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, January 1, 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.

INTRODUCTION

ALZA Pharmaceuticals Corporation was incorporated under the laws of the State of California on June 11, 1968. Its founder, Alejandro Zaffaroni, was a member of the scientific team that invented the birth control pill (Moukheiber 1999). By mid-1980 the company had developed into a leading provider of controlled-dosage drug delivery systems ranging from skin patches to lowcurrent electric devices that administer drugs through the skin. ALZA is responsible for such worldclass delivery systems as "the patch" for Nicoderm CQ, the leading smoking cessation drug. Other drugs utilizing ALZA's technology include Procardia XL, an oral angina/hypertension treatment, and Sudafed 24, an over-the-counter allergy medication.

Prior to the 1990's ALZA's revenues consisted solely of royalties from sales of other companies' products that used ALZA's delivery systems. Early in the decade, ALZA devised a plan to complement its already existing drug delivery systems by developing its own drug products thereby becoming a fully integrated pharmaceutical company. To accomplish its objective, ALZA adopted an off-balance sheet strategy to finance the required R&D activities. During the years 1993 through mid-1997, its required R&D activities were provided through Therapeutic Discovery Corporation (TDC), a development-stage company formed by ALZA. In 1997, ALZA dissolved TDC and created a, a similar development-stage company, Crescendo Pharmaceuticals Corporation, for the same purpose. Crescendo operated during the years 1997 through 2000, after which that company was dissolved. The following paragraphs explain the details of the TDC and Crescendo arrangements and discuss the methods used by ALZA to account for the activities and report the results of the two corporations.

THE TDC ARRANGEMENT

In late 1992 and mid 1993, ALZA created TDC by paying $250 million for the new corporation's common stock. ALZA retained ownership of 100 shares of Class B Common Stock and issued approximately 7.7 million shares of Class A Common Stock to ALZA shareholders as a special dividend of units. Each unit consisted of one share of TDC Class A Common Stock and one warrant to purchase one-eighth of one share of ALZA common stock at an exercise price of $65 per share. The TDC Class A Common Stock and the ALZA warrants were listed and traded independently on the NASDAQ stock market. …

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