAS 13 and FAS 27, requires that additional income realized from renegotiation of existing leases be recognized over the remaining life of the lease. Xerox knowingly or recklessly violated these GAAP provisions by recognizing immediately the revenue from the price increases and lease extensions.

51. Xerox senior management was well aware that its practice violated GAAP. In early 1999, Xerox's outside auditor informed the company that its accounting for price increases and lease extensions violated GAAP. Xerox did not comply with GAAP following this advice, but merely reduced the amount it recognized. Even so, Xerox recognized $84 million of non-GAAP revenue in the first quarter of 1999 and $47 million in the second quarter of 1999. Of this total of $131 million, Xerox reversed $89 million in the second half of 1999, resulting in a net impact for 1999 of $42 million.

B. Improper Increases in Residual Values of Leased Equipment

52. GAAP requires that at the inception of a lease, the lessor must establish and record the "estimated residual value" of the leased equipment, i.e., the estimated fair value of the equipment, if any, at the end of the lease term. FAS 13, as amended by FAS 23, prohibits increasing the estimated residual value for any reason after it is first established.

53. Despite this prohibition, from 1997 to 1999, Xerox recorded adjustments of more than $95 million to make upward revisions retroactively to the net residual values on machines in its Europe, Brazil, United States, Argentina and Mexico operating units. These write-ups, which were credited to cost of sales, were often recorded close to the end of quarterly reporting periods as a gap-closing measure to help Xerox meet or exceed internal and external earnings and revenue expectations. In some instances, the revisions increased the residual value of the machines by as much as 50 percent. In total, the revisions inflated Xerox's reported pre-tax earnings by a net of $43 million during 1997-2000.

54. Notwithstanding the clear requirements of FAS 13, Xerox senior financial management created an internal accounting policy in late 1996 that permitted retroactive write-ups of net residual values. When this policy, ACC 603, was presented to Xerox's outside auditors in 1996, the audit engagement partner initially objected on the grounds that the provision violated GAAP. After arguments with Xerox senior financial management, the auditors approved its implementation in 1997, however, the practice continued to be the subject of criticism from the auditors through 1998.

55. Xerox knew or was reckless in not knowing that its retroactive increases to the residual values of its machines violated GAAP, specifically FAS 13 as amended by FAS 23. This violation of GAAP contributed to Xerox materially misstating its financial results in numerous public filings, including its second and third quarter reports in 1997, its annual report for 1997, its third quarter report in 1998, and its annual report for 1998.

C. Acceleration of Revenues from "PAS" Transactions

56. In 1999, Xerox pulled forward $400 million in revenue and $182 million in profit before taxes by selling to investors the revenue streams from portfolios of its leases that otherwise would not have allowed for immediate revenue recognition. These transactions were known as "PAS" ("Portfolio Asset Strategy") transactions. Although prior to 1999 Xerox had entered into PAS transactions, in 1999 it quintupled the amount of those transactions compared to 1998. The dramatic and material increase in Xerox's 1999 PAS transactions resulted, in large part, from Xerox being unable to sustain a business model in Brazil that relied on sales-type leases. In 1999, Xerox Brazil changed its business model from its traditional sales-type lease model to one based on rental contracts. Because, under GAAP, the revenue from rental contracts cannot be recognized immediately, Xerox entered into PAS transactions to allow such immediate revenue recognition.

57. All of the PAS transactions were crucial to Xerox's ability to close the gap between actual and expected results, and they had a material impact on Xerox's reported results in 1999. Even Xerox's outside auditor recognized that such transactions were used to "bridge the gap" and complained that such quarter-end transactions were creating "undue time pressures." Xerox knew or was reckless in not knowing that the increased use of PAS transactions compared to prior years resulted in a substantial and material increase in its results and earnings trends in 1999 and would have a negative impact on future periods. Despite this knowledge, Xerox knowingly or recklessly failed to disclose this crucial information in its public filings and other public disclosures. Xerox's failure violated its disclosure obligations imposed by the antifraud provisions of the Exchange Act and Item 303 of Regulation S-K.

D. Fraudulent Manipulation of Reserves and Other Income

58. Xerox also pumped up its earnings by nearly $500 million through the release into income of excess or "cushion" reserves originally established for some other purpose. Xerox's use of these reserves violated GAAP and its intentional or reckless use of reserves for this purpose without disclosure was fraudulent.

