Rising completion in the corporate world in the 21st century has compelled corporations to come up with different ways to keep up with the pressure. With lax regulation and gaping loopholes in the existing financial regulation laws, some companies have resorted to fraud in order to maintain their market positions and prospects. One of the most common frauds in recent corporate history is financial statement fraud. This practice is responsible for the fall of many companies and massive layoffs with negative impacts on their respective economies. Financial fraud is defined as the intentional falsification of information on a company’s financial statement, popularly referred to as “cooking the books”. Wells (2011, p. 78) defines it as the deliberate misrepresentation and/or omission of financial details of a company in the financial statement purposely to deceive financial statement users like authorities and investors and creditors. According to the SEC, financial management is also referred to as ‘earnings management’ which involves the use of various forms of trickery effectively distorting a company’s financial figures to achieve a desired company image.
This form of fraud is almost exclusively perpetrated by top management of a company by virtue of their access sensitive corporate information and data and they have overwhelming influence on employees and auditing firms, thus it is also referred to as fraud management. Financial fraud can take many forms such as fictitious revenue projections, concealment of liabilities and expenses, improper or inadequate disclosure and inaccurate asset valuation. This discussion will focus on premature revenue recognition with special reference to the Xerox scandal. It is important reiterate that the Xerox case is best placed to illustrate financial statement fraud especially considering it took place before other big cases such as Worldcom and Enron.
Overview of Xerox Scandal
Xerox for a long time was a global market leader in document management and had an exceptional record in the manufacture and sale of color and black and white printers, photo-copiers and digital production and printing systems. During the time, Xerox’s Palo Alto Research Center produced cutting edge technologies including Ethernet, graphical user interface and their printer that had the potential to make the company a long term player in its niche market. However, complacency from Xerox management enabled younger focused companies especially Japanese to take advantage of PARC technologies to produce cheaper more efficient products that those of Xerox. The result was a fall in Xerox market share from 95% to slightly less than 15% on the face of cutthroat completion from canon and Ricoh (Riley & Rezaee, 2009, p. 60).
Under the leadership of Chief Executive Officer and Chairman Paul Allaire, the company adopted new approaches to improve employee culture which emphasized leadership and quality. Allaire’s approach was based on the projection that the 90’s decade will be a rough operating time for Xerox and effective management policies had to be put in place to ensure profitable revenue growth as well as exceptional productivity. He therefore pushed for aggressive productivity and revenue goals that will be innovated and implemented by management. Allaire and his CFO led Xerox throughout the 90’s on the face of growing competition from foreign markets and onslaught from desktop printers.
Despite the competition, Xerox seemingly continued to do well financially by posting impressive revenue figures through late 90’s effectively meeting Wall Street and investor’s expectations through rising stock prices. Xerox’s financial health was far from what was being projected. To maintain the rosy image, Xerox’s top management coerced the accounting department to come up with ‘creative’ creative accounting practices in order to maintain their generous perks and the ‘successful’ image to Wall Street and stockholders.
In May 2000, Xerox publicly admitted to accounting malpractices in its Mexican unit. The announcement prompted n investigation from the SEC that which found the said irregularities in the Xerox Mexican unit. Internal concern from employees such as James F Bingham, a 15 year Xerox veteran, and assistant treasurer at Xerox led to a full blown exposure of the financial malpractices in Xerox prompting an investigation of the entire company by SEC. Bingham was one of the accountants called upon by management of the company to manipulate figures according to the wishes of management. He acknowledged that him and fellow accountants were assigned targeted profit figures that they were supposed to meet through accounting manipulation. Realization by Bingham that the company was headed to bankruptcy made him approach the CFO and the new CEO but he was frustrated in his efforts to expose the rot and help the company get back on track. After a dossier developed by Bingham was exposed, the SEC launched a full scale invest investigation on Xerox in a bid to assure investors of the status of the company.
