Merck & Co., Inc.

But more than any one factor, many financial observers said the seemingly
endless litany of corporate scandalEnron, WorldCom, Tyco, ImClone, Qwest,
Bristol Myers-Squibb, Merck and on and oncoupled with the shakiness of the
underlying economy have finally pushed investors close, if not beyond, that
mystical tipping point known as "capitulation." That's when they finally cut their
losses and move their money out of stocks.1
The above quote appeared in the Sunday edition of the Washington Post on July 14, 2002. In the
prior week, the Dow Jones Industrial Average had dropped 700 points and the NASDAQ had
now lost three-quarters of its value from its peak in early 2000. The author of this article argued
that the large number of accounting scandals since Enron in October of 2001 had been the largest
factor leading to investors pulling money out of the stock market. The latest revelation in the
Summer of Scandals was Merck, which had the best reputation of any company that was tarred
by scandals during this period, and thus was arguably the most shocking revelation to date. At
the start of the week, the Wall Street Journal ran an article alleging that Merck had falsely
booked $12.4 billion in revenue over the past three years. Don Imus, a famous radio talk-show
host at the time, predicted at least a 300-point drop in the Dow upon seeing this article.
Recent Wharton grad, Kimberly Ulrich, was a junior partner at a hedge fund on Long Island.
She read the Merck article on the LIRR the day it came out and pondered whether she should
look into it further. She normally steered away from NYSE stocks because their rich public
information environments generally limited the potential for trading profits (unless she was able
to get an insider tip). But the Merck situation intrigued her because it was solely based on what
seemed to be a fairly minor accounting issue. From prior experience, she knew that there were
often big price movements in the weeks following such a scandal. Either the market overreacted
to what turned out to be a nonissue, in which case it was an excellent buy opportunity, or the
initial scandal was the tip of the iceberg (especially as other business journalists smelled blood),
in which case it was an excellent short-sale opportunity.
Ulrich decided to spend an hour or so looking into Merck. First, she downloaded EITF 99-19 on
Gross vs. Net Revenue Recognition (Exhibit 1) and worked through a couple of the Illustrative
Examples in the statement (Exhibit 2) to get a feel for whether Merck had any basis for its
accounting choice. Then, she pulled the two Wall Street Journal articles concerning Mercks
accounting for revenue in its Medco unit (Exhibit 3). Before even downloading the Merck 10-K
and Medco prospectus, she had a pretty clear idea of what to do in this case.

Quoted from As Stock Prices Fall, So Do Investors' Hopes by Ben White, Washington Post, 7/14/2002, p. A1

Merck & Co., Inc.

Exhibit 1: Excerpts from EITF Abstract, Issue No. 99-19, Reporting Revenue Gross as a
Principal versus Net as an Agent2
ISSUE
1. Diversity exists regarding whether a company should report revenue based on (a) the gross
amount billed to a customer because it has earned revenue from the sale of the goods or services
or (b) the net amount retained (that is, the amount billed to a customer less the amount paid to a
supplier) because it has earned a commission or fee. The issue often arises with companies that
sell goods or services over the Internet. Many of those companies do not stock inventory and
may arrange for third-party suppliers to drop-ship merchandise on their behalf. Those companies
also may offer services that will be provided by a third-party service provider. However, the
issue is not limited to companies that sell products or services over the Internet. For example, the
issue may arise in, but is not limited to, transactions related to advertisements, mailing lists,
event tickets, travel tickets, auctions (and reverse auctions), magazine subscription brokers, and
catalog, consignment, or special-order retail sales.
2. How companies report revenue for the goods and services they offer has become an
increasingly important issue because some investors may value certain companies on a multiple
of revenues rather than a multiple of gross profit or earnings. Net income generally does not
differ based on whether a company reports revenue on the gross amount billed to the customer or
the net amount retained.