59. FAS 5, "Accounting for Contingencies," allows a company to establish reserves for identifiable, probable and estimable risks and precludes the use of reserves for general or unknown business risks, including excess reserves, because they do not meet the accrual requirements of FAS 5. Any reserves that do not meet the accrual requirements of FAS 5, when identified, should be immediately released into income. The systematic or timed release of excess reserves into income violates GAAP. From 1997 through 2000, Xerox knowingly or recklessly violated GAAP by repeatedly manipulating the release of approximately $496 million of reserves to close the gap between actual results and earnings targets; this amount includes the effects of improperly timed reserve releases of $78 million which affected only interim periods within a fiscal year. Failing to disclose the reserve releases caused Xerox's financial reports to be materially false and misleading.

60. In addition to the reserves, Xerox fraudulently manipulated a windfall of interest income from tax refunds to improperly increase earnings by $157 million from 1997 through 2000. Rather than recognize the gain associated with the successful resolution of a dispute with the Internal Revenue Service upon the exhaustion of all legal contingencies, as required by GAAP, Xerox senior management recognized the income over several years to meet earnings targets.

1. The Rank Reserve

61. In June 1997, Xerox purchased the Rank Group plc's 20 percent stake in Rank Xerox Ltd., Xerox's European subsidiary, making Xerox the full owner of Rank Xerox Ltd. In connection with this purchase, Xerox fraudulently established a $100 million reserve for "unknown risks" arising out of the transaction. In establishing the reserve, Xerox failed to comply with FAS 5.

62. Xerox knew or was reckless in not knowing that the Rank Reserve was created for "unknown risks associated with" the transaction, as was documented by the company. The Rank Group indemnified Xerox for any liabilities arising from the sale. Xerox's outside auditor advised the company that the potential tax exposure arising out of the transaction was "remote to low." Six months after establishing the Rank Reserve, Xerox told its outside auditor that the company had no contingent liabilities arising from the Rank acquisition. Nevertheless, Xerox fraudulently booked a $100 million reserve in violation of FAS 5.

63. Beginning in mid-1998, Xerox began charging expenses against the Rank reserve for items unrelated to any risks arising from the acquisition. It continued to draw down on this reserve for unrelated expenses each quarter until it was exhausted at the end of 1999. Internally, Xerox regarded the reserve as an "Interdivisional Opportunity" or an "Unencumbered Reserve" that was used by Xerox Europe to boost its reported results as needed. Xerox knew or should have known that its use of the Rank reserve was not in conformity with GAAP and caused its financial reporting to be false and misleading.

2. Excess or Cushion Reserves

64. Xerox fraudulently released into income approximately 20 other excess reserves totaling $396 million to improve earnings from 1997 through 2000. The company knew or was reckless in not knowing that these accounts were used unlawfully. A mid-level manager in Xerox's corporate accounting department tracked excess corporate reserves by preparing schedules called "Interdivisional Opportunities" and "List of Unencumbered & Other Reserves." Senior management reviewed these excess reserves on a quarterly basis and released them when needed to close the gap between operational earnings and Wall Street expectations. Below are examples of the more significant excess reserves which were abused by the company:

65. Vacation Pay Accrual Reserve: In 1993, Xerox changed its vacation policy by limiting the amount of accrued vacation an employee could earn. This policy change resulted in an over-accrual of vacation pay of approximately $120 million. Beginning in 1994 and continuing through 1997, Xerox systematically and improperly released the over-accrual at a rate of $7.5 million per quarter -- $30 million per year.

66. FAS 106 Reserve: Xerox created this reserve in 1992 when it adopted FAS 106, which relates to accounting for post-retirement benefits for employees. The balance of Xerox's FAS 106 reserve was $40 million at the end of 1996, when no additional liabilities remained. During 1997 and 1998, Xerox systematically released the reserve into income at the rate of $5 million per quarter until the reserve was exhausted.

67. Reserves in Other Current Assets: At the end of 1996, excess reserves in this account totaled $24 million, consisting of four components -- a customs duty reserve of $4 million, an inventory reserve of $8 million, a miscellaneous reserve of $6 million and an unidentified provision for Xerox Brazil of $6 million. During 1997, Xerox used the excess in this reserve for various purposes, including classifying it as an Interdivisional Opportunity and releasing various components into income to close the gap in at least two quarters and transferring one component to another reserve to cover a shortfall there.

