The Pharmaceutical Industry under IFRS Rules

Written By: Amenda Lin

The global trend towards applying International Financial Reporting Standards (IFRS) has altered the pharmaceutical manufacturing industry's annual reporting methods. For analysts, investors and other users of financial statements, meanwhile, IFRS has shifted the focus of analysis when looking at financial reports.

PricewaterhouseCoopers (PwC) performed an analysis of the 2006 annual reports issued by the world's twelve largest pharmaceutical manufacturers to have applied IFRS. The resulting report mainly looks at IFRS application and how it affects the transparency of financial statement disclosures in the pharmaceutical industry, as well as the consistency and comparability of financial statement expression within a single industry. The following are some of the key points from this research on IFRS and financial reporting in the pharmaceutical manufacturing sector:
International Accounting Standard No. 38 (IAS 38) "Intangible Assets" gives rules on how pharmaceutical makers are to disclose R&D expenditures capitalized into intangible assets. These rules coincide with the capitalization requirements given in Taiwan's Statement of Financial Accounting Standards (SFAS) No. 37 "Accounting for Intangible Assets".

Similarly, IAS 36 "Impairment of Assets" governs how pharmaceutical companies in a business combination or cooperative research setting must handle certain accounting entries and valuations. The standards also govern how drug makers should:

  • Disclose division-level financial information;
  • Recognize corresponding rebates and allowances when disclosing details on operating income; and
  • Disclose operating risks and related response measures.

For the first two items above, some further analysis and explanation is in order:

Under IAS 38 (Intangible Assets), R&D expenses incurred in the research phase may not be capitalized, while expenses occurring in the development phase must be recognized as expenses as they occur, with the exception of expenses that simultaneously satisfy each of the following criteria, and which may be capitalized:
  • Introduction of a product on the market has become technically and commercially feasible;
  • Development phase expenses can be measured reliably, and;
  • It can be shown that the capitalized intangible asset is capable of generating economic benefits sufficient to cover the associated cost.

The technical feasibility mentioned above must be judged in the context of an industry's special circumstances. In the pharmaceutical manufacturing industry, a judgment on whether development stage expenses may be capitalized may depend on whether the product can win approval under national health and safety regulations. Being approval under one country's regulations does not mean a drug will be approved in other countries, but getting approval under health and safety regulations is generally still taken to be the best evidence that the above capitalization criteria can be met. However, if an enterprise can obtain regulatory approval in its primary market (say the U.S. or the EU), then the evidence in support of capitalizing development stage expenses will be much more persuasive.

In practice, the timing of technical feasibility is also an issue, with many different interpretations. That is, should it be when applying for new drug licensing or when a new drug is approved for sale, or when a license is obtained from an advanced country?

PwC's analysis found that before adopting IFRS, of the twelve largest drug manufacturing companies to apply them, only Belgium-based UCB S.A. capitalized as intangible assets the development expenses it incurred prior to obtaining legal approval for products, as it was entitled to do under Belgian accounting standards. The remaining eleven corporations all recognized expenses in the years they occurred. Nonetheless, as disclosed in UCB S.A.'s 2005 annual report, after switching to IFRS accounting principles UCB booked a reversal of over €300 million in intangible assets, leading to a lowering of its net assets as of December 31, 2004 from €1.965 billion to €1.645 billion.

Also, prior to applying IFRS, when pharma corporations obtained through a business combination intangible assets capitalized from development costs, the assets were added to their goodwill valuation. Under the rules of IFRS 3 (Business Combinations), however, intangible assets that had been subsumed in goodwill must be listed in the balance sheet separately at their acquisition cost, and any expenses pertaining to in-process research and development acquired in a business combination must also be recognized, valued, capitalized, and listed separately in a table of goodwill assets, all at their purchase prices. In addition, IAS 36 (Impairment of Assets) requires annual estimation of impairment losses on those assets.

IFRS are only a series of principles, so while the relevant government agencies adopt targeted incentives and a more accommodating attitude for parts of the pharmaceutical industry, such as new drug developers, cooperation within the industry is all the more important in order to unify financial reporting disclosure formats, as such a unified format will strengthen credibility, coordination, comparability and usability.

Amenda Lin is a partner at PricewaterhouseCoopers Taiwan. Please send your comments and questions to: amenda.lin@tw.pwc.com .

The article was published in Economic Daily News on 25th February, 2008