• See the litigation release
• See the complaint filed in the U.S. District Court, Southern District

This brings to a head, if not a conclusion, the spurious charges by Biovail that various hedge funds and analysts conspired to bring down the stock price of the firm. We know now that the firm's own managers decreased the value of the firm by their accounting frauds.

The SEC's complaint claims that Biovail overstated its earnings from 2001 to 2003 through three schemes. First, Biovail removed $47 million of research and development expense from its income statement by transferring these costs to a special purpose entity. (The cynic in me is wondering how many SPEs are legitimate and how many are created primarily to deceive investors and creditors.) Second, Biovail created a fictitious bill-and-hold transaction, adding $8 million to income. Third, Biovail intentionally understated foreign exchange losses by $3.9 million. (The Ontario Securities Commission is also investigating these schemes.)

While the managers do not admit or deny these allegations by the SEC, the firm has agreed to pay a $10 million fee. And they promise never to do these things again.

I find the case interesting because I did a consulting gig with Banc of America Securities (BAS) in 2003 on this firm. Specifically, BAS asked me to evaluate the transparency of Biovail's accounting report and evaluate how well it was doing. I was asked not to comment on the stock price of the firm.

My September 27, 2003, report stated the following:

• The intangible assets are amortized over too long of time periods. The firm should utilize shorter amortization periods.
• I do not approve of the deferral of advertising costs, though if it is over a short period the amounts might prove immaterial.
• Stock-based compensation should be expensed. It amounts to about 8 or 9 cents per share. It is interesting that Biovail changed three of its assumptions for the computation of the stock-based amounts it displays in the footnotes. Changes with respect to the life of the options and the risk-free rate improve pro forma earnings, while the change to volatility hurts pro forma earnings. The net effect of these assumptions reduces the amount shown as stock-based compensation.
• The Zovirax, Wellbutrin, Vasotec, and Adalat obligations are imputed at rather low interest rates, rates that are close to the risk-free rates. Among other things, this must assume that there is no credit risk. Higher, more appropriate, rates would reduce the liabilities and increase interest costs.
• I would capitalize all leases. Capitalizing Biovail's operating leases would add about $10 million or so to the liabilities. It has no effect on the lifetime expenses, but changes the composition from rental charges to depreciation and interest expenses.
• Deferred financing costs, which are listed as assets, are actually contra-liabilities.
• The managers of Biovail sometimes refer to the asset write downs as nonrecurring, though they recur often.
• Obtaining a favorable supply price when an agreement is modified does not justify its booking. Given Biovail did book the transaction, the question is whether they reduced cost of sales or created a deferred cost. Clearly, they should not reduce their expenses.

My major comment, however, was that earnings per share were dismal and free cash flows were atrocious for three years in a row. While I could not have known then that the managers were engaging in an accounting fraud -- neither could the external auditors -- I could easily determine that its cash position was hemorrhaging. If the earnings had any real quality, the business enterprise would have shown some positive free cash flows. As it was, free cash flows were significantly negative during this three-year period.

I don't think society or the accounting profession has done much to alter the incentives for managers with respect to accounting fraud, so accounting frauds are going to be with us for a long time to come. Fortunately, the SEC with its subpoena powers can investigate what corporations are really up to in their financial reports. In the mean time, any investor or analyst who is trying to discern how well a company is doing should visit the cash flow statement. Sometimes one can disguise manufactured earnings for a while; however, it is hard to exaggerate earnings for extended periods of time because it is virtually impossible to also manipulate the cash balance. Cash is too easy to audit.

I believe that's what happened with Biovail. Instead of a conspiracy designed to drive down Biovail's stock price, I think a number of researcher analysts at BAS, Gradient Analytics, and SAC discerned the miserable free cash flows of Biovail. From there is was easy to recommend the sale of this stock or even to sell it short.

The SEC has now exposed Biovail's accounting shenanigans. Who's next?

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor 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 Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.