Areena Shigri

Accounting 9993
05/20/2020

Management Incentives
1 Identify the metrics against which the management team was evaluated and
compensated. What Incentives does this compensation structure create?
Valeant Inc. considers multiple factors in evaluating the performance and total

compensation of the executive directors. Valeant Inc. described its compensation strategy

based on a “pay for performance compensation” where performance is ultimately associated

with generating returns for shareholders. Compensation package for executive directors

includes; base salary, incentive pay, retirement and welfare benefits, and executive benefits

and perquisites. However, the company prefers to use long term equity compensation, which

is based on Total Shareholder Return (TSR) performance.

According to Valiant Pharmaceutical International Inc.’s proxy statement, the

company requires a significant portion of total compensation to be directed to the

achievement of particular total shareholder revenue. The executives are rewarded with long

term equity when total shareholder revenues are met or exceeded. This compensation aims to

ensure that the director’s interests are aligned with the company and shareholder interest.

However, such compensation plan could incentivize executives to manipulate the company’s

earnings in an attempt to increase its stock value.

Furthermore, the stocks options received by executives could also lead management

to take high risk without looking at repercussions. For example, as mentioned in Financial

Shenanigans chapter 15, CEO Pearson’s stock-based compensation would top out if the

company’s share price appreciates 60% annually which created huge incentive for

management to make serial acquisitions, to grow as much as possible. Management was

driven to constantly do deals to grow and drive up the share prices even if the acquisitions

would not successfully pan out for the company. The company acquired Biovli and ignored

the red flags that included the company’s history of unethical and illegal behavior. This

shows that compensation plan such as Valeant’s could lead management to make risky

investments that could negatively affect the company in the long run.

Subsequently, the executives are entitled to the AIP bonus when they meet the

performance targets. The Talent and compensation committee considers the performance of a

specific executive, such as financial goals or cost targets. The financial goals are based on

targets for Cash EPS and revenue growth. According to the company proxy statement, 80%

of the executive compensation is based on Cash EPS and revenue growth metric to encourage

the executives to improve their performance to increase their compensation. However, Cash

EPS is a non GAAP metric used by the company and should not be considered as a surrogate

or cash flow. This metric fails to show company’s ‘true’ earnings as it excludes major

expenses associated with mergers and acquisitions; which counts for one of Valeant’s largest

expenses. Additionally, the financial goals or cost targets set by the compensation committee

to motivate executives does not lead to generating actual cash flows and fails to portray the

overall economic health of the company. This misalignment of the company’s performance

goals with creating shareholders value causes executives to compensate themselves at the

expense of shareholders.

The chart below shows the financial Objective under 2014 AIP
 .

2. Using the agency theory perspective describes how this compensation

structure might seem appropriate from the shareholder perspective and describe how
this compensation structure could go wrong for the shareholder.
The agency theory arises when there is a conflict of interest between various company

stakeholders. The conflict arises due to the separation of owners and managers, where each

party has its interest. According to a study conducted by Ross (2013), the agency problem

mostly arises due to problems with incentives. To solve the problem, the organization should

come up with an appropriate compensation method that rewards performance but, at the same

time, reduce the risk of shareholder wealth.

The compensation structure implemented by Valiant Pharmaceutical International Inc

might appropriate since its meant to compensate the director for their performance while at

the same time aligning their interest with the shareholder. The compensation structure

rewarded the directors with long term equity, which made them not only the directors but also

the shareholder. The strategy was aimed to create an incentive to manage the company

prudently while avoiding excessive risks (Proxy Report Pg 44). Additionally, most

shareholders would want to see a strong association between executive compensation levels

and investment returns. The use of Total shareholder revenue ensures that the incentives

awarded to executives are aligned with shareholder’s interest. Higher TSR leads to higher

capital gains for shareholders.

