In this case study we present the problems created by misinterpretation of AccountingStandardsby a company and the independent auditor's failure to identity and report these problems. The company, Medicis Pharmaceutical Corporation (Medicis), made several mistakes in the revenue recognition process as it relates to Sales with a Right to Return. Ernst & Young, their auditor for over two decades, did not exercise professional skepticism in conducting the audits and thus failed in their duty to ensure that investors receive reliable information. This eventually led to litigation with heavy penalties for the company and its auditors. The primary objective of this case understands the complexities of an audit engagement and the role and responsibilities of the auditor. This case is designed for a (second) undergraduate or a master's levelauditingcourse with a difficulty rating of 3. The case may be assigned as a homework assignment or in class discussion in small groups towards the end of the semester.

CASE SYNOPSIS

Medici's manufactured and sold pharmaceutical skin care products to wholesalers and retail chains. While the products were good, the company 's sales practices were aggressive. The company offered a very generous return policy that should have alerted the auditors that the accounting revenue recognition standards may be misinterpreted. Initially both the company and their auditor got a pass as their return policies were common practice in the pharmaceutical industry. However a second class-action lawsuit and oversight of PCAOBpunished the company and their auditors with fines and penalties. This is a cautionary tale for companies that try to recognize questionable revenues.

COMPANY HISTORY

Medici's was founded in 1987 by Johan Shacknai (Bloomberg News, supra). Registered in Delaware, the company's principal offices were in Scottsdale Arizona and traded on the New York Stock Exchange (NYSE) from 2005 through 2012 under the ticker symbol MRX. (Bloomberg News, November 26, 2015). For more than 20 years, Medici's audits of financial statements were conducted by Ernst & Young, a Big 4 accounting firm (PCAOB News Release, February, 2012). Medici's developed and sold time-dated pharmaceutical products, such as Solodyn and Ziana, acne prevention drugs, primarily to wholesale distributors and retail chain drugstores (collectively, the "customers") (Ibid). Management practice of channel-stuffing and misinterpretation of revenue recognition standardsled to misstatement of financial statements over a six-year period resulting in litigations and penalties.

In 2012, Valeant Pharmaceutical International, a Canadian drug maker, acquired Medicis for $2.6 billion (Ibid). One of the terms of the merger was that Medicis would delist its stock from the NYSE but continue to operate as a subsidiary of Valeant Pharmaceuticals International which traded on the Toronto Stock Exchange under the ticker symbol VRX. Johan Shachnai continued as the CEO of the subsidiary company. In July 2018, the company changed its name to Bausch Health Companies Inc. and is listed on the Toronto Stock Exchange under the ticker symbol BHC.

ACCOUNTING MISTAKES

Medici's developed and sold time-dated pharmaceutical products, such as Solodyn and Ziana, acne prevention drugs, primarily to wholesale distributors and retail chain drugstores. The company's "returns goods policy" gave the customers the right to return the product if the product was returned within 4-6 months before expiration or up to 12 months after expiration (collectively, the "expired product"). Most of its products had a shelf life of 18-24 months. According to the "Returns Goods Policy," upon return of the product, customers received full credit in the amount of the original purchase price or pricing one year prior to the date Medicis receives the return. The policy did not require the customer to purchase the same or similar product to receive or use the credit for returning the expired product. Customers would, however, routinely purchase the same product within the same quarter in which the return credit was issued. Medici's "Returns Goods Policy' (Figure 1) did not distinguish between returns replaced in the quarter and returns not replaced in the quarter (PCAOBRelease No. 105-2012-001, February 8, 2012).

At the time of sale, Medicis would record product revenue and estimate future product returns, reducing revenue in its financial statements. Although not set forth in its returns policy, the estimated reserve was calculated at replacement cost for the expired product, even though the customer receives full credit in the amount of the gross sales price for the product returns, regardless of when the customers used their credit to buy a "replacement producti' During the 2006 audit, it was determined that 97% of all sales returns were for expired products and that 72% of all expired products returned were replaced in the same quarter. By estimating the returns reserve at replacement cost, rather than gross sales price, Medicis reported an 85% gross margin at the time of sale, even though it issued a credit for the gross sales price, when the product was eventually returned. This method had a material impact on Medici's returns reserve estimate, resulting in approximately a $54 million difference in the reserve estimate (PCAOBRelease No. 105-2012-001, supra).