6. The Task Force reached a consensus that whether a company should recognize revenue based
on (a) the gross amount billed to a customer because it has earned revenue from the sale of the
goods or services or (b) the net amount retained (that is, the amount billed to the customer less
the amount paid to a supplier) because it has earned a commission or fee is a matter of judgment
that depends on the relevant facts and circumstances and that the factors or indicators set forth
below should be considered in that evaluation. The Task Force reached a consensus that none of
the indicators should be considered presumptive or determinative; however, the relative strength
of each indicator should be considered.
Indicators of Gross Revenue Reporting
7. The company is the primary obligor in the arrangementWhether a supplier or a company
is responsible for providing the product or service desired by the customer is a strong indicator of
the company's role in the transaction. If a company is responsible for fulfillment, including the
acceptability of the product(s) or service(s) ordered or purchased by the customer, that fact is a
strong indicator that a company has risks and rewards of a principal in the transaction and that it
should record revenue gross based on the amount billed to the customer. Representations (written
or otherwise) made by a company during marketing and the terms of the sales contract generally
will provide evidence as to whether the company or the supplier is responsible for fulfilling the
ordered product or service. Responsibility for arranging transportation for the product ordered by
a customer is not responsibility for fulfillment.
2

The complete EITF Abstract is available at http://www.fasb.org/pdf/abs99-19.pdf .

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Exhibit 1 (continued): Excerpts from EITF Abstract, Issue No. 99-19

8. The company has general inventory risk (before customer order is placed or upon customer
return)Unmitigated general inventory risk is a strong indicator that a company has risks and
rewards as a principal in the transaction and, therefore, that it should record revenue gross based
on the amount billed to the customer. General inventory risk exists if a company takes title to a
product before that product is ordered by a customer (that is, maintains the product in inventory)
or will take title to the product if it is returned by the customer (that is, back-end inventory risk)
and the customer has a right of return. Evaluation of this indicator should include arrangements
between a company and a supplier that reduce or mitigate the company's risk level. For example,
a company's risk may be reduced significantly or essentially eliminated if the company has the
right to return unsold products to the supplier or receives inventory price protection from the
supplier. A similar and equally strong indicator of gross reporting exists if a customer
arrangement involves services and the company is obligated to compensate the individual service
provider(s) for work performed regardless of whether the customer accepts that work.
9. The company has latitude in establishing priceIf a company has reasonable latitude, within
economic constraints, to establish the exchange price with a customer for the product or service,
that fact may indicate that the company has risks and rewards of a principal in the transaction
and that it should record revenue gross based on the amount billed to the customer.
10. The company changes the product or performs part of the serviceIf a company
physically changes the product (beyond its packaging) or performs part of the service ordered by
a customer, that fact may indicate that the company is primarily responsible for fulfillment,
including the ultimate acceptability of the product component or portion of the total services
furnished by the supplier, and that it should record revenue gross based on the amount billed to
the customer. This indicator is evaluated from the perspective of the product or service itself
such that the selling price of that product or service is greater as a result of a company's physical
change of the product or performance of the service and is not evaluated based on other company
attributes such as marketing skills, market coverage, distribution system, or reputation.
11. The company has discretion in supplier selectionIf a company has multiple suppliers for
a product or service ordered by a customer and discretion to select the supplier that will provide
the product(s) or service(s) ordered by a customer, that fact may indicate that the company is
primarily responsible for fulfillment and that it should record revenue gross based on the amount
billed to the customer.
12. The company is involved in the determination of product or service specificationsIf a
company must determine the nature, type, characteristics, or specifications of the product(s) or
service(s) ordered by the customer, that fact may indicate that the company is primarily
responsible for fulfillment and that it should record revenue gross based on the amount billed to a
customer.

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Exhibit 1 (continued): Excerpts from EITF Abstract, Issue No. 99-19

