Ernst & Young one of the biggest audit firms in the United States was ordered to pay a fine of $2 million as settlement related to audits it had done for Medicis over a period of three years (2005-2007). The main issue that led to the litigation was the failure by Ernst & Young to accurately evaluate Medicis` sales returns reserve from the firm`s financial statements. According to Public Company Accounting Oversight Board (PCAOB), Ernst & Young failed to fulfill its core responsibility, more so given its position as one of the big four in the U.S. market.Ernst & Young had audited Medicis` books for more than two decades (PCAOB, 2012). Ernst & Young neither admitted nor denied any wrongdoing on its part.
When PCAOB conducted an audit inspection, they found evidence that the auditing firm- Ernst & Young- had raised questions internally but went ahead and allowed faulty assumptions to pass without challenge (Whitehouse, 2012). This boils down to Ernst & Young’s internal controls. An auditor firm is charged with the responsibility of ensuring that no important piece of information is overlooked. Considering the fact that there was evidence indicating Ernst & Young had raised questions concerned some of the flawed assumptions clearly indicate that the existing internal controls at the audit firm were inadequate. If the company had strong internal control procedures, no questions could have been overlooked or left unanswered. Where quality internal controls exist, all issues raised during audits, including questionable accounting procedures, are thoroughly examined and no stone is left unturned.
The American Institute of CPAs (AICPA) has developed a code of professional conduct that governs the activities of all accounting firms, and all accounting firms are expected to adhere to the code of conduct. The code of conduct has four major parts- principles, rules of conduct, ethical rulings, and interpretations of the rules of conduct (Arens, Elder & Beasley, 2012). The rules of conduct explicitly enumerate the rules that all CPAs must follow (AICPA, 2015). For a big auditing firm like Ernst & Young, they have internal ethical standards that differentiate them from the rest of other players in the industry. However, the present case relates to basic ground rules that all audit firms have to follow. All auditing companies should never overlook any questionable entries in a client`s financial statement or any questionable methods used. There was an evident failure on the part of the auditing company because the audit firm failed to look at the client`s financial statements comprehensively. Even after the audit firm discovered that the client`s audit contravened both GAAP and its own internal accounting guidance, no appropriate action was taken, instead, professionals from Ernst & Young made a decision to consult internally and came to the conclusion that their client`s flawed accounting practice was supported by accounting rationale (PCAOB, 2012).Audit firms such as Ernst & Young have a legal and ethical responsibility to comply with the rules and regulations, and not engage in illegal practices just because they want to maintain good business relationships with their clients. It is therefore evident that despite the existence of internal ethical standards within the audit firm in addition to the code of professional conduct, Ernst & Young personnel deliberately chose not to follow the standards. As one of the big four in the audit industry, Ernst & Young has strong ethical standards, however, it appears that the leadership as at that time was lacking in values, which led them to approve their client`s accounting practices even though inconsistencies had already been discovered earlier (Arens, Elder & Beasley, 2012).
The particular rule of conduct that was committed by both Medicis and Ernst & Young relates to FAS number 48, which deals with recognition of revenue when there is a right of return (Whitehouse, 2012). The audit firm and the client had reached an agreement on how Medicis would record its product returns.Medicis has a provision that permitted its customers to return expired goods to be exchanged for fresh goods. Based on this agreement, Medicis made an estimation of how much goods will be returned based on the returns made in the past periods. According to PCAOB (2015), where there is an arrangement for return of goods, accounting rules requiresthat,the company established a reserve for estimated returns at the gross selling price for the goods. However, Medicis decided to use a replacement cost approach, which Ernst & Young accepted. This resulted in revenue misstatement and reserves for returns were understated.
The best method of preventing this type of behavior is for auditors to comply with their professional code of ethics and to pay attention to detail when conducting audits. As indicated in the case, Ernst & Young noted that the client`s practices violated GAAP and its own accounting procedures, but still chose to ignore the issue. Had the auditors done their work, the client would have corrected the mistake and complied with GAAP. Secondly, auditing firms such as Ernst & Young have to amend their procedures and policies to ensure the quality of their audits is beyond reproach. In this regard, Ernst & Young noted that it had made changes in its procedures and policies to address the numerous loopholes that led to the issue as a way of enhancing the quality of its audits. This indicates that professional societies, particularly the audit firms have the biggest role in preventing such behaviors in the future.
AICPA. (2015). AICPA code of professional conduct.
Arens, A., Elder, R., & Beasley, M. (2012). Auditing and assurance service:An integrated approach. Upper Saddle River, NJ: Pearson Prentice Hall.
PCAOB. (2012). PCAOB announces settled disciplinary order for audit failures against Ernst & Young and four of its partners.
Whitehouse, T. (2012). PCAOB Levies $2 Million fine on E&Y, four partners. Complianceweek. IV