Bristol's revised approach to accounting for excess inventory leaves the company room to offer trade incentives in the future.

The company's March 10 earnings restatement primarily reflects a decision to account for sales to Cardinal and McKesson over the past four years under a consignment model. However, the criteria outlined by the company for applying that model do not rule out all trade incentives.

In fact, Bristol is telling investors up front to expect that the company will continue to experience fluctuations in trade buying patterns.

"Once the consignment model is no longer applied, we expect the buying patterns and fluctuations in inventory levels in the wholesalers will have an effect on our financial results and prior period comparisons," CFO Andrew Bonfield told a March 10 conference call.

Bristol restated 1999-2002 earnings to reflect inventory overstocking for its pharmaceutical products - and for a long list of other "errors" in accounting (see ¹ [A#00650110027]).

The primary basis of the restatement is a decision that trade incentives offered to McKesson and Cardinal were so generous as to require consignment accounting. In particular, the terms of the wholesaler contracts were such that "substantially all the risks and rewards of ownership do not transfer upon shipment," Bristol explained.

² Bristol's restatement press release outlines a four-part test to determine when sales to wholesalers cross that threshold and require consignment accounting.

Bristol's definition: "sales made to wholesalers (1) as a result of incentives, (2) in excess of the wholesaler's ordinary course of business inventory level, (3) at a time when there was an understanding, agreement, course of dealing or consistent business practice that the company would extend incentives based on levels of excess inventory in connection with future purchases, and (4) at a time when such incentives would cover substantially all, and vary directly with, the wholesaler's cost of carrying inventory in excess of the wholesaler's ordinary course of business level."

Bristol points out that the "the determination of when, if at all, sales to a wholesaler meet the foregoing criteria involves evaluation of a variety of factors and a number of complex judgments."

The emphasis on "judgement," presumably intended to mitigate any assumption that the company deliberately created misleading accounts, also indicates the degree of flexibility that Bristol will retain in future wholesaler transactions.

The criteria do appear to set two limits on incentives offered to wholesalers. First, Bristol must be careful to ensure that there is no implied guarantee that the incentives will be extended for future purchases. Second, the company will have to ensure that the incentives are not tied to the cost of carrying inventory.

Bristol first disclosed the inventory issues in an SEC filing a year ago (³ Also see "Bristol Takes Stock: Hayden To Head U.S. Rx After Lane Departs" - Pink Sheet, 8 April, 2002., 2002, p. 3). The company initially intended to work down the inventory levels during 2002, with the impact reported only as adjustments to earnings per share levels.

The Securities & Exchange Commission began looking into Bristol's accounting for inventory levels during the summer (⁴ 'The Pink Sheet' July 29, 2002, In Brief). After initially maintaining that its inventory accounting practices were appropriate, Bristol announced in October that it would restate its earnings from 1999 onward ("The Pink Sheet" Oct. 28, 2002, p. 16).

The restatement leaves Cardinal and McKesson in an awkward position. Neither intends to restate its results to change any accounting for the Bristol transaction, but regulators are likely to ask for reassurance that the wholesaler's position is appropriate.

McKesson described its contract with Bristol as in keeping with its buy-side business practices - while acknowledging that the terms were quite attractive.

McKesson maintains that it appropriately recognized the transactions as purchases. From the wholesaler's point of view, it took on ownership of product and the inventory risk. McKesson noted that it only records a sale when the product is shipped to an end user. The company notes that it maintains a good relationship with Bristol.

The Bristol restatement also has a ripple effect on Sanofi, the innovator and copromotion partner for Plavix and Avapro .

Sanofi said March 12 that it would not be restating its 2002 results, because the profits it reported are "based solely on invoicing for the year, in compliance with French accounting principles."

Bristol's restated 2002 numbers include higher sales for Plavix and Avapro ($1.89 bil. and $586 mil.) than were reported by Sanofi ($1.7 bil. and $410 mil.). However, Sanofi notes that Bristol's numbers include sales previously invoiced. According to Sanofi, the invoicing for the products in 2002 was "of the same order of magnitude" as the underlying demand.

Bristol's restatement includes a frank acknowledgement of the reasons behind the inventory build-up.

It "was primarily due to sales incentives offered by the company to its wholesalers. These incentives were generally offered towards the end of the quarter in order to incentivize wholesalers to purchase products in an amount sufficient to meet the company's quarterly sales projections established by the company's senior management."

The press release implies that Bristol management went beyond offering incentives. The decision to restate was made "to correct errors in timing of revenue recognition for certain sales to certain U.S. pharmaceutical wholesalers," Bristol said.

The consignment accounting approach apparently was developed after the restatement process began: "Since that time, the company has undertaken an analysis of its transactions and incentive practices with U.S. pharmaceutical wholesalers. The company has now determined that certain incentivized transactions with certain wholesalers should be accounted for under the consignment model."

Bristol determined that its sales to Cardinal and McKesson included incentives that required consignment accounting. For Cardinal, the incentive practices triggered that criteria as of July 1, 1999, Bristol said; for McKesson, the trigger date was July 1, 2000. The value of the inventory affected by the restatement was approximately $2 bil.

The contracts include incentives based on inventory levels above two weeks for Cardinal and three weeks for McKesson, Bristol noted.

Although the company plans to maintain inventory levels of approximately four weeks going forward, the two- and three-week levels in the contracts formed the basis to calculate the amount of the restatement.

Bristol noted that, as part of the inventory management plan it implemented in April 2002, "the company entered into agreements for an orderly workdown that provide for [Cardinal and McKesson] to make specified levels of purchases and for the company to offer specified levels of incentives through the workdown period."

Bristol expects that the consignment model will no longer apply to sales to Cardinal and McKesson by the end of 2003.

One exception is in Bristol's specialty distribution operation, Oncology Therapeutics Network. Under a March 2001 agreement with McKesson, the wholesaler provides warehousing and order fulfillment services that also qualify for consignment accounting, Bristol said. That treatment will continue until the contract expires in 2006. The amount of revenue impacted is relatively small: $81 mil. restated in 2001.

Sales to other wholesalers did not trigger consignment criteria, Bristol said, although there still was a significant increase in inventory through those channels: Bristol estimated that the impact of inventory workdowns during 2002 was $550 mil. to $750 mil.

The company believes the workdown through wholesalers other than Cardinal and McKesson is complete, although the company noted that there could be anywhere from $100 mil. in excess inventory to $100 mil. in reduced inventories still in those trade channels.

The earnings restatement includes a large silver lining for Bristol: revenues in 2003 will be approximately $425 mil. higher as sales originally recorded in prior years are carried over into the new year (see ⁵ Also see "Bristol Restates, But Reforms Continue; Q3 Charges Show Old Habits Die Hard" - Pink Sheet, 17 March, 2003.).

Bristol noted that the consignment inventory remaining on the books from Cardinal and McKesson is worth $470 mil. at invoice prices. The amount of carryover revenue recorded during the year will depend on the final sales price after any discounts or other contracting provisions are applied. Bristol will record the revenues as product in inventory is shipped to end users, using first-in-first-out accounting.

Cardinal, McKesson Incentives Are At Center Of Bristol Restatement

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