13. The company has physical loss inventory risk (after customer order or during shipping)
Physical loss inventory risk exists if title to the product is transferred to a company at the
shipping point (for example, the supplier's facilities) and is transferred from that company to the
customer upon delivery. Physical loss inventory risk also exists if a company takes title to the
product after a customer order has been received but before the product has been transferred to a
carrier for shipment. This indicator may provide some evidence, albeit less persuasive than
general inventory risk, that a company should record revenue gross based on the amount billed to
the customer.
14. The company has credit riskIf a company assumes credit risk for the amount billed to the
customer, that fact may provide weaker evidence that the company has risks and rewards as a
principal in the transaction and, therefore, that it should record revenue gross for that amount.
Credit risk exists if a company is responsible for collecting the sales price from a customer but
must pay the amount owed to a supplier after the supplier performs, regardless of whether the
sales price is fully collected. A requirement that a company return or refund only the net amount
it earned in the transaction if the transaction is cancelled or reversed is not evidence of credit risk
for the gross transaction. Credit risk is not present if a company fully collects the sales price prior
to the delivery of the product or service to the customer. Credit risk is mitigated, for example, if
a customer pays by credit card and a company obtains authorization for the charge in advance of
product shipment or service performance. Credit risk that has been substantially mitigated is not
an indicator of gross reporting.
Indicators of Net Revenue Reporting
15. The supplier (not the company) is the primary obligor in the arrangementWhether a
supplier or a company is responsible for providing the product or service desired by a customer
is a strong indicator of the company's role in the transaction. If a supplier (and not the company)
is responsible for fulfillment, including the acceptability of the product(s) or service(s) ordered
or purchased by a customer, that fact may indicate that the company does not have risks and
rewards as principal in the transaction and that it should record revenue net based on the amount
retained (that is, the amount billed to the customer less the amount paid to a supplier).
Representations (written or otherwise) made by a company during marketing and the terms of the
sales contract generally will provide evidence as to a customer's understanding of whether the
company or the supplier is responsible for fulfilling the ordered product or service.
16. The amount the company earns is fixedIf a company earns a fixed dollar amount per
customer transaction regardless of the amount billed to a customer or if it earns a stated
percentage of the amount billed to a customer, that fact may indicate that the company is an
agent of the supplier and should record revenue net based on the amount retained.
17. The supplier (and not the company) has credit riskIf credit risk exists (that is, the sales
price has not been fully collected prior to delivering the product or service) but that credit risk is
assumed by a supplier, that fact may indicate that the company is an agent of the supplier and,
therefore, the company should record revenue net based on the amount retained.

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Exhibit 2: Illustrative Examples from EITF No. 99-193

e-Furniture.com
e-Furniture.com facilitates the sale of home furnishing products. Each product marketed has a
unique supplier and that supplier is identified in product catalogs distributed to customers. eFurniture.com maintains no inventories of products in advance of customer orders. eFurniture.com takes title to the products ordered by customers at the point of shipment from
suppliers. Title is passed to the customer upon delivery. The gross amount owed by a customer is
charged to the customer's credit card prior to shipment and e-Furniture.com is the merchant of
record. e-Furniture.com is responsible for collecting the credit card charges and must remit
amounts owed to suppliers regardless of whether that collection occurs. Suppliers set product
selling prices. e-Furniture.com retains a fixed percentage of the sales price and remits the balance
to the supplier. Written information provided to customers during marketing and included in the
terms of sales contracts states:
e-Furniture.com manages ordering, shipping, and billing processes to help you
purchase home furnishing products. e-Furniture.com does not buy, sell,
manufacture, or design the products. When you use e-Furniture.com, you are
purchasing the products from the Suppliers. e-Furniture.com has no control over
the quality or safety of the products listed. Orders will not be binding on eFurniture.com or the Suppliers until the applicable Supplier accepts them. eFurniture.com will process your requests for order changes, cancellations, returns,
and refunds with the applicable Supplier. All order changes, cancellations,
returns, or refunds are governed by the Supplier's policies, and you agree to pay
additional shipment costs or restocking charges imposed by the Supplier. You
agree to deal directly with the Supplier regarding warranty issues. eFurniture.com will not be liable for loss, damage, or penalty resulting from
delivery delays or delivery failures due to any cause beyond reasonable control.
Custom Office Corp.
Custom Office Corp. receives an order for a large quantity of desks with unique specifications.
Custom Office and the customer develop the specifications for the desks and negotiate the selling
price for the desks. Custom Office is responsible for selecting the supplier. Custom Office
contracts with a supplier to manufacture the desks, communicates the specifications, and
arranges to have the supplier deliver the desks directly to the customer. Title to the desks will
pass directly from the supplier to the customer upon delivery. (Custom Office never holds title to
the desks). Custom Office is responsible for collecting the sales price from the customer and is
obligated to pay the supplier when the desks are delivered, regardless of whether the sales price
has been collected. Custom Office extends 30-day payment terms to the customer after
performing a credit evaluation. Custom Office's profit is based on the difference between the
sales price negotiated with the customer and the price charged by the selected manufacturer. The
order contract between Custom Office and the customer requires the customer to seek remedies
for defects from the supplier under its warranty. Custom Office is responsible for customer
claims resulting from errors in specifications.
3

These examples are drawn from EITF Abstract 99-19, with the company names made up by the case writer. Any
resemblance to actual companies is purely coincidental.

