Ligand

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Go to the PCAOB website and find information related to the Ligand case (under Disciplinary Proceedings). Discuss the separate-but-related issues affecting both the engagement partner who was disciplined and the public accounting firm monetary penalty. Present your thoughts about the fairness and appropriateness of the PCAOB's actions related to the individual partner and the firm.

Advanced Auditing Summer 2017 Ligand Pharmaceuticals Lecture Notes NOTE: When answering the questions in the test on the Ligand Pharmaceuticals case, the information contained in the readings that have been assigned for the Ligand Pharmaceuticals case control; that is, if anything I say during this lecture or anything contained in these lecture notes conflicts with what you encounter in the readings assigned for this case, you should rely on the readings when answering the test questions. (The reason for this statement is simple: For the lecture, I will sometimes draw on sources that are not listed in the reading list for this topic; I have found that dates, names, and dollar amounts can vary among media sources. Therefore, to increase the likelihood that you do well on the tests, I will confine answers to those found in the reading material, including the text, assigned for this case.) I. II. This case is about a company feeling pressure to report sales and an audit partner who did not exercise a sufficient degree of professional skepticism and thus did not perform well in his role as the public watchdog. History of Ligand Pharmaceuticals A. Ligand originally began in September 1987 as a company named Progenx, Inc., a company that licensed technology to develop cancer detection and therapy products. It was formed by Brook Byers, partner in Kleiner Perkins Caufield & Byers, a San Francisco venture capital firm. Progenx, Inc. was located in La Jolla, California. B. Byers recruited Howard Birndorf in 1988 to serve as chief executive. Howard, who had a graduate degree in biochemistry, was also an entrepreneur, having launched biotechnology start-up companies. C. In 1989, Progenx, Inc. shifted its emphasis to infrared work and licensed its technology from the Salk Institute. In December of that year, it changed its name to Ligand (a reference to the chemical complex that forms around a central atom or molecule). D. In 1991, Birndorf departed to work on another start-up company and was replaced by David Robinson, an executive with 20 years of experience at major pharmaceutical companies. At that time, Ligand had 71 employees (small by industry standards) and still had no sales. When Robinson became chief executive, he expected to make the business successful within five years and then leave the company. He stayed for more than 10 years because success didn't come within the five years. E. In 1991, Ligand entered into the first of many collaboration agreements with Pfizer Inc. to develop osteoporosis therapies. F. In 1992, Ligand entered into another agreement, this one with Allergan Inc. The two companies agreed to work together on skin disorders, specifically Kaposi's sarcoma, caused by AIDS. The agreement required Allergan to invest $20 million in Ligand. 1 During this year and for the first time, Ligand was able to book revenues even though it had no products to sell. It did this as a result of arrangements with some well-established drug companies. Although Ligand reported $5.5 million in revenues in 1992, it incurred a $14 million net loss. In 1993, it reported $16.1 million in revenues and a loss of $19.5 million. G. Also in 1992, Robinson worked on an initial public offering (IPO) of Ligand's stock, but before the IPO could occur, the value of biotech stocks dropped and the IPO had to be postponed. By the end of 1992, underwriters for the Ligand IPO devised a new way to attract investors: Create two classes of stocks, Class A and Class B, each with similar voting rights. The IPO would only comprise Class A shares, which would trade publically. The venture capitalists and insiders who owned stock prior to the IPO would own the Class B shares and have the opportunity to convert 25% of their Class B shares to Class A shares. At the end of two years after the IPO, if the value of Ligand's stock was below $15.875 (it was initially offered at $11 per share), the company would issue additional shares to Class A shareholders to make up the difference in value. The IPO agreement gave Robinson two years to increase the value of Ligand stock so that Ligand would not have to issue additional shares. To do this, Robinson entered into additional collaborative agreements with other pharmaceutical companies. Nevertheless, the stock had a value of $12 per share at the end of the two-year period. In late 1994, Ligand converted Class A shares into Class B Shares and issued additional shares to Class A holders to make up the difference in value. As a result, insiders lost value because the ownership of non-insiders (those who owned stock due to the IPO) increased from 25 percent to 30 percent. H. It continued to enter into collaborative agreements with other pharmaceutical companies after 1994 and in late 1998 increased its ability to make sales in the United States by establishing a 20-person sales force. In 1999, Ligand was able to increase its force to 40 when it received FDA approval on two drugs within the space of one week, which boosted the perception that it would be profitable. Unfortunately, Ligand was not profitable that year nor was it to be profitable in any other year. Because of increasing levels of sales, it was able to maintain the perception that it would eventually become profitable one day and thus was able to continue to forge research agreements with profitable companies, such as Bristol-Myers Squibb, which signed an agreement with Ligand in the year 2000. I. Throughout the year 2000 and in later years, Ligand would continue its