In the late 1990s, James Fazio reached what many CPAs consider the pinnacle of success in the accounting profession, namely, partnership in one of the Big Four public accounting firms. For more than a decade Fazio served as an audit partner with Deloitte & Touche in that firm's San Diego, California, practice office. Similar to his colleagues within Deloitte and the other major accounting firms, Fazio's professional life was disrupted by the Enron and WorldCom debacles. The sudden collapse of those two large companies following the turn of the century prompted a public outcry to impose more rigorous regulatory controls over the financial reporting function for publicly owned companies. The federal government's response to that outcry would further complicate the already complex and stressful nature of James Fazio's professional role as an audit partner with a Big Four accounting firm.

In the summer of 2002, the US Congress hurriedly passed the Sarbanes-Oxley Act (SOX). The SOX legislation contained the most far reaching financial reporting reforms at the federal level since the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. Those reforms included a requirement that public companies have their internal controls over financial reporting standards audited by an independent accounting firm. This reform forced companies to spend billions of dollars to rethink and completely overhaul their internal control systems.

SOX also established a new regulatory structure for the independent audit function that had far reaching implications for the major accounting firms. The role of the Public Company Accounting Oversight Board (PCAOB) was to strengthen and improve the independent audit function for public companies and therefore minimize the likelihood of audit failures.

Deloitte's 2003 Ligand Audit

In early 2004, the 43 year old Fazio was overseeing the 2003 audit of Ligand Pharmaceuticals, a San Diego based company whose stock was traded on the NASDAQ exchange. As the audit engagement partner for Ligand, Fazio had a wide range of responsibilities. The following excerpts from Deloitte's Accounting and Auditing Practice Manual at the time addressed the role and responsibilities of an audit engagement partner:

It is the responsibility of the engagement partner to form the audit opinion, or to disclaim an opinion, on the financial statements.

The Engagement Partner has the final responsibility for the planning and performance of the audit engagement, including the assignment, on the job training, and audit work of professional staff, and the implementation of the decisions concerning matters that have been subject of consultation…

The knowledge and skills of the Engagement Partner should be matched with the needs and characteristics of the engagement.

For several years, James Fazio had been involved in his office's "High Technology Group." Because of his experience with emerging growth companies, Fazio seemed well suited to serve as the audit engagement partner for Ligand, which was still in a developmental stage. In company press releases, Ligand described itself as an "emerging R&D and royalty driven Biotechnology Company." The company's principal products included a painkiller and several cancer treatment drugs. Rising expectations for the company's future had caused its stock price to soar from under $4 per share in early 2003 to nearly $24 per share in early 2004 despite the company never having reported an operating profit.

Deloitte requires each audit engagement team to assess the degree of engagement risk posed by a given audit. Fazio and his subordinates concluded that the 2003 Ligand audit posed a greater than normal degree of engagement risk due to questions surrounding Ligand's accounting for sales returns. Ligand's distribution channel consisted principally of three large drug wholesalers. The latters purchased Ligand's products and then marketed them to pharmacies and other healthcare facilities. Ligand recorded product shipments made to the three wholesalers as consummated sales although the wholesalers had the right to return any products that did not sell through to their customers. Because of this revenue recognition policy, Ligand was required to record a reserve (allowance) for expected future sales returns at the end of each accounting period.

By early 2004 when Deloitte was auditing Ligand's 2003 financial statements, the company had been marketing its major products for only a short period of time, which meant that Ligand's accountants had limited historical experience on which to base their estimates of future sales returns. Complicating matters was the difficulty Ligand had in obtaining sales and inventory data from its three wholesalers.

Ligand typically shipped product to those wholesalers twelve month before the expiration date of the given product. The wholesalers generally had the right to return product received from Ligand in a twelve month window that extended six months on either side of a product's expiration date. To properly assess the quantity of future sales returns, Ligand's accounting staff needed up to date sell through data from its wholesalers. However, the wholesalers failed to provide these data on a timely basis. In fact, Ligand often received large and unexpected shipments of product returns from the three wholesalers.

The limited sales return data available to Ligand during 2003 suggested that the company was significantly underestimating its rate of product returns. Shortly before Deloitte completed the 2003 Ligand audit in early March 2004, Ligand received additional information from its wholesalers regarding the return rates experienced by its major products. Although this information was available from the company's accounting staff, the Deloitte auditor did not review it. As a result, the value of sales returns indicated that the allowance for future sales returns was inadequate.

Fazio was aware of the difficulty Ligand had in estimating its future sales returns and the fact that the projected return rates being applied by the company appeared insufficient given the actual sales returns data available from the company's wholesalers. Despite this knowledge, Fazio authorized the issuance of an unqualified opinion on Ligand's 2003 financial statements on March 10, 2004.

The following month, Fazio supervised Deloitte's interim review of Ligand's financial statements for the first quarter of 2004. During that engagement, Fazio and his subordinates obtained Ligand's sales return data for the first two months of fiscal 2004. Those data alone demonstrated that the year-end allowance for sales returns was significantly understated. However, Ligand's accounting staff also provided forecast data to the auditors indicating that the company would experience a large amount of additional returns from fiscal 2003 sales during the remaining months of 2004. Despite the considerable evidence that Ligand's 2003 year-end allowance for sales returns was materially understated, Fazio failed to recommend that the company recall and restate the 2003 financial statements.

Question:

Identify the accounting standards and concepts that dictate the proper accounting treatment for sales returns. How were these standards and concepts violated by Ligand?