The Securities and Exchange Commission sued KPMG, LLP, and four KPMG partners in 2004 in connection with the Xerox Corporation audits from 1997–2000. According to the SEC, KPMG allowed Xerox to manipulate its earnings by mak-ing “top-side” adjustments to its financial statements at year-end to meet earningstargets. KPMG auditors in Europe, Brazil, Canada, and Japan warned KPMG auditors in Rochester, New York, the main Xerox office, that its executives were preparing entries to improve revenue and that the entries distorted true income.

The partners charged in the lawsuit worked in KPMG’s New York headquarters or in its Stamford, Connecticut, office near the Xerox headquarters. The partners ignored the warnings from those working on the audit in KPMG offices around the world and failed to investigate the practices Xerox used to manipulate income.

According to the SEC, the auditors failed in their professional duty as auditors because they did not want to risk a “lucrative financial relationship with a premier client.”

To manipulate earnings, Xerox accelerated the recognition of revenue from its sales type leases. According to the financial reporting framework (U.S. GAAP), revenue related to a product’s value should be recognized immediately, but revenue related to financing, servicing, and supply services should be recognized over the life of the lease. Beginning in 1997, Xerox recognized financing and service revenue as part of the value of the equipment, allowing it to recognize revenue immediately. Either executives in Stamford or local managers gave instructions for the calculations to use to accelerate revenue recognition. Xerox told KPMG that it needed to make these changes because the method previously used to calculate revenue was outdated.

When the accelerated revenue policies became known to KPMG auditors in Europe, Brazil, Canada, and Japan, they expressed reservations about the change.

Some of their comments included these: the new method was “not supportable” and

it presented an “unnecessary control risk with regard to accounting methods.” KPMG auditors in the United Kingdom (U.K.) repeatedly objected to the new revenue calculations, stating that they carried a “high risk of significant misstatement” and were

“potentially arbitrary.” In 2000, the U.K. auditor told Michael Conway, the partner in

charge of the audit in the United States at that time, that the method for accelerating

revenue did not produce earnings results that reflected economic reality.

Ronald Safran, KPMG engagement partner for Xerox in 1998 and 1999, expressed misgivings to Conway, the managing partner of KPMG’s Department of Professional Practice, in 1999. Safran expressed concern about the risk of fraudulent financial reporting at Xerox. He worried about its tendency to adjust its methods to accelerate revenue recognition late in the year so the auditors would not have enough time to review the proposed change. Safran believed that company executives made adjusting entries at the end of the quarter as needed to meet earnings targets. He also believed that KPMG had an obligation to report these concerns to the Xerox Audit Committee but did not do so and ultimately signed off on the 1999 financial statements.

After the investigation, Xerox restated its earnings for $6.1 billion for 1997–2000.

The company also paid a $10 million civil penalty for the earnings fraud. 4

a. Describe how the audit risk model might have helped the auditor perform the

Xerox audit.

b. Did the auditors assess control risk too low? Explain your answer.

c. Did the auditors assess inherent risk too low? Explain your answer.

d. How should an auditor use materiality to plan the audit work related to revenue?

e. Why did the auditors fail to give Xerox a qualified opinion or to ask the company to stop its accelerated revenue recognition program?