When Would a Life Science Company Not Need an Audit?
There’s a common misconception about financial statement audits being required for regulatory compliance by the Food and Drug Administration (FDA) or another regulatory body. While there are numerous types of audits, this article refers only to financial statement audits, which don’t provide any assurance regarding regulatory compliance.
An audit isn’t a method of cleaning up your company’s books and records. An auditor must maintain independence, which prevents them from taking on any management responsibilities.
Aspects of an Audit for Life Science Organizations
Below are some of the most common audit readiness challenges seen among life science organizations. Preparing for your first audit, this list can help identify applicable topics to your company that might need to be assessed further.
Debt, Equity, Preferred, or Common Stock
A common way for companies to fund operations in the pre-revenue phase of its business is through the issuance of equity securities. There are two primary types of securities that might be issued.
Types of Security that Represent Ownership in a Company
- Common stock. Shares of common stock entitle the holder to vote on company matters brought to the shareholders, allowing them to participate in distributions when a liquidity event occurs after preferential payments have been made to preferred shareholders.
- Preferred stock. Shares of preferred stock often includes an option for the holder to convert the shares into common stock. In addition to the right to vote on company matters brought to the shareholders, preferred stock may have dividend rights and will receive payment in preference to any common shareholders upon the occurrence of a liquidity event.
Preferred stock may also have other terms and conditions negotiated as part of the equity raise that can have complex accounting implications.
Indicators that Further Accounting Analysis Is Needed
Asking the following questions can help you asses the depths of your accounting-analysis needs.
- Did the company incur direct costs as a result of the equity financing? Direct costs should be capitalized on the balance sheet as contra-equity.
- Were other instruments issued in conjunction with the equity, such as warrants to purchase stock?
- Could the preferred stock be redeemed for cash in the future? Sometimes this might be triggered by the occurrence of a future event, for example, a change in control. Other times it might be tied to the passage of time, where the investor could choose to demand repayment after a certain date at a fixed price.
The Articles of Incorporation (AOI) and the Stock Purchase Agreement (SPA) are helpful documents to review when evaluating whether preferred stock has a redemption feature.
- Does the purchase agreement provide for a contractual commitment for a future financing event upon the occurrence of a contingent event, such as enrollment of a certain number of patients in a clinical trial or regulatory approval of a drug by the FDA?
This is often referred to as Tranched Preferred Shares or Milestone Shares and often has various accounting implications.
These factors could require additional accounting considerations within preferred stock financing.
In addition to preferred stock, another way early stage companies raise funds is through the issuance of convertible debt which also creates accounting complexities. There are typically features of convertible debt that must be accounted for separately from the debt, such as the ability to convert to equity at a discount.
Other debt and equity items to be aware of that could require further analysis include preferred or common stock warrants issued to debt holders, suppliers, or other third-parties involved with the company; stock issued to founders; and stock issued in exchange for services.
Any time these debt or equity items are being discussed, companies could consider consulting with accountants prior to executing any agreements to ensure the accounting implications are understood.
A 409A valuation is a report issued by an independent third-party that appraises the value of a company’s common stock. The primary purpose of the valuation is to comply with appropriate tax reporting for equity awards, whether they are stock options or stock grants. Additionally, understanding the valuation of your common stock is necessary to account for equity-based awards.
Determining the valuation of common stock is a complicated process that requires analysis of all facts and circumstances specific to both the company and the industry in which it operates.
If you have equity-based awards such as stock options, restricted stock awards, or restricted stock units, obtaining a 409A report at least annually, and at any time a financing event occurs, will ensure you’re both prepared for an audit and meeting tax compliance regulations.
Stock Based Compensation
Early-stage companies typically issue equity to employees in the form of non-qualified or incentive stock options, restricted stock awards, or restricted stock units. This is referred to as stock-based compensation and the awards are used as a tool to compensate employees for their services in lieu of cash compensation.
For example, an employee may receive stock options that vest over time and if they terminate employment any unvested stock options will be forfeit. This creates an expense for the company to record within its financial statements over time.
Depending on the volume and complexity of the awards granted to employees, a company may be able to track the information manually or could require software tools to assist with the tracking, expense recognition, and financial statement disclosures.
Awareness of the types of awards granted by the company is important, including when awards are granted or whether the terms of any awards have been modified after issuance. Both the initial grant and subsequent modifications create an accounting event.
When a new business is formed, founders might receive common stock in exchange for either an upfront cash infusion, their contribution of intellectual property, or other intangible assets. The exact details may vary but it’s important to understand the arrangement’s terms to ensure that the common stock issued at formation is appropriately accounted for.
The first thing to assess is whether the common stock was issued at fair value, which can be difficult to determine when a company is in its infancy. Often the common stock purchase agreements may require the holder to purchase the common shares at their par value, but par value isn’t necessarily equivalent to the fair value of the common shares.
Utilizing the closest 409A valuation to the issuance date can be a helpful data point. If the shares are purchased below the current fair value, the company may have additional expense to record for the difference.
Additionally, understanding whether the common stock is tied to vesting or continued employment is important as it could create compensation expense to be recorded over time.
In-Process (IP) R&D
A founder may receive common stock in exchange for investing intellectual property into the company. This could be in the form of patents, trademarks, or more unobservable items, such as the knowledge, skills, and expertise that they bring to the company.
In addition to founder stock, companies may enter into licensing agreements or asset purchase agreements that result in the acquisition of intangible assets. An assessment must be made as to whether these intangible assets have alternative future use, and accordingly, should be capitalized at inception or should be expensed as R&D costs at formation.
