Complex accounting expertise or common sense?

As legal counsel to a public registrant, imagine your client asking for your advice on the following questions:

• Can we help fund the startup of a new distribution customer that will buy more of our products? We really want to set this customer up so that we can charge the customer higher prices than regular customers and have control over what the customer buys.
• In addition, would there be a problem if we increase credit limits for the customer so that we can continue making sales, even when the customer has past due accounts receivable balances?
• Finally, we have decided to acquire the customer but don’t want anyone to know. Can we change our disclosure policies to avoid having to say anything in our public filings about this relationship?

As farfetched as those questions sound, they are based on the actual facts in the recent Accounting and Auditing Enforcement Release issued by the U.S. Securities and Exchange Commission related to a settlement with Valeant Pharmaceuticals International.

Valeant is a publicly traded global pharmaceutical and medical device company that develops, manufactures and markets a broad range of branded, generic and branded-generic pharmaceuticals, over-the-counter products, and medical devices. The customer referenced above is a mail order pharmacy, Philidor Rx Services LLC.

Answering the questions raised above involves an appreciation for the applicable Generally Accepted Accounting Principles and SEC reporting requirements for public registrants. While aspects of technical and complex accounting matters may be involved, common sense may be equally or more useful when advising a client on these topics.

Before addressing the questions, here’s a highlight of several key facts reported in the release about Valeant and Philidor’s relationship:

• In 2013, Valeant “helped establish” Philidor with an advance of $2 million and entered into agreements with Philidor to dispense Valeant’s products.
• Approximately 95 percent of the product dispensed by Philidor and its affiliated pharmacies consisted of Valeant branded drugs.
• Toward the end of Q3 of 2014, Valeant received a $75 million order from Philidor, which was put on hold because it exceeded Philidor’s credit limit. Valeant approved a $70 million credit increase to process the order, and did so without proper justification.
• In Q4 of 2014, Valeant received an additional $130 million order from Philidor. Once more, Valeant approved Philidor’s credit increase, and also granted extended payment terms, without proper justification. At this time, Philidor’s accounts receivable balance was approximately $78 million, of which approximately $41 million was past due.
• Of significance, the $130 million order included one-time special pricing in which Philidor paid 4 percent over the wholesale cost.
• The $130 million order was also unique because Valeant was out of stock for a certain product and requested Philidor accept a substitute product.
• The $130 million order, with its one-time pricing and product substitution, occurred less than two weeks before the Dec. 15, 2014, date when Valeant acquired the option to purchase Philidor for $100 million in cash and would begin consolidating Philidor in its financial statements.
• Upon the closing of the option agreement, Valeant determined that it would consolidate Philidor in its financial statements and would have to wait to recognize the Philidor revenue until Philidor sold the product through to patients.
• Valeant erroneously recognized revenue for the $130 million when the product was delivered to Philidor. Valeant later restated the revenue from the order.
• Next, Valeant evaluated its disclosure obligations in light of the option agreement. As of Dec. 1, 2014, Valeant’s disclosure thresholds required Valeant to disclose details about transactions the size of the Philidor transaction, including mentioning the acquiree by name, in its annual report on Form 10-K for 2014.
• On Dec. 10, 2014, Valeant increased its thresholds in an amount that exceeded the anticipated total option purchase price for Philidor such that Valeant would no longer disclose transactions of Philidor’s size by name in the 2014 Form 10-K.
• Management informed the board of directors’ audit and risk committees about the increased disclosure threshold, including its impact on disclosure of the Philidor option transaction.
• Valeant reported misstatements in its restated financial statements filed on April 29, 2016, reducing previously reported fiscal year 2014 revenue by approximately $58 million, and net income by approximately $33 million. Those amounts reflect permanent reductions to Valeant’s previously reported financial results.

While numerous parties understood Valeant’s relationship and dealings with Philidor, certain facts were concealed. In fact, two executives, one from Valeant and one from Philidor, were convicted for self-dealing and a kickback scheme connected to the option agreement.

Even recognizing that conduct, there still appears to have been a lack of proper skepticism and judgment applied by members of Valeant’s management team and others with corporate governance responsibilities.

Returning to the questions raised above, below are considerations and concerns that counsel should raise if ever asked to advise on similar subjects.

• Can we help fund the startup of a new distribution customer that will buy more of our products?

Generally, the answer is “no” if the company wants its sales to meet the revenue recognition standards.

If the new customer lacks funds and isn’t adequately capitalized, then it also likely will not have the financial capacity, independent of the funding, for sales to meet the collectability standard for a valid sales transaction under Generally Accepted Accounting Principles.

The general revenue recognition criteria under GAAP include evidence of an arrangement, delivery, pricing that is fixed and determinable, and collectability for the receivable.

Questions and comments about charging the customer higher prices than regular customers and having control over what the customer buys should immediately raise concerns about the integrity of the overall relationship.

Also of concern, if the funds are used by the customer to pay the company for the product, then the funding isn’t a loan or equity investment but, in substance, is still an account receivable and not likely collectable, which thereby defers the recognition of revenue until the product is sold to an end customer.

Questions and comments about charging the customer higher prices than regular customers and having control over what the customer buys should immediately raise concerns about the integrity of this overall relationship. These matters are perfect examples of using common sense to ask your client: Is there something else going on here?

• Would there be a problem if we increase credit limits for the customer so that we can continue making sales, even when the customer has past due accounts receivable balances?

This question should trigger two reactions: Why would you want to do that, and are you sure you will be able to collect the receivable timely (if at all)? Hearing that the need to increase the credit limit is arising while prior receivables are unpaid and aging just adds to concerns.

Putting the company at risk of delivering a product for which payment may not be ultimately collectable, or may require the customer to sell in order to pay the receivable, raises obvious revenue recognition concerns and potential harm to the business’s liquidity by potentially wasting valuable assets.

In sum, yes, this is a problem, and it also raises concerns and questions about revenue pressures and company culture to achieve targets and goals.

• Finally, we have decided to acquire the customer but don’t want anyone to know. Can we change our disclosure policies to avoid having to say anything in our public filings?

With an appreciation for the facts surrounding Philidor, it’s difficult to understand how the Valeant audit committee agreed to change its disclosure rules to avoid making more information about the transactions and the relationship available to the public.

For counsel advising on an issue like that, one should ask the obvious question: What is it about this deal that warrants changing the established disclosure rules and practices for the company?

If the answer is the avoidance to make information public, then a refresher lesson on the purpose of the company’s disclosure process for material events is required. Changing company policies and practices for the convenience or avoidance of specific events or transactions creates a control environment with no standards, and likely a failure to comply with SEC disclosure requirements.

Legal counsel advising on questions such as these would have adequate grounds to advise the company regarding a need for an independent investigation and inquiry into the transactions and the pressures giving rise to the conduct.

While the Valeant and Philidor relationship undeniably involves aspects of technical and complex accounting matters, common sense may be equally or more useful in assessing what the right answers are, and whether the parties involved were engaging in proper conduct or playing games to achieve a financial reporting result.

Joseph J. Floyd, a CPA and attorney, is a partner and co-founder of Floyd Advisory, a consulting firm in Boston and New York City that provides financial and accounting expertise.