|
Changes
in IFRS
The International Accounting Standards Board
(IASB) has provided a 'stable platform' for
making the transition to IFRS, thanks to an
ambitious work programme covering business combinations,
share-based payments, short-term convergence
with US GAAP, as well as improvements to a number
of existing standards. Several pharmaceutical
companies already report under IFRS. But many
more pharmaceutical concerns will join them
in 2005 - and the differences in the point from
which they are starting will contribute to the
discussion of how the new standards and amendments
should be applied.
Identifying the
broader issues
Some of the issues that affect companies in
the pharmaceutical sector are common to companies
in other sectors, too. They include:
- Stock-based compensation: Compensation
charges for options based on fair values are
measured at the date of grant and recognised
over their vesting period. This will probably
have a significant impact on both large, multinational
pharmaceutical companies and development-stage
companies that compensate employees with share
options and other equity-based schemes.
- Business combinations: All business
combinations must be accounted for using the
purchase method. Assets and liabilities will
have to be recognised at fair value and goodwill;
indefinite-life intangibles and intangibles
not ready for their intended use will have to
be capitalised and reviewed for impairment on
an annual basis.
- Financial instruments and derivatives:
Most financial instruments, including derivatives,
must be recorded in companies' financial statements
at fair value, with changes going to either
income or equity, depending on the nature of
the instrument. Companies will also need to
identify and value embedded derivatives.
- Pensions: Employer-sponsored pension
plans must be included in companies' balance
sheets using actuarial valuation techniques.
The resulting net pension assets or liabilities
could be significant, and the related change
in recognition of pension expenses could substantially
vary from expenses based upon employers' contributions
to their plans
Industry-specific
issues
Other issues are specific to the pharmaceuticals
sector, and can be linked to the industry value
chain
Intangibles
One area of particular interest to large pharmaceutical
companies is the treatment of intangibles. Companies
currently reporting under IFRS have already
established principles for the capitalisation
of internal development expenditure, but the
amendments to IAS 38 create a difference in
the treatment of externally purchased 'development'
projects. This has caused widespread debate
within the industry.
We believe that capitalisation of internal development
costs should begin no later than when filing
for final scientific regulatory approval occurs,
a view that is based on the approval success
rate after filing - and the failure rate preceding
it. IAS 38R (Revised) specifies six criteria,
all of which must be met before an enterprise
can capitalise internal development expenditure;
thereafter, capitalisation of such expenditure
is mandatory. The following general guidance
should be applied:
- Technical feasibility of completing
the intangible asset so that it will be available
for use: Demonstrating the technical feasibility
of new compounds prior to submission for final
regulatory approval may be difficult, although
it is not impossible. The nature of the compound
must be considered. Is it, for example, a drug
in a proven therapeutic category, using proven
delivery methods? Or is it a medicine for which
there is a significant unmet need and which
may therefore be treated favourably by the regulatory
authorities? In some cases, the probability
of regulatory approval will be clear from the
Phase 3 clinical trial results, and capitalisation
can begin thereafter. In other cases, recent
regulatory approval experience could cast some
doubt on the probability determination and further
development costs may need to be expensed.
In either case, filing for final regulatory
approval creates a strong presumption that management
believes a drug is technically feasible - although
neither the application nor approval itself
is necessarily sufficient. Whatever assessment
management makes, that assessment should be
applied consistently. For instance, a decision
to start production of inventory or launch a
marketing campaign is persuasive evidence that
management thinks regulatory approval is probable;
therefore, the criterion is satisfied.
- Intention to complete the intangible
asset and use or sell it: There are no specific
considerations for pharmaceutical companies
relating to this criterion. Management's intention
to complete a development project will therefore
have to be assessed on an entity-by-entity and
project-by-project basis (e.g. formulation of
a specific plan, allocation of resources to
the project or establishment of other contracts
in association with the project).
- Ability to use or sell the intangible
asset:This criterion may be demonstrated before
filing for regulatory approval, if, for example,
other entities are actively interested in purchasing
the compound or the company has market evaluations
showing the compound's sales potential, once
it is approved. Exceptions might exist where
an entity has obtained regulatory approval of
a drug but does not have (and cannot obtain)
the manufacturing or marketing capacity to produce
and sell it.
- The intangible asset will generate probable
future economic benefits, or demonstrate the
existence of a market or the usefulness of the
asset if it is to be used internally: Pharmaceutical
companies develop drugs to meet specific therapeutic
needs. They assess the potential market for
those drugs during various stages of development,
and constantly reassess whether it makes economic
sense to proceed. For example, rival drugs may
have entered the market or other factors reduced
their commercial potential or probability of
successful approval, and all such issues should
be considered.
- Availability of adequate technical,
financial and other resources to complete the
development and to use or sell the intangible
asset: This criterion should be assessed on
an individual project and entity basis, by reviewing
the project plans and considering whether they
seem viable, given the entity's history with
such projects.
- Ability to measure reliably the expenditure
attributable to the intangible asset during
its development: Management must have systems
that can capture data to distinguish development
costs from research and other costs. There are
no particular considerations when applying this
criterion to a pharmaceutical company.
The factors to consider in valuing inventories
before product approval are similar to the above
factors regarding development capitalisation.
For instance, assertions underlying the probability
of economic benefits would affect both inventory
valuation and the decision whether to capitalise
development costs.
Collaborations
and strategic alliances
In addition to conducting internal research
and development programmes, many pharmaceutical
companies also engage in collaborations and
strategic alliances with other life sciences
organisations. The advantages of this approach
can be significant. Biotechnology companies
often have promising compounds in development
but need access to cash and production and marketing
expertise. In return for this support, pharmaceutical
companies can increase the opportunities for
filling their pipelines. Pharma-pharma deals
are also common, as companies increase their
focus on core therapeutic areas and territories
and divest non-core products to enhance their
productivity, efficiency and ability to innovate.
Not only is the number of industry collaborations
increasing, so is their complexity. They might
typically include elements such as research
funding (fee-for-service, FTE funding), co-development
(cost sharing), co-marketing and co-promotion
(profit sharing), traditional in-licensing (upfront
and milestone payments and royalties), equity
investments and/or product acquisitions, loans
(convertible, forgivable, straight), product
swaps and combinations of the above.
Companies participating in collaborative undertakings
must consider how the costs and income generated
from such activities should be accounted for
and disclosed. This means understanding the
economic substance of each arrangement, including
the rights and obligations of all the parties;
and using accounting practices that follow the
economic substance, as well as adhering to the
guidance for development costs, intangible assets
and revenue recognition.
The solutions to this chapter illustrate some
of the implications of accounting for commercial
situations under IFRS, with simple examples
of various technical problems and how they might
. be solved.
However, covering every eventuality would clearly
be impossible, and here a note of caution is
necessary. Many of the solutions we describe
are based on simplified versions of often complex
situations and are intended as indicative guidance.
In reality, each case must be evaluated individually
and assessed on its own merits. Revenue recognition
matters, in particular, depend heavily upon
the circumstances surrounding a transaction.
The value chain and associated IFRS accounting
issues
|
