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Ernst & Young Settles a $2 Million Slap on the Hand With the PCAOB

And no, before anyone asks, this has nothing to do with Lehman.

According to the PCAOB, Ernst & Young settled with the Board yesterday related to three EY audits of Medicis Pharmaceutical Corporation to the tune of $2 million, the largest civil penalty levied by the PCAOB to date. Note that a settlement doesn't mean EY admitted to actually bumbling any of these audits, it simply means they no longer wanted to deal with the PCAOB's shit.

From the PCAOB:

"These audit partners and Ernst & Young — the company's outside auditor for more than 20 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."

In the audits of Medicis's Dec. 31, 2005, 2006 and 2007 financial statements, the Board found 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's reserving for its sales returns was not in conformity with U.S generally accepted accounting principles (GAAP).

The company corrected its accounting for its sales returns reserve and filed restated financial statements with the Securities and Exchange Commission as a result.

The Board found that during the audit periods in question, E&Y and its responsible partners failed to comply with PCAOB standards in evaluating Medicis's practice of reserving for most of its estimated product returns at the cost of replacing the product, instead of at gross sales price.

The Board also found that, in auditing the company's Dec. 31, 2005 financial statements, 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.

The Board further found that, two months later, during an internal audit quality review of the Dec. 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.

The Board found that they 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.

It's also worth noting that the PCAOB found good cause to make the hearing against EY public, however none of the respondents consenting to public proceedings, therefore said proceedings remained non-public. Too bad EY couldn't do the same with the settlement.

As a result of the PCAOB's work, E&Y partner Jeffrey S. Anderson is censured from associating with a PCAOB-registered accounting firm, with the right to petition to remove the bar after two years, and was 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.

In addition, 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.

The entire disciplinary order may be found via the PCAOB here but really, you know everything you need to know if you managed to read this whole thing.

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