How to account for commercial terms payments – the right way
Solid accounting practices are fundamental to enhancing and preserving the value of your pharmacy business. The converse, of course, is also true: bad accounting can undermine pharmacist-owners' ability to sell their pharmacy when, how and for how much they hope to.
In a previous article we look at inventory accounting and how not doing it right can impact a pharmacy’s attractiveness in the market. In this piece, we are going to discuss an accounting gaffe that we see quite often: putting commercial term payments on your books in the incorrect way.
Commercial terms payments are typically tied to a contractual arrangement between a pharmacy and a manufacturer or wholesaler. Without any significant rise in dispensing fees in the last decade, these commercial terms have become an integral part of the pharmacy industry and a significant contributor to the financial well-being of pharmacy businesses.
Yet they also create, for at least some pharmacist-owners, a bit of an accounting conundrum. Are rebates revenue? Should they be treated as a kind of windfall cash or should your business count on receiving them? And if you get money back on a medication you’ve already purchased, how does that impact the value of your inventory?
Getting the answers to those questions right is important, because questionable financial records are almost always a red flag for potential buyers. Poor accounting will undermine their ability to properly value the company, and buyers don’t like taking on uncertainty risk.
So how do you do it right? Here are three commercial terms accounting practices pharmacist-owners should resolve to address – preferably long before they decide they want to sell their business:
Stop recording commercial terms payments as revenue.
The simple reason for not recording commercial terms as revenue is that they are not revenue. Instead, they represent a reduction in a pharmacy business’s Cost of Goods Sold (COGS). So, they should be recorded that way. The process is simple: pay full invoice price for a widget, get back the commercial terms payment, and apply it to your pharmacy’s COGS line. If you don’t, then it could create a misleading calculation of your pharmacy’s percentage gross margin – something most buyers care about a lot.
To express gross margin as a percentage, you subtract COGS from gross revenue and divide the result by gross revenue. Recording commercial terms payments as revenue inflates revenue and increases COGS, resulting in an inaccurate percentage for gross margin. The difference between gross margin calculated the right way and the wrong way might not seem huge, but a few percentage points can make a big difference in the eyes of a potential buyer.
An example: A pharmacy sells $100,000 in widgets that it paid full invoice for at $50,000, then receives a commercial terms payment of $10,000. Recording that as revenue, gross margin would come in at $60,000 ($110,000 - $50,000 = $60,000). Recording commercial terms as COGS yields the same result in dollar terms: $100,000 – ($50,000 - $10,000) = $60,000. But gross margin percentage will be different: in the first (incorrect) case, it would be 54.5%; in the second (correct) case, it would be 60%. Accuracy matters.
Record pending commercial terms payments as accounts receivable.
We have found that many pharmacist-owners (or their accountants) just record commercial terms payments as cash when the payments come in and don’t put them down beforehand as accounts receivable. That’s not right. Expected payments should be part of AR. That’s the only way to come up with a reliable calculation for working capital (another thing potential buyers will take a close look at).
Buyers will be looking for that reliable calculation, which is why it’s important to get this accounting practice right early on. If a pharmacist-owner fixes the mistake, but only in the year before they sell, the buyer will be looking at five years of financial records and wondering why there has been such a big and sudden change in accounts receivable. You do not want to sow the seeds of doubt in a buyer’s mind.
Record inventory at net cost rather than invoice cost.
The valuation of a pharmacy’s inventory should include the reduction to COGS from commercial terms payments. That will create a reliable record of the real value of widgets that have turned through inventory. If you don’t record it at net cost, then inventory value if falsely inflated, and a potential buyer will find it challenging to come up with an accurate assessment of working capital – current assets (which include inventory) will be higher than they should be. This can be a particular challenge when it come to preparing closing financial statements.
Like other accounting best practices, the goal of recording commercial terms payments the right way is twofold: first, it gives you, the pharmacist-owner, a better view to the profitability and value of your business, and second, it gives potential buyers peace of mind in knowing that they can trust your numbers – and, ultimately, you.
Proper accounting for commercial terms payments is fairly clear and easy to do, so don’t wait to start doing it right.