Accounting For The Pharmaceutical Industry

The pharmaceutical industry is one of the most complex and heavily regulated industries in the world. Accounting is not just about numbers; it’s about compliance, R&D costs and navigating the complex supply chains that come with the industry. In this post, we’ll look at the specifics of accounting for the pharma industry, the key metrics and accounts and best practices for financial accuracy and compliance.

The Pharmaceutical Industry

The pharmaceutical industry has long development cycles, big R&D spending and strict regulatory requirements. Bringing a new drug to market can take years and involves big costs that need to be managed and reported. The industry is under constant scrutiny from regulatory bodies like the U.S. Food and Drug Administration (FDA), the European Medicines Agency (EMA) and other global counterparts.

In Hong Kong, the Department of Health (DH) serves as the primary regulatory authority for pharmaceutical products. The DH ensures the safety, efficacy, and quality of all pharmaceutical products sold within the territory, overseeing their manufacturing, importation, exportation, and distribution. Additionally, the Hong Kong Centre for Food Safety (CFS) plays a role in regulating pharmaceutical products, particularly those found in dietary supplements and traditional Chinese medicines. The CFS monitors the safety of these products, which may contain pharmaceutical ingredients.

What Is Accounting For The Pharmaceutical Industry?

Accounting in the pharmaceutical industry means recording, classifying and summarising financial transactions specific to this industry. This includes R&D spend, managing inventory of raw materials and finished goods, and compliance with various regulations. Pharmaceutical accounting also means handling complex revenue recognition due to the long development cycles of drugs and the unique nature of licensing agreements.

Why Is Accounting Important For The Pharmaceutical Industry?

Accounting is critical for the pharma industry as it provides financial transparency, supports strategic decision making and ensures compliance. With the high costs of drug development and the potential for big revenue from successful products, accurate financial reporting is key. Robust accounting practices also help pharma companies to maintain investor confidence, secure funding and manage risks around intellectual property and product liability.

What’s Different About Accounting For The Pharmaceutical Industry?

The pharma industry has the following challenges:

1. R&D Spend: A large portion of pharma spend is on R&D, which must be tracked and reported.
2. Regulatory Compliance: Every aspect of pharma from drug development to marketing is regulated. Accounting needs to comply.
3. Long Revenue Cycles: Developing, testing and getting a new drug to market can take years, and requires special revenue recognition methods.
4. Inventory Management: Pharma companies must manage complex inventory of raw materials, work-in-progress and finished goods each requiring detailed accounting.

Key Metrics In The Pharmaceutical Industry

It will be essential to note that in the pharma industry, there are several key metrics that are normally used to evaluate the financial health of the company as well as its operational efficiency and performance. These measures give information about the R&D, profitability and business success.

1. Research and Development (R&D) Metrics

• R&D Intensity: The percentage of revenue spent on R&D shows the company’s focus on innovation and long-term growth. Higher R&D intensity means more focus on new products.
• Return on Research Capital (RORC): Measures the financial return from R&D investments by dividing gross profit by the previous year’s R&D spend. It shows how well the company is converting R&D spend into profitable products.

2. Profitability Metrics

• Gross Margin: The ratio of gross profit to revenue. It shows production and pricing efficiency. A key indicator of the company’s ability to make a profit from its core operations.
• Operating Margin: The ratio of operating income to revenue. It shows how well the company controls its operating expenses and how efficiently it runs the business.
• Net Margin: The percentage of revenue left as a profit after all expenses including taxes and interest are deducted. It shows the overall profitability of the company.

3. Liquidity and Solvency Metrics

• Quick Ratio: Measures the company’s ability to meet short-term obligations using its most liquid assets. It’s calculated by subtracting inventories from current assets and dividing the result by current liabilities.
• Current Ratio: Shows the company’s ability to pay off short-term liabilities with short-term assets. A ratio above 1 is good for short-term financial health.
• Debt to Equity Ratio: The ratio of total debt to shareholders’ equity. It shows the company’s leverage and its dependence on debt for funding. A lower ratio means lower financial risk.

4. Return on Investment Metrics

• Return on Equity (ROE): Measures the return on shareholders’ equity. It’s calculated by dividing net income by total equity. ROE shows how well the company is using its equity base to generate profits.
• Return on Assets (ROA): The ratio of net income to total assets. It shows how efficiently the company is using its assets to generate profit.

5. Market and Sales Metrics

• Market Share: The company’s share of sales in a particular market or segment. It shows the company’s position in the industry.
• Sales Growth Rate: The percentage increase in sales over a period. It’s a key metric to measure the company’s sales growth.

6. Productivity and Efficiency Metrics

• Inventory Turnover: Measures how often the company’s inventory is sold and replaced over a period. Higher turnover means better inventory management.
• Days Sales Outstanding (DSO): The average number of days it takes to collect payment after a sale. Lower DSO means better credit and collections.

