Memo

To: Jennifer Reynolds-Moehrle

From: A Good Student CC: Accounting Dept Date: 10/11/2000 Re: McKesson HBOC

NOTE FROM PROFESSOR REYNOLDS-MOEHRLE: This student did an excellent job of responding to the questions posed in the assignment. Your assignment is slightly different, in that you are also required to provide a 340a level discussion of the revenue recognition issues. You must convince me that you understand what was wrong with the way your company handled revenues.

McKesson has been one of the leading health care suppliers in North America for over a decade. Recently they have been, to quote their own management, "undertaking numerous strategic initiatives to further focus the company on our core health care business and enhance our competitive business." Roughly translated they have been buying and selling. Buying health care related companies with customer bases that would expand McKesson's base, and selling companies that are outside of the health-care field. In each of the last three years, they have purchased three to six companies.

HBO Co., a technology company, looked like a good fit to management. They envisioned a "gain of $75 million from a combination of cost savings and cross-selling of each other's products to hospitals and other health care providers." Obviously, they did not get that 75 million but they did get a new customer base of 65% of the hospitals in North America.

HBO Co. certainly looked better than it turned out to be. It was named Georgia's top performing public company in

1997 and 1998. Its market capitalization had jumped from 100 million in 1991 to 13 billion in 1998. By October of 1998, it was being touted as one of the nation's leading health-care software and service companies. HBO Co.'s shares had appreciated almost 1400% in the 5 years 1992-1997, and it ranked second in the S & P 's 500 in stock performance. McKesson's performance by comparison was "sluggish" or "anemic" depending on whom one quotes. Actually, its growth while much slower than HBO Co. was very steady and very good for the health care industry as a whole.

In October 1998, the two companies announced that the acquisition that had fallen through the previous spring was back on, pending final approval of their boards and shareholders. The merger was to be a tax-free pooling in which the shareholders of HBO Co. would receive almost 14 billion in McKesson stock. In January 1999 the acquisition process was completed. Because the two companies had previously used different accounting years, HBO Co.-

December 31, and McKesson- March 31, all of the financials for HBO Co. had to be converted.

It was not until April that the routine audit procedure of verifying contracts was undertaken. It was quite a shock to get one of those letters back with a negative response, a $20 million dollar software purchase that had not gone through. Within days, several additional letters were received saying that additional contracts had contingencies not listed in the contract, and that those conditions had not yet been met. Shortly thereafter, a full-scale investigation was launched. Salesmen were interviewed, and they related how they had been "encouraged" to backdate contracts to help certain accounting periods look better. Filing cabinets were examined and retrieval experts examined the computer system.

The internal and external audits exposed dozens on instances of accounting improprieties 1) Booking sales contracts that were not final. 2) Falsifying contract dates. 3) Shipping and booking software upgrades that a customer had merely agreed to consider. 4) Numerous side-letters stating contingencies to contracts (these letters were in various places, but none were with the contracts they limited). And 5) Recording as current sales subscription sales. Then in June, some deleted computer files were retrieved and a secret list of improperly recorded contracts was found.

The finding of this file suggested that some HBO Co. executives knew about, recognized the extent of, and had intentionally concealed "problems" related to the accelerated revenues.

In the final tally: 1999 revenue was cut by 245.8 million, 1998 revenue was cut by 48.4 million, and 1997 revenue was cut by 33.2 million. Of this 327.4 million McKesson estimates probably rebooking 160 million in revenues as future sales; 115 million might be rebooked at some point; and that approximately 50 million will never be recaptured.

How did a company that looked so good get into so much trouble? It is hard to pinpoint, but some comments by

HBO Co.'s former CEO, Charles McCall, give one room to speculate. He said the restatement of 327 million is misleading. Much of it represents a different interpretation of accounting rules. "I would argue that the way we recognized the revenue wasn't wrong, it may have been aggressive." He also acknowledged, "We may have caused some of the accounting problems." When HBO Co faced a slow down because of their clients' preoccupation with

Y2K the company set up extra incentives for sales reps to close deals earlier in the year for an added 2% commission.

