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R & D entities: is control possible without owning a single share of stock?

ABSTRACT: This case addresses the accounting for the relationship between a pharmaceutical company and a research and development entity that it created and for which it raised operating funds via a limited private offering. After the offering, the pharmaceutical company does not own any of the R & D entity's stock. However, the stock is callable for a fixed period by the pharmaceutical company and the operating agreements between the two entities leave little room for the R & D company to make any substantive decisions on its own, or to direct its current and future operations. Most of the questions in the case deal with the issue of whether control exists, the impact of that answer on the consolidated financial statements, and the details and costs of calling the stock.

Data Availability: The companies utilized to construct this case are disclosed in the case.

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BACKGROUND

Pharmco (1) is a successful, well-established pharmaceutical company in the United States. Its mission is to discover, patent, test, and market economically viable drugs approved by the Food and Drug Administration. The time between discovery and final approval in this industry may take ten years, leaving only ten patent-protected years to recover the invested costs and make a reasonable profit. Because many drugs do not make it through, or even to, the approval process, successful drugs must recover their own costs and the costs of abandoned drugs. Finally, all costs classified as "research and development" (R & D) must be expensed in the period incurred, creating a tremendous drag on corporate earnings and an incentive to terminate potentially nonproductive projects as early in the process as possible. The significant nature of these R & D activities motivates firms to find ways to minimize the impact of R & D costs on their financial statements.

FORMATION OF DISCOVERY CO.

Pharmco incorporated Discovery Co. (hereafter Disco) in January 20X1 for the stated purpose of engaging in research, development, and clinical testing of therapeutic products for the treatment of heart disease. Disco commenced operations two months later in March 20X1, after it received net proceeds of $80 million from an unusual limited private offering (LPO). (2) The LPO totaled 2.5 million "units" consisting of one share of Disco "callable" common stock and one warrant to purchase one share of Pharmco common stock. Each unit sold for $32.50. As explained in "The Purchase Option and Warrants" section that follows, the "call" feature of Disco's common stock gave Pharmco the sole right to purchase Disco's common stock at specified prices during the following four years. The warrant gave Disco's shareholders the option to become shareholders of Pharmco. It was exercisable at any time until December 31, 20X4 at an exercise price of $40 per share, about $5 per share less than the current trading price of Pharmco on the day of the LPO. Pharmco did not purchase any of the units, nor did Pharmco loan any monies to Disco.

STRUCTURE AND OPERATIONAL DETAILS OF DISCO

Prior to the LPO, Pharmco selected Disco's initial board of directors and established its corporate headquarters as subsequently explained. In addition, Pharmco entered into several operational agreements with Disco.

Board of Directors

Disco's board of directors is composed of five members. Two members are upper management employees of Pharmco: the Chairman of the Board is President and Chief Executive Officer of Pharmco, and the other member is the Senior Vice President of Pharmco. The other three members are neither employees of Pharmco nor Disco; however, two of them also are on the board of directors of a company similar to Disco that has almost an identical arrangement with Pharmco.

Corporate Headquarters

Disco is headquartered in the British Virgin Islands. Shareholder services are performed by Pharmco at its headquarters in the United States. Disco's annual meeting is also held at Pharmco's headquarters. Other than three corporate officers (President, Secretary, and Treasurer), Disco has no employees or operational location (however, see the details of the "Development Agreement" that follow).

Technology License Agreement

Disco has an exclusive, worldwide license to Pharmco's technology relating to products that Disco will be developing for potential commercial production. In 20X1, Disco paid a nonrefundable fee of $8 million from the LPO proceeds to Pharmco for this agreement.

Services Agreement

Disco also has a contract with Pharmco that requires Disco to utilize certain Pharmco management and administrative services and pay Pharmco a fee based upon the cost of the services provided.

Development Agreement

Disco is obligated, via a "Development Agreement," to engage Pharmco to perform all of Disco's research, development, and clinical testing activities related to products under development. Moreover, Disco is required to use all of the net proceeds of the LPO, plus any interest or other income earned thereon, to pay Pharmco for its services, which will be billed at cost. The only exclusions are for specific amounts necessary for working capital and amounts needed to pay for the technology license agreement with Pharmco.