3. Manipulation of Tax-Related Income

68. From 1997 through 2000, Xerox systematically released into income more than $150 million in tax-related interest that under GAAP Xerox should have recognized in 1995 and 1996.

69. In 1995, Xerox received a final favorable court decision that entitled Xerox to a refund of Advanced Corporation Tax ("ACT") it paid in the United Kingdom in 1974, and interest accrued on that tax. Xerox had paid this tax from 1974 through 1989, and the 1995 ruling meant Xerox also would be reimbursed for those taxes and receive accrued interest. By the end of 1996, Xerox knew it was entitled to approximately $237 million in accrued interest. Under GAAP, Xerox was required to recognize the full $237 million as income in 1995 and 1996. Instead, Xerox recognized only $80 million, and used the balance as another tool to "close the gap."

70. Xerox's financial management referred to this ACT interest as the "ACT Fund," and recognized the income on an as-needed basis over several years. They kept track of the ACT Fund as a "cushion," and included it on a List of Unencumbered and Other Reserves available to help meet performance targets. For example, in 1998 a senior financial officer noted that ACT interest was a source Xerox was drawing from to cover unusual expenses and "to meet plan."

71. Xerox's improper accounting for ACT interest understated Xerox's earnings for 1995 and 1996 by a total of $157 million, and overstated earnings in 1997-2000 by the same amount. In addition, Xerox failed to disclose the impact of the ACT interest on its financial results.

E. Failure to Disclose Factoring Transactions

72. In its 1999 annual financial statements, Xerox fraudulently failed to disclose $288 million of 1999 year-end factoring transactions that allowed the company to report a positive year-end cash balance, instead of a negative number. In accounting for the $288 million, Xerox failed to disclose the material impact of these transactions on its cash position and thus misled investors by appearing to generate cash from its operations. Xerox sold or "factored" receivables at a discount. In other words, Xerox sold its future stream of cash at less than its full long-term value to realize instant cash. This dramatically improved Xerox's year-end cash position.

73. Throughout 1998, analysts looked to Xerox to increase its liquidity and called for a stronger year-end cash balance throughout 1999. However, due to poor performance and varying liquidity pressures, Xerox was unable to generate the cash demanded by analysts as evidence of a healthy balance sheet. In an attempt to create liquidity, Xerox Treasury, in the fourth quarter of 1999, instructed its largest operating units to explore the possibility of consummating factoring transactions with local banks. Xerox operations worldwide consummated $288 million of factoring transactions that materially affected its 1999 operating cash flows by approximately 24 percent and allowed it to report a positive year-end cash balance of $126 million. Xerox failed to disclose these transactions in its 1999 financial statements.

74. Xerox senior management was aware of the implications of these transactions. They were characterized internally as "expensive" and "merely window dressing." Xerox management believed that if the market learned of its cash problems that would signal "major operational/control issues."

75. Xerox also violated GAAP with respect to $54 million of the $288 million in factoring transactions. Although it recorded these proceeds as the result of sales by Xerox France and Xerox Mexico, Xerox agreed that it would reacquire the receivables after December 31, when the books were closed on 1999 and the proceeds could be reported as part of cash flow in Xerox's year-end financial report. This action violated GAAP and FAS 125 by accounting for these transactions as true sales. Xerox was aware of the buy-back provisions but failed to disclose them or to reverse the French transaction in its 2000 Annual Report.


A. Failure to Disclose Policies and Risks of Unusual Leasing Practices

76. During the relevant time period, Xerox failed to disclose certain leasing practices that materially affected an understanding of the operating and financial risks of part of Xerox's business. The company frequently enters into longer-term sales-type equipment leases and service arrangements promising "total satisfaction guaranteed" throughout the lease term. However, Xerox expects the equipment conveyed at the beginning of the lease to become economically unusable to the customer many months before the end of the lease term. Under these arrangements, the company is contractually required to incur the expenses of any extraordinary refurbishment or machine replacement. Disclosure has never been provided about the material risks and associated costs of this unusual business practice, nor the accounting treatment afforded to these arrangements.

B. Improper Record-Keeping at Xerox Mexico

77. From 1997 through the first quarter of 2000, senior management of Xerox's Mexico subsidiary ("XMEX") fraudulently overstated revenue by $170 million. XMEX management did this to meet demanding profit and revenue targets set for the subsidiary by Xerox corporate management.

