Assistant Managing Editor

Recognizing collaboration revenue has never been as easy as it sounds - that impressive $100 million up-front payment, for instance, actually might be amortized over the life of the partnership. But increased SEC scrutiny on collaboration revenue, combined with the growing complexity of biotech deals, has proved a headache for accounting departments throughout the biotech industry.

Much of that is due to the fact that existing accounting requirements at the SEC and the Financial Accounting Standards Board (FASB) for recording collaboration revenue is unclear.

According to a recent study commissioned by the Biotechnology Industry Organization and conducted by Glass, Lewis & Co. Inc., that lack of clarity hurts the biotech industry in particular, since partnerships are necessary to drive costly drug development progress. And those hardest hit tend to be the small to mid-sized firms that risk denting investor confidence by having to restate their financials due to revenue recording missteps.

"We can't rewrite the whole accounting system to work for biotech," said Paul Cleveland, executive vice president and chief financial officer of Affymax Inc., which suffered a short delay in going public due to revenue recognition issues. But "we need clarity and simplicity so that everyone understands how the rules need to be applied," he added.

The authors of the Glass Lewis study likened the current state of collaboration revenue recognition to "throwing a dart in the dark - hope for a bull's eye, but be satisfied with just hitting the board. Miss the dart board . . . and end up with a SEC inquiry or a restatement."

Data compiled by Glass Lewis showed that revenue recognition errors are responsible for the largest percentage of financial restatements every year, and in 2007, the biotech and drug development industry had the third highest number of restatements out of 15 industry groupings.

And having to restate financials carries its own penalty. The study's authors pointed to results from a separate April 2008 study by the Department of the Treasury, which showed that firms forced to restate their financial statements due to revenue-related errors saw share prices drop an average of more than 5 percent on the news.

On top of that, restatements also might lead to shareholder class-action lawsuits, taking focus and time away from drug development efforts.

Though not tasked with having to restate its financials, Affymax had its own unexpected troubles with the current SEC and FASB rules when it first filed for an initial public offering.

"We and our auditors had submitted a registration statement for an IPO," Cleveland told BioWorld Today, but the SEC accounting review came back with revenue recognition requirements that were "different from any other biotech filing."

As a result, "we had to postpone our IPO and revise our accounting, and then we had to actually amend the collaboration agreement" with partner Takeda Pharmaceutical Co. Inc., Cleveland said.

Osaka, Japan-based Takeda gained global rights to erythropoiesis-stimulating agent Hematide in two 2006 partnerships - a Japanese deal valued at $102 million and a second agreement covering the rest of the world that is worth up to $545 million. (See BioWorld Today, Feb. 14, 2006, and June 28, 2006.)

The trouble spot for Affymax centered on the collaboration's joint steering committee, a particularly tricky area for collaboration revenue recognition.

Recent accounting interpretation considers participating on such a committee to be a "deliverable" in terms of revenue. That means, under current rules, a company is precluded from recognizing revenue - such as milestones and up-front payments - until the joint steering committee has concluded its work.

The problem is that most collaborations are open-ended, since it's difficult to project how long it might take a drug to get through development.

In Affymax's agreement with Takeda, no deadline was stated as an end to the joint steering committee's work, meaning that all revenue would have to be deferred indefinitely. Making the issue even stickier was the fact that the SEC considered product sales revenues to be included in that deferred revenue.

"That means we'd forever be a loss-making company, even if we had billions in product sales," Cleveland said. "So we went to Takeda and put an end date on the joint steering committee obligation."

Fortunately, for Affymax, the snag resulted only in a delay in its IPO filing. The firm succeeded in pricing 3.7 million shares at $25 apiece in late 2006, raising about $92.5 million in gross proceeds. (See BioWorld Today, Dec. 18, 2006.)

But, given the risky market conditions of the past few years, "it could have been a fatal delay," Cleveland said.

Another firm that encountered problems due to the rules regarding joint steering committees was Cambridge, Mass.-based Curis Inc. It ended up having to restate more than two years of financials after the SEC informed the firm in 2006 that it should not have recorded $7.5 million in license and maintenance fees from partner South San Francisco-based Genentech Inc., relating to the companies' June 2003 Hedgehog antagonist collaboration.

The company instead had to defer recognizing that revenue until after its contractual steering committee obligations ended.

The accounting errors resulted in a delayed third-quarter filing for Curis, as well as a delayed 2005 annual report.

The Glass Lewis study examined the filings of 25 biotech small to mid-sized biotech companies, which totaled 60 collaborations. Of those 60 deals, 38 provided for joint steering committees.

The best way to sidestep the problem is to "avoid an indefinite joint steering committee," Cleveland said, at least until the SEC and FASB can make some revisions in the current accounting rules.

The study authors also offered some advice for biotech firms to prevent errors in their financial statements. For one, companies could define an end date to the collaboration. That would eliminate some of the guesswork in terms of deferred milestones and other payments.

Other recommendations were to ensure that auditors review collaborative contracts prior to finalization and to clearly document the rationale and assumptions used to determine the accounting treatment.