As specialist auditors to innovative biotech and life sciences companies on AIM and AQSE, we frequently advise on the key challenges CFOs face in these sectors. In this article, Joseph Brewer, a partner in our listed audit team, explores five common financial reporting issues that businesses in this industry often encounter.
- Intangible assets – Recognition and impairment testing
Intangible asset recognition and impairment issues present challenges for biotech companies, given the sector’s reliance on research and development (R&D) and the uncertain future economic benefits of intellectual property. Under IFRS, biotech firms must determine whether to recognise internally developed intangible assets, such as patents and drug formulations. This generally requires the company to demonstrate technical feasibility and a clear path to commercialisation. Recognising intangible assets is particularly complex in the biotech sector, where many projects remain at the early research stages or face high or uncertain regulatory hurdles.
Additionally, the risk of impairment of recognised intangibles is a frequent issue, especially when clinical trials fail, or market conditions change. IFRS requires biotech companies to regularly evaluate these assets for indicators of impairment, considering factors like changes in development timelines, shifts in market demand, and competitive pressures, which can lead to significant write-downs. These issues require robust judgement and often result in material adjustments to the financial statements, reflecting the inherent volatility and risk in the biotech industry’s innovation-driven landscape.
- Going concern assessments and disclosures
Going concern assessments are particularly critical for pre-revenue biotech companies, where the lack of commercialised products and heavy reliance on external funding can pose significant challenges. These companies often operate with limited cash reserves, facing potentially long development timelines and uncertain regulatory outcomes, which heightens the risk of running short on cash before achieving profitability.
Under IFRS, management must evaluate whether there are material uncertainties that cast significant doubt on the company’s ability to continue as a going concern, a determination that is challenging in the biotech sector. This involves assessing the availability of future financing, the ability to meet upcoming financial obligations, and the progress of ongoing research and clinical trials.
The outcome of these assessments is crucial, as a going concern disclosure can affect investor confidence, access to new funding, and the company’s overall valuation. For pre-revenue biotech companies, maintaining a going concern status often hinges on future fundraising, achieving key development milestones, and carefully managing operational cash flow.
- Revenue recognition, including royalties
Revenue recognition in the biotech sector can present complex challenges, especially in contracts which feature milestone payments, licensing agreements or royalties, rather than traditional sales revenue. Under IFRS 15, biotech companies must carefully gauge the timing and amount of revenue to recognise from these arrangements, which often involves significant judgement.
Milestone payments tied to R&D achievements or regulatory approvals require thorough evaluation to decide when the revenue should be recognised—either at the point in time when the milestone is achieved or over time if obligations remain. Licensing agreements, common in this sector, can further complicate revenue recognition, as they often include multiple elements such as upfront payments, development support, and royalties. These must be unbundled, with revenue recognised separately for each performance obligation.
Royalties, which are typically based on product sales, pose added challenges as they require careful consideration of the timing of revenue recognition, often linked to the sales-based or usage-based nature of the royalty agreements.
Accurately accounting for these revenues is crucial for biotech companies, as it directly affects their financial statements, investor relations, and compliance with financial reporting standards.
- R&D tax credits
HMRC statistics show that the science sector benefitted from over £1.5billion in R&D tax credits in 21/22. The recognition of R&D tax credits is a vital yet intricate aspect of financial reporting for biotech companies, given the sector’s heavy investment in research and development activities. Under IFRS, R&D tax credits can be recognised as income if they meet certain criteria, primarily when it is probable that the credits will be received, and the amount can be reliably measured. This requires a detailed understanding of the relevant HMRC R&D scheme and its eligibility criteria. The complexity arises in deciding when and how much of the tax credit to recognise, and typically this calculation will involve the input of external R&D specialists.
Additionally, the timing of recognition can significantly impact financial statements, as these credits can offset substantial R&D expenses, reducing the company’s reported losses and improving cash flow. The receipts from tax credit are, in some cases, a key factor in going concern assessments. However, judgement is needed to assess the probability of receiving the credits and therefore to ensure that the recoverability of a tax receivable is supported through expert input.
- Share option accounting
Share option accounting is a critical area for biotech companies, which often use share options to attract and retain talent while conserving cash. Under IFRS 2, share options granted to employees must be measured at fair value on the grant date and expensed over the vesting period. Determining the fair value involves significant assumptions about share price volatility, the options’ expected life, risk-free interest rates, and dividend yields.
For options with performance conditions, more complex valuation methods like the Monte Carlo simulation may be required, and small finance teams can find these models challenging and costly.
Accounting for modifications, forfeitures, and eventual exercises adds further complexity, requiring detailed financial reporting processes.
What next?
Addressing these financial reporting challenges early is essential for accurate and timely year-end reporting. Gravita are specialist auditors and advisers to the biotech and life sciences sectors. Learn how our expert team can support your business by contacting Joseph Brewer, Audit Partner in our London office.
If you’re an established company listed on AIM or AQSE growth markets, we have the expertise you need. For more information about how we can help, click here.
