CASE STUDY: PolyMedica Corporation (A) Northwood University DeVos Graduate School of Management September 17, 2012 PROBLEM STATEMENT PolyMedica’s method of capitalizing direct-response advertising expenditures rather than expensing the cost is under investigation by the U. S. Securities and Exchange Commission (SEC) and has caused concern for investors who are questioning the legitimacy of this practice. ANALYSIS
PolyMedica is a leading provider of direct-to-consumer medical products and conducts business through its Liberty Diabetes, Liberty Respiratory, and Pharmaceuticals segments. The issue at hand concerns the divisions of Liberty Diabetes and Liberty Respiratory and the reporting of their advertising expenses. PolyMedica capitalizes and amortizes its direct- response advertising cost, generally over a 2-4 year period, in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 93-7.
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Under the Financial Accounting Standards Board (FASB) guidelines, this rule allows such cost to be capitalized when; (a) the advertising generates sales to customers who respond explicitly to the advertisement and (b) the advertisement results in a likely future benefit. To understand why this circumstance is being challenged, it is important to examine how PolyMedica concluded that the capitalization method was justifiably used for their business. EXPENSING THE DIRECT-RESPONSE ADVERTISING EXPENDITURES AS INCURRED
In may countries outlays for advertising must be expensed immediately because they are difficult to value objectively. While this eliminates the possibility of management abuse of reporting on the uses of these resources, it makes it more difficult to assess the firm’s profitability by comparing the cost of critical resources with the revenues they generate. (2000, Choudhary and Healy, p. 5) If PolyMedica had chosen to expense the cost as incurred, their assets would reflect a decrease from $250,969 to $186,908 in 2003 and from $224,392 to $172,280 in 2002.
Rather than showing income, they would have reported net losses resulting in reduced earnings consecutively in 2002 and 2003 and shareholders would most likely not have received dividends as a result. CAPITALIZING THE DIRECT-RESPONSE ADVERTISING EXPENDITURES One of the core arguments in favor of capitalizing expenditures were that the company had taken actions to establish a practice that would prove and account for the streams of revenue generated from deliberate and specific advertising campaigns.
In compliance with the SOP 93-7, PolyMedica has gone to great lengths to set up numerical coded tracking system for their advertising. They established over 1,000 (800) numbers to trace each of their advertising campaigns, built-in alerts to remind them when a customers’ prescriptions are due or expired, and managed all the insurance claims. PolyMedica established this process as a business strategy and the tracking system enabled them to measure and match sales and advertising performance and to monitor financial success, failures, growth and profitability.
Our opinion is the current method of capitalizing direct advertising expenditures provides a more accurate account of the revenues generated by specific sales and is offset by the systematic approach of recognizing the expenses within an accounting period and over time. The procedures they have in place substantiate their recording approach and are in compliance with SOP 93-7. By reporting the direct expense advertising as an asset, the company was able to report an increase in income, from $31,467 mil to $48,409 mil over a three-year period, which assists in the liquidity of the company.
Due to the long term nature of capital expenditures classified as assets, capitalizing and depreciating them over time allows companies to report a gradual expense and revenue stream. RECOMMENDATION The following are recommendations that we suggest PolyMedica immediately exercise for managing the accountability of financial reporting, profit making strategies, and performance measurements; • Develop communication, transparencies and full disclosure strategies for accounting and marketing practices reviewed by auditing authorities. Re-examine how PolyMedica makes money, its business development strategy and the consequence it may have on the company’s financial performance. • Perform an internal audit of the company’s expense recording system, revenue producing and marketing initiative strategies, and examine the consequences and/or benefits on the company’s financial performance. References Choudhary, Preeti and Healy, Paul M. (2000). Business Analysis and Valuation Using Financial Statements: Expense Recognition, 2nd Edition, Cincinnati, OH: South-Western.