ALZA Corporation: A Case Study concerning R&D Accounting Practices in the Pharmaceutical Industry

By McCoy, Tim; Hoskins, Margaret | Journal of the International Academy for Case Studies, March-April 2007 | Go to article overview

ALZA Corporation: A Case Study concerning R&D Accounting Practices in the Pharmaceutical Industry


McCoy, Tim, Hoskins, Margaret, Journal of the International Academy for Case Studies


CASE DESCRIPTION

The primary subject matter of this case concerns variable interest entities (VIEs), accounting for research and development (R&D) arrangements, and consolidated financial statements. The case has a difficulty level of four for five, appropriate for senior or first-year graduate level. The case is designed to be taught in one class hour and is expected to require three hours of outside preparation by students.

CASE SYNOPSIS

This case illustrates the innovative off-balance sheet financing techniques used by ALZA Pharmaceuticals Corporation in the 1990s to fund its R&D activities. The case shows that, although ALZA technically adhered to generally accepted accounting principles (GAAP) in effect at the time, its financial statements failed to reflect economic reality by overstating revenues and net income. The case is a prime example of how accounting for VIEs prior to current GAAP failed to capture economic reality. The case details two of ALZA's R&D funding arrangements, illustrates the accounting practices used to capture them, and evaluates the manner in which their results were reported in the financial statements. Furthermore, the accounting and reporting procedures used will be compared to those required by ARB No. 51, Consolidated Financial Statements, FASB Interpretation No. 46(R) Consolidation of Variable Interest Entities--an Interpretation of ARB No. 51, and EITF 99-16, Accounting for Transactions with Elements of Research and Development Arrangements. This comparison will help students understand the relevance and need for the new pronouncements.

INSTRUCTORS' NOTES

In a strategy decision to become a fully-integrated pharmaceutical company, ALZA Pharmaceutical Corporation devised two off-balance sheet R&D arrangements. The first was Therapeutic Discovery Corporation (TDC), which operated from mid-1993 through 1997. The second was Crescendo Corporation, which operated from 1997 through 2000. In both arrangements, ALZA invested cash in the corporations, issued stock in the new corporations to ALZA stockholders, and performed R&D activities for the new corporations. Amounts invested in the new corporations flowed back to ALZA and were recorded as R&D revenue. Since ALZA was recording both the revenue received from TDC and Crescendo and its own expense, the company claimed that the impact on income was not significant.

This case reviews the journal entries made to record the investments in TDC and Crescendo and leads students through an evaluation of ALZA's claim that the arrangements had an insignificant impact on its reported net income. This case illustrates that ALZA's assertion is not an accurate assessment of the impact of the arrangement. Without the R&D arrangements, ALZA would simply be recording R&D expense as it was incurred, thereby reducing net income by the amount of R&D expense. Using TDC & Crescendo arrangements, ALZA recorded both revenue and expense, thereby eliminating the reduction of net income for its R&D expense. Students are asked to evaluate ALZA's accounting and reporting procedures in light of ARB No. 51, Consolidated Financial Statements, FASB Interpretation No. 46 (R) Consolidation of Variable Interest Entities--an Interpretation of ARB No. 51, and EITF 99-16, Accounting for Transactions with Elements of Research and Development Arrangements.

The following pages explain and provide details about the suggested answer to each question asked in the case.

DISCUSSION QUESTIONS

1. What effect did the TDC and Crescendo arrangements have on ALZA's R&D reported on the income statement? What were the balance sheet effects?

Table 1 provided in the case and reproduced below shows the Product Development Revenue recorded on the books of ALZA and the R&D Expense recorded on the books of TDC during the years 1993 through 1997. As shown, the total revenue recorded by ALZA was $275. …

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