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.”
Somehow, we’ve got to do better!