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Accounting for research

01 August 2014

Pfizer’s bid for AZ reveals the complexities of capitalising on R&D

In May 2014, Pfizer, the US pharmaceutical giant, made a takeover bid for the UK firm Astra Zeneca (AZ). It was the largest ever overseas bid for a UK company.

The UK government expressed concerns about the risks to UK intellectual property, R&D, science base and jobs. The US Congress opposed Pfizer saving tax expenses by moving domicile to the UK. The story highlights the complexities of the pharma industry and the difficulties surrounding R&D reported in financial statements.

Aside from tax benefits, the bigger prize at stake for Pfizer was access to some of the key drugs currently being trialled by AZ. The cautious reporting treatment of drugs in a pharma company’s pipeline means that most research conducted by companies in this sector fails to be recognised in their balance sheets. The difficulty in predicting which products will successfully reach the market also means published financial statements in pharma company takeovers are of limited value.

Pfizer’s takeover bid was not just for obtaining access to the current stock of AZ’s pharmaceutical products. Pfizer was more concerned with AZ’s potentially lucrative drug products that are currently at laboratory stage or under trial. In particular, the scientific community considers that AZ’s revolutionary cancer antibody has potential to become a multi-billion pound blockbuster. As with most pharmaceutical research the costs are astronomical – with no guarantee that it will yield worthwhile results. In practice, the majority of spending on research by pharma companies is ultimately unproductive and leads to no end product or the product later fails medical trials.

However, the accounting treatment of AZ’s cancer research normally requires the costs to be written off as they are incurred as an expense in the income statement. This current and cautious accounting treatment can be traced back to the collapse of Rolls-Royce in 1971. Prior to the company’s funding problems, there were no UK accounting rules on reporting research and development. Accountants rather arbitrarily decided if research was to be treated as an expense to be written off immediately against profits or capitalised as an asset because of its potential to generate future revenue.


Lessons learned

The collapse of Rolls Royce illustrated the dangers of unjustly capitalising research to preserve earnings levels. Rolls Royce had contracted with Lockheed to develop a new generation of aircraft engine and the contract was subject to strict terms. The research fell behind schedule and cash flow was becoming exhausted. Yet the company’s dire financial position was not wholly reflected in its income statement because it had been capitalising up to 50% of its research costs.

The amount of research capitalised was being carried forward with no certainty its value would ever be realised. Before long, Rolls Royce was capitalising an unsustainable research balance to avoid decimating earnings in the income statement. The firm collapsed with no finished product to generate income.

As a result of the demise of Rolls Royce, the accounting regulators in the 1970s issued SSAP13, ‘Accounting for research and development’, which required most categories of research to be written off, immediately as they were incurred, to the income statement. A company could only capitalise tightly defined ‘development expenditure’. These new rules meant the research stage of a project or product must have been completed and be satisfactorily assessed as to its financial and technical feasibility before it could be capitalised. These fundamental principles formed the basis for reporting R&D spending in subsequent accounting standards.

Under the current requirements in IAS38, ‘Intangible assets’, AZ has written off all of its research to its income statement. The company states that because there are regulatory and other uncertainties over the outcome of its product development, the expenditure fails to meet the criteria for capitalisation. It concedes that this failure to meet the capitalisation criteria is ‘almost invariably the case prior to approval of the drug by the relevant regulatory authority.’ As a result, AZ’s 2013 financial statements simply, but significantly, note that, ‘no amounts have met recognition criteria [for capitalisation].’


Future cash flow

In 2013, AZ reported R&D expenses amounted to $4.8 billion – all written off immediately against earnings. To put the size of this spending in context, research expenses in 2013 amounted to nearly 20% of group turnover and is over $1 billion more than reported operating profits. In 2013, AZ had a difficult financial year with net earnings falling to $2.6 billion. Given Pfizer’s £69 billion offer, it means that AZ was valued at a highly optimistic multiple of historical annual net earnings. Pfizer clearly expects the drugs and treatment in AZ’s laboratories to have strong earnings potential in the coming years.

In this industry, there are few quick fixes that can swiftly generate streams of cash flows from new products. Many R&D cycles take 10–15 years to bring a new product to market. However, the balance sheets of all pharmaceutical companies are not important. The key asset of such companies is the extent to which their research projects will ultimately lead to solid year-on-year future cash flows. In practice, neither the balance sheet, nor indeed the income statement, provides any significant means of assessing the likely outcome of the company’s research. The billions of dollars spent on research can be recovered from just one successful drug. The financial statements provide little guidance on identifying if any products will be successful or profitable.

None of this has deterred other US pharma companies from seeking mergers with UK and Irish companies – albeit on a smaller scale. Abbvies has agreed a takeover of Jersey-registered and Dublin-based Shire, Medtronics reached a deal with Dublin’s Covidien and Valeant has been pursuing Buckinghamshire firm Allergan.

However, as most larger-scale takeovers tend to destroy shareholder value, and given the high level of Pfizer’s bid, AZ’s board may well have done the US predator a favour by rejecting its offer.


John Stittle is a Senior Lecturer at the University of Essex

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