Roundtable: Accounting for Medical Technology 4298

FINANCE

In these times of accounting scandals and Sarbanes-Oxley requirements, medical device executives can't afford to neglect their numbers. Although tightly controlled and transparent accounting practices are mandates among public companies, private entities—particularly those that may want to position themselves for an eventual sale or initial public offering—can also reap significant benefits by adhering to stringent guidelines in their financial management.

To find out more about accounting challenges facing medical device manufacturers, MX recently spoke with five experts in the field (see sidebar).

MX: The field of accounting is a complex one, and many people who don't work in the industry may not quite understand how the industry is divided. Perhaps you can start by providing some background on how the accounting industry is organized.

Tracy T. Lefteroff: The big dividing line in accounting is between the audit practice and the tax practice. People working on the audit side are focused on producing financial statements related to generally accepted accounting principles (GAAP) and the associated Securities and Exchange Commission (SEC) offerings and filings that are a part of that process.

The tax practice is totally different. People working on that side of the industry are focused on income tax filings, income tax consulting, and compliance issues related to U.S. and foreign taxation, as well as state and local taxation.

In addition to audit practices and tax practices, most accounting firms have another division called the advisory practice. These practices, which used to be referred to as management consulting, can encompass a variety of different services that aren't audit or tax related. Such services may include due diligence and transaction services, as well as human resource applications or merger integrations—essentially anything outside the realm of pure tax or pure audit.

Jim, you work within a company that makes use of such services. Are the dividing lines Tracy outlined similar to the way in which you think about these functions?

James Press: Yes, I think along those same lines. In addition, companies have to take into consideration the need to maintain independence in these functions. The external public firms we hire need to be independent. They can't be performing management functions, and if a firm handles a company's tax provision, it should not be handling the company's audit, and vice versa.

When medtech manufacturers outsource accounting services, it's not a one-stop shopping trip like it was 10 years ago. Instead, if we hire PricewaterhouseCoopers (PwC; New York City), it may be for tax work, audit work, or consulting work—but not for a combination of those services. But regardless, we do need all three offerings.

Scott Taylor: If a company hires our firm to be its auditor, the only other function we might perform if the company requests it is to prepare the company's income tax return.If a company hires our firm to do its consulting, we can handle the Financial Accounting Standards (FAS) 109 work, which is the income tax provision and deferred income tax calculation.

We can also do stock valuation work. Some of the professionals in our valuation department can help assign value to equity instruments or help evaluate a company's stock compensation and accounting under FAS 123R.

A Turning Point

It has now been five years since passage of the Sarbanes-Oxley Act, which was intended to reduce the possibility of corporate misbehavior. How would you characterize the general attitude of the American public toward corporations today?

Lefteroff: I'm not sure the general public fully understands Sarbanes-Oxley. Obviously the accounting firms and the companies that are subject to Sarbanes-Oxley understand the extent of the law, but most members of the general public may not fully appreciate how comprehensive and complex the process of complying with Sarbanes-Oxley really is.

Jim, from an individual company's standpoint, has Sarbanes-Oxley proven to be a useful tool or just a compliance pain?

Press: When Sarbanes-Oxley initially emerged, the rules were very unclear. Public auditing firms and industry members had to struggle to interpret the rules in terms of what needed to be tested, how certain processes should be documented, and what phrases in the legislation, such as material weakness, really mean.

Since the legislation went into effect, all those details have been hammered out. But in doing so, all kinds of issues can arise. Compliance with all of these new requirements, for instance, can be a very expensive proposition for a growing company that hasn't broken even yet. So it becomes important to figure out how companies can comply in an economical manner, so that compliance doesn't become a financial burden.

There has been pressure recently to make the requirements of Sarbanes-Oxley a bit more manageable. How do you see this situation playing out?

Taylor: I don't think the law will be changed, but I expect regulators will put out more guidance for people working in this area. Such guidance will likely direct them to take more of a top-down, risk-based approach to internal control auditing.The spirit of Sarbanes-Oxley—which was to improve internal controls—has had a favorable outcome for all companies. The act promotes good internal controls so it should position companies for growth in the future. The way it was implemented caused companies to react negatively because the cost of compliance was so high. Now it's starting to shift to a more top-down approach. Hopefully that shift will reduce the cost of Sarbanes-Oxley Section 404 compliance.

