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Greater earnings volatility is predicted across the pharma industry

17 January, 2007

The pharmaceutical industry may experience greater volatility in its reported earnings in the coming years, claims KPMG International.

KPMG also suggests that the pharmaceutical industry remains one of the riskiest industrial sectors around, thanks to the potent combination of regulatory, pricing and legal risks which the industry has to face on a daily basis.

In launching their latest Pharmaceuticals Disclosures Handbook – an annual report on the state of risk reporting across the pharma industry – KPMG highlights how a massive US$200 billion of intangible assets now resides on the balance sheets of the top 10 pharma companies (by turnover) alone; all of which can be considered at risk as the value of those assets is underpinned by product performance in what is an increasingly risky marketplace.

While the companies surveyed do now make extensive disclosures about the risks posed by issues such as government investigations into drug pricing and promotion for example, exactly how this may impact future earnings is less clear, giving rise to KPMG’s concern over increased volatility.

Head of the KPMG’s Australian Pharmaceuticals industry group, Paul McDonald, noted that whilst the Handbook focused on the larger international pharmaceutical companies, there are some important lessons for Australian companies. In particular, the level of disclosure of risk factors and their potential impact on asset carrying values and future earnings is more extensive in some other jurisdictions.

“Whilst the new International Financial Reporting Standards adopted in Australia better aligned our reporting practices with the global standards, there still exist some significant differences in the level of disclosures.

“Big Pharmas in the US and UK tend to set the high water mark in terms of informing the market of industry-specific risk factors, and it is clear that some local companies have some way to go to meet these standards of disclosure.

“Larger Australian-based global players have disclosures that approach international best practice, but the same cannot be said for some mid-cap companies in the biotech sector, where analysis of risk factors around early stage products and regulatory issues is sometimes less transparent,” said McDonald.

Speaking from a global perspective, John Morris, Global Head of KPMG’s Pharmaceuticals practice, said: “Complexity and risk seem to be the two key words which epitomise the findings of our latest Handbook. Companies are making great efforts to ensure that stakeholders are fully appraised of these complex risks and how they are to be managed but the exact impact of these risks on future earnings appears increasingly difficult to quantify.”

“To further muddy the waters, the Handbook highlights just how many differences still exist between the different ways in which companies are choosing to report on key risk areas. It was hoped that the similarity of the recently adopted International Financial Reporting Standards (IFRS) to US GAAP (Generally Accepted Accounting Principles) would result in more comparable reporting across the sector. Our research showed that this has not yet happened. Despite unearthing plenty of examples of improved risk disclosure, critical accounting policies and complex judgments, there were still many differences between companies’ approaches to reporting.”

KPMG’s Handbook highlights how it has been another busy year for the pharma industry. Further high-profile product safety issues resulting in billion dollar legal claims have occurred alongside continued consolidation of the generics sector, speculation of another big pharma takeover and biotech acquisitions undertaken by companies desperate to access new technologies or early stage products.

Not unsurprisingly, this changing environment has led to more comprehensive disclosures of business risk, with product liability and drug pricing being among risks which are most commonly reported on. One topic whose importance rarely appears to diminish is revenue recognition, with KPMG’s analysis revealing this to be one of the most complex and judgmental areas of accounting for the industry. Companies surveyed have provided greater analysis of ‘gross to net’ revenue deductions and the impact of licensing arrangements, reinforcing the suspicion that this could remain a major area of focus for the SEC and other similar bodies.

John Morris concluded. “One issue which does not appear to have had much of an impact on the industry is the adoption of IFRS. KPMG’s review of 2005 filings show that the impact was not as great as we may have anticipated. What did become apparent though was the variety of exemptions taken under IFRS 1, meaning that it remains difficult to make a proper comparison between IFRS preparers. This lack of consistency can also be applied to the industry’s approach to taxation. Having analysed the various tax disclosures and tax rates of the companies surveyed, it was interesting to see that the spread of effective tax rates across the sector equates to several billion dollars of shareholder value; something which does not seem to sit easily with the assertion that this is a global industry.”