(Reuters) -- The watchdog board for corporate auditors on Wednesday said it has imposed a $2 million penalty, its largest fine ever, on accounting and consulting firm Ernst & Young LLP in a settlement involving past audits of Medicis Pharmaceutical Corp.

The Public Company Accounting Oversight Board said it also sanctioned four current and former Ernst & Young partners for violating PCAOB rules in the audits of Medicis, which sells prescription drugs for asthma and skin conditions.

Ernst & Young settled without admitting or denying the PCAOB's findings. The audits in question involved Medicis' 2005, 2006 and 2007 financial statements, the PCAOB said.

"These audit partners and Ernst & Young - the company's outside auditor for more than 20 years - failed to fulfill their bedrock responsibility," PCAOB Chairman James Doty said in a statement.

"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 case," Doty said.

In a statement, Ernst & Young said it cooperated fully with the PCAOB's investigation. "We have implemented changes to our policies and procedures that directly address the PCAOB's concerns," Ernst & Young said.

Medicis said in a statement that it immediately corrected accounting errors related to the past audits; restated its financial statements; and that it "cooperated fully with the PCAOB in its investigation of E&Y."

The PCAOB said Ernst & Young failed to properly evaluate a material part of Medicis' statements - its reserve for sales returns. Medicis estimated returns and reserved mostly for the cost of replacing products instead of for gross sales price.

The PCAOB said auditors knew or should have known that this method of reserving was not supported by audit evidence.

Ernst & Young personnel doing an internal quality review of the 2005 audit found that Medicis' reserve method conflicted with Generally Accepted Accounting Principles, the prevailing U.S. standards for accounting, the PCAOB said.

However, the Ernst & Young reviewers accepted another flawed accounting rationale for justifying the reserve method used by Medicis, the PCAOB said.

Ernst & Young is the third of the Big Four auditors sanctioned by the PCAOB since it was created in 2002 under the post-Enron Sarbanes-Oxley Act.

Last April, the PCAOB fined an Indian affiliate of PwC $1.5 million for audits of software company Satyam Computer Services. In December 2007, it fined Deloitte & Touche LLP $1 million over its audits of Ligand Pharmaceuticals Inc.

The Big Four are Ernst & Young, PwC, Deloitte and KPMG.

Ernst & Young also faces a lawsuit by the New York Attorney General over audits of failed investment bank Lehman Brothers.

(Reporting by Dena Aubin; Additional reporting by Patrick Temple-West; Editing by Kevin Drawbaugh, Phil Berlowitzz; For more Reuters tax and accounting coverage, see http://blogs.reuters.com/taxbreak/)

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