Securities and Exchange Commission
Litigation Release No. 17465 / April 11, 2002
Accounting and Auditing Enforcement Release No. 1542 / April 11, 2002
Securities and Exchange Commission v. Xerox Corporation, Civil Action No. 02-CV-2780 (DLC) (S.D.N.Y.) (April 11, 2002)
Xerox Settles SEC Enforcement Action Charging Company with Fraud, Agrees to Pay $10 Million Fine, Restate Its Financial Results and Conduct Special Review of Its Accounting Controls
On April 11, 2002, the Securities and Exchange Commission filed a civil fraud injunctive action in the United States District Court for the Southern District of New York, alleging that from at least 1997 through 2000, Xerox Corporation, a Stamford, Connecticut-based public company, employed a variety of undisclosed accounting actions to meet or exceed Wall Street expectations and disguise its true operating performance from investors. These actions, most of which violated generally accepted accounting principles (GAAP), accelerated Xerox's recognition of equipment revenue by over $3 billion and increased its pre-tax earnings by approximately $1.5 billion over the four-year period from 1997 through 2000.
The complaint alleges that these accounting actions, which often were approved, implemented and tracked by senior Xerox management, had a substantial impact on Xerox's reported performance. For example, in the fourth quarters of both 1998 and 1999, accounting actions generated 37% of Xerox's reported pre-tax profit. The Commission's complaint further alleges that by 1998, nearly $3 of every $10 of Xerox's annual reported pre-tax earnings resulted from undisclosed accounting actions. Without these accounting actions, the complaint alleges, Xerox would have fallen short of market earnings expectations in virtually every reporting period from 1997 through 1999.
The allegations in the complaint center around seven different accounting actions that Xerox used to help meet or exceed market expectations from 1997 to 2000. Many of these actions accelerated Xerox's recognition of revenue into current periods at the expense of future periods. According to the complaint, Xerox fraudulently disguised these actions so that investors remained unaware that the company was meeting earnings expectations only by using accounting maneuvers that could compromise future results.
The complaint alleges that several of the accounting actions related to Xerox's leasing arrangements. Under these arrangements, the revenue stream from Xerox's customer leases typically had three components: the value of the "box," a term Xerox used to refer to the equipment; revenue that Xerox received for servicing the equipment over the life of the lease; and financing revenue that Xerox received on loans to its lessees. Under GAAP, Xerox was required to book revenue from the "box" at the beginning of the lease, but was required to book revenue from servicing and financing over the course of the entire lease. According to the complaint, Xerox relied on accounting actions to justify shifting more lease revenue to the "box," so that a greater portion of that revenue could be recognized immediately.
The complaint alleges that the two accounting actions with the largest impact on Xerox's financial statements were methodologies that Xerox called "return on equity" and "margin normalization." Xerox used the return on equity method to shift revenue to equipment that the company historically had allocated to financing. Margin normalization shifted revenue to equipment that historically had been allocated to servicing. These two methodologies, which did not comply with GAAP, increased Xerox's equipment revenues by $2.8 billion and its pre-tax earnings by $660 million from 1997 to 2000. The complaint alleges that Xerox fraudulently failed to disclose to investors its use of and changes to these methodologies which were changes in accounting methods and changes in accounting estimates.
The complaint also alleges that Xerox used approximately $1 billion of additional accounting actions to artificially improve its operating results. By using these accounting actions and failing to disclose their use, Xerox violated GAAP as well as disclosure requirements. These additional actions included the improper use of "cushion" or "cookie jar" reserves, the improper recognition of the gain from a one-time event, and miscellaneous lease accounting related actions.
In addition, the complaint alleges that Xerox misled investors by failing to disclose the impact that approximately $400 million in sales of leases had on its 1999 operating results. The effect of these undisclosed sales was to immediately recognize income that otherwise would have been recognized in future periods. Although the company earlier had entered into similar transactions in small amounts, none compared in size or scope to the 1999 sales, which added $182 million in pre-tax profits to Xerox's 1999 results.
As alleged in the complaint, Xerox's fraudulent failure to disclose these accounting actions, most of which violated GAAP, resulted in Xerox filing periodic reports with the Commission 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 that were filed or in effect during this period which included four offerings that registered nearly $9 billion dollars worth of debt securities.
Without admitting or denying the allegations of the complaint, Xerox consented to the entry of a Final Judgment that permanently enjoins the company from violating the antifraud, reporting and recordkeeping provisions of the federal securities laws, specifically Section 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 ("Exchange Act") and Rules 10b-5, 13a-1, 13a-13, 12b-20 and 13b2-1 promulgated thereunder. In addition, Xerox agreed to pay a $10 million civil penalty and to restate its financial results for the years 1997 through 2000. Xerox also agreed to have its board of directors appoint a committee composed entirely of outside directors to review the company's material internal accounting controls and policies. Finally, as part of the settlement of this action, the Commission entered an Order exempting Xerox from certain filing requirements of the Exchange Act to extend, until June 30, 2002, the date by which Xerox and its finance subsidiary, Xerox Credit Corporation, may file annual reports on Forms 10-K for the fiscal year ended December 31, 2001, and quarterly reports on Forms 10-Q for the quarter ended March 31, 2002. (See Securities Exchange Act Release No. 45730 (April 11, 2002).)
The SEC is continuing its investigation of this matter as it relates to other parties.