While some figures in financial statements are relatively straightforward, others are more complex. Some of the more complex figures require judgments about future events. For example, a certain number of accounts receivable will not be collected, but neither the actual bad accounts nor the number of them is actually known. Therefore, some model is used to estimate the number of doubtful accounts. The allowance for doubtful accounts, the method of depreciation of assets, provisions for legal contingencies, hedging and derivative valuations — all of these things require estimates, and estimates always involve some assumptions.
For the sake of comparability between periods, such assumptions are expected to remain the same, unless a good reason arises to change them (ASC 250-10-45-19). Undisclosed changes in assumptions could result in misleading figures: for example, what looks like a growth in revenue could really be due to a change to a company’s estimated sales reserve.
Wisely, changes like this must be disclosed. According to ASC 250-10-50-4, “the effect on income from continuing operations, net income, and any related per-share amounts…shall be disclosed for a change in estimate that affects several future periods.” What follows is a brief example from real life showing the potential implications of these changes and the information that can be gathered from taking note of the disclosures.
Medicis Pharmaceutical (CIK: 859368) was acquired by Valeant Pharmaceutical on December 11, 2012. The acquisition was announced at the beginning of September 2012, for $44.00 per share ($2.6 billion total) in cash, which represented a 39% premium on Medicis’ stock price as of August 31, 2012.
Prior to the acquisition, Medicis was a consistently profitable company, and in its press release dated August 8, 2012, Medicis forecasted Q3 FY12 revenue between $185M-$200M, compared to $197M actual revenues for the prior quarter, and $185M actual revenues for Q3 FY11.
However, as noted in the Company’s third quarter 10-Q filed on November 9th, during the quarter that ended on September 30, 2012, Medicis effected a change in accounting estimate with respect to its sales return and allowance reserve applied to certain of its products.
4. CHANGE IN ESTIMATE
During the three months ended September 30, 2012, the Company reduced its estimate for the amount of expected future returns of SOLODYN®, based on recent historical experience and the reduced amount of units that flow through the traditional wholesale and retail chain drugstore channel that has resulted from the Company’s alternate fulfillment initiatives. As a result, the Company decreased the reserve for sales returns for SOLODYN® by $11.5 million, and correspondingly increased managed care and Medicaid reserves for SOLODYN® by $3.4 million and increased the reserve for consumer rebates for SOLODYN® by $1.3 million. The net $6.8 million reduction in these reserves increased net income for the three and nine months ended September 30, 2012 by $4.4 million, or $0.07 per common share.
As noted in the footnote to the quarterly financial statements for that period, this change in accounting estimate increased net income by $4.4 million, or $0.07 per common share. Without this change, the Company would have sustained a sizable loss for the period, since net income including the change in estimate was only $0.9 million. Further, excluding the $6.8 million net adjustment to the sales reserve, revenue for the quarter would have been $173 million – well below the estimates. This would have been the first quarterly loss for Medicis in at least two years, capping off a string of somewhat declining results for the Company.
Is it possible that a large quarterly loss for the period would have had a material effect on the market’s response to the acquisition, hurting Valeant’s stock price as a result? One thing to keep an eye on in the future is whether Valeant reports will continue to show a strong performance as a result of the Medicis operations.
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