RESEARCH AND DEVELOPMENT AFFILIATES
Because GAAP in the United States requires that all expenditures for research and develop-
ment (R&D) be expensed, ﬁrms have looked for alternative methods of ﬁnancing R&D that
postpone the associated earnings charge. Alternate ﬁnancing methods may also have the fol-
• Targeting investors who are attracted by the risk/reward characteristics of speciﬁc projects
• Focusing management attention on speciﬁc projects by placing their development in a
We discuss the two most common forms of these arrangements, R&D partnerships and de-
velopment companies. The drug and biotechnology industries have been the most common
users of these techniques, perhaps because R&D is focused on the development of discrete
1. Examine the motivation for the establishment of R&D arrangements.
2. Show the effect of R&D arrangements on the amounts and timing of research and de-
3. Show the effects of R&D arrangements on reported net income, stockholders’ equity,
and ﬁnancial ratios.
4. Compare the effects of R&D arrangements on companies using accounting methods
that expense all R&D with those permitting capitalization.
RESEARCH AND DEVELOPMENT PARTNERSHIPS
An R&D partnership raises funds from investors. Those funds are then used to pay the com-
pany for research. Any patents or products resulting from that research belong to the partner-
ship, but the company can either purchase the partnership or license the product. Thus, the
company controls the technology without reporting the expenses resulting from research
costs, as the “revenue” from the partnership offsets the research expense.
This arrangement has many of the attributes of an option; the ﬁrm has a call option on
the patents or products developed for the partnership, with the purchase price being the exer-
cise or strike price. Shevlin (1991) treats such limited partnerships (LPs) as an option and
uses option pricing theory to value the LP:
The value of the LP call option to the R&D ﬁrm may be decomposed into the present value of
the underlying project ﬁnanced by the LP (an asset) less the present value of the payments to
the limited partners if the ﬁrm exercises its option (liability).1
Terry Shevlin, “The Valuation of R&D Firms with R&D Limited Partnerships,” The Accounting Review, Jan. 1991,
RESEARCH AND DEVELOPMENT PARTNERSHIPS W15
SFAS 68 (1982), Research and Development Arrangements, sets criteria to distinguish
true transfers of risk from disguised borrowings. The following are indicators that there has
not been a true transfer of risk:
1. The company has an obligation to the partnership (or investors) regardless of the out-
come of the research. Such obligation may take the form of a guarantee of partner-
ship debt or granting of a “put” option to the investors.
2. Conditions make it probable that the company will repay the funds raised by the part-
nership. Such conditions include the company’s need to control the technology
owned by the partnership or relationships between the company and the investors
(e.g., top management invests in the partnership).
If there has not been a true transfer of risk, then the company is required to expense the ac-
tual research costs and treat funds received from the partnership as borrowings.
When the requirements of SFAS 68 are met, however, the company can recognize rev-
enue from the partnership to offset R&D costs. The result is, in effect, a deferral of research
cost until products are sold (and license fees paid) or the partnership is purchased. Such
arrangements are disclosed in ﬁnancial statement footnotes and analysts should be alert to
their effects on reported income.
In recent years, a new vehicle has largely superseded the R&D partnership: a separate
development company that sells “callable common” shares to the public. The shares are often
packaged with warrants of the (parent) company to make the resulting “units” more attrac-
tive to investors. The new common shares are callable at prices that promise a high rate of
return to investors if the venture is successful. These vehicles are similar to R&D partner-
ships in their effects on the ﬁrm.
Analysis of Firms with R&D Afﬁliates
The impact of R&D afﬁliates on reported ﬁnancial results is favorable as research costs are
offset by “revenue” from the afﬁliate. Reported income would be lower if these costs were
funded by borrowing (or from the ﬁrm’s own assets). Further, obtaining those funds would
require additional debt or equity capital. R&D ﬁnancing arrangements permit the company to
conduct research without incurring debt or equity dilution, in addition to avoiding the effects
of reporting the research costs as an expense.
There is a cost to this capital, however. When the partnership is purchased or the
callable common is called, a substantial cash payment or share issuance is required. Given
the risk, investors in R&D afﬁliates require a high rate of return.
The second cost factor is the impact when the afﬁliate is purchased. At that time, the
purchase price must be written off as research costs.2 The resulting write-off usually exceeds
the amount of funds originally raised. But that write-off is delayed until the partnership is
purchased. In effect, these arrangements permit the deferral of research costs, but with the
penalty of a high interest factor (cost of capital).
