UNITED STATES DISTRICT COURT
FOR THE SOUTHERN DISTRICT OF NEW YORK

The Securities and Exchange Commission ("the Commission") alleges for its First Amended Complaint as follows:

1. Defendants KPMG LLP ("KPMG") and certain KPMG partners permitted Xerox Corporation ("Xerox") to manipulate its accounting practices and fill a $3 billion "gap" between actual operating results and results reported to the investing public from 1997 through 2000. The fraudulent scheme allowed Xerox to claim it met performance expectations of Wall Street analysts, to mislead investors and, consequently, to boost the company's stock price. The KPMG defendants were not the watch dogs on behalf of shareholders and the public that the securities laws and the rules of the auditing profession required them to be. Instead of putting a stop to Xerox's fraudulent conduct, the KPMG defendants themselves engaged in fraud by falsely representing to the public that they had applied professional auditing standards to their review of Xerox's accounting, that Xerox's financial reporting was consistent with Generally Accepted Accounting Principles ("GAAP") and that Xerox's reported results fairly represented the financial condition of the company. There was no watchdog at Xerox. KPMG's bark sounded no warning to investors; its bite was toothless.

2. KPMG's foreign affiliates in Europe, Brazil, Canada and Japan, and even KPMG auditors at Xerox's U.S. operations facility in Rochester, N.Y., repeatedly warned the defendants (who worked in Stamford, Connecticut and New York), that Xerox's revenue accounting was seriously deficient. But the defendants ignored these warnings as well as their own doubts. They neither satisfied their professional obligations to examine Xerox's accounting critically nor required Xerox to produce evidence sufficient to satisfy a skeptical auditor that the questionable accounting actions fairly reflected business reality.

3. Rather than put at risk a lucrative financial relationship with a premier client, the defendants abdicated their responsibility to challenge Xerox's improper accounting actions and make the company report its financial results accurately. Year after year, the defendants told the public that they had conducted a professional audit and that Xerox properly prepared and reasonably presented its financial results when, in fact, the defendants knowingly or recklessly allowed Xerox to use self-serving, untested assumptions and improper accounting methods to report impressive, but fraudulent, revenues and earnings. After this fraudulent conduct was investigated and exposed, Xerox, employing a new auditor, issued a $6.1 billion restatement of its equipment revenues and a $1.9 billion restatement of its pre-tax earnings for the years 1997 through 2000.

4. The defendants misrepresented to the public that audits meeting professional standards had been completed and they issued unqualified approval of Xerox's publicly reported financial accounting. In doing so, the defendants failed to exercise the professional care and skepticism required under Generally Accepted Auditing Standards ("GAAS"). The defendants knew, or were reckless in not knowing, that Xerox's financial reports failed to comply with GAAP and were otherwise false or misleading. As a result, the defendants violated the antifraud provisions of the federal securities laws by knowingly or recklessly misleading the investing public. The defendants also aided and abetted Xerox in filing false financial statements with the Commission.

5. The Commission requests that each defendant be enjoined from further violations of the antifraud and other provisions of the federal securities laws as alleged herein and that each defendant pay a substantial monetary penalty. The Commission further requests that KPMG account for and disgorge all fees from Xerox by which it was unjustly enriched from 1997 through the end of its audit engagement.

JURISDICTION

6. The Commission brings this action pursuant to Section 20(b) of the Securities Act of 1933 ("Securities Act") [15 U.S.C. §§ 77t(b)] and Section 21(d) of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. §§ 78u(d)].

7. This Court has jurisdiction over this action pursuant to Sections 20(b) and 22(a) of the Securities Act [15 U.S.C. §§ 77t(b) and 77v(a)] and Sections 21(d) and 27 of the Exchange Act [15 U.S.C. §§ 78u(d) and 78aa].

8. The defendants, directly or indirectly, made use of the means and instrumentalities of interstate commerce, of the mails, or of the facilities of a national securities exchange in connection with the acts, practices, and courses of conduct alleged herein.

9. The defendants, directly and indirectly, have engaged in, and unless restrained and enjoined by this Court will continue to engage in, transactions, acts, practices, and courses of business that violate or aid and abet violations of Section 17(a) of the Securities Act [15 U.S.C. §77q(a)] and Sections 10(b), 10A, 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act [15 U.S.C. §§ 78j(b) and (A), 78m(a), 78m(b)(2)(A) and 78m(b)(2)(B)] and Rules 10b-5, 12b-20, 13a-1, 13a-13 and 13b2-1 thereunder [17 C.F.R. §§240.10b-5, 240.12b-20, 240.13a-1, 240.13a-13 and 240.13b2-1].

THE DEFENDANTS AND XEROX

10. Defendant KPMG LLP, the United States partnership that is part of KPMG International, a Swiss "non-operating association," maintains its headquarters in New York City. KPMG International is one of the largest public accounting firms in the world, with over 700 offices in 152 countries, and KPMG is the third largest accounting firm in the United States. KPMG International employed over 100,000 people in 2002 and had worldwide revenues of $10.7 billion. KPMG emphasizes in its promotional literature that its audits are to assist management in finding more profits. In 2002, for example, KPMG advertised its audit services to prospective clients as one which "helps clients manage risk and uncover hidden opportunities that can result in improvements in performance and greater growth for their businesses." KPMG's sales literature also told potential customers: "Our audit and attestation, business risk management, performance measurement, and knowledge services have expanded well beyond traditional financial statement requirements to help clients link risk with business strategies that can drive their success."

11. KPMG was Xerox's auditor for approximately 40 years, through the 2000 audit. KPMG was paid $26 million for auditing Xerox's financial results for fiscal years 1997 through 2000. It was paid $56 million for non-audit services during that period. KPMG maintained offices at Xerox's Stamford location and its partners regularly met with the company's financial managers, attended meetings of the Audit Committee of the Board of Directors and had access to most Xerox financial records.

12. Defendant Michael A. Conway, 59, a resident of Westport, Connecticut, is a certified public accountant. He has been KPMG's Senior Professional Practice Partner and the National Managing Partner of KPMG's Department of Professional Practice since 1990. He was the senior audit engagement partner on the Xerox account from 1983 to 1985. He again became the lead worldwide Xerox engagement partner for the 2000 audit when KPMG replaced defendant Ronald Safran as engagement partner after Xerox complained about Safran to KPMG's chairman, Stephen Butler. Conway also is a member of the KPMG partnership board and is chairman of the KPMG Audit and Finance Committee.

13. Defendant Joseph T. Boyle, 59, a resident of New York City, is a certified public accountant. He was KPMG's "relationship partner" for the Xerox engagement in 1999 and 2000 and is a managing partner of the New York office of KPMG and of the Northeast Area Assurance (Audit) Practice. As the relationship partner, Boyle's chief duty was serving as liaison between KPMG and the Xerox Board of Directors, including its Audit Committee.

14. Defendant Anthony P. Dolanski, 56, a resident of Malvern, Pennsylvania, was a certified public accountant and was the lead engagement partner overseeing Xerox's audits from 1995 through 1997. He left KPMG in 1998. He is currently the chief financial officer of the Internet Capital Group, a public company.

15. Defendant Ronald A. Safran, 49, a resident of Darien, Connecticut, is a certified public accountant. He was the lead engagement partner on the 1998 and 1999 Xerox audits. He was removed as engagement partner after completing the 1999 audit when Xerox's chief executive officer ("CEO") and chief financial officer ("CFO") complained to KPMG Chairman Butler about his work. Safran has been employed by KPMG or its predecessor since graduating from college in 1976.

16. Defendant Thomas J. Yoho, a resident of Greenwich, Connecticut, is a certified public accountant. Yoho was the concurring review partner for KPMG on the Xerox audit from 1994 until after the 2000 audit was completed and KPMG was replaced as Xerox's outside audit firm. Among the responsibilities of the concurring review partner are to review key audit work papers and audit reports and confer with the rest of the engagement team as necessary to give additional assurance that financial statements conform to accounting, reporting and regulatory requirements and that the audit of those financial statements was performed in accordance with professional auditing standards. The concurring review partner also is charged with, among other things, ascertaining if disclosures are understandable, appropriate, complete and in compliance with relevant professional standards. Yoho has been employed by KPMG or its predecessor since graduating from college in 1970.

17. Xerox Corporation is a Stamford, Connecticut based company incorporated in New York, which manufactures, sells and leases document imaging products, services and supplies in the United States and 130 other countries. In 2000, Xerox employed approximately 92,500 people worldwide, 50,000 of them in the United States. In June 2002, Xerox reported restated revenues of $18.8 billion and a restated net loss of $273 million for the year ended December 31, 2000.

18. Xerox is a public company whose securities are registered with the Commission pursuant to Section 12(b) of the Exchange Act and it is required to file periodic reports with the Commission pursuant to Section 13 of the Act. Its securities are listed on the New York and Chicago Stock Exchanges and also are traded on the Boston, Cincinnati, Pacific Coast, Philadelphia, London and Switzerland exchanges. Throughout the relevant time period, Xerox's stock was covered by Wall Street analysts who routinely issued quarterly and annual earnings estimates.

19. On April 18, 2002, this Court enjoined Xerox from future violations of antifraud and other provisions of the securities laws and rules alleged to have been violated in a Complaint filed by the Commission [SEC v. Xerox Corporation, 02 CV 2780 (DLC)]. Pursuant to a consent to settlement by Xerox, the company also was assessed a civil penalty of $10 million -- the highest ever paid in a Commission case alleging accounting fraud. In consenting to settlement, Xerox neither admitted nor denied the allegations of the Commission's Complaint.

THE FRAUDULENT SCHEME

A. Revenues and Earnings Were Manipulated by "Topside" Adjustments

20. United States securities markets rely on the integrity of the officers and directors of public companies and on independent auditors to insure that financial reports are meaningful, economically realistic and truthful. Using the tools of financial reporting to stretch, inflate, distort or lie about corporate results injures confidence in these markets and is unlawful. GAAP, which are intended to impose reasonable accuracy, uniformity and consistency on public accounting, can be manipulated for unlawful purposes. Public auditors fail in their duty to identify and correct such misleading and deceptive accounting if they are not independent, skeptical, forceful and effective as is required by the standards of their profession, including GAAS.

