By Olga Usvyatsky
Marketwatch recently reported that several large pharmaceutical companies — including Pfizer (PFE), Eli Lilly (LLY), Bristol Myers Squibb (BMY), and Merck (MRK) — all recently changed how they calculate non-GAAP numbers.
Starting from first-quarter 2022, the companies no longer exclude expenses related to acquired in-process research and development (IPR&D) when calculating their non-GAAP metrics. The change in non-GAAP accounting was interesting because it was material, industry-wide and prompted by SEC comments.
We decided to follow Marketwatch’s lead and dive deeper into non-GAAP IPR&D adjustments. In addition to the Big Pharma firms identified by Marketwatch, at least three other large pharmaceutical companies also modified their non-GAAP presentations to remove IPR&D adjustments: Biogen ($BIIB), Regeneron Pharmaceutical ($REGN), and AbbVie ($ABBV).
Non-GAAP numbers can dramatically increase reported net income. According to Calcbench’s study of 123 companies, the average adjusted net income exceeded GAAP net income by about $460 million, or about 14 percent. R&D-related expenses appear to be one of the largest reconciling items for non-GAAP, totaling more than $6 billion and explaining 6.3 percent of the $85.9 billion difference between GAAP and non-GAAP net income numbers.
For the four companies identified by Marketwatch, the difference was even more significant. Adjusted net income was about $64 billion, more than 30 percent larger than GAAP net income of only $47.6 billion. Research and development adjustments totaled about $5 billion, explaining roughly 30 percent of the difference between GAAP and non-GAAP values.
In first-quarter 2022, non-GAAP numbers exceeded their GAAP equivalents by about $6 billion, or almost 40 percent. A quick look at the Q1 earnings releases confirmed that Q1 2022 R&D-related non-GAAP adjustments were material to three out of four companies:
Non-GAAP measurements are not defined in GAAP, and there is no uniform rule that prescribes how changes in the presentation should be reported. Although new non-GAAP methodology did not affect Merck’s (MRK) first-quarter EPS, the company recast the previously reported 2021 non-GAAP balances for comparability purposes.
So why did large pharma players choose to make a change that requires substantial explaining in earnings releases and recasting previously reported numbers? According to Eli Lilly’s April 14 8-K filing, the change was prompted by SEC Division of Corporation Finance comments:
“Beginning with the press release announcing its financial results for the quarter ended March 31, 2022 (the “Earnings Release”), Eli Lilly and Company (the “Company”) will not include adjustments for upfront charges and development milestones related to in-process research and development (“IPR&D”) projects acquired in a transaction other than a business combination in presentations of its non-GAAP financial measures. The Company is making these changes to its presentation of non-GAAP financial measures following guidance from the U.S. Securities and Exchange Commission (the “SEC”).”
The primary objection of the SEC appeared to be the recurring nature of the IPR&D expenses. Question 100.01 of Regulation G states that a non-GAAP metric could be misleading if it excludes “normal, recurring, cash operating expenses necessary to operate a registrant’s business.”
Below is an excerpt from SEC comments to Eli Lilly:
"For each type of acquired IPR&D transaction (i.e., asset acquisitions, license agreements, etc.), explain to us why you believe it is appropriate to include non-GAAP adjustments for these upfront payments given that these expenditures appear to be normal, recurring, cash operating expenses necessary to operate your business. Refer to Question 100.01 of the Non-GAAP Financial Measures Compliance and Disclosure Interpretations.”
While reading SEC comment letters and companies’ earnings releases, we noticed several interesting disclosures.
First, one of the justifications for including IPR&D adjustments was comparability among companies that report under GAAP and under IFRS. We do not know whether divergence between GAAP and IFRS is a common explanation for the usefulness of the non-GAAP metrics, but the disclosure looked interesting enough to mention. Under GAAP, IPR&D acquired through asset acquisition is expensed if it has no alternative future use. Based on the comment letter, 14 out of 17 projects for which Eli Lilly recorded IPR&D charges were asset acquisitions.
From the Eli Lilly’s response to SEC comments:
“Some of our peers report their financial results in accordance with International Financial Reporting Standards (IFRS). Under IFRS, an entity is permitted to capitalize the upfront charges related to acquired IPR&D in an asset acquisition. Our adjustment for the “buy-in” investment related to acquired IPR&D as part of non-GAAP financial measures allows more comparability of financial results among our peers, including companies reporting under IFRS.”
Additionally, while the pharmaceutical companies above discontinued IPR&D exclusions in their earnings releases, Regulation G does not apply to metrics used for compensation purposes. At least one of the companies (namely, Pfizer) noted that the company plans to continue excluding IPR&D in setting executive compensation targets:
“Beginning in the first quarter of 2022, we no longer exclude any expenses for acquired IPR&D from our non-GAAP Adjusted results but we continue to exclude certain of these expenses for our financial results for annual incentive compensation purposes.”
In other words, while Adjusted EPS in an 8-K filing and an Adjusted EPS in the proxy statement might have a similar labeling, the values of the two non-GAAP numbers could be different. To make it clear, companies are allowed to set compensation practices of their choice. Using different metrics to explain operational results and to set compensation goals is permissible. A practical takeaway for investors is to be mindful of the differences when analyzing (and comparing) two adjusted numbers.
Generally (and without any relationship to the pharma industry and IPR&D adjustments), metrics used for compensation purposes could be difficult to understand because unlike the metrics presented in 8-K filings, there is no requirement to reconcile them to the most comparable GAAP number. As stated in a recent Bloomberg article:
“One improvement many investors want: Requiring companies to detail precisely how they calculate the adjusted, non-GAAP metrics they use for compensation purposes.”
Going back to a recent change in non-GAAP IPR&D accounting, the IPR&D expenses appear to be material, and a distinction between regular and acquired R&D expenses is arguably useful in understanding results of operations of pharma companies. A recent memo from BDO suggested what companies can do to inform investors without violating Regulation G. Although the SEC objected to presentation of the non-GAAP IPR&D adjustments, companies can still present IPR&D as a stand-alone item or as a separate line on the face of the income statement.
To summarize, investors may need to read pharma sector earnings releases carefully in the next few quarters to make sure that non-GAAP numbers are comparable. Although many large pharma companies already changed their non-GAAP accounting to follow SEC guidance, others may still exclude IPR&D expenses from their adjusted numbers, or transition to the new methodology gradually over the next few quarters.
Olga Usvyatsky is a PhD student in accounting at Boston College and occasional contributor to the Calcbench Blog. She can be reached at firstname.lastname@example.org.
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