The financial crisis was a period of difficulty for investors to know the undisclosed financial liabilities of banks and other financial institutions. Investors were amazed when banks which had large contingent liabilities to off balance sheet entities were forced to take on their books in 2007-2008. This portrays that audit committee-SOX reforms were ineffective hence the need for a different approach (Pozen, par. 1).
Despite expertise use, compliance with SOX rules, independence of audit committee members and external auditors and thorough assessment of internal controls with no reports of weakness, financial institutions are still taking big risks. This is because audit committee members have a difficulty in ascertaining the core judgement of management and external auditors despite the huge amounts of data that they are presented with. The detailed information including detailed financial statements and lengthy SEC filings shows how difficult it is for audit committee members, no matter how intelligent, to pick out from this mass of data the key judgments made by management and external auditors (Pozen, par. 2-5).
To increase effectiveness, audit committees should request three specific pieces of information from the company’s external auditors. First, they should request a highlight of all end-of-quarter or financial-year transactions such as sales, borrowings and tax-motivated deals from the external auditor. They should also explain the preference to company alternatives for example hedge accounting unlike other related alternatives in accounting literature. Finally and most important of all, external auditors should provide the audit committee with key policy information of the company and its top competitors in terms of revenue recognition, warranty and retirement plan obligations, tax reserves, valuation of good will and other intangibles. This enhances the full understanding of the audit committees unlike the example of Medco, a Pharmaceutical Benefits Manager (PBM) which counted customer drug co-payments as revenues and expensed the co-payments solely made by a health insurer. The highly learned members (of the Merck audit committee) were not aware that Medco’s accounting treatment of drug co-payments was followed by only two of the four largest PBMs (Pozen, par. 4-6).
Moreover, the audit committee should also provide critical financial reports of company accounting methods to the audit committee meetings to allow the audit committee chairperson to hold informal discussions and address issues in the financial reports. This is in an effort to point out any accounting gimmicks by companies to improve revenues or net income and to get to the company’s core earnings by stripping away these gimmicks as well as non-recurring items, changes in tax rates and gains or losses from currency movements. All these pieces of information should be sent to the audit committee at least one week before the committee meets. This enhances the audit committee to make early preparations and gather adequate information (Pozen, par. 7-9).
However, it is hard for the above measures to guarantee discovery of fraudulent practice because it is difficult to detect a clever fraudster. Therefore, the measures help the audit committee to identify management and external auditor judgement regarding financial statements. This also helps the audit committee to focus on objective reviews to ascertain the accuracy and reliability of the company’s financial situation (Pozen, par. 10).
Different GAAP Treatments Available for Drug Co-payments
At the time of Medco spin-off, the two different GAAP treatments depicted are non-compensation (convention of compensation) and consistency. The Medco accounting treatments raise questions and lack consistency as stipulated by GAAP. This is because the Merk audit committee was not aware that “Medco’s accounting treatment was followed by only two of the four largest PBMs” (Pozen, par. 9).
This quote infers that Medco and other PBMs did not follow a fixed accounting treatment. Furthermore, Medco does not enter other similar items in the same way, an approach which s contrary to GAAP about consistency. This is evidenced by the fact that it does not disclose all expenses but only the drug co-payments. In addition, Medco seems to compensate revenue to expenses, and fails to reveal this information to the Merk audit committee, an accounting gimmick which is against GAAP on non-compensation. This is contrary to the non-compensation treatment, which stipulates that Medco should have disclosed all financial details. In addition, it should not have compensated revenue with an asset or a debt with an asset. Medco also seemed not to apply the utmost good faith treatment of GAAP as it expensed the co-payments which were kept by a health insurer (Pozen, par. 9).
Potential Impacts of Medco Approach and the GAAP Approach
Companies that use Medco’s accounting gimmicks are bound to face a lot of challenges and uncertainties in the course of operations. This may negatively influence the investor as he fails to get a truer picture on the financial position of the company and he may therefore incur losses unknowingly.
The quality of earnings for a Medco-like company may be questioned creating uncertainty on its financial prowess hence its survival. This may scare away investors as they lack confidence of achieving positive returns on their investment. The Medco approach can result to losses due to the indeterminate nature of currency movement as a result of the accounting gimmicks Medco applies. This can scare away foreign investors as they are not sure of achieving gains incase they invest in the company. On the other hand, the company which uses GAAP approach (“other approach”) is geared towards success as it enhances a true and fair opinion and determination in terms of its financial position (Pozen, par. 4). Such a company will enhance quality of its earnings because of the influx of both foreign and local investors. This is because its approach eliminates uncertainty as its revenues and tax rates can be well determined, the non recurring items and accounting gimmicks are stopped and this results to an increase in revenue (Pozen, par. 5).
My Opinion on the Best way to Account for Drug co-payments
The best way to account for drug co-payments should be in line with GAAP in terms of prudence, utmost good faith, sincerity, permanence and full disclosure (materiality).Pursuant to these GAAP treatments, all the PBMs should follow a similar accounting treatment to enhance a true and fair opinion by the Merk audit committee. Furthermore all PBMs including Medco should show full details of their financial information and should not seek to compensate revenue with an expense. The PBMs like Medco should be sincere and reveal all information regarding their assets and revenues as this will ensure fair competition with other PBMs and protect the investors from uncertainty which can cause them to incur losses. Under these circumstances, determination of tax rates of the PBMs is also easier.
If the above takes place, an accurate determination of the financial position of the PBMs can be ascertained which enhances comparison with other PBMs. This enhances the principle of permanence of method as stipulated by GAAP (Pozen, par. 9).
Pozen, Robert C. What Audit Committees Don’t Know. Harvard Business School: Brookings, 2011. Print.