Investing in China’s Pharmaceutical Industry; Capital Markets and Financial Reporting: What To Consider?

When investing in China’s pharmaceutical industry, there

may be capital markets and financial reporting considerations

which will impact either the ultimate exit strategy for financial

buyers or the assessment of a business’s operating results for

strategic buyers.

Investors should understand that, when investing initially

in a Chinese pharmaceutical company, the target will most

likely not be using a comprehensive set of accounting rules

such as International Financial Reporting Standards (IFRS) or

Accounting Principles Generally Accepted in the United States

(US GAAP). Such a comprehensive basis of accounting would

be required if the company were to ultimately list on a foreign

market or to converge with the investor’s basis of accounting

for consolidation purposes. Although public Chinese

companies were required to adopt Chinese Accounting

Standards (CAS), which converges significantly with IFRS,

with certain differences, from January 1st, 2007, adoption was

not required for private companies. As a result, most private

companies in China prepare their accounting records on a

cash basis for tax purposes, and more significantly, many

transactions are unrecorded and undisclosed.

There are several implications the investor needs to consider:

• Ongoing monitoring of the performance and prospects

of the investment: Whether the investor plans to continue

operating the Chinese pharmaceutical company as part

of their ongoing business or to exit the investment at

some time in the future, they must be able to monitor the

performance and prospects of their investment in order

to make informed operating and financing decisions.

The investor will therefore need access to financial

information prepared with guidelines they are familiar with

and which ensure that all significant transactions and

events are disclosed and accounted for consistently and

transparently. It is likely that the target company’s historical

books and records will not provide this level of information

and that the investor will require some form of conversion

or reconciliation to a comprehensive basis of accounting.

Such conversion or reconciliation would require qualified

people either at the target company or through external

advisors familiar with the target’s operations, the Chinese

regulatory, tax and legal environment, and the appropriate

basis of accounting, be it IFRS, US GAAP, CAS or some other standard. For example, recognizing revenue is a

significant challenge for pharmaceutical companies, due

to the level of risk involved in the underlying products and

processes, with complex arrangements made to mitigate

these risks. In addition, most of these arrangements tend

to be non-standard and verbal, making their accounting

even more challenging. Qualified personnel can assist the

investor in reviewing these contracts and assessing the

financial reporting implications of these arrangements to

help the investor better monitor the true performance of

the company and their investment.

• Accounting for the investment: A strategic buyer planning

to operate a Chinese pharmaceutical company as part

of their business will need to properly account for their

investment in that company. If the target’s financial

statements, books and records are based on a different

set of accounting standards, there will be significant

implications for ongoing internal management and external

financial reporting requirements. Further, the target

company may continue to have home country filing or

other regulatory requirements under their domestic GAAP,

for which the investor would then be responsible.

In order to properly account for the acquired subsidiary

or investment, the target company’s accounting policies

and records will need to be converted to and aligned with

the investor’s group policies and guidelines. Without first

converting the target’s financial information, the investor

will not be able to appropriately consolidate or equity

account for the acquired interests. Depending on the

target’s accounting guidelines, significant adjustments

might be needed to align the records to reflect consistent

accounting policies. The investor will also need to

implement internal reporting processes and procedures in

order to perform this conversion on a periodic basis and

in a timely manner so that ongoing reporting requirements

are met. Even if the target does appropriately apply

CAS, which reflects most of IFRS’s principles, there are

still areas where both guidelines differ and areas where

CAS is silent, which may be relevant to accounting for the

target. The investor will need to understand the target’s

accounting policies so that they are aware of the business

and accounting implications of the target’s business

arrangements under their own operating and financial

reporting framework. Further, accounting for business

combinations and consolidated financial statements is

increasing in complexity and evolving constantly. This

will affect the extent and nature of the valuations required

during acquisition due diligence and for purposes of any

ongoing financial reporting. This will impact the planning

around the acquisitions/investments and require increased

involvement of valuation and accounting specialists before,

during and after the transaction.

• Planning for the ultimate exit strategy: If the investor plans

to exit the investment in the future through, for example,

an initial public offering, then a significant amount of

advance preparation would be required to prepare the

company for listing. This includes preparing the company’s

financial statements using accounting guidelines permitted

by the relevant exchange and regulatory bodies. There

are several Chinese pharmaceutical companies currently

listed in the United States, such as Mindray Medical

International Ltd, Simcere Pharmaceutical Group, Wuxi

Pharmatech and American Oriental Bioengineering, which

include both foreign private issuers as well as domestic

registrants, and which all report under US GAAP. While

foreign private issuers have the option of reporting under

IFRS, most of them continue to report under US GAAP

for various reasons, including comparability of financial

information with peer companies, compliance with

financing arrangements, etc. Conversion from IFRS to US

GAAP (or vice-versa) is a complicated process, which must

be managed carefully by qualified personnel.

Credit: PriceWaterhouseCoopers; Investing in China’s Pharmaceutical
Industry – 2nd Edition; 2009