Yesterday, the SEC settled the last of the cases it brought against Xerox, KPMG, and certain KPMG partners, according to an article by Kathleen Day in the Washington Post. The settlement brought a combination of record fines, suspensions from auditing, and censure to several past and current KPMG auditors. In addition to this latest settlement, KPMG agreed to pay $22.5 million last April to settle civil charges that it helped Xerox break securities law. This fine was on top of the $10 million that Xerox paid in 2002 to settle its suit with the agency.
The core issue of these last cases is that the KPMG auditors allowed Xerox to use top-side accounting entries to adjust the timing of revenues between current equipment sales and deferred service revenues. These top-side adjustments resulted in Xerox overstating revenue by $3 billion and earnings by $1.2 billion from 1997 through 2000. In my opinion, the methods that Xerox was allowed to use in its top-side adjustments did not follow FASB 13, but they were not even consistent with leasing industry practices. These methods also were subject to manipulation, and based equipment revenues on non-equipment factors.
Normally, in a sales-type lease, the revenue on the sale is recognized immediately and the interest income portion of the lease is earned over the term of the lease, as in a loan. The amount of the sales revenue in the lease is a function of the present value of the minimum lease payments, as described in paragraph 17(c) of FASB 13. FASB 13 requires manufacturer/lessors to use the implicit rate in the lease to compute the present value of the lease payments. The only components used to calculate this rate are (1) the minimum lease payments, (2) the unguaranteed residual value, and (3) the fair value of the equipment. Fair market value represents the value of the equipment to the user, such as in a cash sale. In the absence of clear-cut information, however, lease accountants need to make reference to normal selling prices, including the effect of volume or other trade discounts, and other sources of information such as recent sales, trade publications, auctions, spot markets, etc.
There are several moving parts in the implicit rate calculation, especially if the lessor is providing multiple deliverables. As a result, it is possible to manipulate the amount of the sales revenue through the present value calculation by using either an interest rate other than the implicit rate or by altering the assumptions used in the implicit rate calculation. Xerox was allowed to use a mix of the two.
This topic has come up at various Lease Accounting Conferences sponsored by the ELA. In response to the SEC action, many lessors have taken an extremely rigid view of how to account for sales-type leases, especially in multi-deliverable situations. These views sometimes are to the exclusion of faithful representation of the economics. Yes, the process may be difficult, especially in a flow business, but if you look to the basic transaction, the economic outcomes and motivations are pretty clear. The upshot of all this is that, while auditors may have latitude in applying FASB 13, they still must adhere to its core principles, as applied in the context of the leasing industry.
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