The Public Company Accounting Oversight Board has censured and penalized Ernst & Young $2 million, its largest penalty against an accounting firm, for violating the audit firm watchdog’s rules. The accounting industry regulator said the firm “failed to properly evaluate” how a pharmaceutical company calculated its reserve for sales returns.
That company, Medicis Pharmaceutical Corp., restated more than three years’ worth of financial statements in 2008, after a PCAOB inspection of E&Y turned up an inaccurate interpretation of FAS 48, “Revenue Recognition When Right of Return Exists.” The company was incorrectly using an exemption to that rule for expired or soon-to-expire products that customers had returned to its distributors, according to the PCAOB. The exemption does not apply to resellers (such as distributors in this case) and can only be used if the product being exchanged is of the same kind and quality (such as a red sweater for a blue sweater). For calculating this reserve, the company was not supposed to consider the two products the same since the returned products were not sellable.
The company was reserving for most of its estimated product returns at the cost of replacing the product rather than at the gross sales price of the product. This practice was a “flawed accounting rationale,” according to the PCAOB, that conflicted with generally accepted accounting principles and E&Y’s own policies. It also had a material effect on Medicis’s revenue calculations.
Moreover, the PCAOB believes E&Y should have done a better job of evaluating management’s assumptions and conclusions. “The auditor’s job is to exercise professional skepticism in evaluating a public company’s accounting and in conducting its audit to ensure that investors receive reliable information, which did not happen in this case,” said PCAOB chairman James Doty in a statement.
The board has also sanctioned four current and former partners of the firm, three of whom will pay the PCAOB a total of $100,000. Two of those auditors, Jeffrey Anderson and Robert Thibault, are barred from associating with an accounting firm that audits public companies listed in the United States.
Medicis and Ernst & Young have settled a shareholder lawsuit stemming from the restatement for $18 million. E&Y is still listed as Medicis’s independent auditor. “We have implemented changes to our policies and procedures that directly address the PCAOB’s concerns and will enhance quality in the future,” according to a statement provided to CFO by spokesman Charlie Perkins.
The PCAOB has censured only one other Big Four firm. In 2007 the board penalized Deloitte & Touche $1 million for continuing to employ an accountant who misjudged the reasonableness of a client’s method for revenue recognition.