What The Heck Are Financial Accruals? A Guide To Understanding The Mysterious Finance Brain

By Chris Chan, clinical finance consultant, Danforth Advisors

Over one score years ago, I joined a large, well-known biotechnology company whose name I won’t mention, but let’s say it rhymes with Senentech.  Hired to lead an R&D finance team that supported the prolific ClinOps organization, I was especially excited because not only would I have access to the fabulous coffee machines, but I was also going to learn the “secret sauce” of how to properly do clinical financial accruals. Although I had substantial experience managing accruals for smaller biotech companies and had given conference presentations and written articles on the subject, I knew that I was mostly winging it on the fly. Surely a hugely successful company with multiple blockbuster drug approvals and billions in revenues and profits possessed the secret to accruals heaven.

During my first week on the job, my finance and clinical colleagues separately approached me and said, “We hear that you know clinical financial accruals. It would be great if you could help us. It is our most painful challenge.” Rather than check for job opportunities at Amgen, I partnered with a team of motivated colleagues and together we implemented a better, more efficient accruals process. I did not get any secret sauce, but we created a nutritious new marinade.

The challenge of clinical financial accruals is a thing, and it continues to vex clinical and finance teams across the biopharma industry. The purpose of this article is to provide clinical professionals with perspectives and guidelines that will help them understand accruals concepts and nuances, interpret those strange requests coming from mysterious finance colleagues, and help reduce pain levels for clinical program managers (CPMs), clinical trial managers (CTMs), and clinical trial assistants (CTAs) all over the universe.

Disclaimer/FDA (Finance Doofus Arachnophobe) Warning Label

Many of the examples and situations discussed in this article are described simplistically and may not fully reflect the underlying complexities. The primary goal is to convey ideas for conceptual understanding. Additionally, the author of this article, as people who know him can affirm, is a goober whose main goal in life is to become a Jedi Knight. As such, it is important to discuss these concepts with your respective (significantly smarter) finance partners to maximize efficacy and specificity.

Basic Definition: What Are Financial Accruals?

Simply put, accruals are an accounting methodology that records expenses or revenues based on when they are incurred or earned, rather than when funds change hands. For clinical trials accruals, we focus on the expense side, specifically what are the values of all services and costs incurred over a specific time period for a clinical study. When your finance partners ask for the accrued expenses for this quarter, they are seeking to estimate the value of all CRO fees, investigator grants (patient visit costs), central and specialty labs, consulting expenses, IRB fees, clinical supply chain logistics costs, comparator drug costs, consulting fees, and so on. That is a whole lot of components, right? The sheer number and complexity of expenses associated with clinical trials are what makes clinical financial accruals so challenging. Unfortunately for your harried finance and accounting partners and you, they are required to generate accruals for every company expense for every period. In other words, they do not harass you because it is enjoyable, even though it sometimes is.

Cash-Basis Versus Accrual-Basis

Although not difficult to understand conceptually, people often get mixed up between cash-basis and accrual-basis thinking, especially in the context of clinical trial activities. One problem is that when it comes to personal everyday expenses, we often intuitively think on a cash basis. If you buy a $300 Bruce Springsteen concert ticket in January for a concert to be held in March, you most likely would think, “I have just incurred a $300 expense for a concert ticket,” as opposed to “I have just prepaid $300 for a concert that will be expensed in March.”

Some common clinical study-centric examples of cash vs. accruals confusion:

1. To obtain this month’s accruals for Vendor A, the CTM asks Vendor A for an estimate of this month’s invoice that will be sent later.
2. Knowing that the company will owe CRO milestone payments of $2 million in June and $3 million in October, the CTM budgets $2 million for June and $3 million for October.
3. The company has received an urgent invoice request from the CRO for an additional $30 million for investigator site payments that the CRO will make on the company’s behalf over the next several months. Because the payment has not been sent to the CRO yet, this $30 million is included in this month’s financial accruals.

For #1, it is important to clarify that reaching out to vendors for invoice estimates is a legitimate and common method to obtain accruals estimates. However, simply taking the invoice amount at face value for accruals is too simplistic. The invoice details must be reviewed to ensure the amount is appropriate. For instance, if major portions of the invoice pertain to work performed in previous periods or are advance payments for anticipated future work, the invoice amount may not be correct for this period’s accruals.

Accrued Liability Versus Accrued Expense

The term “accruals” can itself cause confusion. When people say accruals, they are sometimes referring to “accrued liability,” whereas other times they are referring to “accrued expenses.” While these are related, they are not the same thing.

Accrued liability refers to total expenses incurred to date (on a CRO contract or purchase order, for example) minus the total payments made to date. In other words, it is the amount theoretically still owed (i.e., that the company is still “liable” for). If Study X’s total cumulative expenses on March 31 are $50 million, and the total payments made through March 31 are $48 million, the accrued liability is $2 million.

Accrued expense typically refers to the estimated expense incurred for a given period. If the CRO reports that it incurred a total of $5 million during Q2, the total accrued expense for the quarter is $5 million. However, there is one important nuance to watch out for. Some companies calculate a period’s total expense incurred by factoring in invoices already posted (recorded in the finance systems) and adding an estimated un-invoiced or unpaid estimate. When these companies refer to “accrued expense,” they are only alluding to the incremental unpaid estimate. Consider the following two examples:

• Company A accrues clinical trial expenses by obtaining an all-inclusive expense estimate from their full-service CRO. For this quarter, the CRO report shows that $5 million was incurred across all study activities. Finance accrues $5 million in estimated study expenses for the quarter.
• Company B typically records (books) all invoices received from the CRO as expenses as they come in (after verifying that the invoices contain no advance payments for future activities, etc.). At the end of the quarter, $4 million in total invoices were received and booked. Company B contacts the CRO and asks for an estimate of any unbilled activities for the quarter. The CRO responds that approximately $1 million in unbilled activities were incurred during the quarter. Company B books $1 million as an incremental accrued expense.