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Exhibit 2 (continued): Illustrative Examples from EITF No. 99-19

Cook E-ads Inc.
Cook E-ads provides Internet-based advertising services to companies that want targeted "web
surfers" to see their banner ads. Cook E-ads and the advertiser (in this example, a golf equipment
manufacturer) agree on the goals of the ads and the demographics of the targeted individuals
(that is, golfers). Cook E-ads utilizes data gathered about web surfers through the means of a
software "cookie" placed on the computers of over 2 million people. Those cookies analyze
surfing habits and forward that information to Cook E-ads. As part of this sophisticated overall
service provided to advertisers, Cook E-ads purchases advertisement impressions or space on
various web sites in which the advertiser's message can appear. When a surfer meeting the
demographic profile desired by the advertiser visits a site regarding golf, and if Cook E-ads has
arranged for impressions with that host site, then the surfer will see an ad for the advertiser's
newest equipment styles. Cook E-ads purchases those impressions for $1 per 1,000 impressions
and maintains an inventory of those impressions on certain major host sites that may be of
interest to a number of advertisers. Cook E-ads prices the advertising services that include the
impressions and the system that targets users at $3 per 1,000 impressions. Cook E-ads views
those impressions as minor components of the service product offered. Cook E-ads has
traditional trade accounts receivable terms for its customers.
AdMatcher.com
AdMatcher.com provides the service of matching companies needing advertising space for their
advertisements with companies that have advertising space to sell. AdMatcher.com arranges for
space and marks up the price by its fee (while that fee often is equal to 15 percent of the amount
charged by the supplier of advertising space, the actual fee is a result of negotiations between
AdMatcher.com and its customers). "Advertiser" needs to purchase advertising space.
"Newspaper" is a major newspaper with advertising space to sell. Advertiser and
AdMatcher.com enter into a service agreement for AdMatcher.com to find appropriate
advertising space. The agreement requires Advertiser to accept advertising space located by
AdMatcher.com if certain criteria are met. AdMatcher.com reserves appropriate space for
Advertiser at Newspaper. AdMatcher.com is obligated to purchase the space even if Advertiser
cancels the advertisement; however, since Advertiser has engaged AdMatcher.com to find the
advertising space, cancellation is unlikely. Advertiser pays AdMatcher.com 115 percent of
Newspaper's rate and AdMatcher.com pays Newspaper the net amount. AdMatcher.com
provides Advertiser's advertising copy to Newspaper to print and issue. The contract between
AdMatcher.com and Advertiser requires Advertiser to seek remedies from Newspaper for defects
in advertisements (for example, improper placement or poor quality print).

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Exhibit 2 (continued): Illustrative Examples from EITF No. 99-19

Conso Travel Inc.
Conso Travel negotiates with major airlines to obtain access to airline tickets at reduced rates
compared with the cost of tickets sold directly by the airlines to the public. Conso Travel
determines the prices at which the airline tickets will be sold to its customers and markets the
tickets through advertisements in newspapers and magazines as well as the Internet. The reduced
rate paid to an airline by Conso Travel for each ticket sale is negotiated and agreed to in advance.
Conso Travel agrees to buy a specific number of tickets, and must pay for those tickets
regardless of whether it is able to resell them. Customers pay for airline tickets using credit
cards, and Conso Travel is the merchant of record. Although credit card charges are preauthorized, Conso Travel incurs occasional losses as a result of disputed charges. Conso Travel
is responsible for the delivery of an airline ticket to the customer and bears the risk of physical
loss of that ticket while in transit (although the airline has procedures for refunding lost tickets).
Conso Travel also facilitates resolutions of complaints by its customers regarding service
provided by airlines; however, once a customer receives a ticket, the airline is responsible for
fulfilling all obligations associated with the ticket.
RockBottomFlights.com
RockBottomFlights.com negotiates with major airlines to obtain access to airline tickets at
reduced rates compared with the cost of tickets sold directly by the airline to the public.
RockBottomFlights.com determines the prices at which the airline tickets will be sold to its
customers and markets the tickets through advertisements in newspapers and magazines as well
as the Internet. When marketing and selling tickets to customers, the carrier for a trip is
identified. The reduced rate paid to an airline by RockBottomFlights.com for each ticket sale is
negotiated and agreed to in advance. RockBottomFlights.com pays airlines only for tickets it
actually sells to customers. Customers pay for airline tickets using credit cards, and
RockBottomFlights.com is the merchant of record. Although credit card charges are preauthorized, RockBottomFlights.com incurs occasional losses as a result of disputed charges.
RockBottomFlights.com is responsible for the delivery of an airline ticket to the customer and
bears the risk of physical loss of that ticket while in transit (although the airline has procedures
for refunding lost tickets). RockBottomFlights.com also assists the customer in resolving
complaints with the service provided by the airlines. However, once a customer receives a ticket,
the airline is responsible for fulfilling all obligations associated with the ticket, including
remedies to a customer for service dissatisfaction.

