A biotech company closes a €180M out-licensing deal (an arrangement in which the company grants a partner the right to develop and commercialise one of its assets in exchange for upfront payments, milestones, and royalties). Revenue is recognised at signing. Development costs are capitalised under IAS 38 (recorded as an asset on the balance sheet rather than expensed immediately, on the basis that future revenues will justify the investment) on assumptions the BD team built, the CFO endorsed at board level, and the external auditors signed off on.
Eighteen months later, the partner delays. The milestone slips. A €60M impairment charge follows (a write-down of the asset’s value on the balance sheet, taken through the income statement, when projected future returns can no longer support what was originally capitalised). The shareholders ask one question: how did nobody catch this before it hit the income statement?
The honest answer is uncomfortable: the error was not invisible. It was present in the accounting from day one. It simply passed through every filter in the financial reporting chain without triggering a stop.
The structural problem
Why the financial reporting chain fails on licensing deals
Licensing transactions in pharma and biotech are among the most technically complex arrangements in financial reporting. They combine IFRS 15 revenue recognition, IAS 38 asset capitalisation, IAS 37 contingent liability assessment (an evaluation of obligations that may or may not crystallise depending on future events: earn-outs, clawbacks, and minimum guarantee provisions are common examples), and sometimes IFRS 3 or IFRS 10 consolidation questions (whether the arrangement gives one party effective control over the other, requiring the controlled entity to be included in the controlling party’s group financial statements), all within a single contract, often signed under commercial pressure with incomplete accounting analysis.
The chain that is supposed to catch errors has three links: the CFO and finance function, the audit committee, and the external auditors. In practice, all three can fail simultaneously, in the same direction, for the same reasons, on the same kinds of deals. Each link relies on the judgements made by the link before it. When the original accounting treatment is wrong but plausible, the entire chain can ratify an error without any individual actor behaving improperly.
Failure point one
Where the CFO function fails first
The first failure point is almost always upstream of the audit. By the time external auditors see a licensing deal, the accounting treatment is already embedded in the financial model, the board paper, and often the press release.
Three failures appear most consistently. First, the CFO is brought in after the term sheet is signed. Commercial terms that determine accounting outcomes, whether a licence is a right to access or right to use under IFRS 15 (the distinction determines whether revenue is recognised at a point in time or spread over the licence period), whether development obligations are separable performance obligations (distinct promises that must be accounted for independently), whether contingent milestones meet the variable consideration constraint (the IFRS 15 requirement that milestone payments are only included in recognised revenue to the extent it is highly probable that a significant reversal will not occur), are negotiated by BD and Legal without Finance in the room.
Second, probability assessments are not independently verified. IAS 38 requires that development costs meet all six recognition criteria before capitalisation, including technical feasibility, intention to complete, ability to use or sell, probability of generating future economic benefits, availability of adequate resources, and reliable measurement of expenditure. All six must be satisfied simultaneously. In practice, the assessments are frequently lifted from BD models built to support deal approval, not conservative accounting.
Third, scenario analysis is performed around a base case, not a downside case. The question of what the balance sheet looks like if the timeline slips by 12 months is too often left unasked because the answer is uncomfortable.
Failure point two
Where the audit committee fails to catch it
The audit committee is the board’s primary mechanism for independent oversight of financial reporting. On licensing deals, it tends to fail in a specific and predictable pattern. Audit committee members ask sophisticated questions about the deal itself. What rarely happens is a structured interrogation of the accounting judgements: which recognition criteria are being relied upon, what the key assumptions are, what the sensitivity of the capitalised asset value is to those assumptions.
The committee typically sees the deal through a board paper written by management, which presents the accounting treatment as determined and auditor-endorsed. The committee is not shown the range of defensible positions or the scenarios under which the recognised revenue or capitalised asset would require reversal.
The committee members are often genuinely surprised when the impairment charge arrives, not because they were negligent, but because they were never given the information needed to anticipate it.
Failure point three
Where the external auditors lose the thread
External auditors are the last line of defence. On complex licensing deals, that reliance is frequently misplaced, not because auditors are incompetent, but because the audit process has structural limitations that management understands better than shareholders do.
The first limitation is the sufficiency of audit evidence. When management presents a capitalisation model with an 82 per cent probability of technical success, the auditor is evaluating whether the assumption is supportable, a lower bar than whether it is correct. The second is commercial pressure: pushing hard on an assumption that management is strongly committed to carries professional and commercial cost. The third is timing: by the time the annual audit takes place, reversing the treatment creates a prior period error (a formal restatement of previously published financial statements with a public disclosure explaining what was wrong), a disclosure that management and the board are strongly motivated to avoid.
The intervention points
The three questions that should have been asked
- The CFO, before the term sheet is signed: “What is our accounting position if the partner exercises its termination right at Month 18, and what does the balance sheet look like under that scenario?”
- The audit committee, when reviewing the financial statements: “What is the range of defensible accounting treatments for this arrangement, and where does management’s chosen position sit within that range?”
- The external auditors, before accepting management’s probability assessment: “What independent evidence supports this figure, and what is our responsibility if the asset requires impairment within 24 months of capitalisation?”
The bottom line
What this means for the financial statements
When all three checks fail, the financial statements carry a material error that is formally compliant. The revenue recognised may be defensible under IFRS 15. The capitalised asset may meet the technical requirements of IAS 38. The contingent liabilities (potential obligations whose existence depends on whether a future event occurs, disclosed in the notes rather than on the balance sheet) may be disclosed in footnotes precise enough to satisfy auditors and vague enough to be invisible to most readers.
Almost always, the fix is not more sophisticated standards. It is earlier CFO involvement, more conservative assumption-setting, and an audit committee willing to ask whether the accounting is optimistic rather than merely whether it is compliant.
Back to Insights →