THE PURCHASE OPTION AND WARRANTS

Pharmco has the option to call--i.e., purchase--100 percent, and only 100 percent, of Disco's callable common stock at any time through December 31, 20X4. Pharmco is not obligated to exercise the purchase option and will likely do so only if it perceives that such exercise is in its best interest. The call price increases yearly based upon predetermined amounts per share as follows: 20X1, $48; 20X2, $62; 20X3, $83; and 20X4, $117. In addition, until the expiration or exercise of the purchase option agreement, Disco cannot issue additional common stock, pay dividends, borrow more than $2 million in the aggregate, or merge, liquidate, or sell all or substantially all of its assets without Pharmco's approval.

Due to the limitations imposed by the operational agreements and the purchase option, it is anticipated that by December 31, 20X4, Disco's funds will be substantially exhausted. If Pharmco does not exercise the purchase option, then Disco must find other funds to complete development of any products it believes have potential commercial value, as Pharmco has no obligation to provide additional funding.

The Warrants

The warrants were included in the units sold as consideration for Pharmco's option to purchase the callable stock of Disco. The market value of each warrant at the date of issuance was $6 ($5 intrinsic ["in the money"] and $1 time value).

Financial statements for Pharmco and Disco for the years ended December 31, 20X1 and 20X4 are shown in Exhibit 1.

REQUIREMENTS

Part 1 -- The Situation, Consolidation, and Interpretation

This is an unusual type of corporate relationship. The first set of questions will reinforce your understanding of the relationship and provide evidence on the pros and cons of consolidation.

1. Carefully reread the information provided about the corporate headquarters and the Development Agreement. Which company is actually performing the research and development activities? Justify your response.

2. Assume Pharmco controls Disco. Using the financial statements provided in Exhibit 1, prepare a consolidated balance sheet and income statement for the year ended December 31, 20X1. A suggested format is indicated in Exhibit 2, or you may use the format specified by your instructor.

3. Using the financial statements provided in Exhibit 1, calculate the following ratios for Pharmco without consolidation of Disco and for the consolidated results. Exclude amounts allocated to the noncontrolling interest. If the outcome is different, identify the cause(s) of the difference. For the sake of simplicity, use December 31, 20X1 results when balance sheet data are required:

a. Return on equity (e.g., net income divided by shareholders' equity)

b. Profit margin (e.g., net income divided by total revenues)

c. Return on assets (e.g., net income divided by total assets)

d. Leverage (e.g., total liabilities divided by total assets)

4. Examine your consolidated totals carefully by comparing them to Pharmco's unconsolidated amounts in the first column of your worksheet. Compare the two sets of ratios computed in Question 3. How would consolidating Pharmco and Disco benefit Pharmco's shareholders? What arguments could be made against consolidation? If Pharmco and Disco are not consolidated, then what should Pharmco's annual report disclose about Disco?

Part 2 -- The Control Question

The next set of questions will put you in the auditor's chair, as you will judge whether Pharmco controls Disco using current GAAP guidance; these questions will also ask you to determine the motivation for creating Disco.

1. The concept of control has a long and storied history, starting with the Committee on Accounting Procedure's (CAP) Accounting Research Bulletin No. 51, Consolidated Financial Statements issued in 1959. This early statement did not use the term control, but controlling financial interest. This was generally evidenced by ownership of a majority of the voting shares, and over time, majority ownership became the de facto indicator of control. Utilizing the Accounting Standards--Original Pronouncements binders in your library (or the specific documents provided by your instructor), refer to the FASB's (1999) Exposure Draft (Revised): Consolidated Financial Statements: Purpose and Policy, paras. 1-19 (Volume VII) or the final statement, if issued (Volume V), identify the current definition of control, and evaluate whether Pharmco controls Disco after the LPO. Discuss evidence pointing toward and away from control. What additional information would help in your decision process?

2. Assume Disco is not consolidated because Pharmco is not in control. What appears to be the underlying motivation(s) for creating Disco in this manner? (Note: This question is asking you to "read between the lines" and attempt to decipher Pharmco's primary objectives.) Consider the impact upon Pharmco's financial statements if the work performed by Disco is ultimately:

a. commercially valuable

b. commercially worthless

Do you want to reconsider your response to Part 2, Question 1. Justify your response carefully.

Part 3 -- To Call or Not to Call

The call feature of Disco's common stock is one of the unusual elements of the LPO. At some point within the next four years, Pharmco must determine whether to exercise this right, and if it does, how to account for it.