21. From at least 1997 through publication of the company's 2000 financial report, Xerox abandoned its obligation to accurately report its financial condition. Instead, the company defrauded its shareholders and the investing public by overstating its true equipment revenues by at least $3 billion and its true earnings by approximately $1.5 billion during the four-year period (before taxes, minority interest and equity income -- hereinafter, "pre-tax earnings"). Xerox did so by using undisclosed manipulative accounting devices at the end of each financial reporting period which distorted the true picture of its business performance, always with the result that Xerox reported greater pre-tax earnings than would have been reported absent these devices. These devices (hereinafter referred to generally as "topside accounting devices") defeated the bedrock purpose of the accounting rules and public disclosure -- to fairly, accurately and timely inform the public of the actual financial performance of the company. When Xerox finally restated its financial results for 1997-2000, it restated $6.1 billion in equipment revenues and $1.9 billion in pre-tax earnings -- the largest restatement in U.S. history to that time. The defendants' fraudulent conduct allowed Xerox to inflate equipment revenues by approximately $3 billion and inflate earnings by approximately $1.2 billion in the company's 1997-2000 financial results.

22. Xerox's senior managers were focused on meeting short-term earnings targets. Xerox's financial department made topside adjustments to results reported from operating divisions to inflate revenues and earnings for the purpose of meeting earnings goals and predictions of outside securities analysts. Xerox then trumpeted these results to the public through meetings with the press and analysts and in communications to shareholders, falsely celebrating that Xerox was enjoying substantially greater earnings growth than true results warranted.

23. Most of Xerox's topside accounting devices violated GAAP by inflating business performance. Their impact and that of other manipulative accounting devices should have been disclosed to the public in a timely fashion. By violating GAAP and ignoring disclosure obligations, Xerox's financial reporting for the period 1997-2000 misled investors about the quantity and quality of Xerox's earnings. The aggregate impact of these undisclosed topside accounting devices on pre-tax earnings from 1997 through 2000 was approximately $1.5 billion. By 1998, nearly three out of every ten dollars of Xerox's annual reported pre-tax earnings and up to 37 percent of its reported quarterly pre-tax earnings were due to undisclosed changes to its historic accounting practices and estimates and other improper accounting devices.

24. Dereliction by Xerox senior management and Xerox accountants should have prompted a forceful reaction from the defendants. But Xerox was a star account, providing a steady stream of millions of dollars of revenue to KPMG year after year. Although the defendants sometimes meekly challenged manipulative topside accounting devices at Xerox, they were easily satisfied by untested, self-serving management explanations.

25. The defendants knew, or were reckless in not knowing, that Xerox circumvented customary accounting discipline by using deceptive accounting devices on a quarterly and annual basis to increase reported revenues and earnings. They knew, or were reckless in not knowing, that these devices were easily manipulated by Xerox senior management at the close of each financial reporting period. They knew, or were reckless in not knowing, that the fraudulent accounting devices employed by Xerox led to unrealistic financial results. The defendant partners were told repeatedly by KPMG affiliates abroad and in Rochester that methods adopted by Xerox to "close the gap" between actual and desired results were not based on adequate economic evidence and that they distorted business realities. But from at least 1997 through 2000, the KPMG defendants ignored these warnings and did not demand evidence sufficient to establish that these accounting devices and the assumptions Xerox asserted to justify their use were in fact grounded in business realities or fairly reflected the company's performance. KPMG did not demand that Xerox test, and KPMG itself never adequately tested, the assumptions Xerox used to justify departure from traditional accounting practices. Nor did KPMG test -- or demand that Xerox test -- to determine if the topside accounting devices Xerox used resulted in financial statements which presented "fairly, in all material respects, the financial position of Xerox Corporation," as was certified to investors by KPMG.

26. In the summer or early fall of 1999, Xerox complained to KPMG's chairman, Stephen Butler, about the performance of defendant Safran, who questioned Xerox management about several of the topside accounting devices that formed the fraudulent scheme. Although KPMG policy was to review assignments of an engagement partner after five years, and Safran had been assigned to Xerox less than two years, Butler responded to Xerox's complaints by offering Safran a new assignment in Finland. After Safran declined the new assignment, KPMG replaced Safran as the worldwide lead engagement partner with defendant Conway for the 2000 audit. This was the second time in six years in which KPMG removed the senior engagement partner early in his tenure at Xerox's request.

27. Only in early 2001, after the Commission's investigation was under way and it was clear that the Commission had evidence of Xerox's false and deceptive accounting, did KPMG recommend that Xerox's accounting procedures be examined. KPMG then pronounced itself satisfied with results reported by consultants hired by Xerox, not by KPMG, who acknowledged they did not follow professional audit or attestation standards in arriving at their conclusions. There is no evidence that KPMG independently tested their work. As a result, despite Xerox's clearly unusual accounting procedures and the mammoth errors that resulted, KPMG's auditing approach resulted in a restatement of pre-tax earnings of only $276 million for the years 1997 to 2000.

B. Impact of the Fraudulent Accounting on Xerox's Financial Reporting

28. In fact, many of Xerox's accounting devices accepted by the consultants -- and by KPMG -- were found to depart materially from GAAP when professional audit standards were applied by a new auditor hired to replace KPMG in 2001. The new auditors found $6.1 billion in equipment revenues and $1.9 billion in pre-tax earnings which it required Xerox to restate in order to comply with GAAP.

29. The undisclosed use of topside accounting devices used by Xerox accounted for 4 percent of Xerox's reported first quarter pre-tax earnings in 1997 and between 14 percent and 37 percent of reported quarterly pre-tax earnings thereafter through 1999. Similarly, the impact of these accounting devices on Xerox's reported annual pre-tax earnings grew from 19 percent in 1997 to 27 percent in 1998, and constituted 25 percent of 1999 reported pre-tax earnings. The charts below detail the impact of accounting devices quarterly and annually on Xerox's pre-tax earnings (first two charts) and on earnings per share ("EPS") (second two charts) in each quarter and year from 1997-1999. The blue or darker portion of each bar represents pre-tax earnings as historically calculated by Xerox. The yellow or lighter portion represents the additional reported pre-tax earnings that resulted from undisclosed topside accounting devices, most of which did not comply with GAAP. (The total amounts reflected in the first two charts below exclude the inventory, restructuring and asset impairment charges Xerox recorded in the second quarter of 1998.)

30. As illustrated below, had Xerox reported its revenues and earnings consistent with its accounting in earlier years, Xerox would have failed to meet Wall Street EPS expectations in all quarters in 1997-1999 except the first quarter of 1997. Black numbers reflect EPS accounted for by each color of each column, and the percentage each method of calculation represented of total reported earnings for each period. The red numbers (the number above each column) represent Wall Street's consensus earnings estimates.

(Note: The percentage impact on EPS may be slightly lower than the percentage impact on pre-tax earnings because pre-tax earnings exclude equity income, minority interests and other adjustments, while earnings per share calculations do not).

31. The same information is shown below measured annually.

C. The Defendants Materially Mislead Investors

32. Use of these topside accounting devices distorted Xerox's public financial reports, which were supposed to fairly reflect the results of Xerox's business operations. Investors were not informed that a material component of Xerox's business results was new and untested improper accounting devices highly subject to manipulation. The defendants did not require Xerox to disclose it had changed its methods of accounting in material respects from prior years, and they falsely represented that Xerox was recording earnings and revenues in a manner consistent with GAAP, which fairly reflected the results of company operations. Further, despite Xerox's claimed inability to reasonably estimate the fair value of its products without resort to unreliable topside estimates, the defendants failed to identify material internal control weaknesses.

33. The defendants and Xerox affirmatively misled company shareholders and the public. Xerox annual reports in each year 1997-99 stated the following with the explicit or implicit permission of the defendants:

The consolidated financial statements were prepared in conformity with generally accepted accounting principles and include amounts based on management's best estimates and judgments. . . . The Company maintains an internal control structure designed to provide reasonable assurance . . . that the financial records are adequate and can be relied upon to produce financial statements in accordance with generally accepted accounting principles.... The Company monitors its internal control structure with direct management reviews and a comprehensive program of internal audits. In addition, KPMG Peat Marwick LLP [or, in later years, KPMG LLP], independent auditors, have audited the consolidated financial statements and have reviewed the internal control structure to the extent they considered necessary to support their report . . . .

34. In addition, the defendants affirmatively misled the public by annually providing a "clean" or unqualified Report of Independent Auditors to Xerox which they knew, or were reckless in not knowing, would be included with Xerox's Form 10-K filed with the Commission and in the annual report distributed to the public and shareholders. For each of the years 1997-2000, KPMG represented that the consolidated financial statements of Xerox "present fairly, in all material respects, the financial position of Xerox Corporation" as of year-end and that for those years and each of the preceding three-year periods the financial results were presented "in conformity with generally accepted accounting principles." In fact, KPMG and its defendant partners responsible for the Xerox engagement knew, or were reckless in not knowing, that Xerox filed with the Commission and presented to the public financial statements which were not in compliance with GAAP in material respects and which omitted to disclose that earnings were materially increased by accounting devices described herein, rather than by operating success.

35. KPMG's Report of Independent Auditors for each year 1997-2000 also informed shareholders and the public:

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

36. In fact, KPMG and its defendant partners knew, or were reckless in not knowing, that their audits of Xerox for the years 1997-2000 were not conducted in accordance with GAAS. Their representations to the contrary in their audit reports, which they knew would be included in annual reports and Forms 10-K and referenced in registration statements distributed to the public and filed with the Commission, were materially false and misleading.

37. Among other things, the KPMG defendants failed to perform the Xerox audits with the due care required by Section 230 of the Codification of Statements on Auditing Standards ("AU"), which is issued by the Auditing Standards Board, whose interpretations of the Statements of Auditing Standards constitute an essential component of GAAS. Among other things, the KPMG defendants also failed to obtain, or demand that Xerox produce, sufficient competent corroborating evidence of the need for, or adequacy of, topside accounting devices (AU Section 326, Evidential Matter) that would satisfy an auditor applying an appropriately professional degree of skepticism in any audit (AU Section 316, Consideration of Fraud in a Financial Statement Audit). Nor did the KPMG defendants adequately analyze and assess the control weaknesses inherent in permitting senior managers at Xerox who were compensated based, in part, on financial results, to regularly increase revenue and earnings reported from the field at the close of each reporting period. (AU Section 319, Consideration of Internal Control in a Financial Statement Audit). Nor did the KPMG defendants adequately assess the quantitative and qualitative aspects of misstatements they identified during their audits. (AU Section 312, Audit Risk and Materiality in Conducting an Audit).

