Recent SEC Enforcement Actions

By: Cydney Posner

The SEC announced settlement of two significant actions this week.

First, the SEC announced the settlement of an enforcement action against Coca-Cola.

See: Press Release and Administrative Proceeding.

The action related to Coca-Cola's failure to disclose end-of-quarter sales practices used to meet earnings expectations, as well as misstatements in a Form 8-K concerning an inventory reduction that concealed the impact of past practices.

The SEC found that, at or near the end of various reporting periods, Coca-Cola engaged in "channel stuffing" practices in Japan. To increase sales in the current period, Japanese bottlers were offered extended credit terms to induce them to purchase quantities of beverage concentrate the bottlers would otherwise not have purchased until a subsequent period, resulting in greatly increased inventory levels. The SEC found that this practice contributed approximately $0.01 to $0.02 to Coca-Cola's quarterly earnings per share and was the factor that enabled the company to meet analysts' expectations in 8 out of the 12 quarters from 1997 through 1999. Nevertheless, Coca-Cola failed to disclose its channel-stuffing practice in its periodic reports. In addition, the SEC found that Coca-Cola was aware that that this practice likely could not continue at existing levels and likely would cause a corresponding reduction in sales in a future period, but did not disclose the impact of its channel-stuffing practice on its current income or the likely impact on its future income. It was not until January 2000 that Coca-Cola filed a Form 8-K disclosing a planned worldwide concentrate inventory reduction, of which almost half of the estimated earnings impact would be attributable to an anticipated reduction of sales for Japan.

What is notable in this case is that the SEC did not take issue with the accounting treatment for the channel-stuffed sales. Rather, the SEC's focus was on Coca-Cola's failure to disclose the impact of its practices on current and future earnings, as well as the false statements and omissions within the Form 8-K.

The second matter is another of the SEC's gatekeeper actions, this one involving the settlement of charges against KPMG in connection with its audits of Xerox Corporation from 1997 through 2000. 

See: Litigation and Administrative Proceeding.

The SEC's order found that KPMG caused and willfully aided and abetted Xerox's violations of the anti-fraud, reporting, recordkeeping and internal controls provisions of the federal securities laws and that KPMG violated its obligations to disclose to Xerox illegal acts that came to its attention during the Xerox audits. As part of the settlement, KPMG consented to the entry of a final judgment in the SEC's pending civil litigation for a total payment of over $22 million. The final judgment also orders KPMG to undertake a series of reforms designed to prevent future violations of the securities laws. The SEC's civil fraud injunctive action against the five KPMG audit partners involved in the Xerox audits is ongoing.

The SEC's found that KPMG permitted Xerox to manipulate its accounting practices to close a $3 billion "gap" between actual operating results and reported results. The order states that Xerox used manipulative accounting actions at the end of each reporting period to increase revenue and earnings through the improper acceleration of revenue from long-term leases of Xerox copiers (referred to as "topside adjustments"). These actions involved manipulating Xerox’s historic accounting estimates and methods through changes that the SEC found to be unsupported by economic or business circumstances. In addition, the SEC found that Xerox inflated earnings through the use of "cookie jar" reserves. The SEC charged that these actions violated GAAP, overstated Xerox's revenues by at least $3 billion and its earnings by approximately $1.5 billion, but were not, however, disclosed to investors.

Although, throughout this period, KPMG issued unqualified audit opinions, the order stated that KPMG was very familiar with the practices Xerox used, having received many warnings from member firms of KPMG International in a number of countries that the methods Xerox was using were not based on adequate evidentiary support. One of KPMG's U.S. offices had also warned that Xerox's manipulative practices were creating unnecessary internal control weaknesses. Although KPMG made suggestions, the SEC found that KPMG exerted no pressure on its client to test its assumptions, nor did KPMG demand evidence sufficient to justify these practices or perform its own testing. In addition, the order found that although KPMG became aware that illegal acts may have occurred and raised these concerns to management, KPMG failed, prior to the SEC's investigation, to inform Xerox's board of directors or its audit committee about these illegal acts. Moreover, in 1999 when Xerox complained to KPMG's chairman about the performance of KPMG's audit engagement partner (who had actually questioned Xerox management about several of the problematic accounting actions), KPMG replaced the partner after completion of the 1999 audit. As a result, the SEC found that KPMG violated Section 10A, failed to comply with GAAS, allowed Xerox to take actions that did not comply with GAAP and to manipulate its accounting practices to distort the company's financial results. According to the order, KPMG also failed to insist that Xerox disclose these practices or their impact.

As part of the settlement, KPMG undertook to perform a number of reforms (which companies should then expect to see), including the following :

• examination of an audit client's justification for using accounting practices that depart from GAAP;
• examination of an audit client's justification for departing from its existing accounting systems in favor of making material period-ending adjustments;
• documenting in audit work papers consultations with individuals outside the audit engagement team to the extent the consultation is relied on for purposes of designing the audit program, expressing an opinion on the financial statements or for purposes of client retention;
• reviewing and documenting the circumstances surrounding any change in authority, reassignment or termination of an engagement partner from an audit, other than changes to comply with rules of the SEC concerning independence and partner rotation; and
• establishment of "whistle-blower" channels of communication within KPMG to enable any member of an audit engagement team (including foreign affiliates that provide services in connection with the audit) to express concerns on a confidential and anonymous basis regarding audit procedures or the reasonableness of judgments made in the course of an audit engagement.

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