Beginning in 2006, Medicis applied a different reserve methodology that relied upon significant assumptions that were inconsistent with historical return patterns. The reserve amount was determined by the launch date of the product sold to its customers. If the product was launched within the last 4 years, it was referred to as a "non-legacy product ." If the product was launched more than 4 years before sale, those products were referred to as "legacy products." The estimated reserve amount for sales returns of non-legacy products was based on estimating the total units of inventory in the distribution and retail channels and comparing that total estimate to an estimate of the units of inventory in the channels that would not be returned for expiry due to product demand (the "units-in channel methodology"). The estimated reserve amount for sales returns of legacy products was the same method utilized by Medicis in 2005, based upon replacement cost determined by historical return rates (PCAOBRelease No. 1052012-001, supra).

Audit Failures

Ernst & Young was Medici's auditors for more than twenty years. Assigned to the audit of the Medici's financial statements for the 6-months ended December 31, 2005 was Jeffrey S. Anderson, the supervising senior auditor and Robert H. Thibalt, the independent review partner (PCAOB Release No. 105-2012-001, supra). Despite having questioned Medici's accounting policy of using replacement cost to estimate the year-end sales returns reserve, neither Anderson nor Thibalt objected to this practice. Rather than relying on SFAS 48 Revenue Recognition When A Right of Return Exists, the auditors believed that Medicis had a right to use replacement cost in estimated the reserve for sales returns under SFAS 5 Contingencies. (PCAOBRelease No. 1052012-001, supra). Ernst & Young's audit team, led by Anderson, mistakenly analogized the use of replacement cost to a warranty exception. The auditors believed that, since the final customer was exchanging a product for a similar product, the reserve may be booked at replacement cost rather than at the gross sales price. This created a twofold problem:

1. The final customer was not returning the item.

2. The exchange was not for a same type of product.

Medici's customers were resellers, either wholesalers or retail outlets, not the ultimate consumer. The product being returned was expired and the product reissued was a freshly-dated product. The situation is not an exchange contemplated by SFAS 5, wherein the ultimate consumer returns to the store to exchange a blue shirt for a green shirt or a large sized shirt for a medium-sized shirt (PCAOBRelease No. 105-2012-001, supra).

Furthermore, less than two months after concurring with Medici's use of the so-called "exchange exception" to SFAS 48, Ernst & Young's Audit Review Quality team questioned Medici's accounting rationale but ultimately permitted Medicis to utilize replacement cost to estimate its sales returns reserve (PCAOB Release No. 105-2012-001, supra). This decision was later criticized in 2011 by the PCAOB inspection of the audit. PCAOB Chairman, James R. Doty stated: "[Ernst & Young] 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 audit]" (PCAOBNews Release, February 8, 2012).

MEDICIS AND ERNST & YOUNG DODGE THE FIRST BULLET

On October 3, 2011, shareholders instituted a class action lawsuit in the United States District Court for the District of Arizona against Medicis, Johan Shacknai, Medici's founder and Chief Executive Officer, Richard Peterson, Medici's Chief Financial Officer, Mark Prygocki, Medici's Chief Operating Officer and Ernst & Young (In Re Medicis Pharmaceutical Corp, 2011). In the lawsuit, Medicis was alleged to have violated SFAS 48 which stated that revenue may be recognized on product sales when a right of return exists, but only if certain conditions are satisfied:

1. The returns can be reasonably estimated; and

2. A reserve account for estimated future returns based on the gross sales price of returned products is maintained.

Over a six-year period, 2002 through 2007, the restated financial statements filed by Medicis resulted in an understatement of net income of approximately $1.1 million (Table 1):

Medici's argued that its violation of SFAS 48 was a misinterpretation of a "technical" accounting provision. The shareholders alleged the violation was intentional or with deliberate recklessness and resulted in a manipulation of revenues by management. By "stuffing the distribution channel" with its products that it knew would be returned, Medicis was booking revenues years in advance by "omitting the required reserve and concealing from investors the fact that a material portion of the sales were likely to be returned." Whistleblowers came forth to testify that Medici' s sales returns reserve estimations were "deceptively low and/or were using an inapplicable GAAP exception" (Ibid).

