In a nutshell, the issue concerns how to account for co-payments. Suppose that Company XYZ contracts with Medco, a subsidiary of Merck, to handle certain medical services. Medco then contracts with one or more pharmacists to handle transactions with workers from that corporation. When an employee of Company XYZ goes to a pharmacist to obtain some prescription, he or she pays a small co-payment to the pharmacist, while Medco takes cares of the rest. Of course, Medco does this for a fee, which it receives from Company XYZ. The issue then is how to account for the co-payment. Medco and apparently the SEC believe that it is a revenue (and simultaneously a cost of business).
 
Obviously, it's time to review Accounting 101 and ask what is a revenue. The FASB in Statement of Financial Accounting Concepts No. 6 defines revenues as "inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations."

 

Let's see ... do these co-payments constitute an inflow or other enhancement of any asset? Clearly the answer is no. Do these co-payments settle any of its liabilities? Of course not. The customers pay the co-payment out of their purses directly into the hands of the pharmacist. It does not go to the Medco, nor ever will. Ergo, the co-payment is not a revenue, as any student in an introductory course will understand.
 
On the one hand, we should not let this issue bother us too much, for it does not affect net income. On the other hand, if definitions mean anything, if our words have any import, then perhaps we should insist on applying the terms accurately. This is just the sort of attitude that gave us Enron and Tyco and Ahold. I don't understand why Merck is engaging in these shell games, but it doesn't add to its credibility. It makes me wonder what else is amiss at Merck.
 
PwC, the auditor of Merck, performs a disservice to the investment community and to the accounting profession when it tags along with the managers at Medco and plays this kind of game. Again, on the one hand, this is not a major issue since it does not affect the computation of net income. But, again, this is still a critical subject if only because it reflects an attitude of how the firm wants to convey information to investors and creditors. If PwC does not wish to assume the airs of Arthur Andersen, then I suggest that they abide by the definitions of the FASB. Start with a correct application of "revenue" with respect to Medco.
 
Investors should remember this story if they are ever tempted to price securities on the basis of some multiple of revenues. Hopefully, investors learned their lesson when some of them applied such a metric to dot-coms, only to learn that it is important to pay attention to expenses. Using multiples of revenues is silly in the first place, but when the SEC allows firms to lie about their revenues, then such a strategy becomes down right asinine.
 
Having said all this, I cannot fathom what the SEC is thinking. It used to stand as the investor's protector, but perhaps has decided to change its mission. Hopefully, this situation is just an aberration. Maybe with Donaldson now at the head, some sanity will return to this government agency.
 

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of the forthcoming Hidden Financial Risk, which explores the causes of recent accounting scandals.