Even though equity-based compensation eliminates the conflict of interest between

shareholders and executives, the compensation method creates a lag between the operational

performance and the Total Shareholder Revenue (TSR). The compensation might propel the

interest of the executive at the expense of the shareholder. The executive will be tempted to

manipulate the dividend policy to increase their pay at the expense of the company and

shareholder interest. They may also have an incentive to manipulate earnings for a chance to
increase total stock value. Additionally, it could potentially lead to shareholders having less

ownership in the company as most of the shares would be owned by executives.

3. Thresholds in compensation plans can create risks for shareholders. Valeant’s

compensation structure contained several thresholds for one of its performance metrics.
Describe (a) the thresholds as they relate to the performance metric and (b) the
incentives these thresholds create for management.
Valiant Pharmaceutical International Inc has various thresholds that should be met for

Equity-Based Incentives Compensation to apply. For instance, when the share price exceed

$60 the executive directors were entitled to receive number of common share equal 25% of

the number of share units subject to award, when share price exceed $90 the directors are

entitled to receive number of common share equal 50% of the number of share units subject

to award, when the share price exceeds $120, when the share price exceeds $120 the

executive are entitles to receive number of common share equal 75% of the number of shares

units subject to award.

The thresholds are very critical in determining executive compensation since they are

certain, and the executives are familiar with their application. Compensation creates an

incentive to manage prudently while mitigating excessive risk. Also, it is much more

effective to receive equity awards without the sacrifice of personal funds.

b) Incentives these thresholds create for management.

The thresholds have numerous incentives to the management; fist achieving the

threshold on performance might motivate management to expend more effort and direct

that effort in achieving the company performance. Management view individual threshold

measures as more doable, since they are under their control. Lastly, threshold incentive

increases the chances of achieving the overall company goals.

 Non-GAAP Measures

1. The SEC guidance on non-GAAP measures.

For the longest time, companies have been using the non- GAAP financial

measures to adjust earnings in order to help the investor understand the core business of

the company. However, SEC noticed that the policy opened an avenue for the companies

producing misleading financial reports, companies used to distribute non-GAAP

information through the press release and conference call (FASB 2018).

After the Enron Accounting scandal that led to the introduction of the Sarbanes Oxley Act

2002, the SEC was required to introduce measures to lower misleading investors through non

-GAAP reporting. The SEC warned companies from using Non -GAAP metrics to improve

the appearance of the company’s financial performance. I believe, these are the three most

important elements of the guidance to prevent the management from misleading the financial

statement users.

1. When a company uses non GAAP financial measures they should reconcile the measure to

the most directly comparable GAAP financial measures and include it in their disclosures. As

mentioned in financial shenanigans, often times companies trick investors by providing an

“apples-to-oranges” comparison. Not reconciling with the most comparable GAAP measures

could lead to the company looking better financially. For example, if EBITDA is presented as

a performance measure it should be reconciled to net income and not with operating

income. For example, Sabre Corporation inflated its reported EBITDA by excluding an

important component of its cost structure. The company capitalized its upfront payments of

$71 million and amortized over the contract period This was treated as an amortization

expense in net income but added back in the calculation for EBITDA. This shows that

comparing net income to EBITDA is a better indidcator when looking for ways that

companies could potentially “inflate” EBITDA especially for capital intensive businesses.
 Having this guideline prevents companies from comparing “apples to oranges” and painting

a false picture.

2. Companies should not name these non GAAP measures similar to GAAP items as this can

easily mislead investors. For example, Delphi rountinely headlined its “operating cash flow”

in its earning releases. This is a non GAAP metric that many people confused with CFFO.

