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January 17, 2001 THE WALL STREET JOURNAL PrePaid Legal's Accounting For Commissions Draws Fire By JONATHAN WEIL Staff Reporter of THE WALL STREET JOURNAL Consider the following questions as you read the article below: DISCUSSION QUESTIONS: 1. What is the definition of an asset? Do the company's arguments support recording these sales commission payments as assets? What is the definition of an expense? (Cite your sources for these definitions.) Should these sales commissions be amortized to expense over the lives of the policies sold? 2. What is the impact on PrePaid's earnings of accounting for commissions as assets? What is the implication of the fact that the $156.2 million account balance reported on the balance sheet as Commissions Advances exceeds its shareholder equity balance of $151.2 million? 3. How can the company justify discontinuing amortization of these commission costs when customers cancel insurance policies? Do you think this accounting supports the correct determination of an asset balance? 4. What audit procedures should Deloitte & Touche undertake to assess the carrying value of this asset? Should they examine the recorded expense as well? 5. How do reported assets and earnings impact the assessment of the market value of a stock? Specifically, why does analyst Mark Roberts think that this company's stock is overvalued? PrePaid Legal's Accounting For Commissions Draws Fire By JONATHAN WEIL Staff Reporter of THE WALL STREET JOURNAL To mangle a line from Shakespeare: If an expense were called by any other name, would it not cost just as much? Of course, it would. But if a company incorrectly calls an expense an asset for accounting purposes, it can provide a big boost to earnings, at least in the short term. And that is what critics say is happening at Pre Paid Legal Services Inc., an Ada, Okla., company that sells insurance policies to cover customers' legal costs. PrePaid, which staunchly defends its accounting practices, has reported steady growth over the years. The company, which has a market value of $513 million, reported net income of $48.8 million for its most recent four quarters, up 21% from the same period a year earlier, on revenue of $241.3 million, up 31%. But a nagging issue is the method PrePaid uses to account for the way it pays commissions to its salespeople, whom the company calls associates. Here is how the commissions typically work: Say an associate sells a policy that costs about $25 a month. Even though the customer can cancel the policy at any time, PrePaid pays three years' worth of annual commissions upfront, a total of about $225. As a multilevel marketing company, PrePaid spreads the money among the associate who sold the policy and those sales associates above him in the company's pecking order. That is a big recruiting tool for PrePaid, whose growth is tied chiefly to its ability to expand its sales force. Even when customers cancel their policies before three years, associates don't have to send back any part of the commissions. Instead, the company docks the associates' future pay, if any. To Douglas Carmichael, an accounting professor at Baruch College in New York, those commissions look like ordinary customeracquisition costs that PrePaid should be expensing fully each quarter, because there isn't any guarantee that the customers will keep the monthtomonth policies for three years. But that isn't how PrePaid does it. Instead, Pre Paid classifies the threeyear commission payments as assets, calling them "commission advances" that it plans to write down as expenses over three years. "They ought to expense it immediately," says Mr. Carmichael, who believes the company should change its accounting policy and restate its previous financial reports. "Their accounting doesn't portray economic reality. And economic reality is going to catch up with them one way or another. So it's a stock to avoid." PrePaid insists its accounting methods are proper. The company contends its commission advances are assets because they are associated with a stream of future monthly premium revenue. "They have future economic benefit," says Randy Harp, PrePaid's chief operating officer, who says PrePaid uses internal, undisclosed actuarial data to determine how much it can advance to associates without risking overpayments. "The nearest round lot was three years." Moreover, the company maintains that its accounting policies "are fully consistent with the concept of accrual accounting." The company's books are audited by Deloitte & Touche, which declines to comment. Among the company's critics is Mark Roberts, research director at Off Wall Street Consulting Group in Cambridge, Mass., which in November released a report urging clients to sell the stock. Based on PrePaid's reported cancellation rates and policy counts, Mr. Roberts estimates that PrePaid's policies have an average life of just 2.2 years. So, even