How Auditors Assess Clinical Trial Accruals (And How Automation Can Help)

Introduction (00:00)

In the world of biotech and pharmaceutical companies, clinical trials play a critical role in advancing medical science. However, accurately managing and reporting the financial aspects of these trials, particularly accruals, can be challenging. In a recent webinar, experts from Auxilius and Forvis Mazars shared valuable insights into clinical trial accruals from an audit perspective. This blog post distills the key learnings from that discussion, providing accountants with actionable advice on navigating this complex landscape.

Life Science Hot Topics (02:40)

New and Upcoming Accounting Standards Updates (ASUs)

One significant update is ASU 2023-07, which revises segment reporting for the first time since 1997. This standard requires public entities to disclose significant segment expense categories and amounts, although "significant" is not clearly defined, leading to varying interpretations. Additionally, companies are now required to disclose the title and position of the Chief Operating Decision Maker (CODM), a practice that was previously optional for some. ASU 2023-07 will be effective for 2024 calendar year public companies' 10-K filings, making it essential to prepare ahead of time to avoid compliance issues. Starting in Q1 2024, enhanced interim segment reporting requirements will also take effect. Single reportable segment entities must apply the guidance fully, impacting a wider range of companies than initially expected.

Proposed Changes in R&D Funding Arrangements

Proposed changes to accounting standards for R&D funding arrangements could significantly impact life sciences companies. These arrangements typically involve passive third-party investors funding R&D programs in exchange for milestone payments or royalties contingent on success. These arrangements differ from those that fall under revenue recognition or collaboration guidance, which generally require companies to repay the funds regardless of the outcome. Currently, companies must assess whether derivatives are involved in these arrangements, adding complexity and cost. The proposed changes aim to simplify the process by excluding many R&D funding arrangements from derivative accounting, potentially encouraging more companies to pursue such agreements without the burden of derivative calculations.

SEC Comment Letter Trends

Regulatory scrutiny remains a pressing concern, particularly in relation to SEC comment letters. Non-GAAP metrics continue to be a focal point, with frequent comments addressing their prominence compared to GAAP measures, reconciliation issues, and the appropriateness of adjustments. Companies are also expected to provide clear justifications for the use of non-GAAP metrics.

Disaggregation of R&D costs is another key issue, with companies expected to disclose expenses by product or project category. Despite being an industry standard, many companies continue to omit these details. Revenue recognition under ASC 606 also remains complex, with frequent comments addressing performance obligations, transaction pricing, and timing of recognition. Business combinations present another area of concern, particularly around the distinction between business combinations and asset acquisitions, as well as materiality judgments that omit key disclosures. Consolidations, especially related to variable interest entities (VIEs), are another common topic of SEC comment letters, with the potential requirement to consolidate other entities drawing regulatory attention.

Key Takeaways

Preparation and attention to these accounting changes and regulatory trends are essential for life sciences companies. Proactive compliance with new ASUs and a focus on avoiding SEC comment letters are critical steps in maintaining regulatory alignment and avoiding costly issue

Capital Market Update (09:25)

Recent developments in the capital markets highlight the preparation efforts of many life sciences companies as they anticipate an IPO market recovery. The IPO boom of 2021 has since slowed, but companies are engaging auditors and third-party experts early to ensure they are ready when the market opens up again. Preparing for an IPO can take over 12 months, especially for those without prior audit experience, making early action critical.

Current IPO Market Trends

Proceeds raised in the first half of the year nearly doubled compared to the same period in 2022, and were nearly four times the amount raised in 2021. Life sciences companies dominated Q1 of the year, although broader sectors contributed to a strong Q2, marking the highest level of proceeds since Q4 of 2021. Traditional IPO stock prices for this quarter were up nearly 15%, outperforming the S&P 500. This has resulted in more companies preparing for IPOs, even though the pace of new listings remains slower than expected. An acceleration of IPO activity is anticipated for next year, particularly after the November elections.

SPAC Market Developments

The SPAC market, while slowed, has returned to a more normalized level of activity. Life sciences companies continue to be attractive targets for SPACs looking for reverse merger candidates. Despite the slower pace, Q2 saw 10 SPAC IPOs, 16 SPAC merger announcements, and 10 SPAC merger completions, with SPAC IPOs raising a total of $2.6 billion in the first six months of the year. Though slower than in past years, SPACs remain a viable pathway for companies seeking to enter public markets.

