1. Give some examples of “turning points” or events when KPMG should have acted differently.

2. Describe the level of accounting errors at Xerox from 1997 through 2001.

3. Why do you think the officers and KPMG auditors acted as they did?

Throughout the early and mid-1990s, Xerox financial reports reflected a financially healthy company with revenues rising at a double-digit rate. By the late 1990s, however, Xerox faced increasing competition from Japanese competitors in the digital copier market and it was able to meet Wall Street’s earning expectations only by engaging in massive accounting fraud.

Xerox reallocated revenues from service to the equipment portion of sales-type leases by assuming an artificial gross margin differential between the two lease components (or an assumed profit margin) that had no basis in economic reality. Equipment margins were in fact falling. Xerox used this method to pull forward $617 million of equipment revenues from 1997 to 2000. Internally, KPMG referred to this method as “half-baked revenue recognition.” By relying on this methodology, from 1997 to 1999, Xerox inflated its pre-tax earnings by a net of $43 million. According to the SEC, in 1996, KPMG objected to this practice as violating GAAP but, after arguments with Xerox senior management, approved its implementation in 1998, while continuing to criticize its use. In 1999, KPMG informed Xerox that this practice violated GAAP, but Xerox refused to follow this advice. Nevertheless, KPMG certified Xerox’s 1999 and 2000 financial statements.

In November of 1999, Xerox senior managers discussed the fact that without their accounting actions, Xerox had essentially no growth through the late 1990s. In 2001, Xerox began issuing a series of earnings restatements that would total $11 billion. In late 2001, Xerox announced that PriceWaterhouse Coopers, LLP (“PwC”) was replacing KPMG as the company’s new auditor for the 2001 fiscal year. Xerox paid a $10 million fine to the SEC to settle civil charges and also agreed to complete its restatement of earnings for 1997 through 2001.

Investors such as the Florida State pension plan and other individual investors (plaintiffs) brought suit against the executive officers of Xerox as well as KPMG for fraud. KPMG moved to have the complaint against it dismissed because of its lack of scienter.

JUDICIAL OPINION

THOMPSON, District Judge … It is not hard to visualize a slippery slope where accounting integrity is degraded in tiny increments in the pursuit of earnings consistency. In the case of Xerox, it is troubling that the company could become so financially distressed in such a short period of time. The $10 million fine was the largest ever paid by a public company to settle a case brought by the SEC. The SEC stated that the “largest fine ever obtained by the SEC against a public company in a financial fraud case” was called for “because of the fact that Xerox’s senior management orchestrated a four-year scheme to disguise the company’s true operating performance” and that the size of the fine also reflected, in part, a sanction “for the company’s lack of full cooperation in the investigation.”

To satisfy the requirement for pleading scienter, as set forth in 15 U.S.C. § 78u-4(b)(2), “a complaint may (1) allege facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness, or (2) allege facts to show that defendants had both motive and opportunity to commit fraud.”

[A]llegations of GAAP violations or accounting irregularities, standing alone, are insufficient to state a securities fraud claim.

KPMG contends that the plaintiffs have failed to allege scienter as to it under either the motive and opportunity prong or the conscious misbehavior or recklessness prong of scienter. When the factual allegations in the Complaint are viewed as a whole, the plaintiffs have at a minimum alleged facts constituting strong circumstantial evidence of recklessness on the part of KPMG. The plaintiffs have alleged inter alia, …………………