R&D Afﬁliates Outside of the United States
In jurisdictions that do not require all R&D to be expensed, the incentives for alternative
arrangements are weaker. Under IAS GAAP, as discussed in the chapter, research costs must
be expensed but development costs are capitalized and amortized. Canada has similar re-
quirements, as seen in the analysis of Biovail that follows. However, given the preeminence
of the United States capital market, even non-U.S. ﬁrms may use these techniques to enhance
their earnings reported under U.S. GAAP.
FASB Interpretation 4 (1975) provides that when an acquisition is accounted for under the purchase method of ac-
counting, any portion of the purchase price allocated to R&D must be immediately expensed at the time of the ac-
quisition. Chapter 14 contains more discussion of this issue.
W16 APPENDIX 7-A RESEARCH AND DEVELOPMENT AFFILIATES
Biovail [BVF] is a Canadian pharmaceutical company. It used several R&D afﬁliates to ﬁ-
nance drug development in the 1990’s. We will focus on one such arrangement, Intelligent
Polymers [INP], incorporated in Bermuda.
In October 1997, there was an initial public offering of 3.7 million units at $20 per unit,
resulting in net proceeds after expenses of approximately, $69.5 million.3 Each unit con-
• One Intelligent Polymer common share
• One warrant to purchase one Biovail share at $10 per share (adjusted for subsequent
stock splits) from October 1, 1999 through September 30, 2002
Biovail recorded a credit to equity of $8.244 million to reﬂect the value of the warrants is-
sued and an equal reduction of retained earnings to record the contribution to INP. The net
result of the offering was that INP received $69.5 million of capital with no net effect on
Biovail’s ﬁnancial statements.
At the time of the offering, the two companies entered into a series of agreements, in-
cluding the following provisions:
1. INP agreed to spend the proceeds to develop seven possible products, paying BVF to
conduct the required research.
2. INP would hold the rights to products developed but Biovail would have options to
purchase those rights at predetermined terms.
3. Biovail had the option to purchase all shares of INP at the following prices:
• $39.06 per share before October 1, 2000
• $48.83 per share from October 1, 2000 through September 30, 2001
• $61.04 per share from October 1, 2001 through September 30, 2002
The development agreement resulted in payments from INP to Biovail shown in the follow-
Years ended December 31 1998 1999 2000 Totals
Payments to Biovail $9.7 $33.0 $55.2 $97.9
Biovail’s related costs (6.7) (19.8) (35.2) (61.7)
Biovail gross proﬁt $3.0 $13.2 $20.0 $36.2
Over the three-year period, INP paid Biovail approximately $98 million for research. If
Biovail had conducted the research itself, the total cost would have been nearly $62 million.
The effect of forming INP was to increase Biovail’s reported pretax earnings by the amount
of the payments received. The signiﬁcance of these amounts can be seen from Biovail’s rev-
enues (Exhibit 7A-1), which rose from $111.6 million in 1998 to $309.2 million in 2000.
In 1999, Biovail paid INP $25 million for the rights to one developed drug. On Septem-
ber 29, 2000, Biovail exercised its option to purchase all INP shares, for a total price (includ-
ing bank debt) of $204.9 million. The purchase resulted in a write-off of in-process research
and development (IPRD) of $208.4 million. The write-off resulted in an operating loss for
the year of $78 million. The IPRD was far above the actual research expenditures. However
the creation of INP had the effect of delaying the recognition of these costs in Biovail’s ﬁ-
nancial statement. It also reduced Biovail’s risk; if the INP research had not been successful,
Biovail would not have exercised its option.4
We can see the cost of capital implicit in the creation of INP by examining the invest-
ment from the investor point of view. Ignoring (for the moment) the Biovail warrants in-
All dollar amounts in this section are United States dollars even though Biovail is Canadian.
It is also possible that Biovail would have exercised its option even in the event of failure in order to maintain full
control of its proprietary technology.
RESEARCH AND DEVELOPMENT PARTNERSHIPS W17
cluded in the offering, investors bought INP shares for $20 each. The call prices shown
above provide rates of return of 25% per annum. As Biovail shares rose substantially, trading
above $45 per share in November 2000, the actual return (including the gain in the Biovail
warrants) was even higher. Of course, investors took the risk that the INP research would not
have produced marketable drugs.5
In economic terms, the Intelligent Polymers capital came at a high price to Biovail.
However, the risk reduction may have made the cost of capital acceptable relative to other
sources of capital available at that time. The INP arrangement also resulted in postponed
recognition of the research costs associated with the development of these drugs. As IPRD
write-offs are often seen as “non-recurring” costs, it is uncertain how the ﬁnancial markets
value ﬁrms with such charges.