The key to whether the intangible assets should be capitalized or expensed hinges on whether they have alternative future use, which is further reviewed in section of this article detailing capitalization of R&D costs.
Collaborative Arrangement Accounting
It’s becoming increasingly common for emerging life sciences organizations to enter collaborative arrangements with third parties to develop and commercialize their intellectual property.
These arrangements tend to be complex and highly individualized as to the scope and terms of the arrangement. Determining the proper accounting treatment for transactions occurring under these arrangements can be difficult.
To make matters more complicated, such arrangements are generally under the scope of ASC 808, Collaborative Arrangements, which only provides guidance for presentation and disclosure of transactions occurring in collaborative arrangements and doesn’t provide recognition and measurement guidelines.
Rather, ASC 808 instructs organizations to look to other authoritative guidance to account for the transactions, namely ASC 606, Revenue from Contract with Customers. However, if organizations determine such transactions don’t fall under the scope of ASC 606 or another appropriate standard by analogy, then they should account for the transactions using a reasonable, rational, and consistently applied accounting policy election.
The result is a significant diversity in practice in accounting for such arrangements, and organizations should take due care in their accounting analysis of their collaborative arrangements, as these will likely be subject to thorough examination during a financial statement audit.
Accrual Versus Cash Basis Accounting
Accrual accounting recognizes transactions when services are incurred or provided versus cash basis accounting transactions are recorded when cash is paid or received. GAAP requires financial statements to be prepared in accordance with accrual accounting.
Companies undergoing a first-time audit generally will need to assess whether transactions have been properly recorded and accrued for under accrual basis accounting.
For example, companies with ongoing clinical trials often have a significant lag from when services occur and therefore expenses are incurred and should be recorded to when the expense is submitted to the company.
Whether working with a clinical research organization (CRO) or working directly with sites and hospitals, understanding this timing lag is critical to develop and record an estimated accrual of the expenses incurred but not yet billed.
Companies should determine whether proper cut-off of expenses has been assessed.
Capitalization of R&D Costs
A company should consider whether certain R&D expenses incurred should be capitalized, as not all research and development costs are expensed as incurred. R&D activities that have an alternative future use, such as materials, equipment, or facilities, may be capitalizable. Capitalization of certain costs may be applicable not only for tangible assets but intangible assets as well, such as licenses or patents.
Capitalized assets that aren’t yet placed into service are in-process research and development (IPR&D) and may be acquired through a business combination or an asset acquisition. These assets are measured at their fair value and recognized as an indefinite-lived intangible asset until completion or abandonment of the related project.
When the asset is available for use, the asset is placed into service and amortized over its estimated useful life to R&D expense on the income statement.
Expense Classification and Categories
Classification of expenses is required for GAAP financial statement reporting. Expenses are typically broken out into three general categories:
- General and administrative
- Sales and marketing
- Research and development
ASC 730, Research and Development, lists the following R&D activity examples below.
Example of activities typically included in R&D:
- Contract research arrangements with third parties
- Clinical trial costs including patient enrollment, screenings, and site openings
- Consultants and contractors working on R&D activities
- Laboratory parts and equipment (generally less than one-year economic life or below a company internal capitalization policy threshold)
- Lab space
- Personnel costs, including applicable benefits of employees involved in R&D activities
- Sterilization pre-manufacturing
- Compounds and drug formulation premanufacturing
- Shipping and transportation of R&D items
- Conceptual formulation and design of possible product or process alternatives
- Testing in search for or evaluation of product or process alternatives
- Modification of the formulation or design of a product or process
- Preproduction activities
Examples of activities typically excluded from R&D:
- Routine, ongoing efforts to refine, enrich, or otherwise improve upon the qualities of an existing product
- Legal work in connection with patent applications or litigation and sale of patent licensing
- Administrative personnel costs
While some classification of certain costs may be straightforward, other costs may require more judgement.
Allocation of Shared Costs
Additionally, for GAAP financial statement presentation purposes companies are required to allocate shared costs, such as rent, facility maintenance, or depreciation, which are generally viewed as general and administrative costs.
However, these are shared costs across departments and therefore need to be allocated accordingly. Various methodologies can be used to allocate these costs which is up to management to decide what works best.
ASC 842, Leases
Life science organizations preparing for a financial statement audit will need to consider the impacts of the new lease accounting standard, ASC 842, on their financial statements. The standard supersedes previous lease accounting guidance and entails a significant departure from previous lease accounting practices for lessees.
The standard has already been adopted by public companies, and now private and not-for-profit organizations will be required to implement the standard for fiscal years beginning after December 15, 2021.
The most significant change in the new standard is that leases for property or equipment with terms greater than 12 months are now required to be recognized as assets and liabilities on an organization’s balance sheet. Organizations will need to record a right-of-use (ROU) asset that represents the lessee’s right to use an asset over the terms of the lease, and a corresponding lease liability.
Additionally, the new standard contains a host of practical expedients and accounting policy elections that organizations will need to consider and apply. Organizations will need to identify and evaluate their internal controls related to implementation and post-implementation leasing activities and develop new business processes and IT systems as required to adhere to the standard on a go-forward basis.
For life sciences organizations with leasing activities, regardless of size, properly implementing the standard will require a significant investment of time and resources. Involving the auditors early in the process can be beneficial, as the auditors can provide input and help organizations navigate the complexities of the standard.
We’re Here to Help
For guidance on preparing for a financial statement audit, contact your Moss Adams professional. You can also visit our Financial Statement Audit Services page for additional resources.