Generally speaking, medical device companies seem to be relatively good corporate citizens. The industry has not been hit by the types of scandals that have emerged in other areas. What is your sense of the effects of Sarbanes-Oxley requirements on medical device companies?

Lefteroff: The medical device space is pretty straightforward, quite frankly. There is some industry crossover, however, such as with companies whose devices use software. That adds a little complexity. Device companies can also run into complexities associated with Emerging Issues Task Force (EITF) Issue 00-21, which deals with accounting for revenue arrangements with multiple deliverables.

The key issues to understand in regard to medical device companies are the ways in which they sell their products, the approval processes that medical device companies go through, and how such processes affect the way they operate.

Taylor: I agree that accounting tends to be pretty straightforward for medical device companies. In the past, there hasn't been as much scrutiny on the medtech industry as there has been on the software industry and others in which revenue recognition is more subjective.

However, this may change in the future. There may be more scrutiny by the Securities and Exchange Commission of medical device and biotech companies because of the software that is being incorporated into their products, as well as the multiple element revenue recognition arrangements that characterize the industries. These are areas in which errors and problems can occur.

Press: Regulation is nothing new to the medical device industry. Companies in this industry are regulated by FDA and have to comply with good manufacturing practices (GMPs) and standards of the International Organization for Standardization (ISO; Geneva). Therefore, the medical industry has a mind-set that is tuned in to documentation, controls, audits, and reviews. It's the nature of the industry.

Revenue Recognition

How and when companies recognize revenue seems to be a focus of many recent audits. This area can be tricky, since medical device companies may sell products on consignment, or may sell products that require installation. What are the most-frequent causes of revenue recognition issues for medtech companies?

Taylor: The areas in which problems most frequently arise for medical device companies are situations in which multiple elements are being delivered to a client. For example, a medical device might include both hardware and software components. That makes it difficult to determine the proper time to recognize revenue related to the sale of that product.

The complexity of these issues depends on the company. But generally, ensuring that revenues are recorded in the right period is one of the most challenging accounting issues encountered in an audit.

Carl Saba: Revenue recognition also has a significant impact on the valuation side—and ultimately on financial reporting—because valuations feed numbers back into the financial statements.

Jim, there seem to be multiple situations that present revenue recognition complexities for medical device manufacturers. What has been your experience with situations like these that can raise revenue recognition concerns?

Press: Devices containing software offer some of the greatest challenges in revenue recognition. In fact, I recently received an announcement from a public accounting firm stating that it plans to bring people up to date on the process of software revenue recognition for nonsoftware companies.

One thing the firm specifically stated was that it was going to issue more interpretations on this process because many companies with products and services that include software must consider the procedures under the American Institute of Certified Public Accountants' Statement of Position (SOP) 97-2, Software Revenue Recognition.

Tracy, what are some of the other areas in which medical device manufacturers can run afoul of revenue recognition requirements?

Lefteroff: We could spend a lot of time on the topic of revenue recognition. In fact, EITF 00-21 recently raised the level of complexity to a whole new level. Depending on how a company draws up its contracts, a manufacturer could fall into any number of revenue recognition scenarios that previously didn't exist under the old accounting rules.

Financing Complexities

Emerging medical device companies often go through several rounds of financing on their way to maturity as a private or public company—or to acquisition by a larger entity. What accounting-related difficulties can companies encounter because of such funding transactions?

Saba: I see many companies going through successive rounds of both debt and equity financing. From a valuation perspective, there are a few issues inherent to that process that can affect a company's financials. First, rounds of financing lead to a complicated capital structure for the company in which several different layers may exist. For example, a company may have common stock and several layers of preferred stock with different rights and liquidation preferences, as well as options, warrants, and occasionally convertible debt.

When companies are regularly issuing options, they have to comply with FAS 123R. This standard requires companies to set a price on stock options as they are issued and, subsequently, to expense them.

When my firm is asked to value a company's common stock, the process requires valuation of the equity of the company as well as allocation of that equity value through the company's complicated capital structure. This process can be challenging because much of the valuation hinges on when a liquidity event occurs for the various classes of stock for the various equity and debt holdings.

Jim, your company recently went through a sale that required special accounting considerations.