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Exhibit 3: Merck Articles

Heard on the Street: Merck Included Co-Payments Among Revenue
By Barbara Martinez, The Wall Street Journal, 06/21/2002, p. C1
(Copyright (c) 2002, Dow Jones & Company, Inc.)
PHARMACEUTICALS GIANT Merck & Co. and its pharmacy-benefits unit have boosted their reported
revenue by billions of dollars in 2001 alone through an accounting practice not used by some of the unit's
competitors.
While Merck says it follows accepted accounting procedures in recognizing the revenue, two of its three
biggest rivals use a more-conservative accounting method that doesn't include similar transactions in their
revenue.
The revenue in question is the co-payment -- $10 to $15 is typical in the industry -- made by consumers
with a prescription-drug card to their pharmacy to cover their portion of the cost of a prescription under an
insurance plan. The pharmacy keeps the entire amount of the co-payment, but Merck-Medco -- the soonto-be spun-off pharmacy-benefits unit of Merck -- books the co-payments as revenue. This is despite the
fact that neither Merck nor the Medco unit bills for the co-payments, or gets billed for the payments or
otherwise comes into contact with them.
The accounting treatment, which has no effect on Merck's reported net income, was disclosed to
investors for the first time in a Securities and Exchange Commission filing in April in preparation for an
initial public offering of stock in Medco.
Merck maintains that the accounting treatment is entirely appropriate because it has a residual legal
liability that could require it under certain circumstances to cover additional costs under Medco's
agreements with health-plan sponsors. The drug maker says Medco meets various "indicators" spelled
out in accounting rules for booking such revenue, noting it isn't necessary to meet each and every
indicator. "Recording these co-payments may not be consistent across the industry, but that circumstance
alone is an inadequate and unfair basis for characterizing Medco's practice as `aggressive.'" Merck said
in response to questions about its accounting.
Medco, which manages the pharmacy benefits of 65 million Americans, in 2001 helped process 462
million prescriptions at retail pharmacies; the number of filled prescriptions has grown steadily for the
company during recent years. Merck won't disclose its average co-payment amount, though most copayments industrywide fall between $5 and $50. Assuming an average co-payment of $10 per
prescription, Merck and Medco would have booked roughly $4.6 billion of co-payments as revenue in
2001 alone. That would have been just under 10% of Merck's reported revenue of $47.7 billion last year.
Medco contributed $26 billion in revenue in 2001, or 55% of Merck's revenue.
Medco is the nation's second largest pharmacy-benefits manager, or PBM. Neither AdvancePCS, of
Irving, Texas, the country's largest PBM with 75 million members, nor Express Scripts Inc., of St. Louis,
the third-largest, include co-payments as part of their reported revenue. The fourth-largest company,
Caremark Rx Inc., of Birmingham, Ala., also includes co-payments when tallying revenue. In drug stores,
"AdvancePCS does not bill or collect" for consumers' co-payments because "that is the pharmacy's
responsibility," an AdvancePCS spokesman says. "For that reason, AdvancePCS does not count" such
co-payments as revenue.

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Exhibit 3 (continued): Merck Articles