In 2002, the Securities and Exchange Commission filed complaint against Xerox, the global leaders in the supply of toner-based photocopier machines and associated merchandise. In the complaint, alleged that Xerox employed illegal accounting maneuvers including recognizing sales from leases and including projected revenue from the lease period as revenue from the current period. In effect, Xerox violated the generally accepted accounting principles (GAAP) that only allow companies to recognize entire proceeds of a sale only when certain conditions are met. According to the SEC, Xerox’s approach in recognizing revenue from leases violated GAAP principles and intentionally fooled Wall Street of the company’s financial health from 1997-2000. The maneuvers helped boost Xerox’s revenue figures by $405 million $655 million and $511 million in pretax profits in 1997, 1998 and 1999 respectively thereby exceeding the Wall Street’s First Call Consensus EPS. SEC also implicated Xerox’s management in the scandal and the min perpetrators along with KPMG for colluding to falsify figures in order to close the gap on predetermined revenue and profit goals.
Financial fraud cases such as the one above have become common in the corporate world. The collapse of Enron even led to the enactment of Sarbanes-Oxley act to guard against such cases. Despite the existence of the law however, there are still cases involving a wide variety of financial fraud. Therefore, there is need for a review of the rules governing financial transactions and a reporting to limit such occurrences to the minimum. However, before any recommendations are made, it is important to examine what motivates otherwise honest corporate executives to engage in financial fraud.
More often than not, situational pressure prompts corporate executives to engage in fraudulent financial reporting. Companies go through turbulent times mainly dictated by economic cycles. Situational pressure applies when management is compelled to meet certain targets for purposes of prestige and class. A poor cash position normally pushes companies to overstate assets on the income statement to meet analysts and stockholders expectations.
According to Wells (2011, p. 110), financial statement fraud also occurs when there is an opportunity mainly created by loopholes in the system. Opportunity for financial fraud occurs when there is a complex organization structure, weak internal controls and subjection of financial reports to high scrutiny. Any of the above can easily lead to financial fraud.
Finance professionals also engage in financial statement fraud because they can easily rationalize the malpractice. (Riley & Rezaee, 2009, p. 48) says that some attitudes and ethical values make it easy for some corporate personnel to deliberately commit financial statement fraud with knowledge that they can easily rationalize such action. Common grounds on which corporate individuals rationalize financial statement fraud include, commitment of the same by competitors, argument that the company is protecting shareholder value and convincing accounting professionals that such actions are not criminal.
Both political and finance industry leaders have a responsibility to ensure there are sufficient measures in place to prevent financial statement fraud.
It is important to ensure that factors that lead to situational pressures are minimized. Situational pressures can be avoided through realistic goal setting, elimination of external pressures to ensure accountants are under no obligation to falsify accounting statements. Situational pressures can also be removed through removal of operational obstacles such as capital restraints that block effective financial performance. The pressure can also be eased through formulation and establishment of clear accounting procedures with little or no exemption provisions.
Another way that authorities can reduce financial statement fraud is through reduction of opportunity to commit the malpractice. Reducing of the opportunity to commit is possible through establishment of clear accounting standards in the industry and as well as within company structures. It can also be reduced through careful monitoring of the relationship between different stakeholders including suppliers, buyers and sales personnel. Also it is important to devolve power within organizations by having a chain of command that will ensure accountability and openness. Besides, it is important for companies to establish culture of strong supervisory and leadership relationships.
Financial statement fraud can also be reduced through limiting rationalization platforms. There is need to promote leadership by example by discouraging dishonesty and other situations that will encourage illegal business activities. Companies should be compelled to include a definition and dishonesty and honesty behaviors in their code of conduct manuals. It should be made a standard procedure for all companies to address controversial areas where financial statement fraud is likely to occur. There is also need for concerned authorities and corporations to clearly communicate to employees and people in management the consequences of malpractices such as financial statement fraud.
As mentioned earlier, financial statement fraud is a common occurrence in the corporate world. Certainly, not even laws such as the Sarbanes-Oxley act have been able to stop the trend. The need to project and maintain certain company images and standards will always push corporate professionals to engage in unethical practices. Besides tainting the image of the concerned companies, malpractices such as financial statement fraud are most likely to result to bankruptcy potentially threatening stakeholders’ interests. Though it is not easy to entirely eliminate the above problem, implementation of the above recommendations will most likely seal existing loopholes in the financial regulation system to ensure such malpractices are minimized.
Riley, R. & Rezaee, Z. (2009). Financial Statement Fraud: Prevention and Detection. New York: Cengage Learning.
Wells, J. (2011). Financial Statement Fraud Casebook: Baking the Ledgers and Cooking the Books. London: Sage Publications.