38. Had the defendants performed a professional audit of Xerox as they represented, Xerox could not have filed with the Commission or distributed to the public quarterly and audited annual financial reports which were not prepared in accordance with GAAP in material respects and which contained material misstatements and omissions fraudulently representing that Xerox's revenue and earnings growth was due entirely to business performance.

39. Each of the KPMG defendants knew, or was reckless in not knowing, that Xerox's annual and quarterly financial reports were materially false and misleading. Each of the KPMG defendants also knew, or was reckless in not knowing, that the quarterly reports, parts of which were reproduced in the annual reports, and the annual reports, contained material calculations which were not prepared in accordance with GAAP. The KPMG defendants also knew, or were reckless in not knowing, that the statements in the annual reports invoking KPMG's approval and the KPMG audit report conclusions reproduced in the annual report and Form 10-K filed with the Commission and referenced in Xerox registration statements were materially false and misleading. Each of the defendants also aided and abetted Xerox in filing these false and misleading reports with the Commission.

D. Description of Fraudulent Accounting Devices

40. Although Xerox had resorted to a variety of accounting devices on a more modest scale earlier, these tools grew more central to the company's financial reporting strategy during the period 1997-2000. By 1997, Xerox had substantially departed from its historical accounting methods and GAAP to improperly manage its earnings, to accelerate recognition of equipment revenue, to report higher earnings growth and to meet Wall Street analyst expectations.

41. Despite the material impact of these accounting devices, none was disclosed in Xerox's quarterly and annual financial reports filed with the Commission. Nor were they disclosed in at least seven registration statements that were in effect or were filed with the Commission during 1997-2000, including four offerings that registered nearly $9 billion dollars worth of debt securities. Even so, each of the annual reports, which included quarterly reporting, and the registration statements either contained or referenced letters from KPMG prepared or approved by the defendant KPMG partners in which KPMG stated it had audited the financial results, that the audits were performed according to professional standards, that the financial reporting was consistent with GAAP and that the results fairly presented Xerox's financial condition.

42. Xerox adopted or increased its reliance upon the following accounting devices which caused a material increase in the company's reported equipment revenues and earnings, and which the KPMG defendants knew or were reckless in not knowing made the company appear to have sold or leased more equipment than it would have reported under its prior accounting practices: (1) return on equity (ROE); (2) margin normalization; (3) price increases and lease extensions; (4) retroactive increases to residual values of leased equipment; (5) undisclosed dramatic increases in the sale of future revenue streams; and (6) fraudulent manipulation of reserves. All but practice (5) constituted, individually or in the aggregate, material GAAP violations. All of these devices, individually and collectively, were undisclosed fraudulent devices used to manipulate reported revenues to increase reported earnings.

43. A description of each of these devices is provided below.

1. Fraudulent Lease Accounting

44. Xerox sells copiers and other office equipment outright to its customers for cash, but more frequently enters into long-term lease agreements in which customers pay a single negotiated monthly fee in return for the equipment, service, supplies and financing. Xerox refers to these arrangements as "bundled leases" and the monthly payment as "Total Cost of Ownership" ("TCO"). Although the popularity of bundled leases versus outright cash sales varies somewhat from country to country, Xerox has successfully promoted the leasing concept since the early 1980s so that, beginning at least in the early 1990s, bundled lease transactions constituted the majority of its sales revenue.

45. Financial Accounting Standard ("FAS") 13, an Original Pronouncement of the Financial Accounting Standards Board ("FASB"), sets forth the rules accountants must follow in accounting for leases. Under FAS 13, monthly payments due under ordinary leases are recognized only as they become due during the term of the lease. But FAS 13 requires equipment leases meeting certain criteria to be accounted for as if the lessor sold the equipment and provided financing for the sale. This "sales-type" lease accounting results in immediate recognition of the fair value of the equipment in the quarter in which the equipment is delivered, less any residual value the equipment is expected to retain once the lease expires. GAAP permits financing revenue to be recognized only as it is earned over the life of the lease to provide a constant periodic rate of return. FAS 13 also specifies that the portion of the lease payments that is the fee for repair services and copier supplies also be recognized only over the term of the lease. FAS 13 is intended to impose objective standards of accounting on the allocation of revenues from sales-type leases so that, among other things, equipment lessors cannot arbitrarily manipulate the allocation of lease payments to suit their particular financial reporting purposes.

46. Xerox had an accounting system in place for many years which assigned fair value to the equipment portion ("the box") as each sales-type lease was entered into and assigned remaining anticipated lease revenues to financing, service and supplies according to internal calculations made at the inception of the lease based on terms of the contract, competitive conditions and market finance rates. The fair value of the equipment was recognized immediately as revenue in Xerox's books and records, although actual payments for the equipment portion of the lease were received over the length of the lease. Revenue from financing the lease and providing service and supplies was recognized in Xerox's books and records gradually over the life of the lease. This treatment was in accord with GAAP as long as the rules stated in FAS 13 for calculating the allocation among equipment, finance, service and supplies were followed. This book entry system, which continued to be used at the operational level at Xerox, was deemed satisfactory for accounting for sales revenues with only minor adjustments until the mid-1990s.

47. By 1997, when Xerox encountered growing copier sales competition around the world and perceived a need to continue reporting record earnings increases, Xerox management claimed the operating level allocation of box, service and financing revenues was unreliable and misleading. Xerox told KPMG it was unable reasonably to assign a fair value to equipment sold under a sales-type lease contemporaneously with the sale, as it had in the past. Instead, for public financial reporting purposes, but not for internal operating purposes, the company abandoned the value determinations made at the inception of the lease and substituted a formula which management could manipulate at will. Xerox did no testing to determine if in fact its traditional manner of allocation was unreliable or if the new methodology did a better job of accurately reflecting the fair value of copier equipment.

48. Xerox's topside lease accounting devices consistently increased the amount of lease revenues which Xerox recognized at the inception of the lease and reduced the amount it recognized over the life of the lease. One method was called "ROE" (for "return on equity"), which pulled forward a portion of finance income and recognized it immediately as equipment revenue. The second, called "margin normalization," pulled forward a portion of service income and recognized it immediately as equipment revenue, too. ROE and margin normalization turned FAS 13 on its head by ignoring GAAP's requirement that leasing revenue allocations begin by identifying the fair value of the equipment. Instead, the ROE and margin normalization methods employed convoluted, subjective and defective procedures for estimating revenues from the finance and service elements of the lease agreement. The supposed fair value of the equipment was the remaining value of the lease, after deductions for finance, service and supplies.

a. ROE

49. At least as early as 1995, Xerox's accountants began to exploit accounting opportunities inherent in the ROE method and ignored the methodologies prescribed by GAAP. Xerox justified reductions in its estimate of the fair value of financing by arbitrarily determining that equipment financing should produce no more than a 15 percent return on the equity of Xerox's captive finance operations, regardless of the interest rate stated in an individual lease, regional prevailing interest rates, or rates internally applied at the inception of the lease. A desired return on the finance division's equity always had been a factor in Xerox's accounting for its finance charges. After 1995, however, Xerox formalized its ROE model in a manner that mechanically discounted lease payments at a finance rate that had little relation to market interest rates available to the customer, the actual return on financing to Xerox, or the price at which the equipment actually sold. Between 1995 and 2000, Xerox always assumed a 15 percent return for its ROE formula, everywhere in the world and under all financial and economic conditions, despite significant volatility in the returns actually earned by leasing companies in this period.

50. In most cases, application of ROE was a topside adjustment directed by the Xerox corporate office. Operating units allocated lease cash flows to the box, service and finance components according to long-established procedures. Xerox then recalculated these allocations to insure that financing operations realized no more than a 15 percent return. This practice ignored the real interest rates prevailing where the equipment was leased and the interest rates paid by the customer to lease a copier. It also artificially eliminated the volatility in Xerox's return on equity that a competitive market inevitably produces. Initially, use of the ROE formula was limited to the United States and to Xerox Brazil, where the formula was implemented by at least 1995. As the pressure to meet earnings targets grew, and competition made selling copiers more difficult, ROE was expanded to Xerox in Europe.

51. Topside adjustments grew larger and larger from 1997 through 2000. Altering assumptions in the ROE formula produced lower and lower assumed finance, or "discount," rates. Lower discount rates enabled Xerox to account for more and more of the contractual lease payments up front as equipment revenue. But the use of such lower discount rates was unsupported by either verifiable objective evidence or economic reality. Neither Xerox nor KPMG tested the company's claim that the topside adjustments were necessary to arrive at the actual equipment finance rates appropriate to the customer. Thus, the effect of the topside adjustment on any individual lease transaction's interest rate or equipment price was never calculated and compared to market rates or market prices. Yet, the unrealistic discount rates produced by the ROE formula were increasingly apparent in the operational markets in which ROE was used. For example, the discount rates that were applied to leases in the United States fell below Xerox's own incremental borrowing costs.

52. Continuous changes in underlying assumptions used to calculate the ROE formula and expansion of the formula to new geographic areas resulted in larger and larger portions of finance income being reallocated to equipment revenue for immediate recognition. For example, a lease recorded as generating $15,000 in immediately recognized equipment revenue at the operational level was increased at the corporate level for financial reporting purposes by 6 percent in 1997 and 13 percent in 2000. In this way, additional millions of dollars of equipment revenues and earnings were reported each quarter -- none of which necessarily resulted from the sale of a single additional copier or other Xerox product. Compared to the equipment revenues that would have been reported based on allocations recorded at the operational level, Xerox's ROE formula pulled forward $2.2 billion in equipment revenue and $301 million in pre-tax earnings in the period 1997 through 2000.

