By Jeff Ellis, Audit & Assurance Partner, Professional Practice Director – Life Sciences
Deloitte & Touche LLP
Life sciences companies operate in a world of uncertainty. It is near-impossible to know how variables such as new pricing models, regulatory changes, or mergers and acquisitions (M&A) activity will disrupt the industry beyond the next financial reporting cycle.
Operational executives often make strategic decisions without fully vetting the consequences those decisions may have on financial reporting. Less informed decisions may lead to undesirable financial reporting outcomes…or worse.
In well run companies, operational leaders partner with financial leaders early on to expose uncertainties before any major decisions are made. They collaborate closely in working groups to vet the potential financial reporting implications and make more informed decisions together.
The need for collaboration has never been higher. A wave of financial reporting changes – including those related to revenue recognition, leases, the definition of a business, non-generally accepted accounting principles (GAAP) financial measures, and others – will require due diligence to help financial professionals implement reporting changes in a timely, appropriate and transparent way to stakeholders. These working groups must also exercise sound judgment in applying existing accounting standards involving collaborative arrangements, research and development (R&D) funding arrangements, acquisitions and divestitures, consolidation, contingencies, and taxes.
Consider, for example, the implications of M&A transactions. In light of several failed large deals, some analysts expect that pharmaceutical companies will focus on acquiring smaller companies to strengthen their product portfolios. Asset swaps between pharmaceutical companies may also be more likely as some companies choose to focus on one or two key therapeutic areas. Many medtech companies are also exploring M&A opportunities, particularly acquisitions of data analytics firms. And life sciences companies in general are continuing to divest assets and businesses to free up cash and focus management’s attention on the core business and innovations.
These working groups need to collaborate to ensure that appropriate judgments are made in accounting for M&A transactions. For example, applying the accounting definition of a business is critical to appropriately accounting for transactions as business combinations or asset acquisitions. The determination of whether a group of assets represents a business is also important in divestiture transactions due to the differences in accounting that can exist.
Similarly, when a company sells a business or product line, questions often arise about whether the divested group of assets should be accounted for as a discontinued operation. Here, appropriate application of the accounting guidance – which requires consideration of the company’s business strategy – fundamentally impacts how financial statements are presented.
Drug pricing and revenue recognition
Drug pricing is another uncertain area that affects financial reporting. Many governments have or are seeking to institute drug price cost containment or value-based pricing and reimbursement models.
Value-based payment models reward caregivers for meeting certain performance measures, or penalize them for poor outcomes, medical errors, or increased costs. If a patient doesn’t improve after a defined treatment, for instance, the drug manufacturer could be required to reimburse all or some of the drug cost.
This kind of uncertainty can make the accounting for revenue recognition challenging. Under current accounting standards, product revenue recognition has relied heavily on estimates and assumptions about returns and other potential adjustments where insights from operational leaders are needed. New rules that will soon apply to revenue transactions will require even greater judgments, particularly for these types of pay-for-performance arrangements.
Issues like these – along with the periodic restatements and inquiries into the revenue recognition practices of pharmaceutical and biotech companies – underscore the need for leadership teams to focus on the criteria for recognizing revenue and collaborate in identifying appropriate assumptions to estimate returns, chargebacks, rebates, and other adjustments to revenue.
A third example that illustrates the need for collaboration in financial reporting involves clinical innovation. Innovation is critical for survival as stiff competition and patent cliffs jeopardize revenue. Soaring R&D costs, increased pricing pressures, heightened regulatory scrutiny, and the influx of generics have likely had a chilling effect on clinical innovation. While the cost of taking a blockbuster drug from conception to market has stabilized, R&D success remains hit or miss as peak sales per asset continue to decline.
This has led many companies to seek newer, more efficient R&D models, including entering into various funding relationships to reduce R&D costs through collaborations, licensing deals, and other alliances. As these R&D arrangements become more complex, so do the accounting requirements. Operational and financial executives need to collaborate to properly assess the substance, risks, and deliverables of such R&D relationships and the appropriate accounting requirements to apply.
Putting finance colleagues in a reactive position after a business decision has been made increases the company’s risk that transactions will have unintended financial reporting impacts. When operational leaders and finance leaders collaborate from beginning to end, companies can work toward positive outcomes – both financially and strategically.
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