You are on page 1of 5

Statement of the Problem

PolyMedica Corporation is a leading provider of direct-to-consumer medical products, conducting business through its Liberty Diabetes, Liberty Respiratory and Pharmaceuticals segments. PolyMedica s principal strategy was to leverage its operating platform and compliance management to expand its business. Since 1996, the company had invested in an ongoing program of direct-response television advertising to reach a larger portion of Medicare eligible patient market which resulted in a significant increase of the company s sales. In line with this, the researchers present the questions below that would serve as a guide in formulating practical solutions and decisions regarding the case: 1. What are the differences between an asset and an expense? 2. What are the arguments in favour of capitalizing the direct-response expenditures? What are the arguments in favour of expensing the direct-response advertising expenditures as incurred? 3. What would be the impact on the company s financial statements of capitalizing the direct-response advertising? 4. Were the direct-response advertising expenditures will be considered an expense cost deducted to revenue as incurred; or an asset something that will produce future economic benefits?

Points for Consideration


Listed below are the factors that should be considered in making the analysis on PolyMedica Corporation: Company background: PolyMedica Corporation was a leading provider of direct-toconsumer medical products, conducting business through its Liberty Diabetes, Liberty espiratory, and Pharmaceuticals segments.  Business strategy: PolyMedicas principal strategy was to leverage its operating platforms and compliance management to expand its business.  Accounting policy: PolyMedicas accounting policies regarding advertising expenditures state that direct response advertising and associated costs for its diabetes supplies and related products, included in the Liberty Diabetes segment, for all periods presented are capitalized and amortized to selling, general and administrative expenses on an accelerated basis during the first two years of a four year period.

Direct response advertising and related costs for its respiratory supplies, included in the Liberty Respiratory segment, for all periods are capitalized and amortized to selling, general and administrative expenses on a straight-line basis over a two year period.  Qualification for direct response exclusion: To qualify for the direct response exclusion, companies had to show proof that ads generated specific sales. Ads that only yielded leads for which the company was required to expend additional marketing effort to create a sale did not qualify for the special treatment.  PolyMedicas activity effort: To ensure the customers active and consistent prescription with the patients current test regimen, PolyMedica assigns customer service representatives to confirm additional sale in the event he or she had not returned the reorder card included in the first shipment.  PolyMedica officials statement regarding the controversy: PolyMedicas CEO said, Our business is more akin to an insurance or annuity business than a traditional medical supplier. The formula of our business means we have to do it this way.

Alternatives Analysis
Since 1996, PolyMedica has capitalized its direct response advertising costs and amortized them, generally over two to four years, in accordance with the AICPA's Statement of Position (SOP) 93-7, which provides for the capitalization of such costs when, the advertising elicits sales to customers who respond specifically to the advertisement, and the advertisement results in probable future benefit. And, the predictable, long-lived revenue stream generated by their loyal base of customers sets the company apart from most other companies which serves as the basis for the management capitalization of advertising costs. To understand these circumstances, it is necessary to define assets and expenses and their differences as it relates to this case. Assets are resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. However, expenses are outflows or other use of assets and/or incurrence of liabilities that occur in the delivery of goods and services. With direct-response advertising, the incremental direct costs of the advertising incurred are capitalized if the primary purpose of the advertising was to elicit sales to customers who specifically responded to the advertising and the advertising resulted in probable future benefits. This specifically was a pretty successful campaign, as the company increased its Medicare eligible diabetes customer base from 17,000 to 545,000, as well as its sales in 2003. Thus the company that has ability to show the reasonable proof that requested by SOP 93-7. Given the business process conducted by Polymedica, direct-response advertising expenditures for diabetic and respiratory products and calling service costs meets the capitalized direct-response advertising costs definition under the SOP 93-7.

Furthermore, the company holds that the intermediate steps that occur after someone responds to its direct marketing are more administrative than commercial and therefore should not disqualify the capitalization treatment. Thus, it is an acceptable, but aggressive, form of accounting.