McKesson officials have definitely been on the hot seat this past year. So far, they seem to have done the right things at the right times. In retrospect, they have admitted that they paid too much for HBO Co. as they know it now, and they were too eager to announce the high earnings they thought the merger was creating. They were open with the public about what had happened as soon as they knew things were not right. They fired the people who appeared to have been involved. They allowed the people who should have been aware of what was happening to resign, and they have taken steps to be sure there will not be any more premature booking of revenues. In addition, they have hired or promoted new people and told them to improve customer service and satisfaction, to be sure to retain their customers.

So far their client base seems to be growing not eroding. McKesson HBOC had signed almost $2 billion in new business between April 1 and August 10 of this year. In September, they signed another contract. This contract is with PCS for another $800,000 a year for two years. This contract can be extended an addition three years if both companies choose. Even the customers through the HBO Co. side while taking a "show-me" stance are not backing out just yet.

The biggest cloud hanging over McKesson is composed of lawsuits and investigations. The shareholders are very unhappy that the price of their stock has dropped so dramatically so they are suing. The SEC, and the US attorney's office have both started investigations as to whether SEC regulations were violated. By July 53 lawsuits had been filed in the federal courts, (most are class actions on behalf of shareholders). A half dozen additional lawsuits have been filed in state courts. As of the middle of October, the McKesson HBOC stock had not recovered. It reached it's high in January at 95 and in October was down to 23. See chart below for a comparison of McKesson HBOC's stock price with that of the S & P 500 for the past 12 months. (CHART DELETED)

JOURNAL ENTRIES - illustration of accounting problems

They had booked-- 1) Accounts receivable millions

Sales revenue millions

For sales contracts that were not final. These had to be reversed.

They had booked-- 2) Accounts receivable millions

Sales revenue millions

For sales contracts whose dates had been falsified. These entries had to be reversed, and rebooked in the correct accounting period.

They had booked-- 3) Accounts receivable millions

Sales revenue millions

For sales contracts where there was no actual sale. (The companies had agreed to look at new software.) These entries had to be reversed and are a large portion of the $50 million in lost revenue that McKesson is sure is gone.

They had booked-- 4) Accounts receivable millions

Sales revenue millions

For sales that had side letters. These had to be reversed; some may at some point be rebooked.

They had booked-- 5) Accounts receivable (or cash) millions

Sales revenue millions

Some sales were the equivalent of subscription sales, for future updates to software as those updates are released. Those sales had to be reversed and rebooked as unearned revenue, these will eventually be rebooked as they are earned. Entries should have been--

Accounts receivable or cash) millions

Unearned revenue millions SOURCES OF INFORMATION ON McKESSON

From the Lexis/Nexis data base:

The Atlanta Constitution July 15,1999 Thursday Home Ed., Bus. Sec Page 1C

The Atlanta Constitution July 21,1999 Wednesday Home Ed., Bus. Sec. Page 1D

The Atlanta Constitution August 26,1999 Thursday Home Ed., Bus. Sec. Page 1G

The Atlanta Constitution August 29,1999 Sunday Home Ed., Bus Sec. Page 1Q

Business Wire January 25,1999 Monday Business Wire August 10,1999 Tuesday

Business Wire September 15,1999 Wednesday

Los Angeles Times July 15, 1999 Thursday Home Ed., Bus Sec. Part C Page 2

The Milwaukee Journal Sentinel August 1,1999 Sunday Street Sweep News Show (transcript) July 12,1999 Monday

PR Newswire Association October 14,1999 Thursday Financial News Sec.

On Micro film:

The Wall Street Journal July 15,1999 Thursday Sec. A Page 1 Col. 6

From the library newspaper abstracts data base: Atlanta Constitution October 20,1998 Sec E Page 4 Col. 1 Atlanta Journal Constitution(ATJC) November 14,1998 Sec H Page 1 Col. 2

From Quicken.com Chart of McKesson stock price for last 12 months

From Edgar Plus (with-in Lexis/Nexis) McKesson HBOC Inc. Form 10-K/A document date March 31, 1999 and filing date July 16, 1999.

Note from Professor Reynolds-Moehrle: You should include the author and title of every article you use (from newspapers, internet, magazines, etc.) - This student did an excellent job of writing the paper but would lose some points for having an incomplete bibliography.