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accounting standards and concepts violated by Ligand Pharmaceuticals, as well as the role of the PCAOB as a regulatory body.
Standards for Accounting of Sales Returns
The applicable standard includes FAS 48, which establishes standards for revenue recognition when the right of return exists. FAS 48, issued in 1981, specifies under what circumstances revenue is recognized on a sale in which a product may be returned. For a business that sells its products but gives buyers the right to return the product, FAS 48, paragraph 6, states that revenue from the sales transaction is recognized at the time of sale only if all of the six conditions specified in items a through f were met. One condition which proved a problem for Ligand was that "the amount of future returns can be reasonably estimated (paragraph 8)" (FASB, 1981, p. 5).
Paragraph 6 further specifies that, in the event that all the criteria for recognizing revenue are not met, sales revenue should not be recognized until either the return period has substantially expired, or if the specified conditions are subsequently met, whichever occurs first (FASB, 1981, p. 5).
Paragraph 7 specifies that if sales revenue is recognized because the conditions of paragraph 6 are met, then any losses that would be expected in connection with returns should be accrued in accordance with FASB Statement No. 5, Accounting for Contingencies (FASB, 1981, p. 5).
Paragraph 8 provides guidance as to how factors and circumstances may negatively affect an organization's ability to make a reasonable estimate of future returns. If the product is likely to be significantly affected by external factors, such as changes in demand, then the ability to reasonably estimate the amount of future returns may be impaired. Likewise, if there exists a relatively long period of time during which a product may be returned, this condition also affects the ability to reasonably estimate returns. Or, if there is a lack of historical experience with similar types of sales of similar products, then the ability to make a reasonable estimate may be impaired. All of these conditions apply to the agreements that Ligand had with its three drug wholesalers.
In addition to specifying conditions under which revenue is recognized, FAS 48 also amends Statement 32. Paragraph 9 provides that the reference to SOP 75-1, Revenue Recognition When Right of Return Exists, is deleted from Appendix A and states that the specialized accounting provisions of SOP 75-1 are superseded by FAS 48.
Ligand violated several standards and concepts as set forth in FAS 48. Because Ligand did not satisfy all of the conditions as set forth in FAS 48, paragraph 6, items a thru f, specifically by not being able to reasonably estimate the amount of future returns, they were obligated to recognize sales revenue either when the return privilege had substantially expired, or when conditions itemized in 6a thru f were met, whichever occurred first. If Ligand's wholesalers had cooperated by consistently providing up-to-date sell-through data, then Ligand could have established reasonable allowances for sales returns (2.5% was shown not to be reasonable). Because the returns were shown to be so unpredictable, with Ligand often receiving "large and unexpected shipments from the three wholesalers," Ligand's only option for recognizing sales revenue was to wait until the expiration of the return privilege. Because Ligand's wholesalers had the right to return product received up till six months after the expiration date, then that expiration date plus six months was the sales revenue recognition date that Ligand should have used (FASB, 1981, p. 5).
All of the provisions of FAS 48 paragraph 6 provide specific criteria for revenue recognition, which Ligand ignored; but they also ignored the intent of FAS 48, which was made clear throughout its discussions of revenue recognition concepts. Paragraph 8 sets forth guidelines for the ability to make reasonable estimates. All four guidelines in sections a though d indicate that Ligand's ability to make reasonable estimates was impaired: (a) Their products were susceptible to changes in demand because the products were new, there was no established pattern of demand; (b) There was an 18-month interval form shipping to final expiration date with the result that at any time during the last 12 months of this interval product could be returned; (c) There was no historical experience with similar types of sales of similar products because the products were new; (d) There was no large volume of relatively homogenous transactions, because again, the products were new, and there was not enough data to show that the transactions were homogenous (FASB 48, 1981).
Deloitte had an obligation to disclose the fact that sales returns had been misstated. The applicable standard is contained in AU Section 560, Subsequent Events, issued November 1972. According to AU 560, there are two types of subsequent events which require consideration by management, and evaluation by the auditor. The first type of subsequent event describes the Ligand engagement, where later events provide "additional evidence with respect to conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements" (p. 1). This standard requires that all information that becomes available before the financial statement is issued should be used by management to evaluate the conditions on which the estimates were based. According to the case study, the updated sales return data showed that, in some cases, returns received in early 2004 for products sold in 2003 exceeded the products' total 2003-year-end provision for sales returns. Given that expiration dates for some products shipped in 2003 extended as far into the future as into 2005, the magnitude of materially understated allowances was clear (AU 560, 1972).
AU 560 clearly calls for the adjustment of financial statements based on changes to estimates because of such evidence as Ligand received in their updated sales return data in early 2004. Fazio did not prepare the required adjustment. Fazio's authorization of an unqualified opinion of Ligand's 2003 financial statement on March 10, 2004 was a clear violation of Deloitte's responsibility to adjust the statement based on the additional evidence (AU 560, 1972).
A further violation occurred in April 2004 when Fazio and his staff were presented with Ligand's sales returns for the first two months of 2004. The actual sales returns data again demonstrated the inadequacy of the year-end allowance. Moreover, Ligand's staff also provided forecast data to the auditors showing that there would be additional product returns from fiscal year 2003 sales, underscoring still further the material understatement of 2003 sales returns allowances. Again, Fazio did not recommend that Ligand recall and restate its 2003 financial statements to correct the material understatements that had occurred (AU 560, 1972).
Complaints Regarding PCAOB
Critics claim that the PCAOB does not fulfill its mission of protecting investors. A Washington Post article describes the PCAOB as "slow to act, veiled in secrecy and weak -- or weak-willed" (2010, p.1). The article points out that auditors did nothing to prevent the financial crisis of recent years and provides quotes from court-appointed examiners who investigated corporate bankruptcies.
According to examiner Michael J. Missal, examiner for New Century Financial, KPMG auditors "acquiesced in New Century's departures from prescribed accounting methodologies" and at times "acted more as advocates for New Century" (Hilzenrath, 2010, p.1). Examiner Anton R. Valukas faulted Lehman Brothers auditor Ernst & Young for "among other things, its failure to question and challenge improper or inadequate disclosures" (ibid.).
Furthermore, the article charges that the PCAOB has done little to rewrite standards, which themselves had been widely criticized as having been written by the auditing industry to protect auditors from liability. Another criticism charges that PCAOB enforcement cases against auditors suspected of negligence or complicity in cooking corporate books can take several years,…[continue]
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