78. XMEX's improper accounting actions included concealing $129 million in uncollectible receivables, failing to record $27 million in notes due to third-party resellers of Xerox equipment, and improperly recognizing $14 million in revenue from equipment leased to government customers.

79. Pressured to meet financial targets, in the mid-1990s XMEX relaxed its credit standards and leased equipment to high-risk customers at low initial monthly rates that doubled or tripled after a short introductory period. This practice boosted XMEX's short-term results but quickly created a large pool of delinquent receivables.

80. Rather than write down the receivables or establish sufficient reserves, as required by GAAP, XMEX tried to conceal them by constantly renegotiating its contracts with delinquent customers to report an artificially low number of delinquent receivables and avoid an expensive write-off. Among other fraudulent tactics, invoice dates were changed so that an overdue receivable appeared current.

81. XMEX also fraudulently failed to record $27 million in credits due to third-party resellers of Xerox equipment, known as concessionaires, in order to inflate XMEX's revenues and meet Xerox corporate's expectations. From 1996 through early 2000, XMEX managers secretly rented warehouses to store trade-ins. This practice prevented XMEX's accounting system from automatically generating credits for concessionaires, which would have occurred if the equipment had been brought to XMEX's warehouses.

82. XMEX inflated its revenues by $14 million from 1996 to 1999 by improperly recording revenues from certain government operating lease contracts as FAS 13 sales-type leases that XMEX knew did not satisfy FAS 13 requirements. For these contracts to satisfy FAS 13 criteria as sales-type leases, the contracts had to have a three-year lease term and minimum monthly payments. They had neither. Therefore, the equipment income should have been recorded as received on a monthly basis and not recognized immediately.

83. The actions taken by XMEX personnel represented a substantial and widespread breakdown of Xerox's internal controls at XMEX. The impact of these accounting actions, which were taken by XMEX to mask disappointing operational results and satisfy the aggressive targets of Xerox corporate, totaled approximately $170 million.


Violations of Section 17(a) of the Securities Act and Section 10(b) and
Rule 10b-5 of the Exchange Act

84. Paragraphs 1 through 83 are hereby realleged and incorporated herein by reference as if set forth fully.

85. Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder prohibit (a) employing devices, schemes, and artifices to defraud; (b) making untrue statements of material fact or omitting to state material facts necessary to make the statements made not misleading; and (c) engaging in acts, practices, and a course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security. Section 17(a) of the Securities Act contains similar prohibitions with respect to the offer or sale of any security.

86. Item 303 of Regulation S-K requires an issuer of securities to include in its Management's Discussion and Analysis ("MD&A") section of its periodic filings information that is necessary to an understanding of its financial condition, changes in financial condition and results of operations, among other things. Item 303 further provides that an issuer's management should discuss any known trends or uncertainties that have, or that reasonably expect to have, a material unfavorable impact on net sales, revenues, or income from continuing operations. Item 303 also requires that MD&A should focus specifically on material events or uncertainties known to an issuer's management that would cause a company's reported financial information not to be necessarily indicative of future operating results or future financial condition.

87. In violation of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, Xerox knowingly or recklessly failed to disclose the material impact that each of the accounting actions described herein, other than those at paragraphs 76 - 83, had on its reported financial performance. The financial information released without these disclosures constituted materially misleading statements and omissions because Xerox knowingly or recklessly misrepresented its equipment revenues and earnings as substantially greater than they were and failed to disclose that the reported results were achieved only because the company adopted new accounting methods, many of which violated GAAP, or engaged in other improper accounting practices, rather than because of improved business performance. The repeated use of these accounting changes without disclosure for the purpose of meeting published earnings expectations, achieving bonus targets and other purposes constituted a scheme to defraud.