IPO and SPAC Readiness

Both IPOs and SPACs involve time-consuming and complex processes. It is important for companies to begin preparations early, as the guidance and support of experts are essential to navigating the numerous challenges associated with these pathways.

Critical Audit Matters and R&D Accruals (12:21)

In the life sciences sector, a significant focus lies on R&D accruals and the complexities they introduce, particularly from an audit perspective. These accruals are tied to outsourced R&D activities and clinical trials, which represent a substantial portion of a biotech company's balance sheet, often accounting for 70-80% of total expenditures. Clinical accruals are inherently complex due to the use of outsourced vendors and contractual provisions, and they require careful estimation and validation.

What Are Critical Audit Matters (CAMs)?

Critical Audit Matters (CAMs) are areas in the financial statements that involve significant judgment, complexity, or auditor discretion. They relate to accounts or disclosures material to the financial statements and are communicated to the audit committee. CAMs represent higher-risk areas where auditors adjust their testing procedures. In recent years, CAMs have also been included in the audit report alongside the auditor’s opinion.

In life sciences, CAMs often depend on the company’s stage of development. For commercial entities, common areas include revenue recognition, gross-to-net accounting, government rebates, chargebacks, sales return reserves, and inventory issues. Pre-commercial companies often face CAMs related to collaboration revenue accounting, where judgments are required for recognizing revenue from IP licenses and development agreements. However, clinical accruals are the most prevalent CAM for pre-revenue biotech companies due to their significance and complexity.

Challenges With Clinical Accruals

Clinical accruals track the obligations, prepayments, provisions, and invoices related to R&D activities outsourced to vendors and contract research organizations. The complexity arises from the timing of invoices, the variability of contractual provisions, and the judgment required by management. Clinical accruals are often lopsided on the balance sheet compared to other accounts, which increases their importance during audits.

Auditors scrutinize these accruals closely, focusing on the data sources, the reliability of third-party information, and the accuracy of the estimates. Collaboration with the R&D team is critical to ensure that all relevant contracts, change orders, and progress reports are accounted for in the accrual estimates. Invoices from vendors often lag, and limited detail on these invoices further complicates the estimation process.

Best Practices for Accrual Management

Effective management of clinical accruals requires implementing several key best practices to address the complexities of outsourced R&D activities:

• Collaboration with R&D Personnel: Ensure close collaboration between finance and R&D teams. The R&D team is often responsible for signing contracts and change orders, so maintaining an updated and complete list of contracts is essential.

• Timely Communication with Vendors: Improve communication with vendors and research institutions. Since invoices are often delayed and lacking in detail, the clinical team, which has better relationships with vendors and access to progress reports, should be involved to help finance teams more accurately estimate costs.

• Building a Validation Process: Regularly validate estimates through biweekly calls with the R&D team to ensure no contract changes go unnoticed. Review vendor data thoroughly to ensure that clinical trial progress and costs align with accrual estimates. This validation step should be built into the close process.

• Monitoring Accruals vs. Actuals: Implement a model that monitors accruals against actuals, tracking the history of true-ups. This helps identify discrepancies early and reduces the likelihood of significant adjustments.

These best practices—focusing on collaboration, communication, validation, and monitoring—are vital for managing the judgmental and complex nature of clinical accruals in the life sciences industry.

6 Key Audit Procedures for R&D Accruals

The discussion covered six critical audit procedures that are essential for compliance in the biotech and pharmaceutical sectors. These procedures ensure that clinical trial accruals are accurately recorded and reported, minimizing the risk of errors or misstatements.

1. Testing the Design and Effectiveness of Controls (26:12)

Key considerations:

• Siloed data sets
• Excel reliance for core workflows
• Mapping of clinical + financial systems
• Stakeholder communication + collaboration

Auditors place significant focus on Critical Audit Matters (CAMs), and their procedures are designed to ensure there are no material misstatements, particularly in high-risk areas like clinical accruals. For public companies subject to SOX Section 404, testing the design and effectiveness of controls is crucial, but it also benefits the audit process overall. Strong controls can reduce the need for extensive substantive testing by auditors.

Key practices include having a best-in-class process that involves regular corroboration with clinical teams, maintaining a supportable basis for estimates, validating those estimates, and monitoring accruals against actuals. Companies with minimal or no significant true-ups are generally in good shape for audits.

However, challenges arise when companies rely on manual processes, such as using Excel for mapping clinical and financial systems. Manual processes are more prone to error, and because the source data often comes from third-party vendors outside of internal systems, auditors will need to conduct additional work to verify accuracy. 

