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justify the stock™s trading at nearly 40 times earnings.
Plus, trouble could emerge if the company™s cancellation rate on its policies in-
creases and it can™t somehow recover the commissions it has already paid. Pre-
Paid shrugs this off, arguing that its historic cancellation rate is a manageable
24%. And, Harp (PPLS™s CEO) boasts, “I can predict this business more precisely
than anybody you want to mention.”
Maybe so, but the company™s own ¬gures, disclosed in SEC ¬lings, show that
the rate is on an upward trend. The ¬lings also state that Pre-Paid™s cancellation
rate will rise if newly written policies make up a greater portion of its business,
and the company warns (deep in its 10-K annual report) that it experienced a “sig-
ni¬cant increase” in sales of new contracts last year. Unless this shift is offset by
“other factors,” the 10-K says, ¬nancial performance could be severely hurt. In
other words, Olstein contends, Pre-Paid may face a big write-off at some point.
Exhibit 4 presents the company™s footnote disclosure on its method of accounting for
sales commissions.


MANAGEMENT RESPONSE
PPLS argued that its policy of accounting for commissions resulted in a commission ex-
pense that was more consistent with the collection of the premiums generated by the sale
of such contracts. In addition, between October 1998 and June 1999, management ac-

.........................................................................................................................
3. Analyst Report, David Strasser, Salomon Brothers, August 1997.

4. Herb Greenberg, “Will Pre-Paid Keep Growing? A Company™s HMO-Style Approach to Legal Services Has Won It
Plenty of Fans ”And a Soaring Price. But Shortsellers Say the Numbers Don™t Add Up,” Fortune, November 24, 1997.
274 Expense Analysis




7-26
Expense Analysis




quired 1,384,440 of the ¬rm™s shares on the open market at an average price of $28 per
share.5
Nonetheless, concern over the company™s accounting persisted. In late June 1999,
short sales were 6.5 percent of outstanding shares, more than four times the level of typ-
ical companies.6 The company™s stock traded at $26.63, well off its yearly high of $39.25
and the all-time high of $40.50.
Rick Nelson, an analyst at Furman Selz, summed up the market sentiment this way:
“Insiders feel they™ve got a company that™s trading well off its high where the operating




Pre-Paid Legal Services
fundamentals are going gangbusters. But the shorts have caught on the notion that from
a cash ¬‚ow standpoint, the company just can™t handle the growth, and that their business
model itself will come back to haunt them.”7


QUESTIONS
1. Based on the post-1995 commission formula, calculate the commission that would
be earned by a sales associate who sold a Family Plan with a $19 per month premium.
How much would the company attempt to recover from the sales associate if the cus-
tomer chose not to renew the contract after two years?
2. How should PPLS account for the above transactions?
3. Who do you think has it right? Fortune or PPLS™s management? Why?
4. What actions could PPLS™s management take to change the unease among key inves-
tors about the firm™s accounting and its business model?




.........................................................................................................................
5. Quicken.com, “Insider Trading in Pre-Paid Legal Services.”

6. “Uncovered Short Positions Rise on Big Board and Amex,” The New York Times, June 22, 1999.
7. Ian Mount, “The Long and Short of It,” SmartMoney.com, May 25, 1999.
275
Expense Analysis




7-27 Part 2 Business Analysis and Valuation Tools




EXHIBIT 1
Number of Subscribers to Legal Service Plans in the U.S.,
1981 to 1997

Millions

120
Pre-Paid Legal Services




105
100
98

80

60
58

40

20
15
4
0
1980 1985 1990 1995 2000
The above estimates were developed by The National Resources Center for Consumer Legal Services (NRC) and re-
ported by PPLS in its 1998 10-K Report. NRC estimates included free member plans sponsored by labor unions, the Amer-
ican Association for Retired Persons, the National Education Association, and military services, as well as employer-paid
plans. PPLS estimated that 10 percent of the total legal insurance market was covered by plans comparable to those
provided by PPLS. The other major companies servicing this market were Hyatt Legal Services, ARAG Group, LawPhone,
National Legal Plan, and the Signature Group. The NRC estimated that in 1997 the market share of these firms (and
PPLS) was 79 percent. The market share of PPLS alone was estimated at 15 percent.
Source: Pre-Paid Legal Annual Report, 1998.




