Standford Pharmaceuticals Inc. (SP) researches, develops, and produces over-the-counter drugs. During the year, it acquired 100% of the net assets of Jenstar Drugs Limited (JDL) for $200 million. The fair value of the identifiable assets at the time of the purchase was $150 million (which included $120 million for patents). The plan is to sell the patents to a third party at the end of seven years, even though the remaining legal life of the patents at that time will be five years. SP already has a commitment from a specific third party that has agreed to pay $50 million for the patents (in seven years).

In January, in an unrelated deal, the company acquired a trademark that has a remaining legal life of three years. The trademark is renewable every 10 years at little cost. SP is unsure if it will renew the trademark or not.

Because of the two acquisitions, SP was short of cash and entered into an arrangement with Dev Drugs Corporation (DDC) whereby DDC paid $30 million to SP upfront when the contract was signed. Under the terms, the money is to be used to develop drugs and new distribution channels, and SP has already spent a considerable portion of this money. SP agreed that it will pay DDC 2% of the revenues from the subsequent sale of the drugs (which are now close to the point of commercial production).

Because of the cash shortage, the company entered into negotiations with its bank to increase its line of credit. The bank is concerned about the company's liquidity. SP's top management has graciously agreed to take stock options instead of any bonuses or pay raises for the next two years in order to reduce cash flow constraints.

It is now year-end and SP is preparing its financial statements. It is concerned because one of its major competitors has just come out with several new drugs that will compete directly with the drugs that JDL sells. Management is worried that this may erode the market for JDL's products. In fact, SP is considering selling JDL and has contacted a consultant to find a buyer.

Joe Song, the controller, is preparing for a planning meeting with SP's auditors. The auditors are analyzing SP's draft financial statements to identify critical and high-risk areas. The draft financial statements show the company is barely breaking even. The CFO has commented that the company's share price is likely to "take a tumble," since the company has always been profit- able in past years and its competitors seem to be doing well. Song is also considering the latest news from SP's lawyers-apparently, the company is being sued in a class-action lawsuit (by a significant number of people) for an illness that was allegedly caused by one of SP's main pharmaceutical products. The claim is for an amount equal to revenues from last year. At this point, the lawyers are concerned that the case against SP may be successful and they are trying to estimate the potential loss to the company.

Instructions

Adopt the role of the auditor and prepare an analysis of all financial reporting issues that SP is facing.