However, Delhpi was surrogating “Operating Cash Flow” for GAAP cash flow from

operations. The name was so close to its GAAP compadre that it confused investors into

thinking that this pro forma metric was Deplhi’s actual CFFO. This allowed Dephi to paint a

better picture of the company as there was a difference of 1.368 million between Operating

Cash Flow (non-GAAP) and Cash flow from operations (GAAP). This is one of the many

examples of how companies mislead investors by using names similar to GAAP items when

describing non GAAP items to shift their attention away from certain items. This guideline

prevents management from misleading investors by confusing them through these named

metrics

3. Additionally, when a company adjusts a Non GAAP performance measure they should not

smooth items identified as non recurring when the nature of the charge is such that is it

reasonably likely to recur within 2 years or there was a similar charge or gain within the two

prior years. Often times, many companies will classify charges as a “one time expense” to

hide its current losses. For example, whirlpool reported a profitability metric called ongoing

earnings that is meant to exclude the effects of non-recurring and nonoperating items. The

company reported its restructuring charges as a “non recurring” expense while it has been

on the company’s Income Statement in 23 of the past 27 years. This shows it is not recurring
 and could easily mislead investors to thinking it is and hiding its costs. The guideline

however, prevents management to do this and report its losses as it is.

Does Valeant’s non-GAAP measure fit within the SEC’s guidelines

In 2015, press release Valeant indicated that it reported the following items under non

-GAAP disclosures; inventory set up, PP & E step-up/down, the stock-based compensation,

acquisition of related contingent liability, amortization and impairment of finite-lived

intangible assets and restructuring and integration cost. The non GAAP measures do not fit

within the SEC’s guidelines.

According to the correspondence with the SEC on October 19,2014, the company was

requested to change “cash earning per share” for non- GAAP performance to Earning per

share since it was misleading. The regulation of S-K prohibits the use of confusing similar

titles or description used in GAAP guidelines.

In addition, the company did not disclose the acquisition related expenses, the

amortization asset it acquired and fair value adjustment in presenting the non-GAAP

measures. The inclusion of the items was very important to the investors since the acquisition

of businesses was critical strategy of Valeant.

The company also violated the Regulation G by disclosing percentage increase in Non-

GAAP earning per share and failed to disclose the same in GAAP EPS which declined by

83% from 2013. The failure to disclose a reduction in GAAP was meant to show that the

company was profitable while in actual sense the EPS was deteriorating.

In addition, as mentioned in financial shenanigans, for a period of three years from 2013

-2016, the company reported that a $2.7 billion loss; however, the company boasted a non-

GAAP profit of 9.6 billion. The difference between the GAAP metric and the non-GAAP

metric was 12 billion; the amount is extremely high, considering the fact that one of the non-
GAAP metrics was loss while the GAAP metric was a loss. Therefore, the company should

not be allowed to use the non-GAAP metric since it insinuates that the company is profitable

while the company is unprofitable.

2. Based on what you have learned throughout the course (ignoring SEC guidance), is
Valeant’s adjusted net income metric, an appropriate representation of the business’s
performance? Which adjustments are inappropriate, and why?
No, the net income metric is not an appropriate metric for Valeant since it’s the company

is unprofitable and has huge debt amounting to over $30 billion. The most relevant metric

to use for the company is EBITDA to interest cost of debt. Prior to the company financial

woes, the management had managed to maintain an EBITDA to interest cost coverage

ratio, which did not exceed 4.0. As the company debt increased while profitability

declined, investor could have noticed that the metric was shrinking while at the same

time, the net income metric was improving. Furthermore, it should be noted that the

company.

The non -GAAP adjusted net income is not an appropriate metric to measure the

Valeant performance since it too similar to cash flow and therefore its not appropriate

measure to calculate the company Earning Per Share (EPS). The company continued to

issue adjusted net-income metric its conference call and press release and failed to issue

adjusted Earnings Per Share figures

What is the legal definition of financial reporting fraud? Is Valeant’s non-GAAP

measure fraudulent? Explain.

According to SEC, financial reporting fraud is a deliberate alteration of the company

financial statement in order to mislead the users of financial information and insinuate the

company financial position, performance and cash flow are healthy. The financial

reporting fraud is carried out by the executive in order to achieve a particular objective.
 Valeant preferred to use the non-GAAP guidelines in its press release in order to show

the company was profitable with the aim of convincing the investors to buy its stocks.

The use of non-GAAP guidelines was fraudulent since it was not meant to show the

investor the core business but rather to insinuate that the company acquisition was

reducing the company profitability.

