The SEC outlines in Accounting and Auditing Enforcement Release No. 2234 its assessment of the Xerox fraud. Obtain and read a copy of the enforcement release (try http://www.sec.gov/litigation/ admin/34-51574.pdf). Compared to the information presented in this case would your opinion of KPMG’s audit performance change after reading the enforcement release? Explain your answer.

Question

What will be an ideal response?

Answer 1

Based on the nature of the SEC discussion in the enforcement release students will have a more negative
view of the audit work performed by KPMG. The enforcement release regarding KPMG’s 1997 through
2000 audits of Xerox indicates that KPMG consented to the entry of the order without admitting or
denying the SEC’s findings. The SEC notes that KPMG failed to comply with generally accepted auditing
standards (GAAS) and allowed Xerox to utilize accounting practices that did not comply with generally
accepted accounting principles (GAAP).
Information presented in the enforcement release that was not explicitly presented in the case
related to KPMG’s audit work includes:
KPMG failed to inform Xerox’s Board of Directors or its Audit Committee about illegal acts that had
or may have occurred or that otherwise came to its attention.
KPMG’s U.S. audit partners received warnings from member KPMG firms in Europe, Brazil, Canada,
and Japan that some of the accounting assumptions and methods used by Xerox were not based on
adequate evidentiary support. KPMG also received warnings from KPMG’s Rochester, New York office.

KPMG recommended that Xerox test the accounting assumptions underlying the recording of sales-
type leases but Xerox management did not test and KPMG did not require Xerox management to test

the underlying assumptions.
KPMG did not require Xerox management to provide competent corroborating evidence to support
the assumptions used to record the sales-type leases.
KPMG did not adequately test the assumptions underlying the sales-type leases recorded by Xerox’s
management.
KPMG did not identify as a material internal control deficiency Xerox management’s inability to
estimate the fair value of its products for sales-type leases.
KPMG did not require Xerox management to disclose material changes in accounting estimates used
to report sales-type leases.
The discount rates used by Xerox management to calculate fair value of sales-type leases were not
supported by market rates.
KPMG partners concluded Xerox’s margin normalization method was not consistent with GAAP and
that there was not adequate corroborative evidence to support the margin normalization approach.
KPMG partners concluded that Xerox management used the margin normalization method to engage
in quarter-end transactions to “bridge the gap” (between reported earnings and analyst earnings
expectations) and made last minute adjustments to the normalization method to limit KPMG’s ability
to review and test changes.
Xerox management had imposed restrictions on the discussions that KPMG staff could have with Brazil
and Europe managers regarding the margin normalization method.
KPMG partners knew that Xerox management had reduced the non-GAAP revenue recognition of
lease price increases and extensions to below materiality for the consolidated statements for 1999 and
allowed Xerox management to recognize revenue for the non-GAAP application in prior years because
it was “an immaterial misapplication of GAAP.”
KPMG partners knew that Xerox management was improperly reducing cost of goods sold for
increased estimates of the residual value of sales-type lease equipment sales after the lease was signed
by customers.
KPMG partners knew that Xerox had excess and unknown contingency reserves that were not disclosed
or required to be reversed consistent with GAAP.
KPMG did not adequately assess the quantitative and qualitative aspects of misstatements identified
during the audits.
Prior to 1997 Xerox management had used a variety of accounting practices, on a more modest scale, to manipulate revenues and earnings.
KPMG did not adequately analyze and assess the control weaknesses inherent in allowing senior Xerox
management, whose compensation was partially based on financial results, to adjust revenues at the end
of each reporting period.
Xerox management pressured KPMG to change and KPMG changed the audit engagement partner at
the end of the 1999 audit.
Without reviewing the actual documentation of the work performed by KPMG staff it is impossible to
absolutely agree or disagree with the SEC findings. The known fraud factors, known one-sided nature
of accounting estimate adjustments (income enhancing), and known GAAP departures disclosed in the
enforcement release strongly suggest that KPMG did not conduct its audits in accordance with GAAS and
that it subordinated its judgments to the judgments of Xerox management. KPMG should have exercised
more professional skepticism and required stronger evidence from the client to support the accounting
assumptions and methods used by Xerox. This question highlight to students the importance for auditors
to take a step back from the details of the audit to question whether the accounting assumptions and
methods used by a client in totality fairly represent the economic performance of the company. An auditor
should not allow clients to employ accounting assumptions and methods that systematically portray a biased
representation of the company’s economic performance.