Trading Nation

Are Valeant, Philidor and R&O all the same company?

Valeant & others hit hedge funds
Valeant shares pop
What about Valeant draws Enron comparisons?

Shares of pharmaceutical company Valeant crashed last week after short seller Citron Research alleged that Valeant has created a network of pharmacies to generate phantom sales. Citron notes the oddity of Valeant's owning an option to acquire Philidor Rx Services, which has a relationship with R&O Pharmacy, which apparently owes Valeant money.

Citron further alleged that Philidor and R&O are the same company, which leads to Citron's allegations that the sales Valeant has already booked through R&O (previously recognized as revenue and now sitting in Valeant's balance sheet as money set to be received) appear to be phony. Valeant shot down the claims in a press release, writing that R&O is in fact an "other pharmacy" than Philidor.

So who's right? Are Philidor and R&O the same company? Are Valeant and Philidor the same company? Are Valeant and R&O the same company?

In the case, the answer may come down to semantics, due to the relatively new corporate structure known as the variable interest entity.

Read More Bill Ackman: I bought 2M shares of Valeant today; I believe in the company

A variable interest entity (VIE) is a company with which the reporting company is in some way entangled. This designation, created in the wake of the Enron collapse, means something akin to "ownership-light"; a company that holds a VIE generally enjoys exposure only to the upside of its results, or only to its downside, or it directs the actions of the company. (This explains the name; the company's interest in its VIE may depend on that company's results, thus making it variable.)

The reason that Valeant provides for considering Philidor to be a VIE, and consolidates Philidor's results, is that its option to buy the company exposes it to Philidor's potential upside.

This is where the second layer comes in — the relationship between Philidor and R&O.

In a statement the company released late Wednesday, Philidor echoed what Valeant said about the relationship among the two. It wrote that "Philidor does not currently have a direct equity ownership in R&O Pharmacy or the affiliated pharmacy."

But then things get complicated.

Philidor, however, "does have a contractual right to acquire the pharmacies now or in the future subject to regulatory approval," it added.

Since Valeant's right to buy Philidor lead it to consolidate Philidor's results, does Philidor's right to buy R&O thus lead Philidor to consolidate R&O's results? Does Valeant then consequently consolidate R&O's results, such that all three are the same company from the perspective of an investor reading Valeant's financial statements?

Unfortunately, that's not entirely clear. Representatives for Philidor and Valeant did not respond to emails from CNBC seeking an answer to that question.

And while financial notes might be expected to shed some light, Valeant's 2014 annual report does not even mention Philidor, much less Philidor's treatment of R&O.

To be sure, just because a company has an option to buy a separate company, that does not automatically mean it must be considered a VIE and consolidated as such. Charles Mulford, professor of accounting at Georgia Tech's Scheller College of Business, told CNBC that based on the public facts, "I can't call it; there's not enough information for me to say definitively yes or definitively no."

But if the option effectively gives Philidor exposure to R&O's upside, and there are certain other factors leading to an unusually close relationship between the two companies (such as cash flow going from R&O to Philidor, or Philidor control over R&O's actions) then R&O would indeed need to be considered a VIE of Philidor.

For instance, in PwC's guide to this somewhat fuzzy designation, the accounting house writes that if "the reporting entity holds a non-reciprocal, fixed-price or 'in the money' call option on the other investors' equity investments" in a company, then it is a "strong indicator" that this company must be treated as a VIE.

We already know that Valeant consolidates Philidor's results. If Philidor consolidates R&O's results in turn, then all the results will wind up on the same balance sheets and income statements — Valeant's.

Even if this is the case, it would not directly indicate any type of fraud. However, it would make Valeant's legal action against R&O pretty strange. A company may sue its own VIE, and it is not clear that Valeant directs the actions of Philidor or that Philidor directs the actions of R&O (though it is quite possible). But Valeant is claiming that "R&O sold a substantial amount of Valeant product" and "is improperly holding significant amounts it received from payers."

If R&O's results are consolidated with Valeant's, and the two parties agree that the sales events happened as Valeant describes, then the revenue that Valeant logged due to R&O sales is currently being counted as (Valeant's) accounts receivable, (R&O's) cash, and (R&O's) accounts payable on the combined balance sheet. That means that if Valeant's action against R&O is successful, the end result is merely that Valeant will be able pay down its own accounts receivable with its own accounts payable, by reclassifying certain cash as belonging to Valeant instead of R&O.

On the other hand, if R&O doesn't end up paying Valeant back, then Valeant will be forced to write down its receivables in order to reverse the sale, thus booking a net loss equal to the cost of the goods sold.

Now, the $69 million worth of drugs that Valeant apparently shipped to R&O and for which Valeant is asking for payment is not particularly material for a company that reported nearly $5 billion in revenue in the first half of the year. But for one expert, the small size actually raises alarm bells.

This could be "an erroneous one-off set of transactions, due to an IT system glitch or accounting miscommunication," Victoria Dickinson, a professor at the University of Mississippi's Patterson School of Accountancy, wrote to CNBC. "But if that was the case, you'd think they would have to have some other recourse other than to work through their general counsel (like refuse to fill R&O's inventory orders until they pay up)."

The fact that Valeant sees fit to take legal action over such a small amount could suggest that this is merely the "tip of the iceberg," Dickinson said.

If nothing else, this whole slippery and lightly disclosed situation is flabbergasting; in a Thursday downgrade note, BMO wrote that "while we do not have all the pieces to this puzzle yet, we find Valeant's apparent control over Philidor, and Philidor's alleged activities with other pharmacies such as R&O as aggressive, unusual and questionable."

This fog of confusion stems directly from Valeant's lack of disclosure.

When a company consolidated a VIE on its balance sheet, "generally you need to disclose enough information that a reader can understand the nature of the relationship, so you can convey what the financial impact might be," Travis Drouin, lead partner for audit at Moody, Famiglietti & Andronico, told CNBC.

To date, Valeant appears to have made no attempt to do that.

Hopefully that will change on Monday morning, when Valeant is set to host a conference call "to lay out the facts including allegations made against our company regarding our relationship with Philidor and R&O, our accounting practices, and channel stuffing that contain numerous errors, unsupported speculation and incorrect interpretations of facts and circumstances to the detriment of the shareholders of the Company."

Management certainly has its fair share of critical questions to answer.

Clarification: This story has been updated to more fully reflect the accounting mechanisms by which a variable interest entity would pay down debt that is due to the reporting company that consolidates the entity's financials.