The auditing profession continues to struggle
as its managers and employees make some decisions that are not
appropriate or in the public interest. Too often, the interests of the company
that hired the auditing firm continue to take precedence over the interests of
shareholders, creditors and future investors.
According to Nicholas J. Mastracchio Jr.,
PhD, CPA, an associate professor of
accounting at the University at Albany, “The National Association of State
Boards of Accountancy (NASBA) responded to the recent scandals by forming a
task force to investigate the extent of education in protecting the public
interest. The American Accounting Association (AAA) agreed to cosponsor a
survey of educators on the issue of ethics education on campus. The following
results were obtained:
- 46% of the schools offered a separate course in ethics.
- 68% of those offered the course in the school of business.
- 18% offered the course in the accounting department.
- 56% indicated that the course provided separate coverage for protecting the public interest.
- Where offered, 51% stated it was a requirement for accounting majors.
- Where offered, 45% stated it was a requirement for other business majors.
- 90% indicated that protecting the public interest was covered in the auditing course.”
Despite these efforts, something is still
going wrong too often.
In February 2012, the PCAOB levied a $2
million penalty against Ernst & Young LLP for the way it handled the audits
of Medicis Pharmaceutical Corp. for three years through
2007. Medicis makes dermatological and aesthetic drugs, including acne
treatment Solodyn as well as Dysport, which competes with Allergan Inc.'s
Botox.
The PCAOB Chairman said, "These audit
partners and Ernst & Young — the company's outside auditor for more than 20
years — failed to fulfill their bedrock responsibility, 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."
In
the settlement declaration prepared by the law firm Pomerantz, Haudek, Grossman
& Gross LLP, is the following:
II.
THE LITIGATION
Medicis’s
Improper Accounting For Reserves
13.
The Complaint alleges that Medicis’s business model was premised on its ability
to stuff its wholesale channels with unneeded prescription drugs, which could
be exchanged by customers once the product was near or at expiration. This allowed the Company to manipulate its
earnings – i.e., if the demand for its prescription drugs was too low for a
given period, it could simply push unneeded inventory on to its wholesale customers
which could be returned at a later date once the product expired – and Medicis
could recognize the revenues immediately.
14.
The express dictates of Statement of Financial Accounting Standards No. 48
(“SFAS 48”), however, presented a threat
to this business model, as it required Medicis to establish a reserve for
all of the product stuffed in the channel that would be returned or
replaced. If anticipated returns had to
be deducted immediately from revenues, there would be no benefit to be derived
from channel stuffing and the Company would lose its key tool for manipulating
revenues.
15.
Thus, the Company attempted an end run around SFAS 48, by exploiting an
exclusion provided in footnote 3 of the provision, which states that
“[e]xchanges by ultimate customers of
one item for another of the same kind, quality, and price (for example, one
color or size for another) are not considered returns for purposes of this statement.”
(emphasis added). The Company’s
customers, however, were not “ultimate customers.” Indeed, Medicis’s customers were wholesalers
that sold their product to retailers.
Thus, Medicis’s customer base did not support the application of
footnote 3 to any of the Company’s sales.
16.
Furthermore, Medicis deemed unsalable, expired prescription drugs as the “same
kind, quality, and price” as drugs that
were at least fifteen months from expiration.
As such, it treated its anticipated returns as “warranty exchanges,”
which allowed it to reduce revenues by the much less substantial replacement
costs. Such a position was wholly
untenable, especially in light of the fact that confidential witnesses attested
to the fact that expired products returned by Medicis’s customers were destroyed
by the Company—proof that Medicis understood they had no value, let alone value
equivalent to salable products. Yet,
despite this accounting ploy, the Company consistently represented in its Class
Period financial reports that “provisions for estimates for product returns . .
. are established as a reduction of product sales revenues at the time such
revenues are recognized,” indicating to investors that it was reserving for
returns as a reduction from gross revenues—not replacement costs—in accordance
with SFAS 48.
17.
The Complaint alleges that this accounting manipulation could not have occurred
without the imprimatur of Medicis’s auditor, EY, which signed on to the Company’s
annual financial reports as compliant with Generally Accepted Accounting Principles
(“GAAP”) for each 10-K the Company filed during the Class Period.
The PCAOB
supports these allegations in its Order Making Findings and Imposing Sanctions document
dated February 8, 2012:
C.
Summary
7.
This matter concerns Respondents' failures to properly evaluate a material component
of Medicis's financial statements – its sales returns reserve. Specifically, Respondents failed to comply
with PCAOB auditing standards in evaluating Medicis's sales returns reserve
estimate, including evaluating Medicis's practice of reserving for most of its
estimated product returns at the cost of replacing the product
("replacement cost"). The
audit evidence available to Respondents indicated that, at all relevant times, Statement
of Financial Accounting Standards No. 48,
Revenue Recognition When a Right of Return Exists ("SFAS 48")
applied to Medicis's product sales subject to a right of return due to
expiration and required Medicis to reserve for all of those estimated returns
at gross sales price. Reserving for most
of its estimated returns at replacement cost, rather than gross sales price,
resulted in Medicis's reported sales returns reserve being materially
understated and its reported revenue
being misstated.6/ Overall, Respondents'
approach to evaluating Medicis's sales returns reserve methodology and estimate
was inconsistent
with their obligations to exercise professional skepticism as the Company's
independent auditor [emphasis
added].
The impact
of these findings on people’s lives are reflected in the following sanctions from
the PCAOB press release:
“In
addition to the censure and fine of E&Y, the Board 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, and imposed a
$50,000 civil money penalty against him. Anderson was the lead partner for the
Dec. 31, 2005 and 2007 audits, and participated in the audit quality review and
the consultation.
The Board
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, and imposed a $25,000 civil money penalty against him. Thibault
was the independent review partner for the Dec. 31, 2005 and 2006 audits, and
participated in the consultation in a National Office role as a member of
E&Y's Professional Practice Group.
The Board
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 Dec. 31, 2005 audit, he led the Dec. 31, 2006 audit, and concurred with the
consultation conclusion.
The Board
also censured E&Y partner Thomas A. Christie, who was the second partner,
supervised by Anderson, on the Dec. 31, 2007 audit.”