1. Assume the December 31, 20X4 deadline is approaching and the R & D appears promising.

a. What method(s) of financial analysis will Pharmco use to decide whether to call the common stock? Explain carefully. (Note that with the data provided in the case, you cannot answer the question explicitly--you can only specify a methodology.)

b. Refer to the financial statements for the year ended December 31, 20X4 in Exhibit 1 and assume Pharmco calls the common stock at December 31, 20X4. Calculate the excess of the call price over the fair value of the net assets of Disco.

2. Treatment of this excess also has a long and storied history in GAAP. Referring again to the Accounting Standards--Original Pronouncements binders in your library or the specific documents provided by your instructor, (3) determine the treatment over time by examining and briefly summarizing the guidance in the following documents:

* SFAS No. 2, Accounting for Research and Development Costs, paras. 11(c) and 34 (FASB 1974) (Volume II, issued by FASB, October 1974).

* Interpretation No. 4: Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method, paras. 1-5 (FASB 1975) (Volume VI, issued by FASB, February 1975).

* SFAS No. 141, Business Combinations, para. 42 (FASB 2001a), and SFAS No. 142, Goodwill and Other Intangible Assets, para. 8 (FASB 2001b) (Volume V, both issued by FASB, June 2001).

3. Considering the guidance reviewed above:

a. If Pharmco does not control Disco prior to the call, then how should the excess be accounted for by Pharmco?

b. If Pharmco is in control of Disco prior to the call, then how should the excess be accounted for by Pharmco?

Part 4 -- Potential Rewards to Investors

The following two questions ask you to explain why investors would be willing to buy these unusual securities.

1. Assume Pharmco calls the common stock at December 31, 20X4. Calculate the total return over the entire holding period and the annualized return to the shareholders of Disco based on the LPO price. (Hint: Be sure to consider the value of the warrants in your answer.) Does this provide justification for investing in this unusual LPO?

2. Why do you think a warrant to purchase one share of Pharmco's common stock was included in the units sold to investors?

CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE

Overview and Learning Objectives

This case is based upon a compilation of seven actual situations in the pharmaceutical industry. (4) Although the facts in each situation are not identical, the case presents the basic structure used. On its face, the fact pattern raises many thorny issues in consolidation accounting, foremost among them the issue of whether one company can effectively control another company without owning any of its equity shares. Yet, deeper down is the age-old issue of form versus substance, which has come back into vogue with the Enron (5) debacle.

The case is designed for use in an undergraduate advanced accounting course or an M.B.A. accounting course that includes discussion of consolidation theory and practice. Students will be tempted to read the case and accept the various operational agreements "as they are" with little regard to what is actually going on. Question 1 in Part 1 forces them to look at the essence of the relationship between the two companies to reveal that Disco is essentially a shell company with no employees or operational facilities of its own. Subsequent questions challenge them to evaluate the pros and cons of consolidation, determine if control exists, and decipher what is apparently going on, namely the avoidance of having to book research and development expenses on worthless endeavors. As a result, the case will:

* Solidify students' understanding of the mechanics of consolidation;

* Reinforce the issues and trade-offs involved in the control decision;

* Expose students to an unusual type of security--callable common stock--and how to value and record it in different scenarios;

* Provide a realistic application of net present value analysis;

* Help train students to examine the underlying substance of transactions so they can identify and question suspicious arrangements they will encounter in practice;

* Introduce students to the difficulty of resolving issues involving form versus substance; and

* Enhance understanding of the complexity the FASB faces in setting accounting standards where there is no readily apparent "right" answer.

In order to begin working on the case, students should be familiar with (1) the mechanics of the equity method of accounting and the consolidation process, and (2) basic issues involved in the notion of control. Since callable common stock is unusual, it is helpful to "walk through" how such a security is valued and accounted for.

Implementation Guidance

Over the past several years, the case has been used as a classroom assignment after consolidation theory and mechanics are discussed and straightforward applications in problem assignments attempted. It can be assigned individually or in groups of two or three students. One to two weeks is normally sufficient to research and prepare solutions to the questions.

Due to the complexity of issues in the case, it can be assigned in two parts. Assignment one is composed of Part 1 questions, which deal with understanding the relationship between the two companies and consolidation mechanics. After discussion of these issues, students can then concentrate more clearly on the last three parts, which focus on the primary issues of (1) whether control exists in this situation, (2) Pharmco's apparent motivation for creating Disco in this manner, (3) how to deal with the call feature, and (4) the incentive for investors. If time is limited, then instructors can cover the answers to Part 4 in class as part of the discussion of the case.

