SEC Charges KPMG and Four KPMG Partners With Fraud in Connection With Audits of Xerox; SEC Seeks Injunction, Disgorgement and Penalties


SEC Seeks Injunction, Disgorgement and Penalties

Washington, D.C., January 29, 2003 -- The Securities and Exchange Commission today sued KPMG LLP and four KPMG partners - including the head of the firm's department of professional practice - in connection with the audits of Xerox Corp. from 1997 through 2000. The Commission's action, filed in federal district court in New York, charges the firm and four partners with fraud, and seeks injunctions, disgorgement of all fees and civil money penalties.

The Commission 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 applicable auditing standards and that Xerox's financial reports fairly represented the company's financial condition and were prepared in accordance with GAAP.

"The spectacular upheaval in the corporate landscape over the last year highlights the critical responsibility that auditors have in the financial reporting process," said Stephen M. Cutler, the SEC's Director of the Division of Enforcement. "In their audits of Xerox, KPMG and its partners abdicated that responsibility."

"The investing public counts on the audit profession to do their job with unfailing dedication to the principles of accounting, regardless of the wishes of their audit clients," said Paul R. Berger, an Associate Director of Enforcement. "The failure by the audit firm and its partners in the Xerox case represents a troubling episode and one that cannot and should not be repeated."

The four partners named as defendants, all of whom are certified public accountants, are:

  • Michael A. Conway, 59, a resident of Westport, Conn., 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, Conn., 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.

According to the complaint (a more detailed recitation of the complaint's allegations is attached):

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, Conn., 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.

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. As noted in the complaint: "There was no watchdog at Xerox. KPMG's bark sounded no warning to investors; its bite was toothless."

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 fraud allegations against KPMG and its partners address accounting errors that inflated equipment revenues by $3 billion and inflated pre-tax earning by $1.2 billion for the years 1997 through 2000.

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, 13b2-1 and 12b-20.

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.

The SEC's complaint can be found on the SEC's web site:

For further information contact:
Stephen M. Cutler, Director of Enforcement -- (202) 942-4500
Paul R. Berger, Associate Director of Enforcement -- (202) 942-4560



The Commission's complaint further alleges:

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.

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. In the complaint, the Commission referred 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.

When Xerox imposed these new accounting methods on offices in Europe, Canada, Brazil and Japan, KPMG auditors in those countries recognized that the changes were both unnecessary and unrealistic. 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."

The KPMG defendants sometimes "expressed muted doubts about topside accounting practices" to Xerox management. Defendant Safran, for example, told management at the conclusion of the 1998 audit that accounting adjustments should be entered at the transaction level, rather than at the "top level," so that they could "be effectively monitored and prudently controlled." When nothing was done, Safran told the Xerox Audit Committee a year later with respect to topside accounting adjustments that "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." Safran consulted on these issues with Conway, the national practice partner, and Boyle, the relationship partner assigned to represent KPMG before the Xerox Board of Directors and its Audit Committee. Xerox did nothing to address or correct KPMG's concerns, however, and KPMG did not press more vigorously for action or threaten to qualify its audit report. The fraudulent practices continued and were not disclosed to the investing public.

Indeed, in 1999, Safran contacted Conway and advised him about his heightened concern about the risk of fraudulent financial reporting at Xerox. As the complaint states:

Safran told Conway that he was concerned specifically about the last minute nature of Xerox's changes to the [accounting methodologies used], 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 [the accounting methodologies'] 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 and Boyle that KPMG had a "professional obligation" under GAAS to communicate his concerns to the Xerox Audit Committee. However, Conway, Safran 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 Conway's and Boyle's knowledge and concurrence.

Ultimately, Xerox requested that KPMG remove Safran from the audit and KPMG complied.

Six months after the Commission's investigation commenced into Xerox's accounting and had begun examining KPMG personnel under oath, KPMG requested that Xerox's Audit Committee investigate Xerox's accounting devices. However, KPMG did not perform any audit procedures itself to determine whether Xerox's accounting produced results that conformed to economic reality.

"Instead," as the complaint states, "[KPMG] cited concurring reviews of consultants hired by Xerox who admitted they did not apply professional audit or attestation standards in their studies."

Although Xerox did restate earnings by approximately $276 million that resulted 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. KPMG's failure to require a full restatement ultimately resulted in Xerox's $6.1 billion restatement.

See Also:  SEC Litigation Release
Last modified: 1/29/2003