Securities and Exchange Commission
Litigation Release No. 17954 / January 29, 2003
Accounting and Auditing Enforcement Release No. 1709 / January 29, 2003
Securities and Exchange Commission v. KPMG LLP, Joseph T. Boyle, Michael A. Conway, Anthony P. Dolanski and Ronald A. Safran, Civil Action No. 03 CV 0671 (DLC) (S.D.N.Y.) (January 29, 2003)
SEC Charges KPMG and Four KPMG Partners with Fraud in Connection with Audits of Xerox
SEC Seeks Injunction, Disgorgement and Penalties
On January 29, 2003, the Securities and Exchange Commission filed a civil fraud injunctive action in the United States District Court for the Southern District of New York against KPMG LLP and four KPMG partners - including the head of the firm's department of professional practice - in connection with KPMG's audits of Xerox Corporation from 1997 through 2000. The complaint charges the firm and four partners with fraud, and seeks injunctions, disgorgement of all fees and civil money penalties.
The complaint alleges that KPMG and its partners permitted Xerox to manipulate its accounting practices to close a $3 billion "gap" between actual operating results and results reported to the investing public. Year after year, the defendants falsely represented to the public that their audits were conducted in accordance with generally accepted auditing standards (GAAS) and that Xerox's financial reports fairly represented the company's financial condition and were prepared in accordance with generally accepted accounting principles (GAAP).
The four partners named as defendants, all of whom are certified public accountants, are:
- Michael A. Conway, 59, a resident of Westport, CT, 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 engagement partner on the Xerox account from 1983 to 1985. He again became the lead worldwide Xerox engagement partner for the 2000 audit. Conway also is a member of the KPMG board and is chairman of the KPMG Audit and Finance Committee.
- Joseph T. Boyle, 59, a resident of New York City, was the "relationship partner" on 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.
- Anthony P. Dolanski, 56, a resident of Malvern, PA, 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.
- Ronald A. Safran, 49, a resident of Darien, CT, was the lead engagement partner on the 1998 and 1999 Xerox audits. He was removed as engagement partner at Xerox's request after completing the 1999 audit and was replaced by Conway. KPMG or its predecessor has employed Safran since his graduation from college in 1976.
The Commission's complaint alleges that beginning at least as early as 1997, Xerox initiated or increased reliance on various accounting devices to manipulate its equipment revenues and earnings. Most of these "topside accounting devices" violated GAAP and most improperly increased the amount of equipment revenue from leased office equipment products which Xerox recognized in its quarterly and annual financial statements filed with the Commission and distributed to investors and the public. This improper revenue recognition had the effect of inflating equipment revenues and earnings beyond what actual operating results warranted. In addition, the complaint alleges that the defendants fraudulently permitted Xerox to manipulate reserves to boost the company's earnings.
The complaint alleges that under GAAP, when lessors such as Xerox enter into a "sales type lease" they must recognize immediately nearly all of the revenue attributed to the value of the product, but must spread recognition of financing, servicing and supply revenues over the life of the lease. Traditionally, Xerox local offices in each country booked the value of leased products at the time a lease was entered into, accounting also for the cost of financing and servicing the equipment during the lease period, based on local market conditions. Beginning in at least 1997, Xerox altered its accounting to treat more finance and servicing revenue as part of the value of the equipment, allowing Xerox to recognize a greater portion of revenue from new leases immediately in its financial statements. These calculations were made either by management at Stamford or by local country managers based on explicit assumptions dictated by Stamford, which ignored local economic conditions. The complaint refers to these new methods as "topside accounting devices" imposed by senior Xerox financial managers. Xerox told KPMG it needed to resort to these improper accounting devices because it could no longer rely on the traditional way it established the fair value of its products.
Although adoption of these new methods made Xerox revenue and earnings reports not comparable to earlier periods, and resulted in less revenue and earnings for reporting in future periods, Xerox never informed the public of the changes.
According to the complaint, KPMG affiliate offices in Europe, Brazil, Canada and Japan, as well as KPMG auditors at Xerox's main U.S. operations facility in Rochester, N.Y., repeatedly warned the defendant KPMG partners, who had overall responsibility for the Xerox audit engagement, that manipulative actions taken by Xerox to improve revenues and earnings were unnecessary, were not adequately tested, and distorted true business results. The defendant KPMG partners, who worked near Xerox headquarters in Stamford, Connecticut or at KPMG's New York headquarters, gave little weight to these warnings from on-the-scene KPMG affiliates and did not demand that Xerox justify the reasons for departures from historic accounting methods or establish the accuracy of the new, manipulative practices.
The warnings provided to the defendant KPMG partners from KPMG affiliate offices included the following:
- In 1997, KPMG's Canadian affiliate warned Dolanski that Xerox's new method for moving revenue from financing to equipment was "not supportable" and posed an "unnecessary control risk with regard to accounting records." KPMG's Brazil office told Safran the following year that the finance assumptions generated by Xerox's new accounting were significantly below prevailing interest rates and that they "did not consider all of the uncertainties inherent in [Xerox Brazil's] business and, consequently, on its cash flow." Similarly, KPMG's affiliate in Tokyo in 1999 objected to the use of the new interest rate 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.
- KPMG's affiliate in the United Kingdom voiced numerous concerns to the defendant partners over the years about the new methods of lease accounting imposed by Xerox senior management in Connecticut on European offices. The UK auditors repeatedly informed the defendant partners that there was no objective basis for the new accounting devices, that they carried a "high risk of significant misstatement" and were "potentially arbitrary". In 2000, KPMG in the UK told defendant Conway that Xerox's accounting changes to reduce service revenues and increase equipment revenues "are not considered to produce results which reflect commercial reality."
Although the defendants occasionally voiced concern to Xerox management about the "topside accounting devices" developed and manipulated by senior corporate financial managers to increase revenue and earnings, the defendants did little or nothing when Xerox ignored their concerns and continued manipulating its financial results. The defendants then knowingly or recklessly set aside their reservations, failed in their professional duties as auditors, and gave a clean bill of health to Xerox's financial statements. Rather than put at risk a lucrative financial relationship with a premier client, the defendants failed to challenge Xerox's improper accounting actions and make the company accurately report its financial results.
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. The Commission's complaint alleges that the defendants' fraudulent conduct allowed Xerox to inflate equipment revenues by approximately $3 billion and inflate pre-tax earnings by approximately $1.2 billion in the company's 1997 through 2000 financial results.
The Complaint alleges that each defendant violated Section 17(a) of the Securities Act of 1933 and Sections 10(b) and 10A of the Securities Exchange Act of 1934 (Exchange Act) and Exchange Act Rule 10b-5, and aided and abetted violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Exchange Act Rules 13a-1, 13a-13, 12b-20 and 13b2-1.
On April 11, 2002, the Commission brought an injunctive action against Xerox based on the same allegations of accounting fraud as are alleged against the KPMG defendants, as well as other allegations. Without admitting or denying the allegations of the complaint, Xerox consented to the entry of a Final Judgment that permanently enjoined the company from violating the antifraud, reporting and record keeping provisions of the federal securities laws. Xerox also paid a $10 million civil penalty, agreed to restate its financial statements and agreed to hire a consultant to review the company's internal accounting controls and policies. Securities and Exchange Commission v. Xerox Corporation, Civil Action No. 02-CV-2780 (DLC) (S.D.N.Y.) (April 11, 2002). See Litigation Release No. 17465 / April 11, 2002 / Accounting and Auditing Enforcement Release No. 1542 / April 11, 2002.
The SEC is continuing its investigation of this matter.
SEC Complaint in this matter