Despite whistleblower evidence from seven witnesses (Edwards, 2011), Judge G. Murray Snow dismissed the action (In Re Medicis Pharmaceutical Corp., supra). Judge Snow found that the shareholders did not satisfy the burden of proving, pursuant to Rule 10b-5 of the Securities and Exchange Act of 1934 and the Private Securities Litigation Reform Act that the defendants acted with scienter (i.e. intent to deceive, manipulate, or defraud). Scienter "must [be] state[d] with particularity [of the] the circumstances constituting the fraud or mistake" and requires a strong inference that a defendant acted with the required state of mind to commit intentional acts of fraud or acted with "deliberate recklessness" that amounts to fraud (Ibid). Judge Snow stated that the plaintiffs failed "to allege an accounting error that was so obvious that the defendants must have been aware that their interpretation of SFAS 48 was incorrect' (Ibid). Accounting literature did not make Medici's error obvious. A statement of position relating to another industry, such as the software industry, was rejected by the Court as authoritative literature. The Court went further to acknowledge that "other pharmaceutical companies have attested to the SEC that they too allowed exchanges of expired product for fresh product and then booked revenues using replacement cost' (Ibid). Judge Snow stated that a restatement or an accounting error does not give rise to scienter (Ibid). In his concluding remarks, Judge Snow stated: "even when viewed holistically, the amended complaint does not give rise to a strong inference of scienter with respect to any of the defendants" (Ibid).

ERNST & YOUNG IS HIT BY A SECOND BULLET

On February 8, 2012, the PCAOB brought disciplinary proceedings against Ernst & Young and its individual auditors, Anderson, Thibalt, Ronald Butler, Jr., the second partner in the audit of the December 31, 2005 financial statements and Thomas A. Christie, the second partner in the audit of the financial statements for the year-ended December 31, 2007, for violations of the PCAOB standards of auditing (PCAOB Release No. 105-2012-001, supra). The PCAOB assessed a $2 million civil penalty against Ernst & Young, the largest civil penalty issued by the PCAOB at the time. PCAOB's Division of Registration and Inspections concluded that Ernst & Young's acceptance of Medici's accounting for its sales returns reserve violated PCAOB standards since the accounting did not comply with GAAP (Ibid). The PCAOB Director also found that in auditing Medici's new methodology, Ernst & Young failed to sufficiently audit key assumptions and placed reliance on management's representation that those assumptions were reasonable (Ibid). "Accounting firms and their personnel must continually evaluate their client 's accounting and related disclosures, putting themselves in investor 's shoes." (Ibid) Particularly troubling to the Board was the fact that Ernst & Young's internal audit quality review inspection program discovered the problem with Medici's sales return reserve estimate and "failed to appropriately address a material departure from GAAP regarding the company 's sales returns reserve" (Ibid). Many auditing violations that were identified by the PCAOBincluded:

1. Failure to exercise due professional care in the performance of the audit (PCAOBRelease, supra);

2. Failure to disclose all significant accounting policies of Medicis as an integral part of the financial statements (PCAOBRelease, supra);

3. Failure to appropriately consider or ensure the performance of audit procedures to consider contradictory audit evidence (i.e. sales returns not eligible for exchange treatment) PCAOB, accepted accounting principles (PCAOBRelease, supra);

4. Failure to adequately consider whether any action was required to safeguard against future reliance on Ernst & Young's audit report on the December 31, 2005 financial statements (PCAOBRelease, supra).

