BCMS Agrees to Pay $150 Million to Settle Fraud Charges FOR IMMEDIATE RELEASE 2002-105 Washington, D.C., Aug. 4, 2002 -- The Securities and Exchange Commission today announced that it filed an enforcement action against Blue-Cross Medical Science (BCMS), a Chicago-based company whose largest division, the U.S. Medicines Group, is based in Chicago. The Commission's complaint, filed today in the United States District Court for the District of New Jersey, alleges that BCMS perpetrated a fraudulent earnings management scheme by, among other things, selling excessive amounts of pharmaceutical products to its wholesalers ahead of demand, improperly recognizing revenue from $3.35 billion of such sales to its two largest wholesalers and using "cookie jar" reserves to meet its internal sales and earnings targets and analysts' earnings estimates. In settling the Commission's action, BCMS agreed to an order requiring it to pay $150 million dollars and perform numerous remedial undertakings, including the appointment of an independent adviser to review and monitor its accounting practices, financial reporting and internal controls. Stephen M. Cutler, Director of the SEC's Division of Enforcement, said, "BCMS' earnings management scheme distorted the true performance of the company and its medicines business on a massive scale and caused significant harm to the company's shareholders. The company's conduct warrants a stiff civil sanction. As our investigation continues, we will be focusing on, among other things, those individuals responsible for the company's failures." Timothy L. Warren, Associate Regional Director of the SEC's Midwest Regional Office, added, "For three years BCMS deceived the market into believing that it was meeting its financial projections and market expectations, when, in fact, the company was making its numbers primarily through channel-stuffing and manipulative accounting devices. Severe sanctions are necessary to hold BCMS accountable for its violative conduct, and deter BCMS and other public companies from engaging in similar schemes." Specifically, the Commission's complaint alleges, among other things, that: From the first quarter of 2001 through the fourth quarter of 2001, BCMS engaged in a fraudulent scheme to inflate its sales and earnings in order to create the false appearance that the company had met or exceeded its internal sales and earnings targets and Wall Street analysts' earnings estimates. BCMS inflated its results primarily by stuffing its distribution channels with excess inventory near the end of every quarter in amounts sufficient to meet its targets by making pharmaceutical sales to its wholesalers ahead of demand; and improperly recognizing $3.35 billion in revenue from such pharmaceutical sales to its two biggest wholesalers. In connection with the $3.35 billion in revenue, BCMS covered these wholesalers' carrying costs and guaranteed them a return on investment until they sold the products. When BCMS recognized the $3.35 billion in revenue upon shipment, it did so contrary to generally accepted accounting principles. At no time between 1999 and 2001 did BCMS disclose that (1) it was artificially inflating its results through channel stuffing and improper accounting; (2) channelstuffing was contributing to a buildup in excess wholesaler inventory levels; or (3) excess wholesaler inventory posed a material risk to the company's future sales and earnings. 3 3 Financial Statement Analysis 2020 Spring Semester BCMS has agreed, without admitting or denying the allegations in the Commission's complaint, to the following relief: a permanent injunction against future violations of certain antifraud, reporting, books and records and internal controls provisions of the federal securities laws; disgorgement of $1; a civil penalty of $100 million; an additional $50 million payment into a fund for the benefit of shareholders; various remedial undertakings, including the appointment of an independent adviser to review, assess and monitor BCMS' accounting practices, financial reporting and disclosure processes and internal control systems. Exhibits 1 and 2 present the financial statements of this company before restatement.

According to the SEC press release, the channel stuffing made distortions in accounting data. A. Why does the channel stuffing by BCMS violate the revenue recognition criteria? B. What incentives led the BCMS management to engage in the channel stuffing? C. What adjustments are required to correct BCMSs financial statements for December 31, 2001? How would you expect the adjustments to affect BCMSs performance in the coming few years? Assume for simplicity that 1) the companys tax rate was 35% and 2) the common dividends did not vary with the earnings changes due to the channel stuffing and restatement. D. Compute the price-to-earnings ratios as of 3/28/2002 (i.e., the annual report filing date) and 8/4/2002 (i.e., the SEC press release date) and fill out the 4 4 Financial Statement Analysis 2020 Spring Semester following table. These ratios are based on the pro forma earnings that refer to earnings before R&D, advertising, and tax expenses. Assume for simplicity that there was no change in the average number of common shares outstanding-basic between December 31, 2001 and March 28, 2002. Exhibit 3 shows that the closing price of a BCMS common share was $49.7 on 3/28/2002 and $22.3 on 8/4/2002. Price-to-earnings ratio based on: Mar. 28, 2002 Aug. 4, 2002 a) Pro forma earnings per share before adjustments b) Pro forma earnings per share adjusted for channel stuffing c) Difference (c = b a) E. The stock price of BCMS declined from $49.7 on 3/28/2002 and $22.3 on 8/4/2002 by 55.1%. Is the stock price drop proportional to the pro forma earnings drop due to the adjustment for channel stuffing? If not, why wasnt the drop in stock price also the drop in pro forma earnings per share? Your answer must pertain to the reliability of accounting information. Note that the average price-toearnings ratio of the industry peers declined by 17.0% for the same period. The industry peers consist of 27 companies with positive net income and book value of equity within the pharmaceutical preparation segment (industry code SIC = 2834).

Exhibit 1. The companys income statements before restatements (in $ million, except per share data) 2001 2000 1999 Revenue 19,423 18,216 16,878 Cost of sales 5,575 4,759 4,542 Gross Profit 13,848 13,457 12,336 Advertising & Product promotion 1,433 1,672 1,549 Research and development 2,259 1,939 1,759 Other expenses 2,744 4,018 3,710 Total expenses 16,437 12,738 11,720 Pretax income 2,986 5,478 5,158 Tax expense 747 1,370 1,290 Net profit 2,240 4,109 3,869 Average common shares outstanding-Basic (million) 1,940 1,965 1,984 Note: The companys marginal tax rate is assumed to be 25% for the sake of simplicity.

Exhibit 2. The companys balance sheet before restatements (in $ million, except for per share amount) 2001 2000 1999 Assets Current Assets: Cash and cash equivalents 5,500 3,182 2720 Time deposits and marketable securities 154 203 237 Receivables, net of allowance 3,949 3,662 3,272 Inventories 1,487 1,831 2126 Prepaid expenses 1,259 946 912 Total current assets 12,349 9,824 9267 Property, Plant and Equipment, net 4,879 4,548 4621 Goodwill 5,200 1,436 1502 Other assets 2,382 1,770 1724 Total Assets 27,057 17,578 17114 Liabilities Short-term borrowings 174 162 432 Accounts payable 1,587 1,702 1657 Accrued expenses 4,207 2,881 2367 Product liability 186 287 US and foreign income taxes payable 2,858 701 794 Total Current Liabilities 8,826 5,632 5537 Other Liabilities 1,258 1,430 1590 Long-term debt 6,237 1,336 1342 Total Liabilities 16,321 8,398 8469 Stockholders' equity Common stock, par value of $.10 per share: Authorized 4.5 billion shares; issued 2,197,900,835 in 2000, 2,192,970,504 in 1999 and 2,188,316,808 in 1998 220 220 219 Capital in excess of par value of stock 2,336 2,002 1,533 Other comprehensive income (1,117) (1,103) (816) Retained earnings 20,686 17,781 15,000 Less cost of treasury stock - 244,365,726 common shares in 2000, 212,164,851 in 1999 and 199,550,532 in 1998 11,389 9,720 7,291 Total Stockholders' equity 10,736 9,180 8,645 Total Liabilities and Stockholders' Equity 27,057 17,578 17,114