PCAOB penalizes E&Y, partners over bad Medicis revenue numbers

by Kurt Schulzke

Lapdogs sometimes do bite.  (See important update below.)  In a strangely-worded February 8, 2012 disciplinary order, the PCAOB fined mega audit firm Ernst & Young (E&Y) $2 million while disbarring, censuring and/or imposing fines against four E&Y audit partners individually.  The key finding?  E&Y and its partners failed to properly evaluate the Dec. 31, 2005, 2006 and 2007 sales returns reserves of auditee Medicis:

[I]n 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.

… 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.

In addition, for 2006 and 2007:

E&Y… violated PCAOB standards in auditing the company’s new methodology for calculating its year-end product returns reserve estimates. The Board found that they failed to sufficiently audit key assumptions and placed undue reliance on management’s representation that those assumptions were reasonable.

Fair enough.  But here’s the strange part:

The Board initiated this proceeding on March 8, 2011, and, as required by the Sarbanes-Oxley Act, the proceeding was nonpublic. The Board found good cause to make the hearing in the proceeding public. As permitted by the Act and Board rule, the Division of Enforcement and Investigations consented to making the hearing in the proceeding public. However, as also permitted by the Act and Board rule, none of the respondents consented to making the hearing public, which required the proceeding to stay nonpublic.

I have no idea what this means except that the hearings that led to the disciplinary order were not public.  Maybe after the dog told the owner it was ready to bite, the owner persuaded the dog to do it behind closed doors?  Fits nicely with the SEC’s efforts to deprive investors of valuable evidence in settling fraud charges.

UPDATE – April 4, 2012 :  In conversation with PCAOB Director of Public Affairs Colleen Brennan, it has become apparent that at least in this instance, the privacy of the PCAOB disciplinary hearing was not the fault of the PCAOB but of the Congress who (cleverly or ignorantly) wrote the Sarbanes-Oxley Act so as to largely undermine one the Act’s most important provisions.  As it happens, SOX Act Section 105(c)(2) inexplicably empowers an auditor undergoing PCAOB disciplinary action to effectively hide the related disciplinary hearings from the public.

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