Prepaid Legal Services
The critical risks that they have to control are problems are defaults on premiums, loss of their ML salesmen who are their mall revenue drivers, failure to collect advanced commissions and low membership persistence. Default of premiums can occur when membership persistence is low. This would result in overpayment of commissions to salesmen who are given 3 years advanced commission payment. This is a cost to the company as they can only retrieve back 50% of overpaid commissions. Furthermore, there are also cases of default in the commissions overpaid which rather adds to the cost to the company.
Change of Commission Formula Pre 1995 commission policy resulted In large outflow of money In the beginning year (70%) and smaller outflows in subsequent years (16%). This results in higher cost to company for a fresh sign. This could lead to agency cost where the salesmen are more interested in new signs rather than ensuring that the new customer continues to stay with Prepaid. After 1995, the policy changed to provide a fiat rate of 25% of commission on premiums for Initial and subsequent years with advance payment of 3 years.
There would be a 50% deduction of unearned advances for next sign. This Incentives salesman to not only get new customers but also to ensure that they continue with Prepaid, allowing Prepaid to continue enjoying high persistence in membership. Fortune’s criticism of Pulp’s method for reporting for commissions Rather than recording the commissions as an Instant outflow of money, they spread the recognition of expenses out over a 3 year period and recognize the prepaid commission advance as an asset.
This artificially inflates earnings. It may seem as though it adheres to the matching principle where the expense is recognized as revenue is incurred, however, from the cash flow point of view, this is earnings management as a smoother flow of income is guaranteed with such a method. Furthermore, Prepaid method assumes that most of the new members would continue renewing their contract for 3 years and above. This may not be true considering the face that cancellation rate may rise In lieu of rolling newly written contracts by Prepaid.
While there is currently strong persistence of members as seen from the upward trend, unless there is substantial evidence to show that going forward, this trend would persist, there is no reason for Prepaid to use this aggressive method of accounting. Actions to Improve credibility about business and accounting model provide more informative financial statements about the exact financial position of the company. Furthermore, they should also recognize provisions for commissions that cannot be collected and this should be derived based on past data.