Comparison of Biovail Financial Statements: U.S. vs. Canadian GAAP
Under Canadian GAAP, IPRD and the acquisition cost of drug rights are capitalized and
amortized over the useful life of the products. Both the $25 million paid to INP in 1999 and
the cost of acquiring INP in 2000 resulted in asset recognition (rather than being expensed
under U.S. GAAP). Biovail had written off more than $105 million of IPRD in 1999 from
another R&D arrangement. The difference between the treatment of these transactions be-
tween U.S. and Canadian GAAP can be seen in Exhibit 7A-1.
EXHIBIT 7A-1. BIOVAIL
Financial Data under United States and Canadian GAAP
All data in $US thousands, except per share
Years Ended December 31 1998 1999 2000
United States GAAP
Revenue $111,657 $172,464 $ 309,170
Operating income (loss)* 45,303 (40,160) (78,032)
Net income (loss) 41,577 (109,978) (147,796)
Earnings per share (diluted) 0.38 (1.07) (1.16)
Total assets $198,616 $467,179 $1,107,267
Long-term obligations 126,835 137,504 438,744
Convertible securities 299,985
Common equity 49,888 267,336 237,458
Common shares outstanding 99,444 124,392 131,461
*Includes IPRD charges $105,700 $ 208,400
Revenue $ 98,836 $165,092 $ 311,457
Operating income 35,145 64,117 116,223
Net income 31,419 52,080 81,163
Earnings per share (diluted) 0.29 0.47 0.57
Total assets $199,919 $635,137 $1,460,967
Long-term obligations 126,835 137,594 438,744
Shareholders’ equity 19,091 391,794 839,110
Common shares outstanding 99,444 124,392 131,461
Note: While the treatment of IPRD and the cost of acquired drugs are the principal differences between U.S. and
Canadian GAAP, the data also reﬂect other differences.
Source: Biovail 10-K, December 31, 2000
See footnote 4; for this reason, the risk may not have been excessive.
W18 APPENDIX 7-A RESEARCH AND DEVELOPMENT AFFILIATES
The principal differences are:
1. Under Canadian GAAP, there is a progressive improvement in both operating and
net income, as well as earnings per share. Under U.S. GAAP, the IPRD write-offs re-
sult in operating and net losses for both 1999 and 2000.
2. Canadian GAAP assets exceed those under U.S. GAAP, reﬂecting the capitalization
of drug acquisition costs.
3. Canadian GAAP equity exceeds that under U.S. GAAP, mainly due to the difference
in net income.
The ratio effects of these differences are the subject of Problem 7A-1.
The Biovail—Intelligent Polymers example illustrates the effects of research and develop-
ment arrangements on the ﬁnancial statements of the sponsoring company. Such arrange-
ment can have major impacts on the amount and timing of reported net income, as well as
the balance sheet and cash ﬂow statements. While ultimately, company valuation depends on
research (and subsequent marketing) outcomes, the analyst should carefully consider the ef-
fect of such arrangements on the ﬁnancial statements of affected companies.
7A-1. [Ratio effects of differences in accounting for R&D arrangements].
A. Using the data in Exhibit 7A-1, calculate the following ratios for Biovail for 1998
through 2000 under both United States and Canadian GAAP:
(i) Return on sales (net income margin)
(ii) Return on equity
(iii) Asset turnover
(iv) Equity per common share
Note: use year-end amounts for balance sheet data.
B. Discuss the differences between both the level and trend of the ratios computed in
C. The price of Biovail shares rose from less than $9 per share at the end of 1997 to
nearly $39 per share at the end of December 2000. Discuss which set of ratios ap-
pears to be reﬂected in the market performance of Biovail shares. Discuss any
other factors that may have affected the price of Biovail shares during this time
D. State which of the two methods of accounting for IPRD (immediate write-off ver-
sus capitalization and amortization) comes closest to recognition of the economic
impact of the acquisition of drug rights. Justify your choice.
E. Discuss the limitations of the method chosen in part D.
F. Discuss whether the accounting for internal drug research expenditures should
differ from that for acquired drug rights.
7A-2. [Analysis of R&D Arrangements] In September 1997 ALZA (acquired by Johnson
and Johnson in June, 2001) contributed $300 million to Crescendo Pharmaceuticals, a
newly created company. ALZA formed Crescendo to help fund the development of
new pharmaceutical products. Crescendo and ALZA entered into the following agree-
1. Crescendo was required to spend virtually all of its available funds to fund the de-
velopment (by ALZA) of seven possible new products.