53. Xerox management defended its substitution of lower interest rates produced by the ROE formula by arguing that the rates entered and relied upon at the operational level were too high. But Xerox's own marketing department monitored rates available from other sources and concluded that the rates entered at the operational level were competitive or no more than 2 or 3 percentage points higher than competitor rates. But the ROE formula reduced rates used to prepare the public financial statements by as much as 6 percentage points. In some reporting periods, discount rates on five-year leases to some customers were recorded for financial reporting purposes at a rate below that for which the U.S. government could borrow money for 90 days.

54. The failure of the ROE method to produce realistic market finance rates was particularly pronounced in Brazil. For example, Xerox recorded all of its Brazilian leases in early 1997 assuming a finance rate of 8 percent, then dropped the rate to 7 percent in the third quarter of 1997, and then reduced the rate again to no more than 6 percent beginning in the first quarter of 1998 and continuing through the second quarter of 2000. The ROE formula generated rates even as low as zero percent in certain periods in 1999. These ROE-derived finance rates were based on the costs of Xerox's U.S. finance operations, rather than the currency and costs which were dictating the economic reality of Xerox's lease contracts in Brazil. By comparison even to the short-term inter-bank rates in Brazil, which during the relevant period exceeded 20 percent until the last few months of 1999, Xerox's ROE formula produced clearly absurd results. Had Xerox used even the short-term inter-bank rates in Brazil as an estimate of prevailing finance rates, the company's equipment revenues reported for Brazil would have been reduced by an estimated total of approximately $757 million during 1997-2000.

b. Margin Normalization

55. Competition in Xerox's markets increased in the 1990s, as foreign manufacturers were able to match Xerox technology at lower prices. As a result, margins on Xerox equipment declined, especially outside the United States. Observing this margin slippage in equipment sales, Xerox reallocated anticipated leasing revenues around the world using an accounting device referred to as "margin normalization." This "margin normalization" method, which Xerox used to derive the equipment revenue for sales-type leases, did not comply with GAAP and resulted in artificially high revenue and earnings reported by Xerox.

56. Margin normalization, like ROE, was a topside adjustment directed by the Xerox accounting department in Connecticut near the end of reporting periods. Sales and allocation of revenues were initially booked by operating units, which did not use margin normalization. Then, on a consolidated basis, management in Stamford, Connecticut directed that revenue from service be reallocated to the box based upon what management asserted the margins ought to be, not as they were calculated locally. Xerox even made these reallocations retroactively to transactions that had already been reported in its financial statements, also in violation of GAAP. The result of these accounting devices was to reclassify anticipated service revenues, which were required to be recognized over the life of the lease, as equipment revenues, which Xerox recognized immediately. Xerox was therefore able immediately to increase the revenues and earnings it reported to meet internal goals and Wall Street estimates. In addition to misrepresenting the true financial picture of Xerox, use of this non-GAAP, easily manipulated accounting procedure accelerated into current reporting periods revenues and earnings which properly should have been recognized in future reporting periods.

57. When the methodology was first implemented in Europe in 1997, management reallocated revenue from service to the box so as to achieve equal gross margins on those two components. By the end of 1999, however, Xerox had changed the methodology so often that its reallocation of revenue resulted in a 17 percentage point gross margin differential between box and service with no economic or business circumstances justifying such changes. Margin normalization, in essence, meant that Xerox recalculated its revenues in Europe, Brazil, Canada, Mexico and Argentina to achieve relative profit margins on the service and box portions of its bundled leases modeled on margins realized in the United States. Xerox ignored regional economic and business factors in making these calculations and, therefore, reported revenues and earnings that did not accurately reflect economic realities as recorded directly by those regions at the inception of a lease. The total equipment revenues pulled forward during 1997 through 2000 as a result of margin normalization was $617 million. Of that amount, $358 million was recognized as pre-tax earnings.

c. Price Increases and Extensions to Existing Leases

58. Xerox also used accounting that did not conform with GAAP to accelerate the recognition of revenues and earnings through price increases and extensions of existing leases. From 1997 through the second quarter of 1999, Xerox pulled forward approximately $300 million in equipment revenue and $200 million in pre-tax earnings in this manner to close the gap between actual and expected financial performance. The net impact on pre-tax earnings for 1997-2000, even after accounting for the reversal of certain of these adjustments in 1999 and the reversing impact of the adjustments made in earlier periods, was $58 million.

59. In certain regions, principally Brazil, Xerox negotiated or unilaterally imposed price increases and lease extensions on existing lease customers. GAAP, including FAS 13 and FAS 27, requires that additional income realized from renegotiation of existing leases be recognized over the remaining life of the lease (except when the renegotiation occurs in the last few months of the lease term). Xerox violated these GAAP provisions by recognizing immediately the revenue from the price increases and lease extensions negotiated much earlier than the last few months of the lease term and failed to disclose in its public reports that this, rather than increased sales, was another non-GAAP adjustment contributing to increased revenues and earnings.

60. In early 1999, KPMG defendants Safran and Conway informed the company that its accounting for price increases and lease extensions violated GAAP. Xerox did not then comply with GAAP, but merely reduced the amount Xerox improperly recognized. Shortly after the first quarter 1999 close, Safran met with Xerox's CFO and the Chairman of the Audit Committee and communicated KPMG's position. Even so, Xerox recognized $84 million of non-GAAP equipment revenue in the first quarter of 1999 and $47 million in the second quarter of 1999. Of this total of $131 million, Xerox reversed $89 million in the second half of 1999, resulting in a net impact for 1999 of $42 million in equipment revenue. KPMG took no further action to cause this GAAP violation to be disclosed in Xerox's public financial reports.

d. Improper Increases in Residual Values of Leased Equipment

61. GAAP requires that at the inception of a lease, the lessor must establish and record the "estimated residual value" of the leased equipment, i.e., the estimated fair value of the equipment, if any, at the end of the lease term. FAS 13, as amended by FAS 23, prohibits increasing the estimated residual value for any reason after it is first established.

62. Despite this prohibition, from 1997 to 1999, Xerox recorded adjustments of more than $95 million in retroactive upward revisions to the net residual values of machines leased by its Europe, Brazil, United States, Argentina and Mexico operating units. These write-ups, which had the effect of reducing the cost of sales, were often recorded close to the end of quarterly reporting periods as a gap-closing measure to help Xerox meet or exceed internal and external earnings expectations. In some instances, the revisions increased the residual value of the machines by as much as 50 percent. In total, the revisions inflated Xerox's reported pre-tax earnings by a net of $43 million during 1997-2000.

63. Notwithstanding the clear requirements of FAS 13, Xerox created an internal accounting policy in late 1996 that permitted retroactive write-ups of net residual values. This violation of GAAP contributed to Xerox materially misstating its financial results in numerous public filings, including its second and third quarter reports in 1997, its annual report for 1997, its third quarter report in 1998, and its annual report for 1998.

2. Undisclosed Dramatic Increases in Sales of Future Revenues in 1999

64. In 1999, Xerox pulled forward approximately $398 million in revenue and $182 million in profit before taxes by selling at a discount rights to future revenue streams from existing lease portfolios. This allowed Xerox to immediately recognize revenues which, under GAAP, the company otherwise would have had to recognize over the life of the leases. These transactions were known as "PAS" ("Portfolio Asset Strategy") transactions.

65. Although Xerox had entered into PAS transactions prior to 1999, that year it quintupled the amount of those transactions compared to 1998. The dramatic and material increase in Xerox's 1999 PAS transactions resulted, in large part, from Xerox's inability to sustain a business model in Brazil that relied on sales-type leases. In 1999, Xerox Brazil changed its business model from its traditional sales-type lease model to one based on rental contracts. Because, under GAAP, the revenue from rental contracts cannot be recognized immediately, Xerox entered into PAS transactions to allow such immediate revenue recognition.

66. All of the 1999 PAS transactions were crucial to Xerox's ability to close the gap

between actual and expected results, and they had a material impact on Xerox's reported results in 1999. The substantial increase in the amount of PAS transactions used to close the gap was material and should have been disclosed to shareholders.

3. Fraudulent Manipulation of Reserves

67. Xerox also pumped up its earnings by nearly $500 million through the release into income of excess or "cushion" reserves. The practice provided a "bank account" to help Xerox meet earnings targets when necessary. Xerox's use of these reserves violated GAAP, and its knowing or reckless use of reserves for this purpose without disclosure was fraudulent.

68. FAS 5, "Accounting for Contingencies," allows a company to establish reserves only for identifiable, probable and estimable risks and precludes the use of reserves, including excess reserves, for general or unknown business risks because they do not meet the accrual requirements of FAS 5. When a reserve ceases to meet the accrual requirements of FAS 5, it must be immediately released into income. The systematic or timed release of excess reserves into income violates GAAP.

69. From 1997 through publication of its fiscal 2000 financial report, Xerox violated GAAP by repeatedly manipulating the release of approximately $496 million of reserves to close the gap between actual results and earnings targets. This amount includes $78 million of improperly timed reserve releases, which affected interim periods within a fiscal year. The undisclosed manipulation of these reserves caused Xerox's financial reports to be materially false and misleading.

a. The Rank Reserve

70. In June 1997, Xerox purchased the Rank Group plc's 20 percent stake in Rank Xerox Ltd., Xerox's European subsidiary. In connection with this purchase, and at Dolanski's suggestion, Xerox fraudulently established a $100 million reserve for "unknown risks" arising out of the transaction. In establishing the reserve, Xerox violated GAAP by failing to comply with FAS 5.

71. Senior management at Xerox knew that the Rank reserve was created for "unknown risks associated with" the transaction, as was documented in a memo by Xerox accounting. In fact, the Rank Group indemnified Xerox for any liabilities arising from the sale, backed by a letter of credit.

72. Beginning in mid-1998, Xerox began charging expenses against the Rank reserve for items unrelated to the acquisition. The accounting department continued to draw on the reserve each quarter for expenses unrelated to the acquisition until it was exhausted at the end of 1999. Internally, Xerox referred to the reserve as an "interdivisional opportunity" that Xerox Europe used to boost its reported results as needed. Xerox knew its use of the Rank reserve was not in conformity with GAAP and caused its financial reporting to be false and misleading.

b. Excess or Cushion Reserves

73. Xerox fraudulently released into income approximately 20 other excess reserves totaling $396 million to improve earnings from 1997 through 2000. Staff in the controller's office tracked excess corporate reserves by preparing schedules called "Interdivisional Opportunities" and "List of Unencumbered & Other Reserves." The controller's office reviewed these excess reserve schedules on a quarterly basis and released the reserves when they were needed to close the gap between operational earnings and Wall Street expectations. Two of the larger reserves used to manipulate earnings are described below.

