For the four fiscal years ended in 2000, Xerox paid KPMG $56 million for non-audit services and $26 million for audit services. In comparison, Enron paid Arthur Andersen $51 million for non-audit services and $5 million for audit services in one year. The SEC contends that the total fees paid by Xerox to KPMG were a material inducement for the defendants to permit Xerox's senior management to manipulate its accounting practices so that Xerox could meet the performance expectations of Wall Street's analysts. The SEC contends this misled investors and purchasers of its newly issued debt securities by covering up the fact that severe competitive pressures had adversely affected Xerox.

The alleged fraudulent scheme essentially involved various "topside" manipulations made at Xerox headquarters to inflate current revenues and earnings. A brief description of the various non-GAAP techniques utilized by Xerox and permitted by KPMG illustrate why the SEC believes that the accounting firm and the partners in charge of the audit should be enjoined from future violations of the anti-fraud provisions of the federal securities laws, why KPMG should disgorge all monies paid by Xerox to KPMG from 1997, and that substantial penalties be assessed against each defendant.

Fraudulent Lease Accounting

The bulk of Xerox's revenues are based on long-term leases. In the typical lease, the customer pays a single monthly fee for the equipment, service, supplies and financing. Prior to 1997, and in accordance with FAS 13, Xerox's internal accounting system assigned fair value to the equipment portion ("the box") and assigned the remaining anticipated lease revenues to financing, service and supplies according to internal calculations made at the start of the lease based on the terms of the contract, competitive conditions and market finance rates. The non-box revenues were recognized gradually over the life of the lease.

By 1997, Xerox was under intense competitive pressure and believed it needed to report continued revenue and earnings growth. To do this, Xerox told KPMG that it was no longer able to reasonably assign a fair value to the box. Various devices were devised by Xerox to artificially allocate more revenues to the box than permitted by FAS 13. One method was called the return on equity method, which pulled forward a portion of the finance income from future years into the present year. Another method was called margin normalization, which pulled forward a portion of the service income that should have been allocated over the life of the lease into the initial year's revenue. A third device was to accelerate the recognition of revenues and earnings through price increases and extensions of existing leases. A fourth device was for Xerox to create retroactive adjustments to the net residual values of machines leased by its foreign operating units, which had the effect of artificially reducing the cost of sales.

None of these devices conformed to GAAP. These adjustments were also normally made at the end of a quarter or year.

Other Fraudulent Accounting Devices

A fifth device was to pull forward revenue by selling at a discount rights to future revenue streams from existing lease portfolios. The increased use of this device in 1999 resulted in an additional $398 million in revenue and $182 million in profit before taxes. A sixth device was the manipulation of "created" reserves to assist management in meeting earnings projections.

The SEC contends that KPMG and the three partner defendants had actual knowledge or should have known of each of these fraudulent devices. In fact, certain  KPMG partners, including one of the defendants, had voiced their concerns about some of these devices to both the senior management of Xerox as well as the chief practice partner at KPMG. The SEC contends that at no time did KPMG properly challenge Xerox's senior management's estimates and assumptions to justify these various accounting devices that were not in accordance with GAAP.

The SEC alleges that application of standard GAAS procedures should have caused KPMG and the partners in charge of the Xerox account to identify and act to stop Xerox's fraudulent accounting. The SEC also contends that there were enough red flags recognized by GAAS that required more intensive audit planning and procedures. The SEC complaint details a plethora of red flags including written and oral advices by Xerox affiliates that the non-GAAP devices being used by central management were distorting revenues and income.

Also, the Rochester office had advised KPMG that headquarters was making topside adjustments that were unnecessary. Internal communications within KPMG indicated that some of the partners working on the account had serious concerns about Xerox's "fine-tuning" its accounting practices in order to increase revenues and profits.

What is not said in this complaint is almost as important as the allegations. Where was the audit committee? The only material mention of the audit committee in the SEC complaint was that six months after the SEC began its investigation and after the SEC had taken extensive sworn testimony, it began to investigate the alleged fraudulent accounting practices. Paragraph 140 of the complaint notes that outside consultants hired by Xerox, and apparently not by the audit committee, concluded that KPMG acted properly, but the consultants allegedly admitted that they did not perform any professional audit or attestation standards in their studies. The SEC complaint against Xerox does not even mention the audit committee.

As I previously pointed out in an earlier article, Audit Committee and Management Disclosure Requirements of the Sarbanes-Oxley Act, the audit committee has to become involved in all phases of the audit, including the audit planning, understanding the key assumptions and estimates utilized by management in preparing the financial statements, understanding when those assumptions and estimates are inconsistent with GAAP, reviewing the auditor's management letter and what actions the company took in response thereto, and positioning itself to be in an open line of communication with the internal audit staff, as well the independent auditor, so that disputes as to proper accounting treatment are brought to their attention.

It would appear that there were numerous opportunities between 1997, when the alleged fraud began, and 2001, when the financial statements were first questioned, that the fraudulent practices could or should have been brought to the attention of the audit committee and the audit committee could have stepped in to help resolve what became the genesis for the SEC taking enforcement action against Xerox and its outside auditor, including the partners principally in charge of the Xerox audit.

The SEC's allegations in this complaint also illustrate why the audit committee must be proactive and truly independent. This includes access to and use of independent counsel and financial experts. When senior management is intent on creating accounting devices to artificially inflate revenues, earnings and/or cash flow, the SEC and the Sarbanes-Oxley Act look to the audit committee as the first line of defense to prevent this type of situation.

• The Liability of Financial Professionals
• Sarbanes-Oxley and the "Reliance on Others Defense"
• Defining "Non-Audit" Services: The Audit Committee's Role

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.