EXHIBIT 2
Summary of Commission Rates and Timing of Payment for PPLS

First-Year Commission Subsequent Year Commissions
Pre-1995:
Commission rate 70% of subscription 16% of subscription
Timing of payment At customer sign-up Monthly
1995:
Commission rate 25% of subscription 25% of subscription
Timing of payment Advance of three years™ worth of None for ¬rst three years, then
commissions at customer sign-up monthly
276 Expense Analysis




7-28
Expense Analysis




EXHIBIT 3
Summary Financial information for Pre-Paid Legal Services

Year ended December 31
...............................................................................
(in $000) 1998 1997 1996 1995
......................................................................................................................................
Membership revenues $110,003 $76,688 $50,582 $31,290




Pre-Paid Legal Services
Net income 30,210 18,790 12,470 7,312
Cash from operations $9,895 $7,733 $942 $548
Total assets $167,903 $91,912 $57,532 $35,629
Book value of equity 101,304 70,511 45,474 29,740
New memberships sold 391,827 283,723 194,483 109,922
Period-end memberships in force 603,017 425,381 294,151 203,535
......................................................................................................................................

Source: Annual Reports, 1995“98.




EXHIBIT 4
Financial Footnotes Disclosure of Commission Advance from 1998 10-K

Commission Advances represent the unearned portion of the commissions advanced to Associates
on the sales of Memberships. Commissions are earned as premiums are collected, usually on
a monthly basis. The Company reduces commission advances as premiums are paid and
commissions earned. Unearned commission advances on lapsed Memberships are recovered
through collection of premiums on an associate™s active Memberships. At December 31, 1998 and
1997, the Company had an allowance of $4.0 million and $3.7 million, respectively, to provide
for estimated uncollectible balances. The Company charges interest at the prime rate on unearned
commission advances relating to Memberships that canceled subsequent to the advance being
made.
Data on Commission Advances reported in PPLS™s 1995“98 annual reports are as follows:

Year ended December 31
.............................................................................
(in $000) 1998 1997 1996 1995
........................................................................................................................................
Commission advances ” current $21,224 $15,705 $9,108 $3,923
Noncurrent commission advances, net 60,661 38,038 21,744 8,548
........................................................................................................................................
8
8 E nt i t y Acc o u n t in g An a ly s i s
chapter



F or ¬nancial reporting purposes, an entity is an organization that con-
trols some economic resources. Entities can take many different forms: they can be in-
dividuals, partnerships (such as many professional ¬rms), private or public corporations,
divisions of corporations, private nonpro¬t organizations, and government departments.
Business entity analysis involves understanding how the boundaries of entities are
Business Analysis and 2
Valuation Tools
de¬ned to better evaluate how they are performing. For ¬nancial reporting purposes, an
entity™s boundaries can be speci¬ed narrowly, using a strict legal de¬nition. Such an
approach has been popular in Germany and Japan until relatively recently. However, it
frequently fails to provide investors with comprehensive information on the legal
entity™s risks and performance. Accountants and analysts therefore typically take a
broader view of the entity. This approach focuses on the resources over which managers
have control, rather than the legal entity.
Entity analysis is important for shareholders because it clari¬es which resources they
have a claim over and how those resources are performing. Three speci¬c concerns arise
for shareholders in entity analysis. First, does the ¬rm have hidden commitments or hid-
den losses arising from its investments in other ¬rms? Second, is management siphoning
off resources to other entities that they can control? This can arise if a ¬rm sells to or
buys from related parties that are largely owned by management. Finally, is management
overinvesting in “pet projects” that generate low or negative returns for shareholders?
Entity analysis attempts to answer these questions by understanding how an entity is de-
¬ned, what resources it controls, how it performs, what related-party transactions it un-
dertakes, and how its business segments perform.
Many ¬rms have sizable and complex relations with other companies that create
¬nancial reporting challenges. These include stock investments, stakes in research and
development limited partnerships, and franchising arrangements. For these types of
business relations, a critical accounting challenge is to decide whether ¬nancial perfor-
mance of the two companies should be aggregated as if the ¬rms were a single entity, or
reported for each unit separately. If performance is aggregated, a follow-up question for
analysts is to evaluate how the separate entities are performing, particularly if they are
in very different business segments. The answer to this question is particularly challeng-
ing if the entities buy goods and services from one another.


ENTITY REPORTING CHALLENGES
As shown in Figure 8-1, the critical entity challenge in ¬nancial reporting is deciding
how an entity is to be de¬ned. From an economic perspective, if one ¬rm has complete
8-1




277
278 Entity Accounting Analysis




8-2
Entity Accounting Analysis




Figure 8-1 Criteria for Aggregating Performance of Units and
Implementation Issues

Aggregation Criteria
The resources of one unit are controlled by another.




Aggregate the controlled unit™s performance with that of the controlling
entity. Separately disclose performance data for key business segments.



Challenging Transactions

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