74. FAS 106 Reserve: Xerox created this reserve in 1993 when it adopted FAS 106, which relates to accounting for post-retirement benefits for employees. The balance of Xerox's FAS 106 reserve was $40 million at the end of 1996, when no additional liabilities remained. During 1997 and 1998, Xerox systematically released the reserve into income at the rate of $5 million per quarter until the reserve was exhausted.

75. Whiskers Reserve: The Whiskers reserve had been on Xerox's books so long that neither the controller nor the assistant controller could identify its original purpose and Xerox could not produce any documentation to support it. Rather than reverse Whiskers, as was required by FAS 5, Xerox used $2 million from the reserve to cover operating and litigation expenses in 1998. In the third quarter of 1999, the controller's office released $16 million of the Whiskers reserve to cover taxes for Brazilian contract extension issues. Because the controller's office failed to immediately release this reserve at the time it could no longer determine its purpose, Xerox artificially inflated its income from 1997 though 1999 by $31 million.

76. The table below illustrates the annual gross and net impact on pre-tax earnings from each of the devices that the KPMG defendants knew, or were reckless in not knowing, for the years 1997 through 2000. The net effect turns negative for 2000 because of Xerox's improper acceleration of revenues in earlier years, making revenues unavailable in later years, when they should have been recognized. (The hyphens in the table indicate accounting devices that are not the subject of this Complaint.)

ROLE OF THE KPMG DEFENDANTS IN THE FRAUDULENT SCHEME

77. The KPMG defendants were intimately familiar with Xerox's accounting devices. They reviewed Xerox's quarterly and annual financial reports filed with the Commission. They directed KPMG affiliate offices around the world in conducting the annual Xerox audit and quarterly financial reviews. The defendants prepared, reviewed and commented on the independent audit report for each year they were associated with the audit and reviewed Xerox's management's discussion and analysis ("MD&A") disclosures to insure that they were consistent with the company's financial reports, including the footnotes to those reports. The defendants knew, or were reckless in not knowing, that KPMG's name was invoked by Xerox senior management in annual reports assuring shareholders that KPMG had conducted a professional audit, had found that the company's financial reports were prepared in accordance with GAAP, that they fairly reflected results of operations, and that there were no material weaknesses in internal accounting controls.

78. The KPMG defendants' knowledge of the nature and impact of topside accounting devices on Xerox's financial reporting was such that normal professional audit standards required them to demand and receive satisfactory evidence from Xerox as to why the substituted accounting devices were appropriate and whether topside accounting devices were satisfactorily controlled to avoid manipulation and fraud. The defendants failed to meet these basic requirements of GAAS for identifying and preventing fraudulent accounting at Xerox.

79. Although standard GAAS procedures should have caused the defendants to identify and act to stop Xerox's fraudulent accounting, the defendants also knew or should have known that Xerox exhibited specific characteristics recognized by GAAS of an audit client at higher than normal risk of committing fraud. These audit standards were adopted to force heightened awareness by auditors of the possibilities for fraud and, when risk was found to be high, to require more intensive audit planning and procedures in those areas suggesting high risk. These standards applied to the audits of each of Xerox's fraudulent financial statements filed with the Commission for fiscal years 1997 through 2000.

80. GAAS requires, among other things, that an auditor plan and perform the audit with an attitude of professional skepticism. This requires objective analysis of persuasive evidence to make a reasonable judgment whether financial statements are accurate. When a client can be characterized as a high risk for fraud, as Xerox should have been, then even greater care is required in planning and conducting the audit and heightened scrutiny is to be applied to management's selection and application of significant accounting policies, especially in areas related to revenue recognition, to be sure they are not being used to misstate financial results.

81. GAAS also requires an auditor to assess whether an accounting system is effective. Among other things, an effective accounting system records transactions on a timely basis in sufficient detail to permit proper classification and quantification for financial reporting purposes. As part of this process, the auditor must assess the effectiveness of the client's internal control system for preventing or detecting a material misstatement in the financial reports. Cardinal characteristics of adequate internal controls include, among other things, properly designed procedures to record sales transactions accurately and segregation of duties so that it is difficult to perpetuate and conceal accounting errors or fraud.

82. According to GAAS, if an auditor is in substantial doubt about any assertion of material significance, the auditor must collect sufficient evidence during the audit to remove the doubt or express a qualified opinion or not opine at all on completion of the audit. The same result is called for by GAAS if the auditor concludes the financial statements are materially affected by misstatements which the client refuses to correct.

A. Knowledge of the Defendants

83. Each defendant had ample reason to know that the topside accounting devices imposed by Xerox were unnecessary and distorted the true performance picture of the company. Many warnings were delivered to the defendants by KPMG affiliates in Europe, Brazil, Canada and Japan, which had more detailed knowledge of Xerox financial accounting and business conditions in non-U.S. markets under their jurisdiction than did the defendants in Stamford and New York. Even KPMG in Rochester, N.Y., where Xerox had a major manufacturing and administrative center, warned that topside adjustments were not necessary. Nevertheless, the counsel and concern expressed by these affiliates was either ignored or not effectively addressed by each defendant.

84. When Xerox told the defendants that despite the fact that it had been manufacturing, selling and leasing copiers for decades, the company was unable to estimate the fair value of its equipment, Dolanski (in 1997), Safran (in 1998 and 1999), Boyle and Conway (in 1999 and 2000) and Yoho (throughout 1997-2000) each accepted Xerox's extraordinary assertion. Moreover, in each of the years that these partners led the Xerox account they performed no effective procedures to assess whether Xerox's representation was accurate or whether the accounting devices it used to address this purported issue were appropriate.

85. Dolanski maintained a consolidated "Quality of Earnings" schedule aggregating the total impacts of earnings attributable to accounting devices, including ROE, margin normalization and residual value adjustments. This schedule was shared with Yoho. He was also informed by his affiliate offices in Rochester, Brazil and Europe of the aggregate impact of adjustments resulting from applying and changing these methodologies.

86. When Safran became the engagement partner in 1998, he, too, maintained a consolidated "Quality of Earnings" schedule comparing the aggregate impacts of margin normalization and residual value adjustments, as well as other items, in 1998 to 1997. He, too, shared the schedule with defendant Yoho, among others.

1. ROE

87. Xerox routinely changed the underlying assumptions of ROE and expanded its application to new regions of the world. Each change in the ROE method accelerated recognition of more revenue. KPMG's engagement and review partners signed off on each resulting accounting adjustment without testing, or requiring others to test, whether the results were accurate. They uncritically accepted Xerox's claim that it could not directly calculate the fair value of its products, but had to rely on numerous "adjustments" by senior managers at the conclusion of a financial reporting period, always with the result of boosting revenues and earnings. Nor did they carefully analyze the claimed need for topside adjustments as a material internal controls deficiency.

88. In a letter to the president of Xerox's United States Customer Operations in Rochester ("USCO"), dated February 7, 1997, a KPMG partner addressed the growing reliance on ROE adjustments and opined:

[W]e do not believe that the recognition of sale revenue and the related asset without specific identification to a customer is an appropriate and prudent accounting practice. Leases should be recorded in the detail accounting records and the consolidated financial statements of the company based upon a single fair market interest rate without adjustment for the intercompany transfer of the leases to XCC [Xerox Credit Corporation, Xerox's financing arm]. We recommend that USCO discontinue the financing sale revenue adjustment in 1997 to strengthen its revenue recognition policies, simplify its accounting procedures and maximize cash collections in the event of early settlement of a lease.

89. Defendant Dolanski was sent a copy of the letter. The Rochester KPMG office also warned Dolanski on two occasions that upward adjustments of estimated residual values of leased equipment should not be permitted because they were inconsistent with GAAP.

90. KPMG Canada told Dolanski that the ROE model was "not supportable" and posed an "unnecessary control risk with regard to accounting records".

91. Dolanski also learned from KPMG's Brazilian affiliate that the ROE model was generating implicit interest rates for financial reporting purposes that were significantly below the market rates actually realized in Brazil.

92. When Xerox expanded the use of the ROE model to Europe, Safran knew that KPMG-UK had neither tested nor reached any conclusion as to whether the assumptions underlying the ROE model in Europe were appropriate.

93. When Safran became the worldwide lead engagement partner in 1998, he was informed by KPMG in Brazil that Xerox was "constantly `fine tuning' its accounting policies in order to increase" profits and that "this `fine tuning' [was] carried out with the full knowledge (and often at the suggestion of)" Xerox corporate headquarters in Connecticut. KPMG Brazil told Safran that this "fine tuning" increased the risk of fraudulent financial reporting and that the pressure imposed on Xerox Brazil by headquarters to meet revenue and profit goals increased audit risk. KPMG Brazil also informed Safran that Xerox in Brazil did not adequately document how accounting estimates were calculated.

94. Safran knew that the ROE model failed to account for local rates of financing. In 1998, KPMG Brazil repeated for Safran the concern it identified for Dolanski in 1997: that implied interest rates generated by ROE were significantly below prevailing interest rates and that ROE "did not consider all of the uncertainties inherent in [Xerox Brazil's] business and, consequently, on its cash flow." Safran identified a $40 million audit difference in 1998 in connection with the use of a 6 percent discount rate in Brazil (where market rates exceeded 20 percent). But Safran did not require Xerox to record any adjustment to its books and records.

95. In 1999, KPMG Brazil warned Safran that the ROE model resulted in recording zero percent interest rates for leases in the first and second quarters and urged that use of the ROE model needed to be examined by KPMG in Stamford.

96. Similarly, KPMG Tokyo in 1999 objected to the use of the ROE formula by Fuji Xerox because it did "not match the actual status" of Fuji's business and no procedures had been performed to determine if it might.

97. KPMG-UK told Safran in 1998 that it could not conclude that use of a 15 percent ROE target was appropriate for Europe.

98. In 2000, KPMG's Rochester office informed Conway that fair values recorded by Xerox in its traditional fashion -- before ROE -- adequately represented fair value for revenue reporting purposes.