3. Auditors signed off on Valeant’s financial statements. What difficulties do non-

GAAP measures present for auditors? Explain.

The role of the auditor is to ensure that the management prepares the financial

statement using the Generally Accepted Accounting Principle (GAAP); however, when

the company chooses to use the non-GAAP accounting standard, it becomes complicated

to ascertain whether the guidelines used appropriately. The external auditors’ opinions on

the company’s financial statement and internal control do not cover the non-GAAP

measures. When auditors encounter the non-GAAP problems, they are supposed to

consider if the problem is materially inconsistent with the information appearing the

GAAP prepared financial statement.

Investors

1. Describe each investor’s thesis on the company. Which investor makes a stronger
case? Justify your answer.
On Jun. 8, 2014, Jim Chanos Kynikos President and founder said in an interview with

CNBC that Valiant Pharmaceutical International Inc’s debts burden were unsustainable and

expressed his doubts over the company cash flow. Chanos claimed that Valeant

Pharmaceutical International Inc investors were not only relying on faulty metrics but also

wrong accounting. Chanos believed that Valeant is un-economic to the shareholder since the

companies acquired by Valeant have a very short lifespan compared to their cost. Valeant is a

company that buys drugs and doe not develop them, and therefore adding R&D to the
company cashflow will result in fault accounting and metric for the company (Wapner,

2016).

However, on the following day, Bill Ackman, the founder, and CEO of Pershing Square

Capital Management objected Jim Chanos theory by arguing that accounting for companies

that make substantial acquisition are very complicated. Ackman argued that the bigger

percentage of Valeant business was growing at a smaller percentage without requiring R&D

investment compared to a smaller percentage that was decreasing at a higher percentage

(CNBC US Source, 2014).

The two investors displayed various finance biases; for instance, Bill Ackman displayed

overconfidence bias by suggesting that Jim Chanos was relying on his arguments from

ignorant rather than facts. Subsequently, he argued that pharmaceutical companies that deal

with huge investment should not be subjected to the usual accounting standards and metrics

since they operate in a very complicated industry.

On the other hand, Jim Chanos displayed loss aversion bias by fearing the loss and

dismissing Valeant Economic value. Jim was very unfair to Pearson, the company CEO, who

he claimed was only interested in short term revenue growth and did not mind about the

lifespan of acquired medicine.

Section 2 Group Project and Financial Shenanigans

According to the group report, the major metric in this industry includes; average net

monthly fitness churn, the total workouts, subscription contribution, and the adjusted

EBITDA. It should be noted that the majority of the fitness companies offer both the

equipment and fitness services to their customers. For instance, 77.6% of Peloton Inc.

revenues are generated from the sales of equipment. company to consider using a different

metric to measure the performance of the division.

 An additional metric I would analyze when conducting research for Pelaton would be to

to measure the equipment division through Days of Sales in Inventory. This metric takes

takes into account the period by which the company holds the equipment before the sale. The

time is essential since the company will be generating income from the equipment in terms of

services to its customers

2. Review the company’s filings and perform the analysis.

According to the group analysis, 77.6% of the revenue is generated by the equipment

division; this means that 77.6% of the cost of sales is incurred in this division. Subsequently,

since the service division does not require much of the inventory, we assume that all the

inventories recorded in the company 2019 Q3 results were from the equipment division. The

table below shows the metric calculation and how it reduced significantly in 2019.

Sep. 30, 2019 Sep. 30, 2018

Cost of revenue 95.370 47.03
Inventories, net 205.6 136.6
Inventory Turnover 0.557395675 0.274842782
Day of Sales Inventory 654 days 1328 days
The analysis of DSI reveals that even though the equipment division contributes more

than 77.6% of the company revenue, it takes more than two years to make a sale. The ratio

was even higher in 2018 since the company required three and a half years to clear its

inventory. The metric indicates that the company may struggle to earn revenue in the future

unless the Days of Sales inventory is reduced to a reasonable period.

