How Present Value Can Make Future Trouble
This brings us to an uncomfortable truth about accounting deceptions: They require a receptive audience—lenders or equity investors or analysts or investors who, for their own reasons, want to believe misleading numbers. Many such audiences are won over by a feel-good story or an appeal to fashionable ideas. The rhetoric of globalization, for example, provided a handy hook for a scheme by executives of Xerox to inflate the revenue from office-equipment leases.
When Xerox leases business machines such as copiers and printers to customers for extended periods, it treats the lease as a sale. It books the value of the lease all at once as revenue, even though payments on the machine may extend several years into the future. In effect, the lease is treated as an outright sale financed by the seller, and the periodic lease payments are treated as installment payments on the purchase price.
Under certain conditions, U.S. accounting conventions permit this accounting treatment. The revenue booked is equal to the present value of future lease payments. Here’s how present value works: Say you want to make an investment that will grow to $25,000 in five years. Assuming a constant interest rate of 8 percent, how much principal must you begin with to reach $25,000 in five years? The answer: $17,000 (rounded). That’s the present (or discounted) value of $25,000, assuming it’s invested at 8 percent (the so-called discount rate) for five years. Change any of the terms in that equation, and the answer can change dramatically. For example, assume a discount rate of 4 percent, and the present value of $25,000 leaps to $20,500. A change in management’s estimated discount rate increases the reported revenue on the contract in this example by $3,500, or 20 percent.
The expansive effect of low interest rates on present value did not go unnoticed by Xerox’s sales personnel, whose commissions are calculated as a percentage of revenue, or by Xerox’s managers, whose compensation depended on hitting revenue and earnings targets. In 1996, the company used a discount rate of 20 percent when booking equipment-leasing revenue generated by its Mexican subsidiary. That rate was in keeping with the high interest rates prevailing in Mexico at the time and accurately reflected Xerox’s own borrowing costs. The following year, Xerox calculated lease revenue based on a discount rate of 18 percent, a move arguably justified by a downward trend in Mexican interest rates. But in 1998, while Mexican rates ranged from 24 percent to 30 percent, Xerox slashed its discount rate to 10 percent, and the year after that to 6 percent, although rates in the real Mexican economy stayed much higher. Xerox attributed the growing leasing revenue from Mexico to the success of trade liberalization in the region, not to its favorable present-value calculations.
Why would Xerox use a discount rate so out of line with prevailing interest rates? Remember how low interest rates boost present value, and remember that Xerox posted the present value of equipment leases as revenue. The lower the rate, the higher the present value—and the higher the revenue Xerox booked. Xerox’s questionable accounting practices were not revealed until 2001, when the Wall Street Journal published a series of articles by reporter James Bandler. Bandler depicted a managerial culture that demanded revenue growth at all costs, and he quoted an unnamed employee of Xerox’s Brazil subsidiary, who claimed managers there were playing the same revenue-enhancing games—indeed, the employee claimed the subsidiary would not have reached its revenue targets without the games. The articles also portrayed Xerox’s outside auditor, KPMG, as deeply implicated in the revenue-inflation scheme, with audit partners showing the company how to maximize the revenue it could report from each lease. In 2001, following a lengthy investigation by the Securities and Exchange Commission, Xerox agreed to restate its revenue and income for 1997 through 2000 and pay a $10 million fine. Restated revenue dropped by $6.1 billion, and reported profits, which included a combination of revenue recognition and other reserve adjustments, declined by $1.6 billion. Xerox fired its audit firm, KPMG, replacing it with PriceWaterhouseCoopers.