A spokesman for Caremark said no officials were available yesterday to comment further on the
company's inclusion of the co-payment as part of revenue.
"The fact that two companies are showing it as revenue, while it doesn't alter net income, clearly they're
taking an aggressive stance relative to other companies in the industry," says Charles Mulford, director of
the program in financial analysis at Georgia Institute of Technology in Atlanta. "It overstates total
economic activity at the company."
Revenue recognition has emerged across a range of industries as a hot-button issue during recent
months. In general, growing permutations of once-straightforward sales arrangements have forced
accounting rulemakers to devote significant time to crafting more guidance, addressing factors such as
whether a company takes title to the products being sold, bears the risk of loss for returns or other
matters, or simply acts as an agent or broker with compensation on a commission or fee basis. In 1999,
the Financial Accounting Standards Board issued a dozen pages of guidance, including more than a
dozen specific examples.
Lynn Turner, a former chief accountant at the Securities and Exchange Commission who now is an
accounting professor and director of the Center for Quality Financial Reporting at Colorado State
University in Ft. Collins, says that, in general, for "a PBM that has no legal liability for the co-payment, has
no risk for the co-pay and in fact never ever receives the co-payment, it would not be appropriate under
GAAP [generally accepted accounting principles] to report this as revenue."
After the accounting blowup in the fall of energy-trader Enron Corp., many investors have focused more
on financial-statement fine print, and the SEC has begun a crackdown on practices that falsely pump up
revenue. There isn't any indication that regulators are reviewing Medco's accounting.
Merck, of Whitehouse Station, N.J., and Medco, of Franklin Lakes, N.J., used Arthur Andersen LLP as
their outside auditor until earlier this year, when they joined hundreds of other big companies in firing the
firm; Andersen was convicted this past weekend for obstructing the government's investigation of Enron,
which it audited. Merck and Medco switched to PricewaterhouseCoopers. A spokesman for
PricewaterhouseCoopers says: "As a matter of firm policy, we do not comment on client matters."
Arthur Andersen also last year audited the books of Caremark and AdvancePCS, while
PricewaterhouseCoopers handled the books of Express. At Express, the company doesn't count copayments as part of revenue "because we have no credit risk attributable" to the payments, according to
Chief Financial Officer George Paz. "If a member hands the pharmacy a bad check or a bad credit card,
we don't have to make whole on that payment."
As with shares of other drug makers, Merck stock has been hit by concerns about thin drug pipelines as
important products lose their patent protection. Merck fell 34 cents to $52.50 in 4 p.m. New York Stock
Exchange composite trading, off 30% in the past year while an index of pharmaceutical stocks is down
23%.

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Exhibit 3 (continued): Merck Articles

Merck Booked $12.4 Billion It Never Collected --- Co-Payments to Pharmacies Lifted Drug
Giant's Revenue; Firm Stands by Treatment
By Barbara Martinez, The Wall Street Journal, 07/08/2002, p. A1
(Copyright (c) 2002, Dow Jones & Company, Inc.)
Drug giant Merck & Co. recorded $12.4 billion in revenue from the company's pharmacy-benefits unit over
the past three years that the subsidiary never actually collected, according to a filing with the Securities
and Exchange Commission.
Merck's Medco unit, which manages pharmacy-benefit programs for employers and health insurers,
included as part of its revenue the co-payments collected by pharmacies from patients, even though
Medco doesn't receive those funds. Between 1999 and 2001, co-payments represented nearly 10% of
Merck's overall reported revenue.
Merck first disclosed the accounting treatment in an April SEC filing as it prepared to sell 20% of Medco in
an initial public offering. But it wasn't until a subsequent SEC filing on Friday that the company said
exactly how much revenue was involved.
Merck, based in Whitehouse Station, N.J., says its revenue-recognition policy conforms to generally
accepted accounting principles. The company says the accounting treatment has no effect on its net
income, because it subtracts the same amount as an expense. Medco is the country's second-largest
pharmacy-benefits manager, with 65 million members. Medco reported revenue last year of $29.69
billion, or 59% of Merck's $50.69 billion in revenue.
"For a company such as Merck to reflect as revenues in its financial statements billions of dollars of copayments a customer makes directly to another company, the pharmacy, which the pharmacy collects
and never remits to Merck, just does not reflect the economics of what is occurring," said Lynn Turner, a
former chief accountant at the SEC who is now an accounting professor and director of the Center for
Quality Financial Reporting at Colorado State University in Fort Collins. "If that is what the SEC accepts,
then investors are in trouble and our financial reporting indeed needs improving," he said.
Medco's accounting practice echoes a recent case involving Edison Schools Inc., a commercial operator
of public schools, which was booking as revenue funds that school districts paid directly for teacher
salaries and other costs. The SEC in May found that Edison "failed to disclose that a substantial portion of
its reported revenues consist of payments that never reach Edison." Although Edison's accounting
practice, which didn't affect net income, conformed to generally accepted accounting principles, the SEC
said that "technical compliance with GAAP" doesn't insulate a company from enforcement action if it
makes filings "that mischaracterize its business or omit significant information." The SEC ordered Edison
to add a director of internal audit to its management team. The agency said that Edison would exclude
most of those payments from its reported revenue in the future.
There isn't any indication that regulators have an issue with Medco's or Merck's accounting. The SEC
hasn't asserted that inclusion of co-payments in revenues are inappropriate or not in accordance with
GAAP, according to a Merck official. SEC officials couldn't be reached to comment late Sunday.

