In its biggest enforcement action to date, the Public Company Accounting Oversight Board has fined Ernst & Young $2 million, sanctioned four current and former partners, and fined three of the partners a total of $100,000 to settle allegations that the firm violated auditing standards and rules.

During a 2008 audit inspection, the PCAOB discovered some shaky accounting and auditing for product returns at Medicis Pharmaceutical Corp., not to mention evidence that E&Y questioned itself internally before allowing faulty assumptions to pass unchallenged. Medicis filed a restatement in 2008 to correct more than five years worth of accounting for product returns as a result of the inspection finding. The PCAOB launched a full investigation and enforcement proceeding in March 2011, with E&Y and its auditors settling the matter without admitting or denying the board's findings.

The PCAOB's 25-page enforcement order details the E&Y engagement with Medicis and their agreed rationale for how the company would establish a reserve for sales returns. Medicis, a maker of pharmaceutical products primarily for dermatology purposes, allows its customers to return products that are expired in exchange for fresher products, the accounting for which is addressed in Financial Accounting Statement No. 48: Revenue Recognition When a Right of Return Exists, now found in the Accounting Standards Codification primarily under Topic 605: Revenue, but also under Topics 450 and 460 addressing contingencies and guarantees.

The PCAOB says the accounting requires the company to establish a reserve for estimated returns at the gross sales price for the products, but the company followed a replacement cost approach that E&Y allowed. The effect, the PCAOB said, leads to an understatement of reserves and therefore a misstatement of revenue. Oddly enough, when Medicis restated its results for 2003 through 2008, the adjustments increased revenue over the period by $1.1 million. The company said the restatement related principally to the sales return reserve, but it also included other adjustment and related tax effects.

The PCAOB says the lead partner on the engagement, Jeffrey Anderson, and two partners he supervised, Ronald Butler and Thomas Christie, knew or should have known that Medicis followed a faulty process for reserving for product returns. When E&Y conducted an internal audit quality review of the 2005 audit under partner Robert Thibault, E&Y's own personnel noted the departure from Generally Accepted Accounting Principles and E&Y's own internal accounting guidance, yet failed to adequately challenge it, the board said. Even further, when the company modified its methodology for calculating the reserve for 2006 and 2007, auditors too readily accepted management assumptions and failed to audit them adequately, the board said.

In a prepared statement, E&Y spokesman Charles Perkins said the firm cooperated fully with the PCAOB in its investigation. “This settlement allows us to put this matter behind us,” he said. “We have implemented changes to our policies and procedures that directly address the PCAOB's concerns and will enhance quality in the future. We take these issues very seriously, and remain highly confident in the quality of our audits.”

As the lead partner, Anderson took the biggest personal hit with a $50,000 fine and a two-year bar on being associated a firm registered to perform public company audit work. Thibault was fined $25,000 and barred for one year. Butler was fined $25,000 and censured, or reprimanded, by the board. Christie was censured but not fined. The PCAOB describes Thibault as a former partner with the firm whose license to practice as a certified public accountant is not active. It describes the other three as current partners of the firm. E&Y confirmed one partner has retired and three remain employed with the firm.

The action represents just the type of departure from skepticism that PCAOB Chairman James Doty has been challenging since he assumed his post a year ago. In a prepared statement, Doty said the firm, on the job with Medicis for more than 20 years, failed to fulfill its primary 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," he said.

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