5. Failure to consider subsequent disclosures of facts that existed at the date of the auditor's report (PCAOBRelease, supra);

6. Failure of Ernst & Young to obtain sufficient competent evidential matter to support Medici's significant accounting estimates and key assumptions (PCAOBRelease, supra);

7. Failure to adequately consider whether Medici' s change in methodology for estimating its sales returns reserve for "non-legacy" product returns needed to be disclosed in the entity's Form 10-K (PCAOBRelease, supra); and

8.Issuance of an incorrect audit opinion (i.e. unqualified opinion) (PCAOBRelease, supra).

In the end, the PCAOB concluded that Ernst & Young "failed to identify and appropriately address a material departure from U.S. GAAP" and performed audits "inconsistent with their obligations to exercise professional skepticism as the company's independent auditor " (PCAOBNews Release, supra).

SECOND BULLET STRIKES MEDICIS TOO-CHANNEL-STUFFING

After dismissal of the class action lawsuit by Judge Snow on December 1, 2009, the complaint was amended and discovery was undertaken (In Re Medicis Pharmaceutical Corp., supra, 2011).

The lawsuit against Medicis claimed that the pharmaceutical company was "channelstuffing." (Edwards, 2011). This management sales technique involves claiming that extra product was sold to customers when management of the entity knows the unwanted stock would be returned (Ibid). Medicis was shipping drugs to sellers it knew would not be resold (Ibid). By doing so, Medicis was inflating revenues on paper, allowing it to show consecutive quarters of profits. When the expired product was returned, Medicis would book it at the same value as the returned product originally cost (Ibid). Essentially, this was "an accounting wash," even though Medicis had to make two batches of the product, just to sell one (Ibid). Despite these management techniques, management informed investors and analysts repeatedly that "there was nothing unusual about Medici 's stocking policies" (Ibid). Shacknai, the CEO and founder, called it "a technical issue" (Ibid). Prygocki, the COO, stated that "the deferred tax asset has no impact on cash flow or corporate earnings" (Ibid). Neither of those statements turned out to be true. (Ibid).

Over 500,000 pages of documents, including the production of Ernst & Young's work papers were reviewed (Ibid) and witnesses were deposed. The parties mediated the dispute that allegedly damaged 47.8 million shares of Medici's common stock and another 45,200 stock options (100 shares each) (Ibid). Neither Medicis nor Ernst & Young admitted any wrongdoing, in the class action settlement agreement that was reached in 2011 (Ibid). Medicis and Ernst & Young continued to believe that its sales return reserve methodology "violations" resulted from a technical and unintentional misapplication of SFAS 48 and GAAP. Medicis and Ernst & Young admitted no fraud and no fraud motive was offered. The facts prove that the correct application of SFAS 48 would have resulted in a cumulative understatement of revenues and earnings during the period as a whole. Nevertheless, Medicis agreed to pay $11 million and Ernst & Young agreed to pay $7 million to settle the class action litigation (Ibid).

Required:

The PCAOB cited Medici's auditor, Ernst & Young, for numerous violations of auditing standards. What auditing standards did 1. 1. Ernst & Young violate? How did Ernst & Young violate those auditing standards?

2. What did the PCAOBmean when it said Ernst & Young acted "inconsistent with its obligation to exercise professional skepticism as [Medici 's] independent auditor"? Is professional skepticism required in all audits?

3. Ernst & Young's work papers were requested by the plaintiffs in the class action civil litigation. What are work papers? To whom do work papers belong? What purpose(s) do work papers serve? Why do you think Ernst & Young's work papers were requested in the civil litigation against them?

4. What is the purpose of quality control in an audit firm? Is it required? What was deficient with Ernst & Young's Audit Quality Review of the audit of Medici's December 31, 2005 financial statements?

5. On February 8, 2012, the PCAOB assessed a $2 million civil penalty against Ernst & Young for its violations of PCAOB auditing standards in regard to audits of Medici's financial statements. What additional penalties could the PCAOBhave issued?