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Exhibit 3 (continued): Merck Articles

A pharmacy-benefits manager such as Medco uses the combined buying power of millions of people in its
plans to extract discounts and rebates from drug makers and pharmacies. These companies then pass
on some of the savings to clients -- employers and health-insurance companies -- looking to save money
on prescription drug costs.
Medco's revenue in question is the co-payment -- $10 to $15 is typical in the industry -- paid by
consumers with a prescription drug card to their retail pharmacy to cover their portion of the cost of a drug
under an insurance plan. The pharmacy keeps the entire amount of the co-payment.
Merck contends that it has legal liabilities for the co-payment under certain circumstances, such as if it
transmits electronically to the pharmacist incorrect information about how much co-payment the
pharmacist should collect. But in its SEC filing, the company said it doesn't face a "credit risk," which
would force it to reimburse pharmacies if a customer skipped out on making the co-payment.
The disclosure from Merck comes amid heightened scrutiny over many companies' accounting policies
after several high-profile scandals. Last week, the SEC ordered that chief executive officers and chief
financial officers of more than 900 of the nation's largest companies must swear under oath in writing that
the numbers in their companies' recent financial reports are correct.
Merck declined to say whether the SEC required it to disclose the amounts of the co-payments in its
latest filing, its fourth amended prospectus for the planned Medco initial public offering. But Kenneth C.
Frazier, Merck's general counsel, said the latest filing has been thoroughly reviewed by the agency and
"reflects the discussions we had with the SEC" over the co-payments. "We are proceeding with the
offering and hope to price this week. However, we can't comment further because we are in the quiet
period," he said. An SEC spokesman said the commission's approval of the latest filing is still pending.
The benefits to Medco of including co-payments as revenues aren't clear cut. The accounting treatment,
while making Medco's revenue look larger, actually decreases its gross-profit margins compared with
some of its competitors, which is the opposite of what investors generally like to see. However, some
competing pharmacy-benefit managers and customers say that large revenues and a lower gross margin
are more attractive to potential clients, because they indicate that a company can handle large volumes
and that it passes on more of its profits to its customers.
The largest pharmacy-benefits manager, AdvancePCS, Irving, Texas, and the third-largest, Express
Scripts Inc., St. Louis, don't include the retail-pharmacy co-payments as part of their revenue, while the
fourth-largest, Caremark Rx Inc., Birmingham, Ala., does. Even though Medco recognizes co-payments
as revenue, and Express Scripts doesn't, the companies share the same outside auditor,
PricewaterhouseCoopers. A PricewaterhouseCoopers spokesman said the firm doesn't comment on
client matters.

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Merck & Co., Inc.

Exhibit 3 (continued): Merck Articles

The co-payments that Medco booked as revenue at retail pharmacies in 2001 amounted to $5.5 billion,
representing 11% of Merck's 2001 overall revenue of $50.69 billion. Medco processed more than 460
million prescriptions in its retail pharmacy network last year. The co-payment revenue booked in 2000
was $4.04 billion, or 9.4% of Merck's total reported revenue. In 1999 it was $2.84 billion, or 8.1%. The
company didn't disclose how much it may have booked in revenue from co-payments from 1993 to 1998.
Merck acquired Medco in 1993.
Though the revenue-recognition policy was disclosed within Merck's 200-page SEC filing in April, the
policy wasn't widely known by investors or Wall Street analysts until it was reported by The Wall Street
Journal two weeks ago. Merck's stock dropped 5% to a five-year low after the article was published, and
at least four shareholder lawsuits have been subsequently filed against Merck alleging that the company
falsely inflated its revenue by including the retail co-payments. Merck says the lawsuits are without merit
and it intends to vigorously defend itself against them.
Amid weak stock markets, Merck has in the past two weeks postponed its Medco IPO twice, and its
underwriters have lowered the expected price range to $20 to $22 a share from $22 to $24 a share,
indicating Merck expects to raise between $934 million and $1.03 billion from the offering.
In addition to Medco's revenue-recognition policy, prospective investors have also been concerned about
Medco's continuing relationship with Merck. According to the company's SEC filings, Medco will have to
maintain market-share levels for Merck drugs in its plans or face paying Merck damages for its lost
revenue.

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