Pharma R&D recent trends and accounting implications

However, the natural challenge related to high R&D spend is the associated high expectation from investors for a reasonable return on investment. And these expectations are particularly difficult to fulfil at a time when profitability has been largely constrained in the sector as a result of factors such as rising costs, pricing challenges and regulatory matters.

R&D trends

Success rates for drug candidates between individual phases of the drug-development process and the likelihood of approval are critical. It can take years for a phase 1 asset to achieve regulatory approval, and there are significant differences in overall success rate for phase transition and associated cost and further substantial differences when analysed further by disease area.

The number of drugs in active development has been on an upwards trend for the past 10 years. And the Covid-19 pandemic has had a significant impact, with R&D activity supercharged in 2020 as record amounts of funding were channelled into the sector. 

However, whilst there was still growth in the number of drugs under active development in 2021, the growth rate was less than in both 2019 and 2020. The majority of the growth in 2021 was in the early stages of development (pre-clinical and phase 1). 

Introducing a new drug to the market is not only a complicated process, but also an expensive and risky one. The efficiency of R&D activity – the successful approval and launch of new molecular entities (NMEs) compared to the R&D expenditure – is a key consideration given the rising expectations of investors. 

The importance of R&D for pharmaceutical companies is clear. Yet, paradoxically, accounting requirements do not ordinarily recognise the value and potential of R&D on balance sheet. Additionally, the need for new sources of capital in the life sciences industry is key and hence entities continue to look to innovative R&D funding arrangements.

R&D and accounting

The accounting problem is that, despite the pharmaceutical industry spending billions of dollars on R&D each year, there is no guarantee that the future benefits from any particular R&D project will be realised, and therefore R&D expenditures cannot ordinarily be capitalised under International Financial Reporting Standards (IFRS). 

Specifically, IAS 38 Intangible Assets separates an R&D project into a research phase and a development phase. The accounting standard states that “research” is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding, and that no intangible asset arising from research (or the research phase of an internal project) shall be recognised and expenditure shall be expensed when it is incurred.

“Development” is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.

Under IFRS, development-phase costs can only be capitalised if certain criteria are met. For example, both technical feasibility and probable future economic benefits have to be established. But many pharma companies believe that, because of the uncertainty involved in both the development of and regulatory approval process for new products, they cannot capitalise internal development expenses as an intangible asset until they secure marketing approval from a regulatory authority. 

However, research and development projects acquired as part of a business combination are recognised as an intangible asset if they can be reliably measured.

Better information on intangibles

With the challenges of recognising intangibles on balance sheet, there is considerable debate at the current time regarding both recognition and disclosures for intangible assets. The European Financial Reporting Advisory Group (EFRAG) has recently finished consultation on its discussion paper, Better information on intangibles. This discussion paper considers three approaches:

a)     recognition and measurement in the primary financial statements

b)     information on specific intangibles in the notes to the financial statements or in the management report

c)     information on future-oriented expenses and risk/opportunity factors that may affect future performance in the notes            to the financial statements or in the management report

The future reporting on intangibles and value creation is seen as a key area for connecting financial and sustainability reporting.

Concluding remarks

Whilst R&D is of massive importance to the pharma sector, under IFRS requirements its true value is not usually reflected on balance sheet. Furthermore, current accounting requirements do not capture the basis of value creation or consumption. More focus is undoubtedly starting to be placed on how to provide relevant, comparable, and useful information on intangibles.

As their significance increases, intangible assets are starting to receive more attention from standard setters. It is likely that much of the focus will be on disclosure, but measurement should not be ignored, especially because expenditure and fair value can vary significantly. And whilst there is undoubtedly a demand for useful information, there is also a concern not to require entities to disclose information that is commercially sensitive.

It is a case of “watch this space” at the moment with regard to intangibles, but any developments are likely to be highly significant to the sector.