University of Maastricht School of Business and Economics Maastricht, March 26, 2010 Course: Assurance Services Course Code:

EBC 4037

Xerox Corporation
Case 4.5 Evaluating Risk of Financial Statement Fraud
Juwi Liu Rene den Ronde Anne Vos Jonathan Zichem

Table of Contents
Table of Contents...................................................................................................2 Question 2..............................................................................................................3 Question 4..............................................................................................................3 Question 5..............................................................................................................4 Question 6..............................................................................................................5 Question 7 ...............................................................................................................................6

Question 2 An auditor cannot provide absolute assurance, and even a properly planned and performed audit may not detect a material misstatement that was caused by fraudulent actions. The auditors responsibility will reach as far as reasonable assurance, the auditor will need to carefully plan and perform an audit to this set target. Reasonable assurance refers to whether the financial statements are free from material misstatement due to error or fraud.
A. There are two categories of fraud in financial reporting, fraudulent financial reporting

and misappropriation of assets. Fraudulent financial reporting refers to manipulation, falsification or alteration of financial statements. It can also be misrepresentation or intentional omission, intentional misapplication of accounting principles relating to amounts, classification, presentation or disclosure. Misappropriation of assets refers to embezzling receipts, stealing physical assets or intellectual property, causing a company to pay for goods and services not received and using a companys assets for personal use.
B. The likelihood of a material misstatement due to fraud is greatly influenced by the

following conditions; an incentive or pressure to commit fraud, a perceived opportunity to do so and an attitude to engage in fraudulent behavior. Examples of factors that increase the likelihood of fraudulent actions are; the financial stability or profitability is threatened by economic, industry or entitys operating conditions. Excessive pressure for management to meet the requirements or expectations of third parties. Senior staff / board of directors having a significant financial interest in the company or their compensation are dependent upon performance. Furthermore, the nature of the industry or the firms operations provides opportunities to engage in fraudulent financial reporting. Finally, Ineffective monitoring of management, complex or unstable organization structures, deficient internal controls and so.
C. Wall Street has outlined some expectations that increase tension on management to

perform as required. They were demanding high turnovers and income generation (growth). If a firm did not meet the expectations of these Wall Street requirements, they experienced a downfall in their share price. So, pressure on Xeroxs management to command to the will of Wall Street was high and definitely increased the companys likelihood of committing fraud. Next to this previous mentioned factor, the Xeroxs management remuneration was directly linked to company performance and therefore increased the likelihood to commit fraud. Finally, the company did not want a higher cost of debt of equity capital and therefore needed to maintain their credit rating at the 1997 level and definitely not higher. These previous mentioned factors all contributed to an increased likelihood of Xerox committing fraud. Question 4 The following questionable accounting manipulations by Xerox involve estimates, because: a. The measurement of some amounts or the valuation of some accounts is uncertain, pending the outcome of future events. And, or

b.

Relevant data concerning events that have already occurred cannot be accumulated on a timely, cost-effective basis:

Acceleration of lease revenue recognition from bundled leases. The allocation of the lease payment to equipment and foreign countries and whether or not the lease agreements meets the requirements for a sales-type.

Increasing the expected residual value of previously recorded leased equipment. the electing of the periods to recognize the interest income after the tax dispute. SAS No. 57, describes the auditors responsibility as follow: The auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when management , estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. Accordingly, when planning and performing procedures to evaluate accounting estimates, the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors. The auditor should:

evaluate the accounting estimates by obtaining sufficient competent evidence to provide reasonable assurance about the materiality in relation to financial statements; evaluate whether management has identified all accounting estimates that could be material to the financial statements by considering the circumstances in which the entity operates; evaluate the reasonableness of an estimate by concentrating on key factors that are significant to the accounting estimate, sensitive to variations, deviations from historical patterns and subjective and susceptible to misstatement and bias.i

Question 5 Accounting firms could ensure that auditors do not subordinate their judgment to client preferences on other audit engagements by reducing the risk that an audit is not independent. The risks to be reduced are self-interest risk , self review risks relating to the difficulty of maintaining objectivity in conducting self-review procedures, management or advocacy risk which means the auditor may become closely aligned with the views and interest of management, familiarity risk where the auditor becomes too sympathetic to the clients interest. These risks can be reduced by for example by changing the auditor after a certain period, introducing required quality reviews internally or externally, making sure there are no conflicts of interest.