Extensions

The notion of control and its impact on the financial reports of the entities involved permeate all facets of consolidation theory and practice. The concepts discussed in this case are easily incorporated into the following topics:

* Equity method versus proportionate (pro rata) versus full consolidation: students obtain a better understanding of the issues involved and why, when control exists, full consolidation requires combining 100 percent of a subsidiary even when less than 100 percent is owned.

* Extent of disclosure regarding the relationship: in light of the Enron debacle, a lively discussion can ensue about situations where significant influence, and not control, exists.

* Theory and mechanics of intercompany transaction eliminations: the case helps students focus on the underlying substance of a transaction so they can more easily understand why intercompany transactions must be completely eliminated, even in situations where there is less than 100 percent ownership.

* Changes in ownership percentage: discussions of the financial statement impact when control does or does not exist and handling the excess over the call price in both situations aids understanding the accounting treatment of increasing ownership interest in both control and noncontrol situations.

* Understanding the issues involved in determining whether a variable interest entity (VIE; formerly special purpose entities) is controlled and should be consolidated per FIN No. 46 (FASB 2003): the Enron scandal brought VIE accounting to the forefront, (6) and discussions on the nature of control help students appreciate both the shortcomings in current accounting rules and the realworld difficulties in deciding whether VIEs are controlled. (7)

Student and Faculty Responses to the Case

This case has been used in three different accounting courses at two universities over the last several years. In addition, it has been presented to several faculty groups. The reaction is almost always one of amazement and head-shaking. While both groups acknowledge the complexity of the arrangement, once understood, they are amazed at the ingenuity. Sample student comments include:
    "For me, the case was a cool bit of logic ... a neat bit of
    attempted smokescreen."

    "This case was fascinating in understanding difficult accounting
    set-ups that help you read between the lines to understand what is
    the real truth."

    "The case stimulated my mind to think in a variety of ways; it
    made me able to think about the subject of accounting 'out of the
    box.'"

EXHIBIT 1 Condensed Financial Statements

(amounts in millions)

                               December 31, 20X1  December 31, 20X4
Balance Sheet:                 Pharmco  Disco     Pharmco  Disco

Assets:
 Cash                          500.0     54.1      750.0     0.4
 Prepaid Technology
  License Fee                             6.3                0.0
 Other Assets                  350.0      0.0      360.0     0.0
 Total                         850.0     60.4     1110.0     0.4
Liabilities and Stockholders'
  Equity:
 Unearned Technology
  License Fee Revenue            6.3                 0.0
 Other Liabilities              25.0                40.0
 Common Stock                  450.0               450.0
 Callable Common Stock                   80.0               80.0
 Retained Earnings             368.7    -19.6      620.0   -79.6
 Total                         850.0     60.4     1110.0     0.4

Income Statement:
Revenues:
 Sales                         300.0      0.0      500.0     0.0
 Technology License Fee          1.7                 2.1
 Services Fee                    0.4                 0.4
 Total Revenues                302.1      0.0      502.5     0.0
Expenses:
 Cost of Sales                 120.0               200.0
 R & D Expense                           17.5               17.5
 Technology License Fee                   1.7                2.1
 Services Fee                             0.4                0.4
 Purchase Option                15.0
 Total Expenses                135.0     19.6      200.0    20.0
 Net Income                    167.1    -19.6      302.5   -20.0

Total proceeds from LPO = $80 million, of which $8 million was used to
pay for the technology license, which is amortized over 46 months. The
remaining proceeds, $72 million, must be used for research and
development and for the services agreement, exclusive of working capital
needs. Assuming working capital of $.4 million, $71.6 is amortized over
four years. Of the annual $17.9 million amortization, Disco allocates
$.4 million to the services agreement and $17.5 to R & D.

