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Photograph by Christinne Muschi — Reuters
By Stephen Gandel
October 22, 2015

Valeant’s accounting problems could run deeper than they appear.

This week, the drug company was rocked by allegations that it may be using a specialty pharmacy Philidor, which sells drugs directly to consumers by mail, to inflate its drug sales. Shares of Valeant (VRX) were down by 9% on Thursday to $107, after falling 50% since mid-September, after regulators said they were investigating Valeant’s drug price increases. The company said it would respond to charges related to Philidor on Monday.

But for more than a year, a number of investors have been pointing out problems with how Valeant reports its financial results. One of the most vocal critics has been Australian hedge fund manager John Hempton, who last year wrote a 12-part series on Valeant’s accounting issues on his blog. The biggest issue has to do with a figure that Valeant calls “Cash EPS,” which is a company’s cash flow per share. Valeant has long reported the figure along with its official net income, as measured by standard accounting rules. The company says it’s a better gauge of its results. Unsurprisingly, Valeant’s adjusted results paint a much brighter picture of its performance than its official bottom line.

Valeant is not alone. A growing number of companies—including Twitter and Fitbit, among others—report adjusted results that make their income look better than it is using standard accounting methods. And the Securities and Exchange Commission allows companies to report adjusted results, as long as they are labeled as such and companies also report their official results. But the gap between Valeant’s actual results and its adjusted results are larger than what you typically see from other companies. Even worse, the two sets of results sometimes move in opposite directions.

For instance, in the first nine months of this year, Valeant said its adjusted earnings climbed to $2.7 billion, up 35% from just under $2 billion a year ago. That makes it look like the company is having a great year. By standard accounting measures, though, it’s not. Valeant’s actual bottom line has dropped 81% this year to a mere $70 million.

Valeant gets to its cash earnings by excluding a number of costs that it says represent one-time events. Two biggest costs that make up the difference between Valeant’s actual results and its preferred adjusted results have to do with acquisition-related expenses, namely restructuring charges and writing down the value of some assets, likely drug patents, that it has picked up along with an acquisition.

It makes sense that those costs would be large. Valeant has made a lot of acquisitions in the past year. And it has a reputation for laying off workers, slashing costs, and being ruthless in deciding which drugs in development to continue to pursue when it does an acquisition. Those large charges reflect that. And acccounting rules generally recommend that you write off assets as soon as you think they are worthless. So Valeant’s aggressive write down of drug patents could be viewed as prudent.

Just the same, Hempton has looked at a number of Valeant’s acquisitions and says the costs appear larger than they should be. Of the $8.2 billion in cash earnings that Valeant has reported since the beginning of 2011, $6.3 billion, or 76%, has come from excluding acquisition related costs. Given how often the company reports one-time acquisition related costs, Hempton thinks that Valeant could be improperly including some of its everyday, normal business expenses in with those that have to do with acquiring other companies.

As for Philidor, Valeant denies it is using the specialty pharmacy to boost its sales figures. But a lawsuit claims that Valeant booked $69 million in fictitious drug sales through another, related pharmacy called R&O. It’s impossible to know how much of Valeant’s sales were faked, if at all. Citron Research, which published a report that sent Valeant’s shares plunging, estimates the fabricated billings could amount to a double digit percentage of its sales. Nonetheless, Valeant had over $8 billion in revenue last year. So that $69 million that has been identified so far as potentially fake will not impact the company’s earnings much.

But if Valeant’s costs are being stuffed into a hiding place on one end, and its sales are being stuffed through a specialty pharmacy on the other end, then the company’s actual results—that is, the ones that actually follow accounting rules—might turn out to be a lot uglier than they already are.

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