struggle to become profitable. Around the year 2000, Deloitte & Touche LLP became its auditor. It resigned as its auditor in August 2004 amid allegations that it had performed a substandard audit of Ligand's 2003 fiscal year. 2 III. Issues Associated with the Allegation of a Substandard Audit There were two issues in this case: the failure of the auditor to perform an adequate audit and the failure of the audit firm, Deloitte & Touche, to ensure that the engagement partner on the Ligand audit was competent. a. Failure of Auditor The PCAOB stated, in PCAOB Release No. 105-2007-006 issued on December 10, 2007, that Deloitte partner James Fazio had failed to exercise due professional care; exercise professional skepticism; obtain sufficient, competent evidential matter to afford a reasonable basis about the fair presentation of financial statements; evaluate subsequent events; and supervise assistants. Specifically, in the Release, the PCAOB staid that Fazio had 1. Failed to perform appropriate and adequate auditing procedures related to sales of products by Ligand for which a right of return existed. 2. Failed to supervise others to ensure the performance of these procedures. 3. Failed to perform or, alternatively, ensure performance of procedures that adequately took into account the existence of the following factors that indicated that Ligand's ability to reasonably estimate product returns may have been impaired: a) Limited historical return experience, b) Limited visibility of its distribution channels, c) Periodic excess levels of product in its distribution channels, and d) Consistent and significant understatement of its estimates of product returns. 4. Failed to identify and address the issue of Ligand's policy of excluding certain type of returns from its estimate of future returns and the adequacy of disclosing this exclusion in its financial statements. b. Failure of Audit Firm In PCAOB Release No. 105-2007-005 issued on December 10, 2007, the PCAOB stated that Deloitte had failed to comply with certain PCAOB auditing standards. Specifically, Deloitte had: 1. Failed to staff the 2003 Ligand audit engagement appropriately and so had violated the general rule that registered public accounting firms and their associates comply with PCAOB auditing and related professional 3 practice standards (PCAOB Rules 3100, 3200T)1 and did not assign auditors to tasks and provide proper supervision according to their level of knowledge, skill and ability so that they could adequately evaluate audit evidence (AU 230.06, Due Professional Care in the Performance of Work; now AU-C 200.A16, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards and now found in AS 1015, Due Professional Care in the Performance of Work).2,3 2. Failed to comply with PCAOB auditing standards in performing the audit of Ligand's financial statements for 2003 by not exercising due professional care, exercising professional skepticism, obtaining sufficient competent evidential matter to afford a reasonable basis for an opinion regarding the financial statements and evaluating subsequent events and thus inappropriately expressed an unqualified (now \"unmodified\") opinion on an issuer's financial statements. (The standards violated were AU 150.02, Generally Accepted Auditing Standards, and AU 230, Due Professional Care in the Performance of Work, both of which are now in AU-C 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards and AS 1015, Due Professional Care in the Performance of Work; AU 326, Evidential Matter, which is now found in AU-C 500, Audit Evidence and AS 1105, Audit Evidence; and AU 560, Subsequent Events, and AU 561, Subsequent Discovery of Facts Existing at the Date of the Auditor's Report, both of which are now found in AU-C 560, Subsequent Events and Subsequently Discovered Facts and in AS 2905, Subsequent Discovery of Facts Existing at the Date of the Auditor's Report and AS 2901, Consideration of Omitted Procedures After the Report Date.) Deloitte auditors were required to determine whether Ligand had the ability to make reasonable estimates of future product returns. If a reasonable estimate cannot be made, Ligand was not to recognize revenue from sales until the right of return substantially expired or a reasonable estimate of the returns could be made. 1 See Appendix to these lecture notes for these Rules. 2 For a helpful table to convert AU sections to codified sections see Appendix A of The AICPA's Guide to Clarified and Converged Standards for Auditing and Quality Control at http://www.aicpa.org/research/standards/auditattest/asb/downloadabledocuments/clarity/aicpa_guide_to_c larity.pdf . 3 These are the standards that were in effect at the time the PCAOB addressed this case; for publicallyheld companies, many of these sections have been replaced by AS sections. I have attempted here and in subsequent sections to indicate the AS section that contains the standard. (The AU-C section references are sections that currently pertain only to private companies.) 4 Once Deloitte determined that Ligand had the ability to make reasonable estimates, it was required to determine whether these estimates of future returns were reasonable. Deloitte failed to do this because it either did not perform procedures to evaluate the reasonableness of Ligand's estimates of future returns, or did not perform them with adequate due care and professional skepticism, or the procedures performed produced audit evidence that indicated that Ligand's estimates of future returns were not reasonable and Ligand did not perform appropriate follow-up procedures. Deloitte assessed the engagement risk for the 2003 Ligand audit as greater than normal because of the difficulties associated with product sales and sales returns and its audit team planned to perform specific procedures and increase their professional skepticism to address the greater than normal risk. Deloitte, however, either failed to perform