Michael Chance, executive counsel of the Joint Disciplinary Scheme, said in his report published today that there was no case for the firm or any of its personnel to answer.
There was no scope for the suggestion that the auditors had been "faced with clear evidence of dishonesty and failed to pursue it", he said. His three-year investigation had concluded that they were among those "comprehensively deceived by a fraud which was designed and executed with extraordinary care and skill".
Two fictitious contracts - one for the United Arab Emirates and the other for Pakistan - had been created to deceive the accountants into accepting a certain level of profit, he added.
If Mr Chance had found that there was a case to answer the KPMG partners - Alan Comber and Robert Ferguson - would have to go before a tribunal and could have faced barring from the Institute of Chartered Accountants and unlimited fines.
The inquiry, which was referred to Mr Chance by the Institute in June 1993, stems from the takeover in November 1987 of International Signal and Control, a US-based defence contractor quoted on the London Stock Exchange and headed by James Guerin, by UK electronics group Ferranti. KPMG - through its forerunner firm Peat Marwick Mitchell - was auditor to ISC and became joint auditor to the new company, Ferranti International Signal, after the takeover.
The company became aware of serious concerns about the contracts at the centre of the investigation in August 1989 - a month after Peat Marwick and fellow auditor Grant Thornton signed off the accounts for the year to March 1989. Following a report from accountants Coopers & Lybrand, it sued KPMG for several hundred million pounds and settled out of court in August 1991 for pounds 40m.
Mr Guerin was later jailed after he and others pleaded guilty to various charges of fraud.