88. The aggregate impact of the undisclosed accounting actions resulted, among other things, in Xerox:

a. Increasing its pre-tax earnings from 1997-2000 by approximately $1.5 billion.

b. Failing to disclose that at least between 4 percent and 37 percent of its quarterly reported pre-tax earnings came from one-off accounting actions, and that at least between 19 percent and 29 percent of its annual reported pre-tax earnings came from one-off accounting actions.

c. Increasing its equipment sale revenue by over $3 billion dollars and significantly increasing its quarterly equipment sale gross margins.

d. Portraying the false and misleading appearance of meeting or exceeding earnings expectations of Wall Street analysts in each quarter from 1997 to 1999.

e. Filing periodic reports with the Commission that included financial statements and disclosures that contained materially false and misleading statements and omissions, including 12 quarterly and four annual reports covering the period 1997-2000, and seven registration statements filed or in effect during 1997-2000.

f. Painting the false appearance in its 1999 financial statements that it had a positive year-end cash balance from operations when, in fact, it would have had a negative cash balance except for $288 million in unusual undisclosed year-end factoring transactions, $54 million of which were improperly accounted for as sales instead of short-term loans.

89. In addition to failing to disclose the impact of its actions in its financial statements and periodic reports, Xerox, directly or indirectly, made materially false and misleading statements or omissions about the company's financial performance in other public disclosures, including earnings releases and statements by senior management to shareholders.


Violation of Section 13(a) of the Exchange Act and
Exchange Act Rules 13a-1, 13a-13, and 12b-20

90. Paragraphs 1 through 89 are hereby realleged and incorporated herein by reference as if set forth fully.

91. Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of registered securities to file with the Commission factually accurate annual and quarterly reports. Exchange Act Rule 12b-20 provides that in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.

92. As a result of the accounting actions set forth above, including the failure to disclose certain leasing practices relating to its sales-type leases, Xerox violated Section 13(a) of the Exchange Act and Exchange Act Rules 13a-1, 13a-13, and 12b-20.


Violation of Section 13(b) of the Exchange Act
and Exchange Act Rule 13b2-1

93. Paragraphs 1 through 92 are hereby realleged and incorporated herein by reference as if set forth fully.

94. Section 13(b)(2)(A) of the Exchange Act requires that issuers make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the issuer. Section 13(b)(2)(B) of the Exchange Act requires, among other things, that issuers maintain a system of internal accounting controls that permit the preparation of financial statements in conformity with GAAP. Exchange Act Rule 13b2-1 prohibits any person from directly or indirectly, falsifying or causing to be falsified, an issuer's books and records.

95. As a result of the accounting actions set forth above, as well as the misstatements attributable to Xerox Mexico, Xerox violated Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Exchange Act Rule 13b2-1.


WHEREFORE, the Commission respectfully requests that this Court:


Enter Orders:

A. Permanently restraining and enjoining Xerox from violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder;

B. Permanently restraining and enjoining Xerox from violating Sections 13(a) and 13(b) of the Exchange Act and Rules 12b-20, 13a-1, 13a-13 and 13b2-1 thereunder.


Enter an Order requiring Xerox to restate its financial results for the periods 1997 through 2000.


Enter an order requiring Xerox's Board of Directors to appoint a special committee comprised entirely of outside directors which, within 30 days after the entry of such order, shall retain a qualified consultant, not unacceptable to the Commission, to perform a complete review of Xerox's material internal accounting controls and policies. Within 180 days after appointment, the consultant shall complete its review and submit to the committee a report fully documenting the findings of its review and proposing recommendations. Within 60 days after receipt of the consultant's report, the committee shall submit the report to Xerox's Board of Directors, as well as to the Commission, and within 60 days thereafter, the Board of Directors shall report to the Commission the decisions taken as a result of the consultant's proposed recommendations.


Enter an Order imposing civil penalties on Xerox pursuant to Section 21(d) of the Exchange Act [15 U.S.C. § 78u(d)] and Section 20(d) of the Securities Act [15 U.S.C. § 77t(d)].


Retain jurisdiction of this action in accordance with the principles of equity and the Federal Rules of Civil Procedure in order to implement and carry out the terms of all orders and decrees that may be entered, or to entertain any suitable application or motion for additional relief within the jurisdiction of the Court.


Grant such other and additional relief as this Court may deem just and proper.

Respectfully submitted,


David M. Stuart (DS-6136)
Paul R. Berger
Charles D. Niemeier
James A. Kidney (JK-5830) (Trial Counsel)
Timothy N. England
C. Hunter Wiggins
Charles F. Wright
Fiona A. Philip

Counsel for the Plaintiff
Securities and Exchange Commission
Stop 9-11
450 Fifth St., N.W.
Washington, D.C. 20549-0911
(202) 942-4797 (Kidney)
(202) 942-9581 (Fax)

Dated: April 11, 2002



Modified: 04/11/2002