2. ALZA granted Crescendo a worldwide license to use ALZA technology in con-
nection with product development activities. Crescendo paid ALZA a speciﬁed li-
3. Crescendo granted ALZA options to license products developed, exercisable on a
country-by-country basis after clearance from the Federal Drug Administration
(FDA) or appropriate foreign regulatory body. ALZA also had the right to pur-
chase Crescendo’s right to receive license fees. Both the license fee and the pur-
chase price were based on predetermined formulas.
4. ALZA had the right to purchase all Crescendo shares until January 31, 2002 at a
price equal to the greater of:
(i) $100 million
(ii) The market value of 1 million ALZA shares
(iii) $325 million less all amounts paid to ALZA by Crescendo under the agree-
(iv) A formula based on license fees paid to Crescendo by ALZA over the previ-
ous four calendar quarters.
ALZA could purchase Crescendo shares for cash, ALZA shares, or a combination of
the two. The option deadline would be extended if Crescendo had not yet expended
all of its funds.
On September 29, 1997, ALZA contributed $300 million to Crescendo, of which
$247 was recorded as a “non-recurring” expense. Crescendo shares were distributed
to ALZA’s shareholders and debenture holders as a dividend.
Over the next three years, Crescendo made the following payments to ALZA:
Years Ended December 31 1998 1999 2000
Payments for research $95.0 $90.5 $68.3
Technology fees 10.7 6.7 2.7
Administrative service fees 0.2 0.2 0.2
ALZA paid the following to Crescendo for three drugs that had been successfully
Drug license fees $2.4 $4.5
On November 13, 2000 ALZA paid $100 million to acquire all outstanding
shares of Crescendo. $45.7 million of the purchase price was allocated to developed
products as deferred product acquisition costs and $9.4 million was expensed as
Exhibit 7AP-1 contains ﬁnancial data on ALZA for the three years ended Decem-
ber 31, 2000.
Use the data provided to answer the following questions.
A. Prepare income statements for ALZA for the years 1998 through 2000 assuming
that the Crescendo transactions had not taken place.
B. Calculate the percentage change in each of the following from 1998 to 1999 and
from 1999 to 2000, using reported data:
(iii) Operating income
(iv) Pretax income
C. Calculate the percentage change in each of the following from 1998 to 1999 and
from 1999 to 2000, using adjusted data from part A:
(iii) Operating income
(iv) Pretax income
W20 APPENDIX 7-A RESEARCH AND DEVELOPMENT AFFILIATES
EXHIBIT 7AP-1. ALZA CORP.
All data in $millions, except per share
Years Ended December 31 1998 1999 2000
Net sales $ 289.4 $ 448.0 $607.2
Royalties, fees, and other 233.1 227.1 281.2
Research and development 124.4 120.8 100.1
Total revenues $ 646.9 $ 795.9 $ 988.5
Costs of products shipped (125.7) (158.4) (180.2)
Research and development (182.8) (183.6) (190.8)
Selling and administrative (141.9) (259.0) (349.4)
Merger-related charges — (45.7) —
In-process R & D 00000— 00000— 00.(12.4)
Total expenses $ (450.4) $ (646.7) $ (732.8)
Operating income 196.5 149.2 255.7
Interest and other income 26.4 41.6 59.0
Interest expense 00.(56.7) 00.(58.1) 00.(58.0)
Pretax income $ 166.2 $ 132.7 $ 256.7
Income tax expense 00.(57.9) 00.(41.7) 00.(26.0)
Net income* $ 108.3 $ 91.0 $ 230.7
*before cumulative effect of accounting change
D. Calculate the effect of the adjustments in part A on each of the following for the
three years ended December 31, 2000:
(iii) Operating income
(iv) Operating margin
(v) Pretax income
(vi) Pretax margin
(vii) Times interest earned
E. Describe the effect of the Crescendo transactions on each of the following, using
the results of parts A through D:
(i) ALZA’s reported growth rate for 1999 and 2000
(ii) ALZA’s reported proﬁtability for 1998–2000
(iii) The volatility of ALZA’s proﬁtability for 1998–2000
(iv) ALZA’s reported return on equity for 1998–2000.
Hint: Consider the effect of the Crescendo transactions on ALZA’s equity.
F. Discuss the beneﬁts and drawbacks to ALZA of the Crescendo transactions, using
the results of parts A through E.
G. Considering the Crescendo transactions as a whole, justify the analytical adjust-
ments in this problem.