if Pre Paid is proper in capitalizing its commission expenses, Mr. Roberts says, it should write them down over a period closer to two years than three. While PrePaid shares are 53% off their 52week high of $48.75, he thinks the stock should trade in the low teens. At 4 p.m. Tuesday in New York Stock Exchange Composite trading, PrePaid shares were down 75 cents to $22.69. PrePaid denies it takes too long to write down the commission advances and contends its stock is undervalued. The company says it uses different calculations than Mr. Roberts does to determine the average life of its policies, and that the correct figure is 6.5 years, a figure not disclosed in financial filings. Regulators long have warned investors to be skeptical of companies that record everyday business expenses as assets. In a 1996 speech titled "Dangerous Ideas," the Securities and Exchange Commission's chief accountant at the time, Michael Sutton, said that "concerns about the quality of the asset created, and therefore the quality of earnings, follow" when companies defer customer acquisition costs normally associated with ongoing operations. He explained that "there usually is no direct and traceable linkage between current period expenses and a specific future period revenue, even though it may be possible to associate, at least in part, current period activities with future revenue." The SEC declines to comment on Pre Paid's accounting practices. One thing is certain: PrePaid's commissionadvance assets are ballooning. Over the past four quarters, through Sept. 30, commission advance assets climbed 43% to $156.2 million, as revenue made its 31% jump, and now exceed PrePaid's $151.2 million in shareholder equity. By contrast, the company's allowance for estimated unrecoverable commission advances was unchanged at $4.5 million. Critics also question the way PrePaid treats commission advances associated with lapsed policies. If a customer cancels a policy before three years, the company stops writing down the advances, treating them instead as receivables that is, money owed the company. The company tries to collect the receivables by docking associates' future pay through two types of "chargebacks." Specifically, PrePaid seeks to take half the chargeback out of an associate's future commission advances and the other half from the associate's commissions on renewals of policies that are more than three years old. However, critics note, the company can't dock an associate's renewal commissions if the associate hasn't sold any policies that are more than three years old. And if an associate stops selling policies, the company can't dock future commission advances because there aren't any. Indeed, many associates lose interest after making a few sales; only about 26% of PrePaid's 234,000 associates made a sale during the nine months ended Sept. 30, according to the company. Moreover, the company's balance sheet lumps receivables into commissionadvance assets, meaning investors can't determine which portion is still being written down and which portion isn't. The financials are clear on this point: Over the past five years, PrePaid hasn't written off any commissionadvance assets as unrecoverable. Mr. Harp acknowledges there are some commission advances that the company never will be able to recover through chargebacks to associates. But he says that isn't a problem, because PrePaid makes up for them in other ways. To continue collecting commissions on policies sold more than three years ago, a PrePaid associate must continue to generate business, either selling a certain number of policies each year or buying a policy for personal use. And over the years, Mr. Harp explains, associates in some cases have abandoned "thousands, or hundreds of thousands, of dollars" of commissions for which they could have qualified simply by paying a few hundred dollars or so in annual premiums for a policy of their own. Why would any associate walk away from so much easy money? "I don't know why they do," Mr. Harp says. "But it happens every quarter." Mr. Harp says the commissions that would have been paid to these dropouts totaling millions of dollars over the years are grouped into a pool along with unrecoverable commission advances, something the company hasn't disclosed in financial reports. Historically, Mr. Harp says, those figures have offset each other, making it unnecessary to write off any commissionadvance assets. Mr. Harp says company executives "just never have found it necessary" to disclose this pool's existence before. Messrs. Carmichael and Roberts are skeptical that so many associates would walk away from so much money. At a minimum, they say the company should disclose the actuarial details of this pool, and identify the commission advances that have evolved into receivables. The company says it has no plans to change its disclosures, which it considers adequate. Write to Jonathan Weil at jonathan.weil@wsj.com