Market Overview

A Lesson in History: Legal Services May Not Always Provide Best Advice

In light of the MF Global hearings, investors should always remember that companies are not always forthright about their activities. Sometimes, in the case with Jon Corzine's firm, companies may lie about their risk exposure. Other times, companies may refer to their business practices in an ambiguous way in order to confuse investors - a strategy used by Enron.

While many companies do not do this with malicious intentions, little white lies may not be beneficial to many investors. As many know, history typically repeats itself in strange ways. Today, we look at a publicly traded legal service company, called Pre-Paid Legal Services. While its business model was fairly straightforward, the way it booked revenues and reported them to shareholders was less than immaculate.

Pre-Paid Legal Services, Inc. was one of the first companies to “design, underwrite and market legal expense plans." As a key industry leader, the company greatly benefits from the huge growth in the legal service plan industry. As the market continues to evolve and more individuals are covered, PPD will capitalize on these gains. A key element in their business strategy is selling plans to large groups of individuals like labor unions, American Association of Retired Persons, the National Education Association, military services, government officials, etc. These groups can provide long-term stable profits for the company.

The primary problem that shareholders had regarded the company's revenue recognition methods.

The major problem that was revealed by the 1997's third quarter earnings announcement was that the three-years of advanced commission paid to the Associates from the Memberships they brought into the firm seemed very questionable and possibly did not conform to the GAAP principles. This causes cash flow issues to the company because of the money upfront the company must pay. If we look at the “cash and equivalents” account, it has decreased from $27.722 million in 1997 to $8.604 million in 1998. If this continues, how long will the company be able to continue dishing out such large amounts of commissions to their employees? It seems that they will run out of cash by the end of 1999.

Additionally, because 25% of Members do not renew their membership, this adversely affects PPD because of the advancement they had made. The company clearly states that they only attempt to “recapture 50% of any unearned advance” and even then they have historically had trouble immediately recovering the “majority of such charge-backs."

In addition, because of how PPD is now set up, the company's “financial conditions and results of operations may be materially adversely affected” if the new memberships fall below their historic levels compared to the ratio of prior members. The market may fluctuate and if PPD goes through a downturn, it would be very detrimental to see the company have troubles because of how their commission system is set-up.

The revised earnings better represent the company's earnings because of the income tax breaks that the company has experienced. By implementing allowance accounts, the balance sheet has a more realistic view of the actual commissions paid, including the discontinuation of services by customers.

This is a significant risk, as the company has consistently experienced about 26% drop out rate each year. By accounting for this risk, the income tax paid by the company is altered, and is reflected appropriately in both the balance sheet and income state. Both the allowance account and income tax revision more accurately reflect the company's health, liquidity, and performance.

In response to investors' reaction to the third quarter earnings announcement, PPD's management should revert back to their old accounting methods. These methods include not reporting membership commission advances for three years. In doing so, their prepaid asset account would drastically diminish, but their cash account would replenish and remain consistent.

Furthermore, these methods provide a better indication of the true condition of the business and better the company in the long-run. Under the current methods, PPD suffers from membership lapses and poor persistency. Therefore, the current and long-term commission advances do not properly reflect future revenues that will be recognized by the Company since the clients may not even remain for the full three years.

The investor's have caught wind of this fact and look to the cash flows as a better measure of the business. Since this account is depleting because of the advanced commissions, their unrealizable revenues are overstated.

Pre-Paid Legal Services is a classic case of mismanaged accounting standards. Some could argue that the company did so intentionally, but many could contend that it was a simple accident. Regardless, many investors got hurt because of it. To protect yourself from problems like this, you should learn how to scrutinize companies.

As Warren Buffett once said, he only invests in companies that make sense. This means that if you do not know everything about company, do not invest in it. Make sure you also understand the company's future direction as well. It always pays off to wait a few extra days before making an investment to learn as much as you can.

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