Internal controls over clinical research collaborations

Pharmaceutical companies, especially those in the development stage, often enter into collaboration agreements with bigger pharmaceutical companies that have larger cash flows, more resources, and deeper technical know-how and success when it comes to product development. These agreements often cover a wide array of commercial terms and conditions, including detailing the terms over cost sharing, targets, milestones, and license ownership. These terms and conditions get discussed and reviewed at various levels within both organizations, including at the senior management and board levels, because such agreements have the potential to materially change the trajectory of the company’s growth and future plans. These agreements also create the roadmap for Day One accounting, accounting through the term of the agreement, and the related disclosures throughout the duration of the relationship.

The evaluation of the terms and conditions, and the corresponding accounting, is often unique to the agreement. Such evaluations can be complex and spread out over multiple years. Appropriate accounting and capturing the substance of the transaction are important from an investor reporting standpoint. Given the materiality, there is increased scrutiny from the external audit firm.  It is important for management to have the right set of preventive and detective controls that cover the completeness of the inputs and assumptions used, clerical accuracy, and GAAP compliance.

Recommended internal controls over financial reporting related to the collaborations/joint agreements and associated revenues include the following:

1. Review and approval of the agreement: When a company enters into a new collaboration agreement, there should be controls over the review and approval of the agreement and related addendums by a combination of legal, senior management, and, if needed, the Board of Directors, depending on the materiality of the agreement. Any amendments would require approval by senior management as well.
2. Review of the accounting treatment: The accounting approach should be documented in the form of a position paper detailing the accounting treatment of any non-refundable upfront license or option fees, payments for research and development activities, milestone payments, and royalty payments based on product sales derived from the collaborations. It is important that there are controls over the review of the memo by someone with the required level of experience and expertise. Review procedures often involve:
   • Assessment of performance obligations
   • Determining whether there are distinct licenses
   • Review of the transaction price, including whether treatment of variable consideration should be included in the transaction price
   • Determining whether periods of performance obligation are appropriate given the expected timelines or cost estimates of the contracts by reviewing the prepared timelines and budgets
   • Review of methods and assumptions of measuring progress and revenue over time or over a point in time
3. Updates to the accounting memo and related review: There should be a review over updates to the memo at the end of each reporting period. Change in the assumptions in the memo could result in changes to the method, timing, measure of progress, and amounts recognized in the financial statements. 
4. Assessment of revenue recognition and related review: Depending on the agreement, there could be point-in-time and over time revenue recognition considerations. It is important to establish necessary controls over the development and review of a schedule that reflects the timing of when the company will recognize revenue. Alongside this, controls should be put in place over review of the deferred revenue schedule at the end of each reporting period to help ensure additional funds received, changes to targets, and changes based on the project progression are all factored in in order to calculate necessary adjustments.
5. Cost review: There should be a review and approval of direct labor, direct material, and allocation of overhead costs. 
6. Monthly/quarterly review of the budget-actuals and forecast actuals: Periodic reviews over the actual costs incurred to date and estimated costs to be incurred against a monthly/quarterly budget, as well as a forecast by a senior finance person, should be implemented.

All recommended controls need to have the following characteristics:

• Validation of inputs to source documents for completeness and accuracy
• Validation of assumptions used in the calculations
• Validation of clerical accuracy including test checking of calculations
• Documented review procedures by a competent individual with the right level of experience and expertise
• Periodic review for changes to any of the inputs and assumptions, and the corresponding changes to calculations and schedules

In summary, it is important to set up the right controls both at the inception and during the life of the collaboration agreement. Organizations should make sure the following is done:

• Approval of the collaboration agreement by appropriate level of senior management
• Review of the accounting approach memo detailing the accounting treatment
• Quarterly review of changes to any of the inputs, assumptions, and related calculations
• Review and approval of a deferred revenue schedule and periodic updates to it
• Approval of direct labor, material, and overhead cost allocation
• Review of budget to actual, and forecast to actual variances related to costs

Organizations should implement the above controls in conjunction with other general controls such as approval of journal entries, storing spreadsheets in a secure location, ensuring access is restricted to appropriate employees, and review of footnotes that relate to these collaborations.

Engaging your external auditors at all stages right from the discussion, finalization, approval, and accounting of the transaction, and having communication lines open through the life of the agreement, will help ensure a smooth, cost effective, error free, and timely accounting and reporting process.