99. Boyle, who became the Xerox client relationship partner at the beginning of 1999, learned about the flaws in the ROE model at that time prior to attending his first Audit Committee meeting. However, neither Safran nor Boyle required Xerox to formulate and apply a valid method of estimating its discount rate.

100. In 2000, when Conway became lead engagement partner, he concluded that the ROE model was flawed because it generated discount rates that did not reflect the uncertainties inherent in Xerox's business, such as cancellations, bad debts and lease renegotiations. Conway also knew or was reckless in not knowing that KPMG auditors in Rochester concluded that there was no need for the ROE adjustment because the implicit interest rate used when U.S. leases were initially booked generated an appropriate result.

101. Yoho, as the concurring review partner on the Xerox engagement from 1994 through the conclusion of KPMG's association with the company, knew that Xerox's quarterly and annual reports reflected expanded use of ROE. However, rather than press the KPMG audit team to examine the topside adjustment more skeptically, to demand evidence from Xerox that the methodology resulted in economically realistic revenue allocations or to assess whether ROE was consistent with GAAP requirements, Yoho, year-after-year, accepted Xerox's representations that ROE satisfied GAAP and resulted in fair revenue allocations.

102. In connection with Xerox's Audit Committee special investigation, Conway, Boyle and Yoho were explicitly told what they already knew, or were reckless in not knowing, from prior dealings with Xerox financial reporting: that Xerox had used ROE retroactively to close the gap between actual and planned results. KPMG and its partners knew, or were reckless in not knowing, this information beginning in at least 1997. But even when deniability was impossible after the special investigation, Conway (with Boyle's and Yoho's knowledge) signed off on Xerox's 2000 financial statements without performing any audit procedures to determine whether the ROE model resulted in correctly reported revenue.

2. Margin Normalization

103. KPMG, through its partners, knew about Xerox's use of margin normalization from its inception in 1997. As it did with respect to the ROE model, Xerox management justified using margin normalization by representing to KPMG that it did not know the fair value of its equipment and, therefore, could not allocate revenue appropriately among equipment, finance and service at the inception of a lease. Again, Dolanski, Safran, Conway, Boyle and Yoho accepted this proposition without performing procedures sufficient to verify it.

104. As was the case with the ROE model, Xerox regularly changed the assumptions underlying the methodology and expanded its application to new regions. From 1997 to 1999, the margin normalization methodology changed more than a dozen times. With small exceptions, each time the methodology changed, Xerox recognized more and more revenue immediately and deferred less and less revenue to the future. KPMG's engagement partners signed off on the resulting accounting adjustments without any effort to test whether the results reflected economic reality.

105. In 1997, Xerox represented to Dolanski that because the margin on the service component of its leases in Europe exceeded the margin on equipment, Xerox had to make a topside accounting adjustment to allocate more revenue from total lease payments to the equipment to achieve equal gross margins on these elements.

106. KPMG's affiliate in the United Kingdom voiced numerous concerns to Dolanski about implementing margin normalization on Xerox lease accounting in Europe. The UK auditors told Dolanski there was no objective basis for equalizing margins and noted in their 1997 local work papers that margin normalization carried a "high risk of significant misstatement," that reported margins on bundled contracts were "potentially arbitrary" and that they were based on "little hard evidence". KPMG-UK also raised with Dolanski the possibility of identifying an audit difference for the amount that Xerox had booked due to margin normalization.

107. Dolanski also knew that Xerox restricted KPMG auditors in Europe from discussing margin normalization adjustments with local Xerox management.

108. Dolanski himself concluded in his work papers that margin normalization was a high risk accounting practice. Nevertheless, Dolanski performed no audit procedures to determine whether the diverging margins between the U.S. and Europe or Brazil were economically justified or whether it was economically appropriate to equalize margins on service and equipment. He simply accepted management's assertions and signed off on the adjustments.

109. Near the conclusion of the 1997 audit, the KPMG team concluded with respect to margin normalization that "in our view, central adjustments of this nature should be strongly discouraged. We would also expect this change to be fully implemented at a local level by the end of 1998." Xerox never surrendered senior management's ability to manipulate earnings through margin normalization by implementing the process at the local level. Nevertheless, KPMG, including Yoho, who was concurring review partner throughout the period 1997-2000, never pressed Xerox for stronger evidence either that the procedure's departure from locally entered revenue allocations was necessary or that margin normalization resulted in allocations fairly reflecting business conditions.

110. In 1998, KPMG-UK identified margin normalization as a matter for audit adjustment because there was no support for the procedure and because it was applied in the fourth quarter retroactively to the beginning of the year. The UK office told Safran that Xerox was "playing follow my leader -- whoever has the highest sales margins being the leader" when it applied a margin differential based on U.S. leases. When Xerox Europe calculated its margins based on the relative margins between equipment and service achieved in the U.S., as required by the margin normalization device adopted by Xerox corporate headquarters, KPMG-UK told Safran that it was concerned about management's motives underlying that methodology, and recommended that Xerox corporate headquarters be required to make a stronger defense of the accounting methods imposed on Europe. KPMG-UK also recommended that Xerox in London carry out "a major exercise testing the U.S. allocation model on its leases to see what differences arise." Neither Safran nor Yoho demanded any such defense or testing from Xerox, however.

111. In other communications, KPMG-UK advised Safran that it was concerned that the 1998 margin normalization change was driven by "pressure to deliver budget." Safran agreed, stating:

In the absence of objective evidence of fair value pricing, I am concerned that there is too much judgment applied in the process, and the habit of periodic adjustment of the formula when needed is driven by the wrong motives.

112. In 1999, KPMG Brazil informed Safran that there were sufficient stand-alone service contracts in Brazil to calculate actual margins on service, rather than accept for reporting purposes margins based on U.S. leases. Xerox officers in Stamford told Safran that the Brazilian auditors were wrong and that they were not to discuss margin normalization with local Xerox personnel. Thus, by the end of 1999, Xerox had imposed restrictions on KPMG discussions of margin normalization with local managers in both Brazil and Europe. This raised sufficient red flags for KPMG, Safran, Yoho and Boyle to confront senior management at Xerox about limitations on the audit, but they did not do so.

113. KPMG-UK again raised audit differences over use of margin normalization in Europe in 1999 and urged that the procedure be studied to determine if it reflected commercial realities. KPMG-UK also told Safran that Xerox Europe continued to make retroactive adjustments to margin normalization for prior quarters despite KPMG-UK's admonition that such practices cease.

114. Safran ultimately concluded that the use of margin normalization and the ROE model could result in a "significant accounting surprise" like those that had recently been experienced by Cendant Corporation and Sunbeam, companies sued for financial fraud. Safran even told Conway and Boyle that he regarded the proposed 1999 expansion of margin normalization to Brazil and Mexico as "half-baked revenue recognition".

115. Shortly after the close of the third quarter of 1999, Safran contacted Conway, who was the most senior partner in KPMG's DPP. Safran advised Conway about his heightened concern of the risk of fraudulent financial reporting at Xerox. Safran told Conway that he was concerned specifically about the last minute nature of Xerox's changes to the margin normalization method, and more generally about Xerox's tendency to apply changes in estimates frequently and at the end of reporting periods. Safran later told Conway and Boyle that the problems at Xerox were getting worse. He told them that Xerox was engaged in "quarter-end transactions to `bridge the gap,'" and that Xerox intentionally brought margin normalization changes to KPMG's attention at the last minute to limit the time available for KPMG to complete the appropriate review. Finally, Safran told Conway, Boyle and Yoho that KPMG had a "professional obligation" under GAAS to communicate his concerns to the Xerox Audit Committee. However, Conway, Safran, Yoho and Boyle did not raise any such issues at the next Audit Committee meeting, and Safran ultimately signed off on the 1999 financial statements with the knowledge and concurrence of Conway, Yoho and Boyle.

116. Safran expressed concerns about topside accounting devices to fellow KPMG auditors and, occasionally, to Xerox management, but did nothing either to have the devices corrected or to obtain sufficient evidence that the devices were proper. For example, in his completion memorandum for the 1999 audit, which was circulated within the KPMG audit team, Safran observed that corroborative evidence did not exist to support management's assumption that relative margins around the world should be comparable to U.S. margins. Yoho took no steps to require either Xerox or KPMG to produce corroborative evidence despite having been privy to the concerns of Dolanski and Safran about the unsupported expansion of margin normalization since at least 1997. Instead, Safran, Boyle and Yoho put aside such criticism and accepted Xerox's representation that relative margins between service and equipment in foreign countries should approximate those in the United States. KPMG merely urged Xerox to test such assumptions.

117. In 2000, Conway, Boyle and Yoho were aware of Xerox's continued use of margin normalization. As the new lead engagement partner, Conway learned from KPMG-UK that Xerox Europe's revenue allocation methods, including margin normalization, "are not considered to produce results which reflect commercial reality." In an April 2000 presentation prepared for Conway's visit to KPMG-UK, the Xerox Europe audit team also warned Conway that Xerox Europe "has little empirical data to evidence commercial sales prices or service rates" and that the use of margin normalization "might override/disguise genuine commercial trends". Conway ignored the warnings of his own audit team, however, and either failed to investigate or failed to heed the reservations expressed by local KPMG managers about the use of margin normalization. Instead, in October 2000, he sent the Xerox Audit Committee an analysis of Xerox's revenue allocation methods which did not mention the skepticism of KPMG auditors in Europe and accepted without question management representations that the margin normalization device was appropriate:

These adjustments were made to obtain greater consistency in the worldwide process of revenue allocation and because local and Corporate management collectively concluded that changes occurring in pricing and competitive factors in the marketplace had caused a distortion of revenue allocations from fair value.

118. When questioned under oath in 2001 about the warnings from KPMG in the UK, Conway, who was KPMG's leading expert on professional practices, testified he did not understand what the phrases "commercial trends" and "commercial reality" meant and suggested the UK affiliate was using "British" terms unfamiliar to him. He recalled no discussions with the KPMG-UK auditor on the subject.

119. Yoho acknowledged under oath that he knew of no GAAP rule which would permit use of margin normalization to promote greater consistency in Xerox's worldwide accounting, a justification asserted by Conway. Although Xerox never demonstrated how margin normalization corrected any distortions of revenue allocations since it was adopted in Europe in 1997, or made any attempt to post corrections at the local market level, as KPMG urged in 1997, Yoho continued in 2001 his practice, now four years old, of accepting company representations without demanding testing or adequate justification.