Question 6 Questionable accounting manipulations identified by de SEC during their investigation including the financial statement accountants that were manipulated and the procedures the auditor could have performed to assess the appropriateness: Identified accounting manipulations 1. Acceleration of Revenue Recognition from bundled leases 2. Acceleration of Revenue from lease price increases and extensions 3. Increases in the residual values of leased equipment. 4. Acceleration of revenues from portfolio asset strategy transactions. Financial statement accounts Revenue Audit procedure that could have been performed to increase accuracy. Test of controls should have been performed during the interim control to determine whether or not this stream of other income had controls to prevent errors. As mentioned in the previous point, certain test of controls should have notified the auditor that contract extensions were taking place. For an experienced auditor this should have been the trigger to perform a risk analysis as to what could go wrong with regards to revenue and contract extensions. Residual value increases could have been monitored for example by performing an analysis of the memoriaal bookings. This could have led to show certain adjustments were not being made through the inkoopboek and that these would require more analysis. The acceleration of income due to the sale of rental contracts to investors should have been discovered in the first year the transactions occurred my means of analytics. Auditors would have noticed that the amount of rental contracts would have decreased while revenue increased. This should have led auditors to the conclusion that income was being generated in a different way. More professional skeptism by the auditors from management and up. Although reserves are hard to audit, it is possible that when Xerox asked for a new engagement partner and got that, they realized they could manipulate their reserves just like they did when they wanted a new partner. Auditor independence and integrity played a vital role here. The manipulation of the these other incomes could have been prevented if a proper afloop controle had occurred. This would have showed that the income in question had been matched with accruals taken from previous years. This point should have come up either during the discussion on how the sales procedures are performed during interim audit. Or afloop controle and then it depends on whether factoring

Revenue

Cost of sales

Revenue

5. Manipulations of reserves.

Accruals

6. Manipulation of other incomes.

Other income

7.Failure to disclose factoring transactions.

Receivabl es

transactions are paid for by third parties.

Question 7 The auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when management's estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. The auditor should maintain an attitude of professional scepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditors past experience with the entity about the honesty and integrity of management and those charged with governance. In evaluating the reasonableness of an estimate, the auditor normally concentrates on key factors and assumptions that are significant to the accounting estimate, sensitive to variations, deviations from historical patterns and subjective and susceptible to misstatement and bias.

The auditor normally should consider the historical experience of the entity in making past estimates as well as the auditor's experience in the industry. In evaluating reasonableness, the auditor should obtain an understanding of how management developed the estimate. Review and test management's process. In many situations, the auditor assesses the reasonableness of an accounting estimate by performing procedures to test the process used by management to make the estimate. Develop an expectation. Based on the auditor's understanding of the facts and circumstances, he may independently develop an expectation as to the estimate by using other key factors or alternative assumptions about those factors. Review subsequent events or transactions. Events or transactions sometimes occur subsequent to the date of the balance sheet, but prior to the date of the auditor's report, that are important in identifying and evaluating the reasonableness of accounting estimates or key factors or assumptions used in the preparation of the estimate. In such circumstances, an evaluation of the estimate or of a key factor or assumption may be minimized or unnecessary as the event or transaction can be used by the auditor in evaluating their reasonableness.

Bibliography

(1) Statement on Auditing Standards No. 57 , issued by the Auditing Standards Board. (2) Auditing an international approach by B. Soltani; Chapter 7 Auditor independence and professional ethics Auditing an international approach by B. Soltani; Chapter 18 Corporate fraud, corporate scandals and external auditing. PCAOB AU Section 342 Auditing accounting estimates.