E&Y to Pay $2 Million to Settle Audit Failure Charges

On February 8, 2012, the Public Company Accounting Oversight Board (PCAOB) announced a settled disciplinary order censuring Ernst & Young LLP (E&Y). It imposed a $2 million civil money penalty against the firm, which is PCAOB's largest civil money penalty to date. The PCAOB also sanctioned four of E&Y's current or former partners for violating PCAOB rules and standards.

The order related to three E&Y audits of Medicis Pharmaceutical Corporation (Medicis), and a consultation stemming from an internal E&Y audit quality review of one of the audits. The respondents agreed to settle without admitting or denying the board's findings.

"These audit partners and Ernst & Young - the company's outside auditor for more than twenty years - failed to fulfill their bedrock responsibility," said James R. Doty, PCAOB Chairman. "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."
 
The PCAOB found in the audits of Medicis' December 31, 2005, 2006, and 2007 financial statements, that E&Y and its partners failed to properly evaluate a material component of the company's financial statements - its sales returns reserve.
 
In connection with a 2008 inspection of E&Y's audits of Medicis, the PCAOB Division of Registration and Inspections staff questioned E&Y's acceptance of the company's accounting for its sales returns reserve. E&Y ultimately concluded that Medicis' reserving for its sales returns was not in conformity with US generally accepted accounting principles (GAAP). Medicis corrected its accounting for its sales returns reserve and filed restated financial statements with the Securities and Exchange Commission (SEC) as a result.
 
During the audit periods in question, PCAOB found that E&Y and its responsible partners failed to comply with PCAOB standards in evaluating Medicis' practice of reserving for most of its estimated product returns at the cost of replacing the product, instead of at gross sales price.
 
In auditing the company's December 31, 2005, financial statements, the board also found that E&Y and its responsible partners violated PCAOB standards by accepting the company's basis for reserving at replacement cost when the auditors knew, or should have known, that it was not supported by the audit evidence.
 
Two months later, the board further found that during an internal audit quality review of the December 31, 2005, audit, E&Y personnel, who were not associated with the audit, identified the rationale as conflicting with both GAAP and E&Y's internal accounting guidance that specifically addressed revenue recognition for sales with rights of return. Rather than appropriately addressing this material departure from GAAP, E&Y and its personnel wrongly decided in an internal consultation that another flawed accounting rationale supported the company's existing practice of reserving for most of its product returns at replacement cost.
 
The board also found that E&Y and its responsible partners violated PCAOB standards in auditing the company's new methodology for calculating its year-end product returns reserve estimates for 2006 and 2007. PCAOB found that E&Y failed to sufficiently audit key assumptions and placed undue reliance on management's representation that those assumptions were reasonable.
 
"Accounting firms and their personnel must continually evaluate their clients' accounting and related disclosures, putting themselves in investors' shoes. The audit standard violations outlined in the Board's order are particularly troubling because, when the firm identified the problem itself in 2006, through its internal inspection program, it failed appropriately to address a material departure from GAAP regarding the company's sales returns reserve," said Claudius B. Modesti, Director of the PCAOB Division of Enforcement and Investigations.
 
In addition, the PCAOB: 
  • Barred E&Y partner Jeffrey S. Anderson from associating with a PCAOB-registered accounting firm, with the right to petition to remove the bar after two years. In addition, a $50,000 civil money penalty was filed against him. Anderson was the lead partner for the December 31, 2005 and 2007 audits, and he participated in the audit quality review and the consultation.
  • Barred former E&Y partner Robert H. Thibault from associating with a PCAOB-registered accounting firm, with the right to petition to remove the bar after one year; a $25,000 civil money penalty was imposed against him. Thibault was the independent review partner for the December 31, 2005 and 2006 audits, and he participated in the consultation in a national office role as a member of E&Y's Professional Practice Group.
  • Censured E&Y partner Ronald Butler, Jr., and imposed a $25,000 civil money penalty against him. Butler was the second partner, supervised by Anderson, on the December 31, 2005, audit. Butler led the 2006 December 31 audit and concurred with the consultation conclusion.
  • Censured E&Y partner Thomas A. Christie, who was the second partner, supervised by Anderson, on the December 31, 2007 audit.
The investigation and litigation were conducted by PCAOB Enforcement staff members Mark Adler, Richard Jacobus, John Abell, Raphael Larson, Bernard McDonough, Michael Plotnick, Pamela Woodward, and Tima Hawes.
 
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