120. Conway, Yoho and Boyle knew that topside adjustments increased the risk of misstatements in Xerox's financials and were used to meet earnings targets. Despite this knowledge, however, Conway, Yoho and Boyle did not perform, or require that KPMG perform, any audit procedures to assess whether margin normalization resulted in recognizing the fair value of the equipment at the inception of the lease. Conway signed off on Xerox's 2000 financial statements, only requiring that Xerox restate to correct the "retroactive" application of margin normalization.

3. Price Increases and Lease Extensions

121. KPMG and defendants Safran, Conway, Yoho and Boyle knew about Xerox's improper accounting for price increases and lease extensions by at least the first quarter of 1999. Xerox told Safran that, despite the clearly contrary requirements of GAAP, Xerox's accounting treatment of the increases and extensions was appropriate because it was "pragmatic" and "a fairer representation of the results" of its business. Safran accepted Xerox's position as it related to the company's pre-1999 accounting, because he concluded it was "an immaterial misapplication of GAAP." Safran consulted Conway, Yoho and Boyle (among other partners) on this improper accounting and they agreed with Safran's position.

122. Safran told Xerox's CFO, controller and other senior financial managers that, on a going forward basis, Xerox's accounting for these extensions and uplifts was wrong, and the company should discontinue the practices. Despite Safran's admonition, Xerox did not stop using the accounting devices. Instead, in the first quarter of 1999, the CFO accepted a recommendation from Safran (who had obtained the concurrence of Conway and Boyle) to arbitrarily reduce the amount of revenue Xerox prematurely recognized from price increases and lease extensions to an amount deemed by Safran as quantitatively immaterial -- less than 5 percent of Xerox's consolidated profit before tax. But Safran knew that Xerox still recognized $68 million from these intentional and improper devices -- which constituted approximately 14 percent of first quarter pre-tax earnings. When Safran reported to Yoho shortly before meeting with Xerox's CFO that the GAAP violation would be reduced to a level deemed not to be material, rather than eliminated entirely, Yoho asked "Do we want this [conclusion] in writing?"

123. Xerox's non-GAAP accounting for price increases and lease extensions continued in 1999 despite Safran's first quarter attempts to make a correction. During the second quarter of 1999, Safran allowed Xerox to prematurely recognize $32 million of pre-tax earnings from these accounting devices.

124. In the third quarter of 1999, Xerox committed to cease its improper accounting for price increases and lease extensions. Xerox's CFO told Safran that Xerox would no longer book price increases and lease extensions up front. In connection with his third quarter review, however, Safran discovered that Xerox Brazil was still improperly accounting for revenue from lease extensions and price increases. Safran again raised this issue with the CFO, the controller, and other senior financial managers. Xerox management responded that the XBRA accounting was a "mistake," and told Safran that it would not happen again.

125. At year-end 1999, Xerox reversed the entire amount that KPMG had counted as improperly reported in connection with price uplifts and lease extensions. But, apparently undaunted by KPMG's repeated admonishments, several of Xerox's Latin American operating units returned to improperly accounting for price increases and lease extensions in 2000 while Conway was the engagement partner and both Yoho and Boyle continued on the engagement team.

4. Improper Increases in Residual Values

126. When Xerox proposed its policy permitting the retroactive increase in the residual values of its equipment, Dolanski knew that such write-ups were expressly prohibited by GAAP. He and his staff communicated this to Xerox. However, Dolanski, with Yoho's concurrence, bowed to Xerox management's pressure and approved its implementation in 1997.

127. Dolanski in 1997 and Safran in 1998 and 1999, and Yoho in each of those years, were aware that Xerox was retroactively increasing residual values and that those increases boosted Xerox's reported financial performance. Despite Dolanski's and Yoho's acceptance of the improper accounting practice, the KPMG auditors of Xerox's United States operations in 1997 repeatedly noted in their completion memoranda that retroactively raising residual values clearly violated GAAP. As Safran and Yoho knew, or were reckless in not knowing, these write-ups were frequently recorded near the end of reporting periods as gap-closing measures and Safran believed that this heightened the risk of fraud in the financial statements. In late 1999, Safran told Conway and Yoho of this concern. Nevertheless, Xerox did not disclose, and KPMG did not require Xerox to disclose, this intentional violation of GAAP or its impact.

5. Improper Creation and Use of Reserves

128. KPMG-UK, which performed the due diligence on behalf of Xerox preceding the acquisition of Rank Xerox in 1997, advised the company and defendant Dolanski, the lead worldwide engagement partner on the Xerox account at the time, that the potential tax exposure arising out of the transaction was "remote to low." Dolanski nevertheless encouraged Xerox to book a $100 million reserve in violation of FAS 5.

129. In late 1998 or early 1999, Safran, Conway, Yoho and Boyle learned that Xerox had improperly established the Rank reserve in 1997 under Dolanski's watch, when, as later, Yoho was the concurring review partner. They then permitted Xerox to release the reserve in 1998 and 1999 for expenses unrelated to the purpose for which the reserve ostensibly had been established. However, they did not require Xerox to make any disclosures on the subject or restate its financial statement to correct the improperly accounted income.

130. From 1997 through 2000, Xerox fraudulently released into income approximately 20 other excess reserves totaling $396 million to improve reported financial results. Some of these reserves were maintained at the operational level, but a substantial number -- $225 million as of December 31, 1996 -- were maintained on Xerox's corporate books by senior corporate financial management. Most of these excess reserves were quantified and reviewed by Dolanski and Safran, often on a quarterly basis. In fact, many of these reserves were identified in KPMG audit work papers as either "unspecified excess" reserves or as "opportunities". Dolanski, Safran, Conway and Yoho knew, or were reckless in not knowing, that these reserves were used by senior Xerox financial management as a means to close the gap or to meet Xerox's internal plan.

6. Failure to Disclose Major PAS Transactions

131. Safran and KPMG were aware of and tracked Xerox's use of PAS transactions. Safran, Conway, Yoho and Boyle knew that in 1999 Xerox materially increased use of those transactions to recognize $398 million in revenue that otherwise would have been recognized in later periods under GAAP. They knew, or were reckless in not knowing, that failure to disclose that substantially greater PAS transactions accounted for a material portion of Xerox's annual revenues was a material omission from the company's financial statement. Despite this knowledge, Safran concluded that no disclosure of the impact of PAS transactions on Xerox's 1999 earnings was necessary. This conclusion was condoned by Yoho, Boyle and Conway, who knew of the impact of PAS from materials prepared by Safran, but did not revisit Safran's conclusions.

B. The Defendants Identify Concerns, But Take No Effective Action

132. The defendants expressed muted doubts about topside accounting practices to Xerox management and to the Xerox Audit Committee in year-end letters and reports, sometimes expressing frustration that problems raised in prior years were never addressed. But the KPMG defendants did not comply with their professional obligation under GAAS or the securities laws to require Xerox to change its financial reporting, or, if Xerox declined to do so, to qualify KPMG audit reports, issue no report at all, resign from the audit and, if necessary, notify the Commission that it had resigned because Xerox's financial reporting materially misrepresented the financial condition and operations of the company.

133. KPMG's working relations with Xerox managers sometimes were tense. Defendant Safran, especially, complained to Conway, Yoho, Boyle and others that the Xerox financial department frequently raised significant accounting issues late in the audit period, imposing undue time constraints for review of the proposed devices. Business pressure on the defendants also was immense to set aside reservations, to suspend disbelief, to condone Xerox's accounting devices, and to avoid confrontation with Xerox managers which might occur by forcefully bringing auditor concerns to the Xerox Audit Committee.

134. Xerox asked KPMG's chairman, Butler, to remove Safran from the Xerox audit because Safran questioned some of the accounting devices that were central to the fraudulent scheme. The CFO deemed Safran an irritant because he questioned Xerox management's use of non-GAAP accounting devices and other topside adjustments more than his predecessors. This was the second time the CFO had asked KPMG to remove a worldwide engagement partner from the Xerox audit team. On both occasions, KPMG complied with the CFO's request. The first time, the auditor was replaced by Dolanski.

135. Each of the KPMG defendants was aware that Xerox was a star client of the firm. KPMG had been Xerox's auditor for 40 years and had generated over $56 million in non-audit fees during 1997-2000, as well as $26 million in audit fees. Key elements of the defendants' performance evaluations included retention and expansion of business, including Xerox. No KPMG defendant wanted to risk antagonizing the client or resigning the engagement. Instead, they were content to provide Xerox with a "clean" audit opinion and permit serious accounting failures to continue with, at most, only gentle criticism.

136. In its letter to Xerox management concerning the 1998 audit, written in early 1999, KPMG, through Safran, wrote:

We recommend that the additional use of top-level adjustments be curtailed until systems and record-keeping capabilities are developed to record such adjustment at the transaction level on local books where the accounting records can be effectively monitored and prudently controlled.

137. A year later, in the management letter for the 1999 audit, delivered in early 2000, also through Safran and reviewed by Conway, Yoho and Boyle, KPMG recognized that little or nothing had been done to address this problem. "Ideally, adjustments should be allocated to the contract level to ensure accurate monitoring," Safran wrote Xerox management. In a report to the Audit Committee, also in early 2000, Safran said "we believe the Company needs to improve its analytic processes and controls to confirm that the assumptions used are reasonable and that appropriate fair values are derived from existing methodologies."

138. The KPMG defendants also suspected that Xerox was not adequately informing investors about the timing and use of accounting adjustments. The management letter prepared by Safran's audit team and sent to Xerox's CFO in March 1999, at the conclusion of the 1998 audit, concluded:

The Company does not currently have a formal process for evaluating the disclosures required for unusual and non- recurring items and changes in estimates. We believe that greater discipline over the timing and disclosure of periodic accounting adjustments and unusual and infrequent events is required. A formal process should be adopted to ensure that the Company's disclosures meet the standards of generally accepted accounting principles and the MD&A disclosure rules of the SEC.