7. Pipeline and Product Development Metrics

• Number of New Drug Applications (NDAs): The number of NDAs submitted to and approved by regulatory bodies like the FDA. It shows the company’s pipeline and future growth potential.
• Time to Market: The average time from drug discovery to commercial launch. A shorter time to market means a competitive advantage and faster revenue generation.

Types Of Accounts In The Pharmaceutical Industry

In the pharmaceutical industry, accounts are divided into many categories to make a proper record of various financial activities. These accounts provide the focus on the aspect of pharma operations, such as high research costs, legal conduct/compliance and product revenues. Here are the types of accounts:

1. Assets

• Current Assets:
  • Cash and Cash Equivalents: Bank balances and liquid investments.
  • Accounts Receivable: Amounts owed by customers for products or services sold on credit.
  • Inventory: Raw materials, work-in-progress and finished goods ready for sale.
  • Prepaid Expenses: Expenses paid in advance, such as insurance or rent, which will be expensed over time.
• Non-Current Assets:
  • Property, Plant and Equipment (PP&E): Physical assets like manufacturing facilities and machinery.
  • Intangible Assets: Non-physical assets like patents, trademarks and proprietary technologies.
  • Goodwill: The premium paid over the fair value of net assets during acquisitions, representing brand reputation and customer relationships.
  • Investments: Long-term investments in other companies or assets.

2. Liabilities

• Current Liabilities:
  • Accounts Payable: Amounts owed to suppliers for goods and services purchased.
  • Accrued Liabilities: Expenses incurred but not yet paid, like wages or utilities.
  • Short-Term Debt: Debt obligations due in the next 1 year, including lines of credit or short-term loans.
• Non-Current Liabilities:
  • Long-Term Debt: Loans and other financial obligations due beyond 1 year, including bonds or long-term borrowings.
  • Deferred Tax Liabilities: Taxes owed in the future due to temporary differences between accounting and tax treatments.
  • Other Long-Term Liabilities: Includes obligations like pension liabilities or long-term lease commitments.

3. Equity

• Share Capital:
  • Common Stock: Equity raised from the issuance of shares to investors.
  • Additional Paid-in Capital: Amount received from shareholders above the par value of shares.
• Retained Earnings: Accumulated profits not distributed as dividends to shareholders.
• Other Comprehensive Income: Includes gains and losses not included in net income, like foreign currency translation adjustments or unrealized gains on investments.
• Treasury Stock: Shares bought back by the company and held in its treasury, which can be used for employee compensation plans or other purposes.

4. Revenue

• Product Sales Revenue: Income from the sale of pharmaceutical products, including prescription drugs and over-the-counter (OTC) medications.
• Licensing and Royalty Revenue: Earnings from licensing agreements, royalties on patents and other intellectual property rights.
• Research and Development (R&D) Funding: Revenue from partnerships or collaborations on R&D activities.

5. Expenses

• Cost of Sales:
  • Cost of Goods Sold (COGS): Direct costs of production of pharmaceutical products, including raw materials and manufacturing costs.
• Operating Expenses:
  • Research and Development Expenses: Expenses incurred in development of new drugs and therapies.
  • Sales and Marketing Expenses: Expenses related to promotion and sales of products, including advertising and sales force expenses.
  • General and Administrative Expenses: Overheads like salaries, utilities and office supplies.
• Finance Expenses:
  • Interest Expense: Expenses related to debt servicing, including interest on loans and bonds.
  • Income Tax Expense: Taxes owed based on the company’s taxable income.

What Is The Pharmaceutical Industry Chart Of Accounts (COA)?

The chart of accounts-COA in the pharmaceutical business is as a comprehensive, standardized record of all of the financial accounts that are used for consolidation, including receipts and expenditures. It is widely used in the management, reporting, and analysing the financial performance of companies operating in the pharmaceutical industry. The COA is intended to incorporate the full spectrum of the industry, including extensive research and development expenses, compliance with regulatory requirements, and income derived from product and licensing.

Pharmaceutical COA Features

1. Hierarchical Structure
   • Level 1: Main Sections
     • Assets: What the company owns.
     • Liabilities: What the company owes to others.
     • Equity: Owner’s residual interest in assets after liabilities.
     • Revenue: Income from operations.
     • Expenses: Costs to earn revenue.
   • Level 2: Sub-Sections
     • Current Assets (e.g., Cash, Accounts Receivable)
     • Non-Current Assets (e.g., Property, Plant and Equipment)
     • Current Liabilities (e.g., Accounts Payable, Short-Term Debt)
     • Non-Current Liabilities (e.g., Long-Term Debt, Deferred Tax Liabilities)
     • Operating Expenses (e.g., R&D Expenses, Marketing Expenses)
   • Level 3: Specific Accounts
     • Individual accounts within each sub-section (e.g., Cash and Cash Equivalents, Inventory, Accrued Liabilities)

How To Do Accounting For The Pharmaceutical Industry?

