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We saw you rolling your eyes when we wrote about how important it is to monitor the allowance for doubtful accounts. Well, it turns out we sometimes know what we’re talking about.

Watch List company Par Pharmaceuticals (Pending:PRX) will have to restate results due to accounting errors.

Yahoo reports that

Par Pharmaceutical said on Wednesday it will restate financial results for fiscal 2004 and 2005 and the first quarter of 2006 due to an understatement of accounts receivable reserves.

The understatement resulted from delays in recognizing customer credits and uncollectible customer deductions.

It said it expects the restatement adjustments to reduce revenues by up to $55 million over the applicable periods, prior to any potential recoveries.

We have written about the importance of monitoring accounts receivables reserves in the aformentioned case as well as for Xerox (NYSE:XRX). It is also a component of our “Fundies” worksheet, which helps us keep track of a company’s health. This is a real-life example of why we harp on the accounts receivable reserve so often - a stock that is down more than 4 percent in after-hours trading based on this news.

Let’s look at how the allowances tied in with what was going on in terms of sales and recorded accounts receivable (from the same 10K).

Revenues and gross margin dollars decreased 37.1% and 29.4%, respectively, for the year ended December 31, 2005 from the year ended December 31, 2004. For the year ended December 31, 2004, the Company’s revenues increased 4.5% but the gross margin dollars decreased 12.3% from the corresponding period of 2003. Generic revenues and gross margin dollars decreased 39.6% and 34.5%, respectively, for the year ended December 31, 2005 from the year ended December 31, 2004. In fiscal years 2004 and 2003, all of the company’s revenues were generated by its generic segment. Increased competition has continued to adversely affect pricing and volumes of the Company’s key generic products leading to lower sales in 2005 and gross margin dollars in 2005 and 2004. Branded revenue and gross margins, which were primarily from Megace® ES, were $16,647 and $12,741 for the year ended December 31, 2005, respectively.

It seems sales conditions were difficult in 2005, with a revenue decline of 37.1 percent. Yet gross margin declined by a smaller amount, which is odd in an industry like pharmaceuticals, where much of the costs are fixed (each pill produced has minimal cost, but the plants to produce many pills can be expensive.) Why would gross margin improve as a percentage of sales during a period of declining sales? This itself was an early warning sign that the company’s accounting choices were turning aggressive. However, the company had an explanation:

The Company’s gross margin of $175,413 (40.5% of total revenues) in fiscal year 2005 decreased $72,996 from $248,409 (36.0% of total revenues) in the corresponding period of 2004. The generic product’s gross margin of $162,672 (39.1% of generic revenues) in fiscal year 2005 decreased $85,737 from $248,409 (36.0% of generic revenues) in the corresponding period of 2004. The lower generic gross margin dollars are due primarily to the lower net sales discussed above, partially offset by the increase of other product related revenue. The increase in the generic gross margin percentage was due primarily to the introduction of tramadol HCl and acetaminophen tablets, which due to its exclusivity period contributed a higher gross margin percentage than most of the Company’s other products, the increase of the other product related revenue and the lower sales of paroxetine, glyburide/metformin and metformin ER which after profit splits with partners, have significantly lower gross margin percentages than other products. Gross margin for the branded products was $12,741 for the year ended December 31, 2005 due primarily to the launch of Megace® ES in the third quarter of 2005, which contributed to the higher total gross margin percentage for the Company.

Next we turn to the receivables balance, which declined 3.7 percent from $149.1 million at year-end 2004 to $143.6 million at year-end 2005. The decline in accounts receivable was far less than the decline in sales. Computing a days sales outstanding ratio (for convenience, using year-end receivables rather than the traditionally-used average):

Par pharma 1

From this we see that on top of the decline in sales for 2005, the quality of the sales also declined - the company made sales on credit that it ultimately was unable to collect. We can also estimate how the income statement would have looked had the company only recorded sales of the same quality as the previous year by holding DSO constant at 79:

433,194 * 79/365 = 93,758

Shock of shocks, when we subtract the normalized accounts receivable from that actually recorded we get:

143,608 - 93,758 = 49,858

This number is awfully close to the required restatement of $55 million, allowing for the fact that the company is also restating 2004 and the first quarter of 2006. We can therefore get an adjusted sales number for 2005 by subtracting the $49.8 million of over-recorded receivables from sales:

433,194 - 49,858 = 383,336

By this standard, the sales decline from 2004 to 2005 was 44.4 percent rather than the already-bad 37.1 percent the company originally claimed. We’ll see after the restatement how close this ball-park estimate would have been. In the meantime, listen up when we talk about boring accounting footnotes.

PRX 1-yr chart:

PRX 1-yr chart