EXHIBIT 2 Consolidation Worksheet December 31, 20X1

Balance Sheet                                 Eliminations  Consolidated
                          Pharmco    Disco    Dr  Cr        Totals

Assets:
Cash                        500.0     54.1
 Prepaid Technology
  License Fee                          6.3
 Other Assets               350.0      0.0
 Total                      850.0     60.4
Liabilities and
  Stockholders' Equity:
 Unearned Technology
  License Fee Revenue         6.3
 Other Liabilities           25.0
 Common Stock               450.0
 Callable Common Stock                80.0
 Retained Earnings          368.7    -19.6
 Noncontrolling Interest
 Total                      850.0     60.4

Income Statement:
Revenues:
 Sales                      300.0      0.0
 Technology License Fee       1.7
 Services Fee                 0.4
 Total Revenues             302.1      0.0
Expenses:
 Cost of Sales              120.0
 R & D Expense                        17.5
 Technology License Fee                1.7
 Services Fee                          0.4
 Purchase Option             15.0
 Total Expenses             135.0     19.6
 Total Income               167.1    -19.6
To Controlling Interest
To Noncontrolling Interest


The background material for this case arose from research conducted as a Faculty Fellow at the Financial Accounting Standards Board. The basic fact structure is a compilation of several live R & D entity fact patterns. A related case utilizing a simplified fact structure has also been incorporated into a group of eight "close-call" case studies released with the revised Consolidations Exposure Draft as Example #5. Special thanks to Cathy Coburn at the FASB. Jim Largay, reviewers and participants at the 2000 Western Decision Sciences Institute Annual Meeting, and students in my M.B.A. classes at Pepperdine University for comments on earlier drafts of this case study.

(1) Pharmco is not a real company. The fact pattern in the case, however, is a compilation of numerous actual arrangements in the pharmaceutical industry.

(2) Unlike initial public offerings, limited private offerings avoid much of the cost, delay, and disclosure requirements. From an accounting perspective, the two offerings are recorded identically.

(3) Full text of all FASB statements is now freely accessible via the "FASB Statements" link on their home page, http://www.FASB.org. Note however that these are as originally issued so that they do not include shading or sidebars for amendments made by subsequent pronouncements.

(4) Variations of the type of R & D entity described in the case have been established by the following companies (creator company listed first): Allergan, Inc. and Allergan Specialty Therapeutics, Inc.; BioChem Pharma, Inc. and CliniChem Development Inc; Dura Pharmaceuticals and Spiros Development Corporation II; Genzyme Corp. and Neozyme I and Neozyme II; International Remote Imaging Systems, Inc. and PSI; Immunex Co. and Receptech Corp.; Ligand Pharmaceuticals, Inc. and Allergan Ligan Retinoid Therapeutics, Inc.

(5) See Largay (2002) for elaboration on this issue.

(6) See Hartgraves and Benston (2002) for further details.

(7) Per discussion with FASB personnel, it is questionable whether R & D entities as described in this case are VIEs. Moreover, there may not be a "primary beneficiary," thus consolidation would not be required. In any event, the complexities of FIN No. 46 (FASB 2003) are outside the scope of this case.

TEACHING NOTES

Teaching Notes are available through the American Accounting Association's new electronic publications system at http://aaahq.org/ic/browse.htm. Full members can use their personalized usernames and passwords for entry into the system where the Teaching Notes can be reviewed and printed.

If you are a full member of AAA and have any trouble accessing this material please contact the AAA headquarters office at office@aaahq.org or (941) 921-7747.

REFERENCES

Committee on Accounting Procedure (CAP). 1959. Consolidated Financial Statements. Accounting Research Bulletin No. 51. New York, NY: AICPA.

Financial Accounting Standards Board (FASB). 1974. Research and Development Costs. Statement of Financial Accounting Standards No. 2. Stamford, CT: FASB.

_______. 1975. Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method. Interpretation No. 4. Stamford, CT: FASB.

_______. 1999. Exposure Draft (Revised): Consolidated Financial Statements: Purpose and Policy. Norwalk, CT: FASB.

_______. 2001a. Business Combinations. Statement of Financial Accounting Standards No. 141. Norwalk, CT: FASB.

_______. 2001b. Goodwill and Other Intangible Assets. Statement of Financial Accounting Standards No. 142. Norwalk, CT: FASB.

_______. 2003. Consolidation of Variable Interest Entities. Interpretation No. 46. Norwalk, CT: FASB.

Hartgraves, A. L., and G. J. Benston. 2002. The evolving accounting standards for special purpose entities and consolidations. Accounting Horizons (September): 245-258.

Largay, J. A. III. 2002. Lessons from Enron. Accounting Horizons 16 (June): 153-156.

Michael L. Davis is an Associate Professor at the University of Alaska Fairbanks.
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Title Annotation:Discovery Co.
Author:Davis, Michael L.
Publication:Issues in Accounting Education
Geographic Code:1USA
Date:May 1, 2004
Words:3995
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