2. Reviewing Contractual Documentation, Purchase Orders, and Work Performed (27:38)

Key considerations:

• CRO controls documentation
• Documents living in different environments
• Data needed for testing often stored locally with a single employee

Auditors begin by reviewing contracts, purchase orders (POs), statements of work (SOWs), and other relevant contractual documentation. An accrual model must incorporate not only the initial contracts but also any subsequent amendments. Audit adjustments often arise when unrecorded liabilities surface during procedures such as reviewing board minutes or searching for unrecorded liabilities. These surprises, like an overlooked invoice related to a clinical accrual, can lead to material misstatements, costly true-ups, delayed closes, and even delays in SEC filings.

To mitigate these risks, companies should implement a robust process for accessing and storing documentation, especially when critical documents may reside outside of accounting and finance, sometimes even on individual employees’ laptops. Ensuring that both the clinical and accounting teams have access to this documentation is crucial. Corroboration between departments is vital to ensure that significant amendments are not missed. As companies mature, they should adopt more sophisticated systems for document storage, reducing the risk of knowledge loss when key employees leave.

3. Performing Corroborating Inquiries with the R&D Team (30:29)

Key considerations:

• Clinical and accounting teams have distinct priorities and languages
• Developing a single source of truth for R&D activities translated to F&A impacts
• Dedicating time for necessary conversations/meetings

This step involves discussing clinical trial activities with stakeholders to confirm that recorded costs and accruals are accurate and consistent with trial progress. To stay ahead of the audit process, finance teams should take ownership of interactions with R&D before auditors do. Regular biweekly meetings with R&D should be used to prepare the team for the audit, ensuring they understand the process and what should or shouldn’t be communicated.

Educating the R&D team on their role in the audit is crucial. While this may take time from their regular duties, finance teams must act as coordinators, ensuring R&D's statements align with audit requirements. Clear communication helps avoid misinterpretations between clinical and financial perspectives, ensuring a smoother audit.

4. Obtaining + Inspecting Actual Cost Information Directly From Vendors (31:49)

Key considerations:

• Vendor data/communication lag time
• Level of detail in invoicing
• Disparity in nomenclature/taxonomy requires manual mapping

Auditors gather invoices, receipts, clinical trial activity data, and other cost data from vendors to verify that the reported accruals match the actual incurred costs. 

Even with a thorough close package—complete with spreadsheets, contract excerpts, wire screenshots, and embedded invoices—auditors will often seek confirmation directly from vendors. Auditors may request vendors to confirm data used in management's models or verify trial progress percentages. Third-party information is highly valued but can present challenges, as timely communication from vendors is rare, and invoices are often delayed or lack sufficient detail.

To mitigate these issues, it's best practice to establish clear expectations with vendors upfront. Pre- and post-close meetings with vendors can help ensure timely and detailed communication, reducing the risk of late invoices that could lead to unexpected audit adjustments or late entries.

5. Evaluating Management’s Judgment and Significant Assumptions Using the Evidence Obtained (33:52)

Key considerations:

• Broad range of industry practices today
• Methodology not consistently documented
• Excel doesn't easily translate assumptions and judgement
• Actuals don't always inform/recalibrate forecast on rolling basis

Auditors rigorously test management's judgments and assumptions used to develop key estimates, tracing them to concrete evidence. For simpler items like cash payments, auditors can easily verify data against bank statements or invoices. However, more complex estimates, such as percentages of completion or data from R&D reports outside of the accounting system, require more scrutiny.

To ensure accuracy, auditors check that there is no contradictory evidence from other sources, such as R&D teams or third-party vendors. The reliability of source data and validation checks with the clinical team and vendors are crucial in the clinical accrual process. Monitoring for true-ups is equally important.

To enhance reliability, many companies are adopting system solutions that provide SOC 1 reports. These reports, generated by independent auditors, assure that the software data is complete and accurate. Using a SOC 1-certified system reduces the level of testing auditors need to perform, making it a valuable consideration when selecting vendors and software solutions.

6. Testing the Completeness and Accuracy of the Information Used to Develop the Estimates (36:34)

Key considerations:

• CROS and Investigators/Sites often provide incomplete data, lacking detail
• Invoiceables in Tx areas such as Oncology 

If you're looking to enhance your approach to managing clinical trial accruals or have questions about the audit processes discussed in this post, don't hesitate to reach out to Auxilius and Forvis Mazars. Our team of experts is here to help you navigate these challenges with confidence.