Several factors are deliberated to explain the process of accounting in the pharmaceutical industry, which entails both, financial reporting and compliance with the required regulations and sound financial management. Here’s a step-by-step guide to the accounting process for the pharmaceutical industry:

1. Set Up the Chart of Accounts (COA)

• Design the COA: Develop a classification of the structure of the financial accounts in the pharmaceutical industry. This includes grouping the accounts into the following categories; current assets, fixed assets, current liabilities, non-current liabilities, capital and income and expenditure accounts.
• Assign Account Numbers: For tracking and reporting purposes, it is recommended to give account numbers to each account.

2. Record Transactions

• Document Transactions: A successful management of any business requires keeping full accurate records of all receipts, sales, purchases, operating and investment expenditures.
• Use Journals: Record transactions in journals (e.g., sales journal, purchase journal) on delegation of accounts on debits and credits.

3. Post to General Ledger

• Update Ledger Accounts: After recording transactions in the journal, transfer these to the general ledger where transactions are recorded in accounts.
• Verify: Check that everything is accurate and comprehensive.

4. Reconcile

• Bank Reconciliation: Cross check the bank statements transactions with the cash account entries to rectify the inconsistencies.
• Account Reconciliation: Verify other accounts, for instance, accounts receivable account and accounts payable account with ledger balances.

5. Financial Statements

• Income Statement: Gather all sources of income and all expenditures to arrive at a net income or loss for a certain period.
• Balance Sheet: Demonstrate the company’s assets, liabilities, and equity at a given date.
• Cash Flow Statement: Demonstrate the flow of cash receipts and payments from operations, investments and financing.

6. Financial Analysis

• Calculate Ratios: Calculate efficiency ratios like profitability, liquidity, and solvency ratios to assess the company’s financial health.
• Review Variance: Perform a variance analysis of actuals with budget and forecast to identify major differences and what led to them.

7. Regulatory Compliance

• Adhere to Standards: Ensure that the accounting standards used are properly aligned, for instance, using generally accepted accounting principles (GAAP), international financial reporting standards (IFRS), and industry guidelines such as the food and drug administration.
• Prepare Regulatory Reports: Prepare and submit reports to regulatory bodies, financial disclosures and compliance documents.

8. Tax Management

• Calculate Tax: Examine and determine the amount of tax that a company is supposed to pay calculated from the income and the current tax laws.
• File Tax Returns: Complete and submit tax returns for the company and its employees by adhering to legal requirements of local, state and federal taxes.

9. Audit and Internal Controls

• Internal Audit: Financial processes and records should be reviewed and audited frequently to check the validity and conformity.
• Controls: Use measures to avoid mistakes and dishonesty, for instance, establishing checks and balances, policies or procedures.

10. Review Financial Policies

• Review Policies: Financial policies and procedures should be reviewed from time to time to determine if they help to achieve the organization’s goals.
• Update: Modify policies or procedures for change in laws or regulations, changes in business function or practices of the industry.

What Are The Tax Regulatory Compliance For The Pharmaceutical Industry?

FDA Compliance

Pharmaceutical companies must ensure their financial reporting complies with FDA’s strict regulations, especially on drug approval and market entry costs.

International Financial Reporting Standards (IFRS)

For global operations, IFRS compliance is key. This includes revenue recognition, inventory valuation and IP management standards.

Accounting Automation Tools For The Pharmaceutical Industry

Xero For The Pharmaceutical Industry

Xero offers cloud-based accounting solutions for the pharma industry. It has features like automated R&D tax credit tracking, inventory management and compliance monitoring so companies can maintain accurate financial records.

Accounting Best Practices For The Pharmaceutical Industry

Do:

• Regular Audits: Do internal audits frequently to ensure compliance and accuracy.
• Automated Systems: Implement automated accounting systems to reduce manual errors and improve productivity.
• Stay Up to Date with Regulations: Keep yourself updated with regulatory changes to avoid penalties.

Don’t:

• Neglect R&D Accounting: Not recording R&D expenses accurately can lead to financial misstatements.
• Poor Inventory Controls: Bad inventory management can lead to losses and regulatory breaches.
• Ignore Revenue Recognition Guidelines: Misapply revenue recognition standards can distort financials.

Conclusion

Pharmaceutical accounting best practices are crucial to managing the industry’s unique financial challenges and regulatory requirements. By having comprehensive R&D expense tracking, accurate revenue recognition, effective inventory management and strong internal controls pharmaceutical companies can maintain financial integrity and long-term success. Using technology and staying informed about industry developments will further strengthen the accounting framework and help companies navigate the pharmaceutical industry with confidence.

How FastLane Group Can Assist

Navigating the complexities of pharmaceutical accounting requires expertise and a deep understanding of the industry’s unique challenges. At FastLane Group, a platinum partner and Xero Certified Advisor, we specialize in providing tailored accounting solutions that meet the specific needs of pharmaceutical companies. Our team of experts is equipped with the knowledge and tools to manage your R&D expenses, optimize revenue recognition, and ensure compliance with stringent regulatory requirements.Partner with FastLane Group today to streamline your accounting processes and focus on what matters most, developing life-saving medications. Contact us to learn how we can support your pharmaceutical business with our comprehensive accounting services.