Litigation, Censures, and Fines

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Litigation, Censures, and Fine

ACC 499

February 19, 2015

Litigation, Censures, and Fines

The creation of Ernst & Young began in 1989 with the merger between Arthur Young & Co., and Ernst & Whinney. Headquartered in New York the professional service of Ernst & Young (EY) limited liability partnership has offices located throughout the United States. Ernst & Young is one of the largest business accounting firms in the world, employing over 167,000 in more than 140 countries, providing auditing, consulting, and tax services to a variety of companies. Over the years, the Big Four accounting firm has experienced issues involving ethical violations and professional misconduct (EY Building a better working world).

The primary accounting issues which form the crux of the litigation or fine for the firm, and indicate the impact to the firm as a result of litigation or fines.

For over 20 years Ernst & Young has been the external auditor for Medicis Pharmaceutical, maker of pharmaceutical products for dermatological purposes. The company policy at Medicis allows customers to return expired products in exchange for fresher products. The Public Company Accounting Oversight Board (PCAOB) discovered during a 2008 audit inspection that Ernst & Young had engaged in shaky accounting and auditing for product returns at Medicis Pharmaceutical. Resulting in Ernst & Young being fined $2 million for violating auditing standards and rules. In addition to the fine, four current and former partners were sanctioned and three of the firm's partners were also fined a total of 100,000 to settle allegations stemming from the firm's accounting of the these product returns (Whitehouse, 2012).

Accounting for the return of products is addressed in FASB Financial Accounting Statement NO. 48: Revenue Recognition When a Right of Return Exists which is now addressed in Accounting Standards Codification Topic 605: Revenue, Topic 450 and 460 addressing contingencies and guarantees. The accounting requirements of GAAP states that the company creates a reserve for product returns in which the right of returns is linked to the sale of goods.

Ernst & Young were aware of this and continued to allow Medicis Pharmaceutical to follow a replacement cost approach for five years. The effect was an understatement of reserves and a misstatement of revenue. In March 2011, the Public Company Accounting Oversight Board launched a full investigation and enforcement proceedings, which Ernst & Young along with its auditors settled without admitting or denying the findings of the board (Weil, 2013).

The key inferences of corporate ethics related to internal controls and accounting principles which lead to the litigation or fine for the accounting firm

Internal controls are intended to provide reasonable assurance as regards to the achievement of objectives in the following: effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws an regulations. It's fully expected that corporations comply with these objectives. After the PCAOB review Medicis Pharmaceutical restates its financial reports. Medicis filed a restatement in 2008 to correct more than five years of accounting for product returns in this manner. The restatement for the periods of 2003 through 2008 adjustments increased revenue by $1.1 million over the period. Principally related to sales return reserve, including other adjustment and related tax effects. The restated financial reports reflect the new “technical interpretation” of accounting principles for sales return reserve calculations. Investor confidence has suffered and they should no longer rely on the effectiveness of Medicis internal controls over financial reporting. Medicis prior accounting method for sales return reserves accrued returns at replacement cost, instead of deferring gross sales price based on Medicis assessment of the economic impact on returns affecting the business. They have revised reserve calculation to defer the gross sales value of return product (Taub, 2008). Under the following circumstances it may not be possible to derive a reasonable estimate of the future product returns: changes in demand, lack of prior information, long return period, and minimal consistency (Reserve for Product Returns, 2015).

The primary ethical standards of the accounting organization’s leadership and values which contributed to the approval of the accounting issues and thus created the litigation or fines in question

In the accounting profession as is the case in many professions, ethics are very important. Investors, leaders, and stakeholders consistently rely on the ethical collection and distribution of reliable financial information. The censure and fine leveraged against E&Y when the board found the responsible partners violated PCAOB standards in auditing Medicis new method for calculating year-end products returns reserve estimates in 2006 and 2007. Their failure in sufficiently auditing key assumptions and placed undue reliance on the representation of management reasonable assumptions. On December 31, 2005 an internal audit quality review recognized the rationale conflicting with GAAP and the internal accounting guidance of E&Y that specifically addresses revenue recognition for sale with rights of return. This material departure from GAAP was not properly addressed and E&Y’s personnel decided that another flawed accounting rationale would support their existing practice of reserving most of its product returns at replacement cost (PCAOB Announces Settled Disciplinary Order for Audit Failures Against Ernst & Young and Four of its Partners, 2012).

Identify specific conduct violations committed by the organization and accounting firm in question. Create an argument supporting the actions against the organization and accounting firm, based on the current professional code of conduct for independent auditors and management accountants

The audits conducted by E&Y of Medicis Pharmaceutical violated PCAOB rules and auditing standards. E&Y engaged with Medicis and their reasoning of how the company would establish a reserve for sales returns. The auditing partners of E&Y failed to fulfill their basic responsibility. Auditors have the responsibility of planning and performing audits to obtain reasonable assurance about whether the financial statements are free of material misstatement in accordance with the laws and rules of financial statements of a company. Auditors are able to obtain reasonable, but not absolute assurance that material misstatements are detected. Management auditors are internal and are responsible for appraising the company’s risk management strategy and practices, governance process, internal control, procedures, fraud prevention, and management control frameworks. There is a Code of Ethics and Professional Code of Conduct that all professions are supposed to follow (Handbook of the Code of Ethics for Professional Accountants, 2013).

As professional accountants, E&Y should have complied Medicis financial statements according to the fundamental principles of the profession. These principles are integrity, objectivity, professional competence and due care, confidentiality, and professional behavior. By not being objective and compromising their professional judgement E&Y allowed Medicis to follow a replacement cost approach for five years, even though they were aware of this violation and the misrepresentation it caused in Medicis financial reporting (Handbook of the Code of Ethics for Professional Accountants, 2013).


The partners at E&Y for some reason ignored the fact that Medicis reserving for its sales returns was not in conformity with GAAP, even when it was brought to their attention by an internal audit quality review in December 2005. During this review the personnel of E&Y identified the conflict in both GAAP and their internal accounting guidance that addressed revenue recognition for sales with rights of return. If they had put themselves in the shoes of investors, they would have remembered that they must continually evaluate their client’s accounting and related disclosures (Cohn, 2012).


Cohn, M. (2012, February 8). Ernst & Young to Pay $2M to Settle Audit Failure Charges. Retrieved February 20, 2015, from Accounting Today web site:

EY Building a better working world. (n.d.). Retrieved February 19, 2015, from EY website:

(2013). Handbook of the Code of Ethics for Professional Accountants. New York: International Ethics Standards Board for Accountants.

PCAOB Announces Settled Disciplinary Order for Audit Failures Against Ernst & Young and Four of its Partners. (2012, February 8). Retrieved February 20, 2015, from Public Company Accounting Oversight Board website:

Reserve for Product Returns. (2015). Retrieved February 20, 2015, from Accounting Tools website:

Strayer University. (2013). Accounting undergraduate capstone (2nd ed.). Mason, Ohio: Cengage Learning.

Taub, S. (2008, September 24). Medicis May Restate for Sales Return Reserves. Retrieved February 19, 2015, from CFO website:

Weil, J. (2013, March 10). Ernst & Young gets a slap on the wrist and a love note from prosecutors. Retrieved February 18, 2015, from St. Louis Post-Dispatch:

Whitehouse, T. (2012, February 9). PCAOB Levies $2 Million Fine of E&Y, Four Partners. Retrieved February 20, 2015, from Compliance week website: