Peeling away financial reporting issues one layer at a time

Proposed ASU No. EITF100D – Helping Big Pharma Score Bullseyes on Its Earnings Targets

A couple of weeks ago, I concocted a cautionary tale for undergraduate students out of Proposed ASU No. EITF100F, which dealt with the accounting for a health insurer's legal costs arising from malpractice cases. If you are looking for a slightly more advanced case study, you should check out Proposed ASU No. EITF100D, Other Expenses (Topic 720): Fees Paid to the Federal Government by Pharmaceutical Manufacturers (a consensus of the FASB Emerging Issues Task Force). The problem is slightly more nuanced, but the proposed 'solution' is even more astounding. As I have mentioned before, a telltale sign that the fix is in is when application by analogy of an EITF consensus to similar circumstances is streng verboten.

A Somewhat Simplified Fact Pattern*

Company ABC is a manufacturer of flu vaccine and its fiscal year ends on December 31st. Sales are extremely seasonal; approximately 20% generally occur in the company's third quarter, and the remaining sales occur in the fourth quarter. As a publically traded company, ABC issues quarterly reports for the first three quarters of its fiscal year, and an annual report at the end of the year. [Note: I made sales seasonal to simplify implementation in the first year; there is no loss of generality thereby.]

Health care legislation enacted during the third quarter of 2010 imposes an annual fee on branded prescription pharmaceutical manufacturers. The structure of the fee, and its effect on ABC, is as follows:

  • The fee (technically, an excise tax) owed by each pharmaceutical manufacturer is to be announced in January of each year beginning in 2011; it is payable each March 31.
  • Congress structured the program to raise "aggregate fees" from all pharmaceutical manufacturers of $2.5 billion in 2011, $2.8 billion in 2012 and 2013, $3 billion in 2014, 2015 and 2016, $4 billion in 2017, $4.1 billion in 2018, and $2.8 billion in both 2019 and years thereafter.
  • The aggregate fee for a given year is apportioned among pharmaceutical manufacturers in proportion to the amount of each company's "covered sales taken into account" during the previous calendar year made to specified government programs (e.g., Medicare, Medicaid, military programs, etc.) in the previous year. The ratio of a company's covered sales taken into account and the corresponding total amount for the industry is term a company's "market share."
  • For simplicity, we will assume ABC sells its flu vaccine only to the government programs specified by the new legislation.
  • ABC's "covered sales" in 2010 were $250 million, calculated in the following table (all amounts stated in millions of dollars):

 

Statutory Scale

 

Covered Sales

Percentage of Sales Taken into Account

Covered Sales Taken Into Account

Up to $100

$100.0

20%

$ 20.0

More than $100

$460.0

50%

$230.0

Total Sales Taken Into Account

$250.0

 

  • The aggregate industry sales taken into account across all pharmaceutical manufacturers for 2010 was $10 billion; therefore, ABC's market share of covered sales taken into account was 2.5% (=$250 million/$10 billion).
  • Thus, ABC's pharmaceuticals fee payable on March 31, 2011 is $6,250,000 (=2.5% x $2.5 billion).

Question: How should ABC account for the fees it owes from its sales made in 2010?

The Common Sense Approach

While the situation is somewhat unusual, I don't think that a student would have any trouble applying general accrual accounting rules. A rudimentary solution would look like this:

  • Let's say that $70 million worth of sales actually occurred in the third quarter of 2010. ABC should estimate its market share of covered sales assuming no further 2010 sales would occur, and accrue the appropriate amount of fees. If the estimated fees were $1 million, then ABC would make the following journal entry on September 30, 2010: debit "fee expense" for $1 million; and credit "fees payable" for the same amount.
  • On December 31, 2010, ABC would undertake similar procedures. Assuming that the total amount of fees payable as of that date were estimated to be $6 million, it would the expense for $5 million; and credit the payable for the same amount.
  • When ABC learns, in January 2011, that the precise amount of fees owed for 2010's sales is $6.25 million, it would debit the expense for an additional $0.25 million and credit the payable for the same amount.

Why should the EITF want to get involved if a conceptually valid and consistent solution were so easily obtained? Moreover, ABC could avail itself of the option in the interim reporting standards (ASC Topic 270) to normalize expenses of this nature. For example, those rules permit the accrual of bonuses in the early quarters of the year, even though they might not become earned and payable until the fourth quarter. In this particular case, third quarter sales look overly profitable compared to fourth quarter sales; this is due to the progressive nature of the excise 'tax rate.'

Well, dear students, the EITF did insert itself into this issue, and this is how their proposal would apply to the fact pattern I have provided you:

  • Even though the fees were incurred in 2010, the EITF says that ABC may not recognize them until they become "payable." To the EITF, this means that the fees for the first year under the new law don't become payable until 2011. A pretty strange definition of "payable," don't you think?
  • Accordingly, in January 2011, ABC would debit an asset, "deferred fees" for $6.25 million; and credit fees payable for the same amount. The deferred fees would generally be amortized to expense on a straight-line basis over 2011.

Wow. Even though the fees were incurred from making sales in 2010, the fee expense won't be recognized until 2011. That's practically cash basis accounting, since ABC won't be writing its check to the government until 2011 — and that's the way the actual law works.

Moreover, the "balance sheet" view of accounting that the FASB professes adherence to is thrown out the window. The deferred fee account will be classified as an asset on the balance sheet, even though it doesn't meet the definition of an asset. (While it is true that there won't be a deferred fee "asset" on the year-end balance sheet of calendar fiscal year companies, there will be such an "asset" on every other balance sheet.)

What's the Point?

Why has the EITF proposed such a prosaic solution to a simple problem that any intermediate accounting student should be able to solve from application of the basic rules of accrual accounting? The answer, as is all too often the case, is that some powerful group of preparers is unwilling to apply the simple answer. The right accounting would require estimates, and those particular estimates will add unpredictably to the reported earnings of pharmaceutical manufacturers. In a nutshell, managers hate missing their quarterly EPS targets. It hurts the company's share price, they think, and that really hurts the value of their stock options, restricted stock and cash performance bonuses.  

I have to say that I really can't relate to the way the EITF thinks about accounting problems. What will they think of next? I doubt if it will be investors.

————-

*The facts of the case have been simplified from a description provided by the law firm of Foley Hoag LLP, available at: http://www.foleyhoag.com/NewsCenter/Publications/Alerts/Healthcare/Healthcare-Alert_032410.aspx.

2 Comments

  1. Reply David J Phillips September 22, 2010

    Tom:
    Remember, the Obama administration doesn’t call levies on us “taxes” unless they need to, such as the court challenges to their health care albatross!

  2. Reply Independent Accountant September 30, 2010

    This is stupid. There was no reason for the EITF to look at this.

Leave a Comment