certain planned procedures or performed them without adequate due care and professional skepticism. Specifically, Deloitte did not adequately a. Investigate the significant differences between historical actual returns and Ligand's estimate of future returns. b. Compare Ligand's prior return estimates with subsequent results, even though the audit plan called for making this comparison and the workpapers indicated that Ligand had consistently and substantially underestimated its product returns. Deloitte was to evaluate subsequent events before the audit report was issued; it failed to do this. c. Determine whether Ligand was required to disclose its replacement policy in its financial statements (Ligand was required to disclose this policy and it did not adequately disclose it). d. Consider whether certain information would have affected the audit report had Deloitte known about it at the report date and whether persons currently relying or likely to rely on the financial statements would consider the information important. This information was the fact that Ligand had experienced significant, unexpected product returns during the period and that one or more wholesalers were returning a significant amount of product that was not included in the distribution channel data relied upon during the audit. Deloitte was told about this in April 2004 when it was performing a review of Ligand's first quarter financial statements, and thus should have considered the information when performing the interim review. In response to PCAOB's review of the incident, Deloitte instituted several quality control procedures: a. It established a Leadership Oversight Committee, comprising senior members of its audit practice and firm leaders to address assignment and supervision issues relating to audit partners and directors when quality or other audit performance concerns have been identified through Deloitte's 5 quality control procedures or from any other source (e.g., anonymous complaints). The committee was given the right to place individuals under special oversight with respect to their audit work, to refer individuals for counseling or additional training, to keep individuals from serving audit clients in specific capacities (including, if necessary, to restrict the individual from performing any audits), or to recommend that individuals be terminated. b. It changed its policies and procedures for identifying audit performance issues with audit partners and directors so that Deloitte can increase the likelihood that potential audit quality problems will be brought to the attention of leaders of its audit practice and the Leadership Oversight Committee on a timely basis. It also changed its quality ratings system for audit partners and directors and has attempted to further centralize its internal inspection program at the national office level (this allows assessment and resolution of potential problems to be made by persons who are not as friendly with, or as affected by, the individuals being evaluated; thus it results in a more nearly independent assessment of the issues and personnel involved). IV. Parties Who Were Affected A. Investors B. Public accounting profession: Once again, the reputation of the public accounting profession was besmirched; reputation is one of the factors that cause the auditor's opinion to have worth. C. Deloitte & Touche - The PCAOB censored Deloitte and imposed a civil penalty in the amount of $1,000,000. It also required Deloitte to maintain adequate records in which it is to describe its quality control policies and procedures for identifying and addressing potential audit quality concerns with regard to the performance and assignment of its audit partners and directors including the nature of any concerns, actions taken to address these concerns and the names of the affected persons. D. James Fazio - the PCAOB determined that Fazio warranted sanctions because of his \"...intentional or knowing conduct, including reckless conduct.\" He neither denied nor admitted guilt and was barred from being an associated person of a registered public accounting firm (per Section 105(c)(4)(B) of the 1934 Securities Exchange Act and PCAOB Rule 5300(a)(2)) and would be allowed to file a petition, pursuant to PCAOB Rule 5302(b), two years from December 10, 2007, to request approval from the PCAOB to associate with a registered public accounting firm. E. Ligand restated its financial statements for 2002, 2003, and the first three quarters of 2004. Its loss for 2003 was increased by 2.5 times the loss that was previously 6 reported for that year. Its stock value fell to an amount below $1.50 per share from a high of almost $24 per share. 7 Appendix Rule 3100: Compliance with Auditing and Related Professional Practice Standards A registered public accounting firm and its associated persons shall comply with all applicable auditing and related professional practice standards. [Effective pursuant to SEC Release No. 34-48730, File No. PCAOB-2003-05 (October 31, 2003)] Rule 3200T: Interim Auditing Standards In connection with the preparation or issuance of any audit report, a registered public accounting firm, and its associated persons, shall comply with generally accepted auditing standards, as described in the AICPA Auditing Standards Board's Statement of Auditing Standards No. 95, as in existence on April 16, 2003 (Codification of Statements on Auditing Standards, AU 150 (AICPA 2002)), to the extent not superseded or amended by the Board. [Effective pursuant to SEC Release Nos. 33-8233 & 34-47746 (April 25, 2003); SEC Release No. 34-49624, File No. PCAOB-2003-11 (April 28, 2004); and SEC Release No. 34-72087, File No. PCAOB-2013-03 (May 2, 2014)] Note that at this time, the PCAOB has replaced many of the AICPA audit standards (formerly found in AU sections and now, after a codification conducted by the AICPA, in AU-C sections) with its own AS (Auditing Standard) standards. 8