Valeant Pharmaceuticals International Inc. is a large Canada-based multinational drug company. Its shares are traded on the Toronto and New York stock exchanges. Valeant adopted an aggressive acquisitions strategy, purchasing numerous medical and drug companies and drastically raising the price of t heir products. For example, users of the drug Syprine faced an increase in the cost of a year's supply from $700 U.S. to over $10,000 U.S. following Valeant's acquisition of the original supplier. This practice attracted the attention of the U.S. Congress, which in 2016 called Valeant's CEO, former CFO and a major investor to testify before a House committee. Valeant later lowered some of its prices.

In August 2014, some investors, and later the SEC, began raising concerns about certain Valeant accounting policies. One concern was Valeant's emphasis on "cash earnings per share." This was a version of pro-forma reporting frequently used by managers to inflate their performance. (Section 11.6.3). For example, Valeant's 2014 annual report reported cash earnings per share of US$8.34, compared to GAAP net income per share of US$2. 72. The main reason for the difference was that cash earnings per share excluded low-persistence costs related to acquisitions. However, due to lack of full disclosure of the nature of the costs added back to earnings, rumours arose that Valeant may be excluding persistent costs as well.

Despite these concerns, Valeant's share price continued to rise, reaching a peak of US$260.47 in August 2015. However, a second concern arose that Valeant may have been overstating its revenues and net income. These were triggered by damning reports by a well-known stock commentary and short-seller firm, beginning October 2015. These reports suggested that Valeant may have difficulties increasing its revenues and meeting its long-term debt obligations due t o t he pricing concerns raised by the House committee outlined above.

Also, the reports implied that Valeant may be overstating its revenues and earnings through its revenue recognition policies. Specifically, Valeant had been recording sales revenue upon shipment of product to Philidor RX SeNices LLC, a direct seller of drug prescriptions by mail. The reports raised investor suspicions about Valeant's relationship with Philidor, since recording revenue upon shipment would be acceptable only if Philidor was an independent entity. Furthermore, Valeant was not transparent about its relationship with Philidor, fanning market suspicions about its sales and revenue recognition policies in general. For example, to the extent that Valeant had influence over Philidor, Valeant could require Philidor to sell its (expensive) drug brands rather than cheaper generic equivalents. These suspicions, combined with liquidity concerns and concerns that Valeant was hiding persistent costs through emphasizing its cash EPS, led to a rapid decline in Valeant's stock

price, falling to a low of $8.33 on the New York stock exchange in April, 2017. To help stem this decline, Valeant became more transparent. In retrospect, investors learned that Valeant had had effective control of Philidor for some time, since it supplied management services. In December 2014 Valeant purchased an option to buy Philidor, expiring in 10 years, for $133 million. If exercised, the purchase price was zero. This further strengthened its control.

Valeant decided to consolidate Philidor into its financial statements from December 2014, so that revenue from products shipped to Philidor would not be recognized until sold to outsiders. In 2015, it decided that shipment-based revenue from Philidor recorded prior to the option date in December 2014 should be reversed, reducing 2014 revenue by $58 million and earnings by $33 million. It filed revised financial statements in April 2016.

Required

a. Valeant's emphasis on cash EPS is a version of earnings management, since it attempts to divert investor attention from its much lower GAAP EPS. Does this strategy represent good or bad earnings management? Discuss.

b . Valeant's share price continued to rise until August 2015, despite concerns about its pricing policies and cash EPS. It was not until late September 2015 that share price decline accelerated, as negative reports about Valeant began to appear. Does this price pattern violate securities market efficiency? Explain.

c. Valeant treated Philidor as a variable interest entity (VIE)(see the description of VIE consolidation in Section 1.3). Do you agree or disagree that its consolidation of Philidor from December 2014 was required by GAAP? Discuss. You may wish to consider the issue of rules-based versus principles-based accounting standards (Section 1.6).