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.

2. 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). 3. R&D investments are expected to revenues from new drugs but these future benefits are uncertain. Pharmaceutical companies typically make heavy promotional expenditures in the first few years of product launch, which may create future benefits (i.e., sales promotion). Under the US GAAP, all expenditures on research and development and advertising and product promoting must be expensed as incurred. However, the analyst following BCMS decided to capitalize the companys investments in R&D and advertising & product promotion and amortize the intangible assets using the straight-line method. BCMS report the following R&D and advertising outlays: (in $ million) 2001 2000 1999 1998 1997 1996 1995 Advertising & Product promotion 1,433 1,672 1,549 2,312 2,241 1,946 1,646 Research and development 2,259 1,939 1,759 1,577 1,385 1,276 1,199 What adjustments would be made to the income statement for the fiscal year 2001 and the statement of financial position at the end of the fiscal year 2001? Assume for simplicity that 1) all expenditures on R&D and advertising & product promotions occur evenly throughout the year, 2) only half a years amortization is taken on the latest years spending, 3) the average expected life of investment in R&D is 5 years, 4) the average expected life of advertising & product promotion is 5 years, and 5) the companys tax rate was 35%. (Hint: You may follow the template provided and use the excel spreadsheet.) 5 5 Financial Statement Analysis 2020 Spring Semester 4. Compute the price-to-book ratio as of 3/28/2002 (i.e., the annual report filing date) and fill out the following table. The ratios must be based on the book value of equity per share as of 12/31/2001 before and after adjustments for investments in R&D and advertising. Assume for simplicity that there was no change in the number of common shares outstanding 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. Price-to-book ratio based on: March 28, 2002 book value per share before adjustments book value per share adjusted for R&D & advertising 5. According to the simple residual income valuation framework, a higher price-to-book ratio reflects that a company is expected to generate a superior return on equity in excess of the cost of invested capital where invested capital is measured as the book value of equity. Your answer for the requirement 4 shows the difference between the price-tobook ratios with and without capitalization of R&D and advertising investments. A. What implications does your answer for the requirement 4 have for analysts? B. How should the analyst approach the distortions associated with the accounting standards for R&D and advertising investments?

1999 16,878 4.542 12.336 1,549 Exhibit 1. The company's income statements before restatements (in $ million, except per share data) 2001 Revenue 19,423 Cost of sales 5,575 Gross Profit 13,848 Advertising & Product promotion 1,433 Rescarch and development 2,259 Other expenses 2.744 Total expenses 16,437 Pretax income 2,986 Tax expense 747 Net profit 2.240 Average common shares outstanding-Basic (million) 1,940 2000 18,216 4,759 13,457 1,672 1,939 4,018 12,738 5,478 1.370 4,109 1,965 1,759 3,710 11,720 5.158 1.290 3,869 1,984 Note: The company's marginal tax rate is assumed to be 25% for the sake of simplicity Exhibit 2. The company's balance sheet before restatements (in million for an amount) Asset Cum A Cushman w uivens Time de wit t e securities Receivable, tofawwe SSO 3162 3.949 Prepaid expense Total assets Proxy. Pland Equipamet 47 4568 1.456 5.300 1724 17114 27.057 17 57 Total Assets TIN 157 1.2 1657 Accounts payable Accrued expenses 4_207 2. 1 RS 701 2.x58 1,430 16,321 8469 US and fignincome taxes payable Total Current Listilities Other abilities Langlende Total Liabilities Stockholm Common stock, pur value of 5.10 T sharu: Authorized 4.5 billion shares, issued 2.19790035 in 2000, 2.192.970,504 1999 2. INN, 316 EN 1998 Capital in excess of par value of stock Other comp e n Rated Les of 344 165.726 shares in 2000 212.164, 199 1919 Tol Stockhuluquity Total Stackholder' 220 (1.1171 .103) 20068617,781 1.533 (816) 15.000 11.39 9.720 27057 17.578 17,114 Exhibit 3. RCMS stock prices between 2000 and 2002 w why 50.8500 Jul 2000 Jul 2001 01/02/2002 002 Jul 1999 16,878 4.542 12.336 1,549 Exhibit 1. The company's income statements before restatements (in $ million, except per share data) 2001 Revenue 19,423 Cost of sales 5,575 Gross Profit 13,848 Advertising & Product promotion 1,433 Rescarch and development 2,259 Other expenses 2.744 Total expenses 16,437 Pretax income 2,986 Tax expense 747 Net profit 2.240 Average common shares outstanding-Basic (million) 1,940 2000 18,216 4,759 13,457 1,672 1,939 4,018 12,738 5,478 1.370 4,109 1,965 1,759 3,710 11,720 5.158 1.290 3,869 1,984 Note: The company's marginal tax rate is assumed to be 25% for the sake of simplicity Exhibit 2. The company's balance sheet before restatements (in million for an amount) Asset Cum A Cushman w uivens Time de wit t e securities Receivable, tofawwe SSO 3162 3.949 Prepaid expense Total assets Proxy. Pland Equipamet 47 4568 1.456 5.300 1724 17114 27.057 17 57 Total Assets TIN 157 1.2 1657 Accounts payable Accrued expenses 4_207 2. 1 RS 701 2.x58 1,430 16,321 8469 US and fignincome taxes payable Total Current Listilities Other abilities Langlende Total Liabilities Stockholm Common stock, pur value of 5.10 T sharu: Authorized 4.5 billion shares, issued 2.19790035 in 2000, 2.192.970,504 1999 2. INN, 316 EN 1998 Capital in excess of par value of stock Other comp e n Rated Les of 344 165.726 shares in 2000 212.164, 199 1919 Tol Stockhuluquity Total Stackholder' 220 (1.1171 .103) 20068617,781 1.533 (816) 15.000 11.39 9.720 27057 17.578 17,114 Exhibit 3. RCMS stock prices between 2000 and 2002 w why 50.8500 Jul 2000 Jul 2001 01/02/2002 002 Jul