139. Safran recognized that his concerns about the quality of Xerox's financial reporting were unheeded by company management. In early 2000, in its management letter sent in connection with the 1999 audit, which was reviewed by Yoho, Conway and Boyle, KPMG wrote:

The level of priority given to addressing internal control recommendations raised by KPMG and WWA [Xerox's internal audit department] appears to have decreased as a result of operational priorities. We have noted an increase in the number of repeat points of prior management letters comments. We also note that many of the most significant internal control priorities from KPMG and WWA letters are not resolved for extended periods of time.

140. The KPMG defendants also were aware of the significant impact of changes in accounting estimates and the improper motives underlying such changes. However, each of these partners allowed Xerox to continue to routinely change accounting estimates at quarter end to meet its financial projections without requiring any disclosure of the changes or their impacts.

141. Safran noted in his 1998 management letter the substantial increase in topside adjustments such as margin normalization, ROE and write-ups to residual values. He knew of the heightened control risks associated with such adjustments. Although Safran knew that such adjustments and associated changes in estimate should have been evaluated for disclosure, he failed to require management to perform such an analysis or make any disclosures that would have given investors the ability to judge the impact of accounting rather than operational performance.

142. Safran faced the same issues in 1999 and again failed to require any disclosure of Xerox's changes in estimates or topside accounting devices. In 1999, Safran knew that topside adjustments continued to grow, changes to the margin normalization and ROE methodologies continued to be implemented, there was a heightened risk of fraudulent accounting at Xerox resulting from the frequency and timing of Xerox's changes in estimates, "significant internal control priorities" had not been resolved in a timely fashion and Xerox still had not adequately evaluated whether disclosure of such changes in estimates should be made. He informed Conway, as head of KPMG's Department of Professional Practice, and Yoho and Boyle, as members of the engagement team, of all of these problems. However, none of these more senior partners took any effective measures to assure that the financial statements would contain adequate disclosures.

143. In 2000, when Conway took over the audit, Yoho remained the concurring review partner and Boyle remained as relationship partner. None of them undertook to resolve any of the issues that they knew had been of serious concern to Safran and KPMG auditors in Brazil and Europe during the two years that Safran was the Xerox engagement partner.

144. It was not until 2001, over six months after the Commission commenced its investigation into Xerox accounting and had begun examining KPMG personnel under oath, that KPMG requested that Xerox's Audit Committee investigate Xerox's accounting devices. But KPMG, now under the audit direction of Conway, with Yoho and Boyle continuing their roles, did not perform any audit procedures itself to determine whether Xerox's accounting produced results that conformed to economic reality. Instead, it cited concurring views of consultants hired by Xerox who admitted they did not apply professional audit or attestation standards in their studies. Some of these consultants already worked for Xerox on other matters and were seeking to expand business with the company. Although Xerox restated earnings resulting from some of its topside accounting devices, KPMG knowingly or recklessly continued to allow Xerox's improper use of many such devices in Xerox's fiscal 2000 financial statements.

FIRST CLAIM

Violations of Section 17(a) of the Securities Act and Section 10(b) and Rule 10b-5 of the Exchange Act

145. Paragraphs 1 through 144 are hereby realleged and incorporated herein by reference as if set forth fully.

146. Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder prohibit (a) employing devices, schemes, and artifices to defraud; (b) making untrue statements of material fact or omitting to state material facts necessary to make the statements made not misleading; and (c) engaging in acts, practices, and a course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security. Section 17(a) of the Securities Act contains similar prohibitions with respect to the offer or sale of any security.

147. KPMG and its defendant partners charged with auditing Xerox annually from 1997 through 2000 prepared audit reports which they knew would be filed with the Commission and submitted to Xerox shareholders and to the public. KPMG and these defendant partners represented that KPMG conducted an audit in each of these years in accordance with GAAS, that KPMG planned and performed the audit to obtain reasonable assurances that the financial statements were free of material misstatement, that KPMG assessed the accounting principles used and significant estimates made by Xerox management and that it evaluated the overall consolidated financial statement presentation. KPMG and the defendant partners further represented that, as a result of KPMG's audit, KPMG concluded that Xerox's financial position, including results of operation, were fairly presented in the financial reports and were in conformity with GAAP. Each of these representations was materially false and misleading or omitted to disclose material information which would make the statements not false and misleading. KPMG and the defendant partners also fraudulently permitted Xerox to represent that KPMG had concluded in its audit that internal controls were satisfactory when the KPMG defendants knew, or were reckless in not knowing, that no controls were in place to prevent or correct topside adjustments described herein to reach revenue and earnings targets.

148. In violation of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, defendants KPMG, Dolanski, Safran, Conway, Yoho and Boyle knew, or were reckless in not knowing, that, for each year 1997-2000 in which they were responsible for the Xerox audit, each of these statements in KPMG's audit report and in Xerox's annual report was false and misleading and their publication constituted a scheme to defraud.

SECOND CLAIM

Aiding and Abetting KPMG's Violations of Section 10(b) and Rule 10b-5 of the Exchange Act

149. Paragraphs 1 through 148 are hereby realleged and incorporated herein by reference as if set forth fully.

150. The defendant partners charged with auditing Xerox annually from 1997 through 2000 prepared audit reports which they knew would be filed with the Commission and submitted to Xerox shareholders and to the public under KPMG's name. KPMG, aided and abetted by these defendant partners, represented that KPMG conducted an audit in each of these years in accordance with GAAS, that KPMG planned and performed the audit to obtain reasonable assurances that the financial statements were free of material misstatement, that KPMG assessed the accounting principles used and significant estimates made by Xerox management and that it evaluated the overall consolidated financial statement presentation. KPMG, aided and abetted by the defendant partners, further represented that, as a result of KPMG's audit, KPMG concluded that Xerox's financial position, including results of operation, were fairly presented in the financial reports and were in conformity with GAAP. The defendant partners knew, or were reckless in not knowing, that each of these representations was materially false and misleading or omitted to disclose material information which would make the statements not false and misleading. KPMG, aided and abetted by the defendant partners, also fraudulently permitted Xerox to represent that KPMG had concluded in its audit that internal controls were satisfactory when the defendant partners knew, or were reckless in not knowing, that no controls were in place to prevent or correct topside adjustments described herein to reach revenue and earnings targets.

151. By reason of the foregoing, defendants Dolanski, Safran, Conway, Yoho and Boyle aided and abetted KPMG's violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

THIRD CLAIM

Violation of Section 10A of the Exchange Act

152. Paragraphs 1 through 151 are hereby realleged and incorporated by reference.

153. Section 10A of the Exchange Act requires a public accountant conducting an audit of a public company such as Xerox to: (i) determine whether it is likely that an illegal act occurred and, if so; (ii) determine what the possible effect of the illegal act is on the financial statements of the issuer; and (iii) if the illegal act is not clearly inconsequential, inform the appropriate level of management and assure that the Audit Committee of the client is adequately informed about the illegal act detected. If neither management nor the Audit Committee takes timely and appropriate remedial action in response to the auditor's report, the auditor is obliged to take further steps, including reporting the likely illegal act to the Commission.

154. In the course of auditing Xerox for the years 1997 through 2000, Defendants KPMG, Dolanski, Safran, Conway and Boyle knew, or were reckless in not knowing, for each year in which they were responsible for the Xerox audit, that Xerox was preparing and filing quarterly and annual financial statements and other reports which likely contained material misrepresentations and omissions in violation of the antifraud provisions of the federal securities laws. KPMG, Dolanski, Safran, Conway and Boyle nevertheless did not report these likely violations to the Xerox Audit Committee or take other steps required by the statute when Xerox management and its board did not correct the violations.

155. By reason of the foregoing, defendants KPMG, Dolanski, Safran, Conway and Boyle violated Section 10A of the Exchange Act.

FOURTH CLAIM

Aiding and Abetting Violations of Section 13(a) of the Exchange Act and Exchange Act Rules 13a-1, 13a-13, and 12b-20

156. Paragraphs 1 through 155 are hereby realleged and incorporated herein by reference as if set forth fully.

157. Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of registered securities to file with the Commission factually accurate annual and quarterly reports. Exchange Act Rule 12b-20 provides that in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.

158. As a result of the accounting devices set forth above, defendants KPMG, Dolanski, Safran, Conway and Boyle aided and abetted Xerox's violations of Section 13(a) of the Exchange Act and Exchange Act Rules 13a-1, 13a-13, and 12b-20.

FIFTH CLAIM

Aiding and Abetting Violations of Section 13(b) of the Exchange Act

and Exchange Act Rule 13b2-1

159. Paragraphs 1 through 158 are hereby realleged and incorporated herein by reference as if set forth fully.

160. Section 13(b)(2)(A) of the Exchange Act requires that issuers make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets of the issuer. Section 13(b)(2)(B) of the Exchange Act requires, among other things, that issuers maintain a system of internal accounting controls that permit the preparation of financial statements in conformity with GAAP. Exchange Act Rule 13b2-1 prohibits any person from directly or indirectly, falsifying or causing to be falsified, an issuer's books and records.

161. By virtue of the material misstatements and omissions by the KPMG defendants set forth herein, defendants KPMG, Dolanski, Safran, Conway and Boyle aided and abetted Xerox in violating Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Exchange Act Rule 13b2-1.

PRAYER FOR RELIEF

WHEREFORE, the Commission respectfully requests that this Court:

I.

Enter Orders:

A. Permanently restraining and enjoining each defendant from violating or aiding and abetting violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder;

B. Permanently restraining and enjoining each defendant from aiding and abetting violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder.

C. Permanently restraining and enjoining each defendant from aiding and abetting violations of Section 13(b) of the Exchange Act and Rule 13b2-1 thereunder.

D. Permanently restraining and enjoining each defendant from violating Section 10A of the Exchange Act.

II.

Order defendant KPMG to provide a complete accounting of all fees received from Xerox for any purpose for the audit years 1997 through 2000 inclusive and to disgorge all such fees which constitute unjust enrichment, plus prejudgment interest thereon.

III.

Order each of the defendants to pay a civil penalty under Section 20(d) of the Securities Act [15 U.S.C. § 77t(d)] and Section 21(d)(3) of the Exchange Act [15 U.S.C. § 78u(d)(3)].

IV.

Grant such other relief as this Court may deem just and appropriate.

Respectfully submitted,