Describe how your analysis fits within the context of the rest of the work that was performed
in the paper. Does it add to the group’s conclusions or contradict their other findings?
The inclusion of Day of Sales Inventory agrees with the group since the group conclude

that the company does not use an appropriate metric to assess the equipment division

performance. The group also disagree with the company use of adjusted EBITDA margin as

the key performance metric since it does not take into account depreciation and amortization.

The exclusion of the depreciation and amortization expenses in calculation makes EBITDA a
faulty metric to measure equipment division since the two expenses are crucial to division

performance, from the analysis above, the company has long Day of Sales Inventory (DSI)

which increase depreciation and amortization expenses. Therefore, the exclusion of

depreciation and amortization expenses in EBITDA since they are non-cash makes adjusted

EBITDA misleading.

Section 3 Issue with Accounting Standard

1. How would disaggregated information improve the usefulness of financial statements

for investors?
In October 2008, FASB and IASB published a draft of the Financial statement

presentation. The preliminary FSP requires the entities to classify assets and liabilities in the

balance sheet as if they were being presented in the statement of the cash flow. The initial

draft required assets and liability to be classified into operating, investing, and financing and

then maintained the classification in the income statement (Bloomfield, Hodge, Hopkins, &

Rennekamp, 2010). The disaggregation of data in the financial statement is aimed to provide

additional information to the investors to improve their judgment.

2. What challenges does the FASB face in attempting to accomplish these two goals?

Disaggregation of accounting information has various benefits to the investor since it

provides more information about the financial statement data, especially in the balance sheet

and income statement. However, the project is yet to be implemented due to since numerous

problems encountered FASB and IASB have not been solved. Some of the problems include;

the structure and the content of statements of financial performance varies from one company

to another, insufficient disaggregation of information, the presentation of alternatives reduced

the comparability of the financial statement across the industry and inconsistence in

calculation pf the subtotals

 3. If the FASB were able to successfully accomplish the two goals above with new
accounting guidance, what impact do you think it would have on the proliferation of
non-GAAP measures? Justify your answer.
If FASB and IASB achieve disaggregation of performance and structure performance

statement objective, the financial statement prepared under GAAP and IFRS will be

clearer compared to the current financial statement. The disaggregation of the financial

statement will minimize the need to report the financial performance using the non-

GAAP guidelines since it will take care of non-core business activities such as acquisition

and restructuring in the financing section of the balance sheet and the income statement.

References

Bloomfield, R. J., Hodge, F. D., Hopkins, P. E., & Rennekamp, K. M. (2010). Do enhanced

disaggregation, and cohesive classification of financial information help credit

analysts identify firms’ operating structures? SSRN Electronic Journal.

doi:10.2139/ssrn.1650906

CNBC US Source. (2014, Jun. 9). Ackman says Chanos wrong on Valeant. Retrieved from

https://www.cnbc.com/video/2014/06/09/ackman-says-chanos-wrong-on-

valeant.html
FASB 2018. (2018). Non-GAAP measures: Questions and insights. Retrieved from

https://www.conference-board.org/blog/environmental-social-governance/Non-

GAAP-Measures
Ross, S. A. (1973). The economic theory of agency: The principal’s problem. The American

economic review, 63(2), 134-139.

Valeant Press Release. (2015). Ex-99.1. Retrieved from

https://www.sec.gov/Archives/edgar/data/885590/000119312515057094/d878365de

x991.htm

Valeant Proxy Statement SEC. (2014). Def 14a. Retrieved from

https://www.sec.gov/Archives/edgar/data/885590/000119312515123856/d898925dd

ef14a.htm#toc898925_17

Wapner, S. (2016, Oct. 25). Chanos: Valeant is UN-economic to shareholders. Retrieved

from https://www.cnbc.com/video/2016/10/25/chanos-valeant-is-un-economic-to-

shareholders.html

Wapner, S. (2016, Oct. 25). Chanos: Valeant is UN-economic to shareholders. Retrieved

from https://www.cnbc.com/video/2016/10/25/chanos-valeant-is-un-economic-to-

shareholders.html