Credit: Shutterstock photoBy Audit Analytics :
Every filing season has its fair share of surprises. The current one presents the drama of Valeant Pharmaceuticals ( VRX ), which, as a main attraction, is by no means an everyday affair. After all, how often does one see the loss of $10 billion in valuation in one day? The plunge followed a report released by Citron Research , in which the short-seller accused Valeant of fraudulent financial reporting that inflated the company's revenue. Citron went as far as calling VRX a "new Enron". Its report focused on a specialty pharmacy, Philidor, that is being used by Valeant to fill prescriptions, and over which VRX exercises significant control.
In a 90-page slideshow presentation, Valeant vigorously denied all allegations. An important takeaway from the presentation is that Philidor is consolidated as a VIE - meaning that all the transactions between the two are recorded as inter-company transactions. In other words, the company could not have used Philidor to overstate revenue since all inter-company transactions would be eliminated in consolidation.
Nevertheless, Valeant has faced challenges related to revenue recognition in the past. On the conference call, Valeant stated that its relationship with Philidor goes back to its 2012 acquisition of Medicis Pharmaceutical. Medicis had to resolve its own revenue recognition allegations in a settlement that totaled $18 million . (We also noted that Medicis made a revenue recognition change in estimates that helped meet earnings targets immediately prior to the acquisition). Following the acquisition of Medicis, Valeant discontinued the consumer rebates programs and changed its revenue recognition policy to recognize revenue upon shipment to the distributor, rather than when the distributor ships products to physicians. Another example of revenue issues at Valeant is Salix Pharmaceuticals, which it acquired back in February 2015. Salix had to restate its revenue recognition practices just before the acquisition.
The key question, however, is why up until now Valeant's relationship with Philidor hadn't been disclosed in any of its reports.
According to the Wall Street Journal , Valeant used at least two lines of defense: (( A )) since Valeant views the relationship as a competitive advantage, disclosure could cause significant competitive harm, and (( B )) Philidor transactions are immaterial to VRX as a whole. The WSJ notes that competitive advantage is not a very strong defense in such a controversial case. Indeed, the SEC - understandably - has repeatedly taken the position that all the material information should be disclosed, regardless of potential competitive disclosure. (See, for example, comment 4 here and comment 1 here .) So, the key question here is the materiality of Philidor to Valeant.
Taking a step back for a moment, the question of materiality extends far beyond just this one case. Materiality was a cornerstone of a few recent and very controversial SEC regulatory actions. For instance, the SEC claw-back provision requires companies to recover executive compensation after a material restatement. The suggested rule caused plenty of debates between supporters and opponents , yet it is obvious that, from a practical perspective, the application of materiality is going to be a key component in claw-back enforcement.
Even the concept of materiality is coming under scrutiny . In a controversial proposal issued in September 2015, the FASB aimed to clarify the concept of materiality to better align it with legal definitions. The discussion of the proposed standard at a recent SEC Advisory Committee was heated, with some experts expressing significant concerns that the standard may reduce transparency in financial reporting .
Before returning to Valeant, let's take a look at some of the materiality analysis provisions specified in ASC 250-10-S99 ( SAB 99 ). It is important to note that ASC 250 is mostly applicable to accounting changes and error corrections while a new FASB standard appears to be focusing on the disclosure.
The list above is not comprehensive - there are other tests including, for example, the possible impact on common non-GAAP metrics that companies provide on a supplemental basis.
Back to Valeant. Philidor comprises about 6% of the Valeant's revenue and only about 1% of assets. From a quantitative standpoint alone, Philidor does indeed appear to be immaterial. For instance, SEC regulations require the disclosure of significant clients that represent 10% or more of a company's total revenue. The smallest such client disclosed by Valeant represents $900 million, more than 8 times Philidor's contribution. Based on this analysis, VRX seems justified in omitting the disclosure.
Yet, in the past few years - and as expressed in the excerpt from SAB 99 above - the analysis of materiality has shifted towards some qualitative considerations. In some SEC comment letters , for example, we've seen transactions with relatively high quantitative impact that were deemed immaterial because, from a qualitative standpoint, they would not affect an average investor's judgment. At the same time, the new FASB standard appears to be even more qualitative in nature.
When a stock plunges over 20% in a single day following a disclosure - as happened with Valeant - then it is hard to argue that the transactions, however small they were, were immaterial. Quoting ASC 250-10-S99-1: "When … management … expects (based, for example, on a pattern of market performance) that a known misstatement may result in a significant positive or negative market reaction, that expected reaction should be taken into account when considering whether a misstatement is material."
SAB 99 analysis is more art than science, clearly. There are a lot of judgment calls to be made. Was such a significant market reaction expected or even predictable? Did the Philidor relationship play a significant role in Valeant's operations? Did it have an impact on any regulatory compliance?
At this point, we have more questions than answers. It is quite obvious, though, that quantitative criterion alone is not sufficient in making materiality determinations.
Based on the information disclosed so far, it appears that allegations of channel stuffing are unsupported. Yet, there is a risk that the new board committee, established to investigate the Philidor transactions, will expand the scope of the review to other areas of accounting. This could pose a problem. As we discussed above, VRX's revenue recognition policies have been aggressive in the past - look, for example, at the acceleration of Medicis' revenue discussed above. "Aggressive" by no means equals "illegal" or "unsupportable". But, given the level of scrutiny, we suspect every number on Valeant's financial statements will be placed under a microscope and any controversies (if any exist) would likely not be interpreted in VRX's favor.
See also Apricus Biosciences' ( APRI ) CEO Rich Pascoe on Q3 2015 Results - Earnings Call Transcript on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