Press: I've had a taste of just about every aspect of the financing smorgasbord since I've been with Applied Imaging. In preparing for the sale, it was important for us to have a good relationship with the bank with which we had a line of credit.

Another financial element leading to the sale was a private placement. We wanted to shore up our capital position and revitalize the business with the intent of selling the company, but we had to weigh that against the impact of dilution on current stockholders. The company had to walk a fine line in making the decision on how much to accept in the private placement.

The third event I was involved in was the sale of the company, which included two due diligence reviews. Due to the restatement, one buyer appeared leery and wanted reassurance that our company's revenue recognition practices were cleaned up. And of course, our revenue recognition practices were. Therefore, we passed their evaluations with flying colors from the financial evaluation side. We had multiple bidders to drive up the offering price to purchase our company. That was interesting to watch.

Tracy, what are your thoughts on some of the issues that companies can run into when they are going through funding transactions?

Lefteroff: Usually, private financings are led by venture capital or angel investors. So although issues such as fully diluted outstanding shares are important considerations, the due diligence and the decision-making process tend to be more focused on the technology itself.

Financings in the public environment are more concerned with compliance with the SEC process and the related disclosures, comfort letters, underwriters, and other elements that must be in place. Such elements can present challenges for companies that aren't prepared to be in the public sector or to meet the timetables associated with reporting under the Securities Exchange Act of 1934 after they're public.

A lot of the mergers and acquisitions in the medical device industry involve emerging companies coming out of private ownership into the public arena. When these companies reach this point, are most ready to hit the ground running? Or does it typically take some time for these companies to adjust their financial reporting for the public arena?

Taylor: Private companies may not be ready to handle the requirements that come with being a public company. As public companies, they must complete quarterly filings and have CPAs review their Form 10-Qs, and they must undergo annual audits. Private companies are familiar with annual audits, but the requirements and disclosures of the Forms 10-K and 10-Q are usually a lot more comprehensive.

In addition, as public companies, they must also comply with the requirements of Section 404 of the Sarbanes-Oxley Act and regularly have their internal controls audited.

Where Credit Is Due

Medical device companies often qualify for tax credits related to their investments in research and experimentation. Can you define this credit and how companies qualify?

Lefteroff: The way in which medical device manufacturers qualify for such tax credits is by incurring expenditures that—as defined in the regulations—are for true research and development (R&D).

Companies can run into problems based on what they claim to be truly pioneering R&D. When a company gets audited, the Internal Revenue Service closely evaluates what costs were included in its filing for the tax credit, why those costs were included, and whether the company can substantiate that the costs were truly related to R&D as opposed to selling, general, and administrative expenses, or other areas.

T. J. Sponsel II: The IRS doesn't want to see companies taking the credit on what the agency considers to be routine engineering as a part of the normal development of a product. Rather, the IRS wants to see companies pushing the envelope when it comes to developing new products in-house or helping their clients develop new products or processes.

Does the IRS actually look at companies' laboratory notebooks to determine the extent and focus of their R&D, or is the agency's review based more on the attestation of the companies?

Sponsel: It depends on the level of the audit. The R&D credit is a fairly distinctive credit in the sense that the IRS maintains a dedicated team of about 17 or 18 engineers in Ogden, UT, who work exclusively on this credit. The first thing that team does is ensure a company has put together its documentation in a manner that can be presented to the IRS in the form of a report.

Does the U.S. Patent and Trademark Office (PTO) have access to the material that is provided to the IRS with regard to the basic R&D that a company is doing?

Sponsel: A lot of times, it's the inverse situation. The documents that a company presents to the patent office often provide excellent evidence that the company meets the IRS criteria for the R&D credits.

Is the R&D credit available only at the federal level, or are such credits offered on a state and local basis as well?

Sponsel: The R&D tax credit is a federal credit. However, an increasing number of states are offering their own versions. Currently, about 35–45% of states offer some form of R&D credit.

Press: In regard to R&D credits, there could be some disappointment among companies with net operating losses (NOLs). For many companies, it may be a long time before they receive any benefit of an R&D credit, as there are expirations and caps.

Sponsel: In the case of companies with NOLs, those companies are often acquired by larger companies somewhere down the line. The smaller company's R&D credits—regardless of the company's NOL—do carry forward. And they can be carried over to the acquiring company. And in some states, the credits can actually be sold to outside companies.

Copyright ©2007 MX