Capitalizing the Direct Response Advertising Expenditures


In capitalizing the direct-response advertising, the effectiveness of the advertising is directly related to the amount of sales. The accounting practice of revenue recognition at Polymedica includes an effective tracking system, tying the sale directly to the advertisement. To satisfy the requirements of linking customers and probable economic benefits to specific direct-response advertising, a means of documenting that response is required. The use of 800 numbers, coded order forms, coupons, or response cards; and a log of customers who made phone calls to a number appearing in an advertisement, linking those calls to the advertisement are examples of this. Thus, shows about the correlation between positioning an advertisement in a publication and the resulting audience responses. The system ensures a process of continued business (future economic benefit) which is further expensed as administrative costs. The repeat order process, as well as follow up with physicians and third party payers is required, but does not constitute further marketing. With direct-response advertising, the incremental direct costs of the advertising incurred are capitalized if the primary purpose of the advertising was to elicit sales to customers who specifically responded to the advertising and the advertising resulted in probable future benefits. This specifically was a pretty successful campaign, as the company increased its Medicare eligible diabetes customer base from 17,000 to 545,000, as well as its sales in 2003. Thus the company that has ability to show the reasonable proof that requested by SOP 93-7. Given the business process conducted by Polymedica, direct-response advertising expenditures for diabetic and respiratory products and calling service costs meets the capitalized direct-response advertising costs definition under the SOP 93-7. Furthermore, the company holds that the intermediate steps that occur after someone responds to its direct marketing are more administrative than commercial and therefore should not disqualify the capitalization treatment. Thus, it is an acceptable, but aggressive, form of accounting.

Expensing the Direct Response Advertising Expenditures


If the PolyMedica would record the direct response advertising during the relevant time period as expense, it would be reported that PolyMedica overstated earnings by capitalizing direct response advertising costs related to the acquisition of new customers. Thus, PolyMedica understated operating expenses, overstate assets, and create a false impression of operating efficiencies with the overall effect being that the company misled investors concerning its growth and earnings.

If forced to expense the costs, the assets will decline from US$ 250,969 to US$ 186,908 and US$ 224,392 to US$ 172,280 in 2003 and 2002, respectively. This will yield to a loss of US$ 38,429 for 2003 and a loss of US$ 21,701 for 2002 leaving stockholders to probably receive no dividends for those years. Further, the restatement resulted to reduction of its 2002 earnings to $1.76 from $2.38 per share, a reduction of 26%, and to $2.61 from $3.21, a reduction of 19% in 2003. The arguments raised in expensing this as incurred are that the company would show a more realistic stock value as it would not be misleading in its asset values. In line with this, it would also show a more realistic picture of income performance. Short sellers would feel more confident in representing this to investors.
The decision to capitalize or expense some items depends on management. As such, this choice will have an impact on a company's balance sheet, income statement and cash flow statement. It will also have an impact on a company's financial ratios. Here is what the decision will have an impact on:

y Net income - Capitalizing costs and depreciating them over time will show a smoother pattern of reported incomes. Expensing firms have higher variability in reported income. In terms of profitability, in the early years, a company that capitalizes costs will have a higher profitability than it would have had if it expensed them. In later years, the company that expenses costs will have a higher profitability than it would have had if it capitalized them. y Stockholders' equity Over a long time frame, the choice of expensing a cost or capitalizing it will have little effect on a shareholders' total equity. That said, expensing firms will have a lower stockholders' equity at first (less profit, thus smaller retained earnings).
Cash flow from operations A company that capitalizes its costs will display higher net profits in the first years and will have to pay higher taxes than it would've had to pay if it expensed all of its costs. That said, over a long period of time, the tax implications would be the same. But the choice for capitalizing over expensing have a much

larger effect on the reported cash flow from operations and cash flow from investing. If a company expenses its cost it will be included in cash flow from operations. If it capitalizes, then it will be included in cash flow from investing (lower investment cash flow and higher cash flow from operations).

y
assets.

Assets reported on the balance sheet - A company that capitalizes its costs will display higher total

Financial ratios A company that capitalizes its costs will display higher profitability ratios at the onset and

lower ratios in the later stages. Liquidity ratios will experience little impact, except for the CFO ratio, which will be higher under the capitalization method. Operation-efficiency ratios such as total asset and fixed-asset turnover will be lower under the capitalization method, due to higher reported fixed assets. Furthermore, at the onset, equity turnover will be higher under the capitalization method (lower total equity due to lower net profit). Companies that capitalize their costs will initially report higher net income, lower equity and higher total assets. Remember that, on average, an equal dollar effect on a numerator and denominator will produce a higher net result. That said, on average, ROE & ROA will initially be higher for capitalizing firms. Solvency ratios are better for firms that capitalize their costs because they have higher assets, EBIT and stockholders' equity.

Impact of Assets, Profitability on Financial Ratios

Recommendation

You might also like