Continental Drift at KPMG

Already beset at home, the firm is reeling from scandal and stumbles in Germany

For KPMG, the nation's fifth-largest auditor--and No. 2 worldwide--springtime has brought plenty of storm clouds. In April, the Securities & Exchange Commission filed a lengthy complaint about the firm's audits for longtime client Xerox Corp. (XRX ), and later notified KPMG that it was part of a continuing investigation. Later in the month, the accounting firm's new U.S. chairman, Eugene D. O'Kelly, made headlines: In a memo later leaked, he described to colleagues a meeting with SEC head Harvey L. Pitt in which O'Kelly voiced his concerns about the Xerox matter--a conversation that Pitt denied took place. O'Kelly later said he had only defended KPMG auditors in his discussions with Pitt and that Xerox was not specifically named.

With auditors under scrutiny as never before, these flaps would have been bad enough. But now KPMG faces even more trouble--this time in Germany, a hugely important market for the firm. On Apr. 24, KPMG Germany was forced to disavow the financial reports of former client Comroad, a small software maker based near Munich. The embarrassing reason: On Apr. 23, a new auditor found that 97% of Comroad's reported sales in 2000 came from a nonexistent company. Former Comroad CEO Bodo A. Schnabel is in jail, awaiting trial on fraud charges. In an attempt at damage control, KPMG has said it will reaudit all 35 clients whose stocks trade on Frankfurt's tech-heavy Neuer Markt.

That scandal could set back KPMG's hopes for growth in Europe. Talks to merge with the German unit of Arthur Andersen LP fell apart in the wake of the Comroad scandal. And with investors in Europe starting to flex their muscles, there is also new risk from that quarter. Munich lawyer Klaus Rotter says he may file suits against the auditor on behalf of some Comroad shareholders--an unusual course of action in Germany, which lacks the class action statutes and litigious culture of the U.S. And investors at German software maker SAP organized an American-style shareholder revolt at the annual meeting to block management's decision to hire KPMG as an auditor. That drive was defeated.

Last year, sales of the German unit, which boasts such blue-chip clients as Deutsche Bank (DB ) and DaimlerChrysler (DCX ), surged 25%, to $1.35 billion, more than 10% of KPMG's worldwide total. On Apr. 11, Harald Wiedmann, KPMG's German chief, assured journalists that the talks with Andersen "are on track." The deal would have boosted KPMG revenues in Germany to about $1.8 billion and cemented its dominance in the country. But less than a week after KPMG disavowed Comroad's accounting, Andersen backed out, choosing instead to partner with Ernst & Young Deutschland. Andersen says the decision was not related to the Comroad mess. Wiedmann was unavailable for comment.

There are no signs of major client defections at KPMG Germany, and the firm says its revenues can grow 10% annually. Still, KPMG has two key revenue bases, the U.S. and Europe. With KPMG coming under fire in the U.S. for its part in the Xerox mess, it can ill afford to lose ground in Germany, Europe's largest market.

KPMG's problems in Europe go beyond one botched audit in Germany. A Belgian client, speech-recognition software maker Lernout & Hauspie, imploded two years ago, admitting to nonexistent sales on its books. And last year, another German client, FlowTex, a bankrupt maker of drilling equipment, was found guilty of manipulating sales. The auditor paid creditors $45 million in that case. At the time, KPMG said it made the payment to avoid a long legal battle. "Trust in KPMG just isn't there any more," says Reinhild Keitel, a director at the Protective Association of Small Shareholders, an investor advocacy group.

KPMG may soon find itself part of another nasty and very public scandal, this one in Switzerland, where the firm is the auditor for the organization that oversees World Cup soccer. The president of Zurich-based Fédération Internationale de Football Assn., or FIFA, is now under fire from within the organization for alleged financial mismanagement, bribery, and misuse of funds. Some within the soccer federation are asking if KPMG was diligent enough in flagging any suspected financial wrongdoing. Already, in an echo of the failed merger with Andersen in Germany, Andersen partners in Switzerland have spurned KPMG to merge instead with Ernst & Young. KPMG Switzerland declined to comment.

With both Comroad and FlowTex, KPMG says that it was the victim of fraud--and indeed, some observers think that the "we were fooled, too" defense is valid. "Comroad is not an accounting issue. This is fraud," says Hans-Georg Bruns, a member of the International Accounting Standards Board and the former chief accounting officer for DaimlerChrysler. Still, Comroad's accounting was questioned by the German news media as early as 2001, and KPMG did not quit working for Comroad until Feb. 19.

At the very least, KPMG's problems will accelerate debate about Germany's tepid oversight of financial markets and corporate conduct--a depressingly familiar story.

By Jack Ewing in Frankfurt, with Nanette Byrnes in New York

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