Pharma and biotech companies face significant challenges with regard to treatment of in-house R&D costs incurred in their financial statements.

Sandhya Sama

Several Indian pharmaceutical companies in recent years have demonstrated the capability to successfully carry out financially rewarding research and development (R&D) activities, enabling them to emerge as significant players in the international market.

At present, the main focus of Indian pharma companies is to tap the US generics market. The reason being the market potential in the US and other developed countries where several innovator products are becoming off-patent.

To develop a generic of an innovator drug requires considerable investment towards building research facilities and hiring scientific personnel. Indian pharma companies, with their reverse-engineering skills, have achieved this successfully.

Today, India features in the list of countries which has predominant manufacturing facilities approved by the United States Food and Drug Administration (USFDA). Indian companies are able to build their US generic pipeline with Indian filings of around 408 products.

A generic drug is one that contains the same active ingredient as the original formulation and has same therapeutic effect of the innovator drug. Development of a generic drug takes considerably lesser time and research costs compared to innovator drug. The reason being that generic manufacturers do not incur the cost of drug discovery, and instead are able to reverse-engineer known drug compounds allowing them to manufacture bioequivalent versions.

In most countries, generic manufacturers must only prove that their preparation is bio-equivalent to the existing drug in order to obtain regulatory approval. An application made to USFDA obtaining approval to market generic drug is called Abbreviated New Drug Application (ANDA).

While India progresses in the generic space and incurs costs on in-house development, pharma and biotech companies face significant challenges with regard to treatment of costs incurred in their financial statements. Considering the substantial outlay and time period involved in R&D and obtaining product approvals, revenues are not expected to occur in the same year as the costs recorded. This results in mismatch of costs and revenue recognised in a particular fiscal year.

Although, the Institute of Chartered Accountants of India (ICAI) has issued Accounting Standard 26 (AS 26) for Intangible assets, it is important to understand whether the expenditure incurred on in-house development meets the criteria, namely, identifiability, control and future economic benefits, for capitalisation of development costs as intangible assets under AS 26.

It is a general presumption that the criteria for capitalisation of development costs as intangible assets are not met prior to regulatory approval of the products because of significant uncertainties inherent in the nature of the product.

This is true in the case of development of a new molecule where uncertainty is high due to several stages involved in preclinical, clinical and pharmaceutical development.

Hence, it is difficult to justify capitalisation of development costs in case of a new molecule across various country GAAPs. In generic drug development, which is the subject matter of discussion, the uncertainties involved are significantly lower than in the development of a new molecule.

There are several stages involved in obtaining product approvals under the ANDA route. These include: identifying products with commercial value, initial evaluation of the product for complexity of synthesis, patent search to ascertain whether a non-infringing process is available, legal enforcement, process validation, bio-equivalence studies and ability to produce on large scale and submitting the data to regulatory agencies.

The challenge for pharma and biotech companies is at what stage they should determine whether the criterion laid down in AS 26 has been met. This is a matter of professional judgment now without any clear guidelines.

The exercise of such professional judgment should take into account factors such as technical feasibility, intention and ability to market the product, future economic benefits in the form of margin available in selling price, size of the market, targeted market, availability of technical, financial resources and ability to measure the cost incurred at each stage of development.

The ideal stage would be after establishing complexity synthesis and legal due diligence and, of course, the intention of the management to go ahead with the filing. These stages establish fairly whether the non-infringement process developed has the same therapeutic effect as of innovator drug and has commercial viability.

However, the bigger challenge faced by companies today is how to account for such costs at the reporting date.

Unless the criteria stated in AS 26 are met, one cannot carry forward the research expenditure. In the process, some companies may not be able to leverage full benefit of such capitalisation.

The level and range of subjectivity still available to draw a line between the grey area of R&D can mean that similar set of circumstances would lead to different companies coming up with different answers and, thereby, showing significantly different financial results.