Merck-y Revenue

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By Robert Brokamp (TMF Bro)
July 8, 2002

Add pharmaceutical giant Merck (NYSE: MRK) to the list of corporations engaged in questionable accounting shenanigans. Medco Health Solutions, Merck's massive pharmacy benefits management division, announced that over the past three years, it has booked as revenue more than $12 billion worth of consumer co-payments. In other words, the $10-$15 paid to a pharmacy by a customer filling his prescription was booked by Medco as a sale, even though the money went straight from the customer to the pharmacy -- and was never in Medco's coffers.

In Merck's financials, the increased revenue from co-payments was offset by increased costs, so the practice didn't affect net income. The company claims that the practice is reasonable since, under some circumstances, Merck is liable for co-payments. Furthermore, the company says its accounting is in compliance with generally accepted accounting principles, and that the Securities and Exchange Commission has not taken action against the company. Contrast this to the WorldCom scandal, in which the SEC is suing the company for fraud.

But, at the very least, the practice is misleading: The co-payments represented 10% of Merck's sales over the last three years. At a time when investor confidence in the integrity of Wall Street's leaders and numbers is dangerously low, anything that hints of deception is unacceptable.

This isn't a red-flag event, but it certainly is a yellow one. Unlike most of the other big accounting crises that have taken place over the last several months, this one did nothing to change either the capital structure or the implied profitability of the firm. In fact, it made net margins look a little bit worse, all told, seeing as nearly 10% of Merck's revenues over the past three years generated margins of zero. But Merck has been preparing to spin off 20% of the Medco unit for some time, and in such cases the higher the reported revenues, the better. So, while investors ought to put this event in its proper perspective -- that this revelation isn't a huge deal -- the fact that it exists at all ought to be of grave concern to Merck investors.

The spin-off of Medco has been postponed twice in the past. Whether this recent revelation will prompt a third postponement remains to be seen.

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