Evaluating the Indicators

In evaluating the EITF 99-19 indicators, it is important to note that two of the indicators generally provide very strong evidence of the nature of the transaction. Those indicators are the identity of the primary obligor in the transaction and, when it exists, front-end general inventory risk. The reason those indicators are considered strong indicators is because they affect a number of key risks such as the risk of market price declines, customer satisfaction, obsolescence and excess inventory, etc.

In contrast, indicators such as physical loss inventory risk and credit risk are very weak, sometimes meaningless, indicators. This is because the inherent risks in these areas are often very low to start with, and they are easily mitigated through the use of insurance or well-designed business practices. Therefore, these indicators are only likely to be useful in rare circumstances.

In all situations, judgment should be applied in considering these indicators. Depending on the facts and circumstances of a particular transaction, the importance of certain indicators may rise or fall. For example, back-end general inventory risk may be important for transactions involving products that are often returned or rejected, have high values, and for which there are few orders. Such risk may be an unimportant indicator, however, for low value products for which there are many orders, because the product can just be used to fill the next order.

PRACTICE POINTER: Although the EITF has identified many indicators that are useful in determining whether gross or net reporting should be used, the issue may be thought of, in simple terms, as trying to answer two questions. Answering these questions does not replace a review of the indicators, but it may help to frame the issue in a way that is easier to understand. First, who does the end customer believe it is buying from? If the end customer believes it is buying from the company, the company is likely the primary obligor and likely should report gross. On the other hand, if the end customer believes it is buying from the supplier, chances are that net reporting for the company is appropriate.

Second, is the company’s customer the end customer, or the supplier? If the company’s contracts refer to it as an agent or refer to the product supplier as the customer, chances are that net reporting is appropriate.

Transaction-by-Transaction Analysis

The evaluation required by EITF 99-19 should be done on a transaction- by-transaction basis. It is quite possible that a company will have some transactions in which it operates as a principal, for which gross reporting is appropriate, and others in which it acts as an agent, for which net reporting is appropriate. For example, a catalog company that sells office products may maintain inventories of certain products that are high-volume products, such as pens, paper, and printer cartridges, but have other products, such as furniture and computers, drop-shipped from the supplier. Thus, general inventory risk may exist for some transactions, but not for others. This difference could cause a different conclusion to be reached in evaluating the appropriate reporting for the transactions.

EXAMPLE: GROSS VERSUS NET CONCLUSION DIFFERS FOR DIFFERENT TRANSACTIONS

Express Scripts, Inc. Form 10-K—Fiscal Year Ended December 31, 2005 Revenues related to the sale of prescription drugs by retail pharmacies in our networks consist of the amount the client has contracted to pay us (which excludes the co-payment) for the dispensing of such drugs together with any associated administrative fees. These revenues are recognized when the claim is processed. When we independently have a contractual obligation to pay our network pharmacy providers for benefits provided to our clients’ members, we act as a principal in the arrangement and we include the total payments we have contracted to receive from these clients as revenue, and payments we make to the network pharmacy providers as cost of revenue in compliance with Emerging Issues Task Force (“EITF ”) Issue No. 99-19, “Reporting Gross Revenue as a Principal vs. Net as an Agent.”

EXAMPLE: GROSS VERSUS NET CONCLUSION DIFFERS FOR DIFFERENT TRANSACTIONS (cont'd.)

When a prescription is presented by a member to a retail pharmacy within our network, we are solely responsible for confirming member eligibility, performing drug utilization review, reviewing for drug-to-drug interactions, performing clinical intervention (which may involve a call to the member’s physician), communicating plan provisions to the pharmacy, directing payment to the pharmacy and billing the client for the amount they are contractually obligated to pay us for the prescription dispensed, as specified within our client contracts.

We also provide benefit design and formulary consultation services to clients. We have separately negotiated contractual relationships with our clients and with network pharmacies, and under our contracts with pharmacies we assume the credit risk of our clients’ ability to pay for drugs dispensed by these pharmacies to clients’ members.

Our clients are not obligated to pay the pharmacies as we are primarily obligated to pay retail pharmacies in our network the contractually agreed upon amount for the prescription dispensed, as specified within our provider contracts. In addition, under most of our client contracts, we realize a positive or negative margin represented by the difference between the negotiated ingredient costs we will receive from our clients and the separately negotiated ingredient costs we will pay to our network pharmacies. These factors indicate we are a principal as defined by EITF 99-19 and, as such, we record ingredient cost billed to clients in revenue and the corresponding ingredient cost paid to network pharmacies in cost of revenues.

If we merely administer a client’s network pharmacy contracts, to which we are not a party and under which we do not assume credit risk, we record only our administrative fees as revenue. For these clients, we earn an administrative fee for collecting payments from the client and remitting the corresponding amount to the pharmacies in the client’s network. In these transactions we act as a conduit for the client. Because we are not the principal in these transactions, drug ingredient cost is not included in our revenues or in our cost of revenues.

Revenues from our non-PBM segment, PBS, are derived from the distribution of pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network, the distribution of pharmaceuticals through patient assistance programs where we receive a fee from the pharmaceutical manufacturer for administrative and pharmacy services for the delivery of certain drugs free of charge to doctors for their indigent patients, sample fulfillment and sample accountability services.

Revenues earned by PBS include administrative fees received from pharmaceutical manufacturers for dispensing or distributing consigned pharmaceuticals requiring special handling or packaging and administrative fees for verification of practitioner licensure and distribution of consigned drug samples to doctors based on orders received from pharmaceutical sales representatives.

We also administer sample card programs for certain manufacturers and include the ingredient costs for those drug samples dispensed from retail pharmacies in PBS revenues, and the associated costs for these sample card programs in cost of revenues. Because manufacturers are independently obligated to pay us and we have an independent contractual obligation to pay our network pharmacy providers for free samples dispensed to patients under sample card programs, we include the total payments from these manufacturers (including ingredient costs) as revenue, and payments to the network pharmacy provider as cost of revenue. These transactions require us to assume credit risk. Our PMG subsidiary records an administrative fee for verifying practitioner licensure and then distributing consigned drug samples to doctors based on orders received from pharmaceutical sales representatives.

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Copyright 2006 CCH Publishing, a WoltersKluwer business. Excerpted by permission.