Franklin Drug Ltd. (FDL) is a global public company that researches, develops, markets, and sells prescription drugs. Revenues and net income are down this year, partly because one of the company’s competitors, Balogun Drug Inc. (BDI), has created and is selling generic versions of two of FDL's best selling drugs. The drugs, known as FD I and FD2, are still protected by patents that will not expire for another three years. Normally, when a drug is patented, other drug companies are not legally allowed to sell generic versions of the drug. This practice of patenting new drugs allows the companies that develop the drugs enough time to recover their large investment in research and development of the drugs.
In recent years, however, generic drug companies have become more aggressive in producing and selling generic copies of drugs before patents expire. FDL refers to this practice as "launching the generic products at risk" because, legally, the competitors are not allowed to sell them while the patent is still in force. Currently, FDL has about $2 million in development costs capitalized on the balance sheet. It has launched a lawsuit against BDI, ordering it to cease and desist selling the generic drugs. These types of lawsuits are usually long and very expensive. By the time the lawsuit is settled one way or the other, the patents will have expired. So far, legal costs incurred for the lawsuit are $300,000.
During the year, the patent on a third drug, FD3, expired and several competitor drug companies began actively marketing generic replacements. FDL still has $500,000 worth of FD3 development costs on the balance sheet. Although the increased competition may result in this asset being impaired, FDL feels that it can hold its market share based on FD3's past success in treating patients. So far, sales of FD3 have declined only 3%. On the other hand, the company's share price has declined significantly because of the uncertainty surrounding future sales. Company management is not happy with the drop in share price, because a significant portion of their remuneration is based on stock options.
The company gives volume rebates to some of its larger customers. Under the terms of the sales agreements, the more purchases that a customer makes in a certain time frame, the larger the rebate percentage is on these purchases.
The length of the time frame varies. Three large contracts are currently outstanding at year end with new customers. The time frames on these contracts extend beyond year end. FDL must estimate the volume rebates by considering what the total sales will be under these contracts. The company always bases this estin1ate on past experience.
It is now early January and the auditors are coming in for an audit planning meeting.
Instructions
In preparation for the meeting, you, as audit senior on the job, have done some preliminary research on the company.
Write a memo that outlines the potential financial reporting issues.