If you ask Company A what the accrued expense for the quarter is, the answer is $5 million. If you ask Company B, the answer is $1 million. Both are correct; the difference is simply based on the companies’ respective processes and definitions. To understand your company’s nuances, you should discuss this with your finance gurus.

Getting back to the accrued liability versus accrued expense conundrum, you now know that they are different but related financial concepts. The next time your finance partners ask you for “accruals,” your response should be, “Do you mean accrued liability or accrued expense?” You will impress them and make them feel sheepish at the same time.

Accruals = An Estimate

It is conducive to keep in mind that accruals are estimates, and that perfect or even close-to-perfect accruals are generally not reasonable expectations. The goal is to get as close to reality as possible — like a finance-centric game of horseshoes. In this way, accruals are more like budgeting and forecasting than accounting. Additionally, there is typically a strong correlation between increased precision and required effort and cost. At some point, the effort and cost burden required to achieve incremental degrees of accruals precision becomes infeasible. The appropriate level of precision-to-effort balance is subjective and varies by company. This concept is discussed in greater detail in later sections.

Accrual Methodologies: How Do Other Companies Do It?

While accounting has GAAP (generally accepted accounting principles), accruals is more NAAP (or what I call “no accepted accruals principles”), a characteristic that you should not sleep on. Because there are no standard methodologies, different companies estimate accruals in significantly diverse ways. Some companies use organically generated models that allocate expenses based on cost drivers such as patient enrollment, study visits, and investigator site initiations. Others may enlist the help of specialized service providers that use sophisticated software to generate clinical trials accruals and forecasts. Some companies pay their CROs to provide detailed accruals estimates every period. Still others use the “ping a vendor” method of contacting vendors at the end of every financial reporting period for estimates. There are important pros and cons associated with every methodology. Each one has different cost and effort burdens and corresponds to different precision targets, misstatement risk levels, and so on. The main takeaway is that financial accruals are performed in many ways by different companies, and even within the same company. There are no right or wrong ways to generate accruals, only varying levels of acceptability depending on the company.

Which Accrual Methodology Should You Use?

This is — perhaps literally — the million-dollar question. The subjective answer is that it depends. But depends on what? It depends on a smorgasbord of variables, including but not limited to the number of clinical trials your company is conducting, the size and complexity of each trial, the amount of overall expense and revenue that your company generates, the risk tolerance of your CFO and CEO, the experience level and mood of your financial auditors, the amount of resources that your company is willing to dedicate to the effort, and many other factors.

For perspective, some of the biggest biotech companies use “straight-line” accrual for all their clinical trial contracts. Straight-line accrual is simply taking the total value of the contract, dividing it by the estimated number of contract months, and accruing the equal amounts every month. This methodology is both elegantly simple and frighteningly simplistic. Because clinical activities obviously do not occur in a straight line (it’s more like that of an EKG), the risk of misalignment between accrued expenses and corresponding activities is substantial. However, because larger companies typically have an extremely high volume of contracts, the misalignments tend to average out when all contract accruals are calculated in totality. As such, the risk of material financial misstatement is theoretically diminished. On the other hand, if a smaller company conducting only one or two clinical studies uses straight-line methodology, the risk of material misstatement is enormous and arguably unacceptable. Imagine a scenario in which study activities are significantly frontloaded or backloaded, and the study is stopped early. Your CFO may decide to retire early.

The opposite of straight-line methodology is what I call EMU, or the every micro unit, methodology. The most common example of this is paying the CRO to generate and send a detailed summary of every unit of activity incurred during the period. That would include every patient visit, site initiation and interim monitoring visit, lab specimen assessed, joint team meeting, data management and biostatistical analysis hour, and so on. Combined with the unit costs specified in the work order, these details can help calculate a very comprehensive accrual estimate. So, what is the problem? To demonstrate, consider this question: Have you ever experienced a CRO financial “oops” at the end of or during a clinical study? As in, “Oops, we just discovered many thousands/millions of dollars in study costs that we previously did not account for. These are legitimate study expenses, so please pay us.” Not only are these common occurrences that occasionally consist of shockingly large amounts, but they are, by definition, accrual misses in their entirety. Therefore, even an accruals methodology that incorporates the most atomically granular data and comprehensive process can be far from adequate. Experience shows that even large experienced CROs can find it challenging to provide good accrual summaries. The timing and completeness difficulties that sponsor companies face are also encountered by CROs. In other words, at times, EMU is for the birds.

Choosing an accruals methodology is like learning to ocean surf for the first time. The easiest and cheapest way would be to read some books and watch a few video clips on surfing, then jump right in with your new surfboard. There is a reasonable chance you will be fine (you are one of the fastest swimmers at the YMCA, after all), but the risk is high. Alternatively, you can hire the best world-class instructors to provide expert surfing lessons over many months. They will teach you how to deal with dangerous riptides, how to best position your thighs based on your kneecap shape, and personally accompany you into the wavy waters. While this entails considerably greater effort and cost, your risk of injury is significantly reduced. Does it eliminate all risk? No, because you still can bump into a passing shark that takes a bite of your butt. Or in the middle of the risk spectrum, you can hire Jeff Spicoli to provide surf lessons accompanied by miscellaneous herbal delights.

So, the answer to which accruals methodology you should use? Only you can determine it, based on your variables and risk tolerances.

Accruing For Investigator Grants/Patient Visit Costs

The good news is that accruing for investigator grants is quite straightforward (especially compared to accruing for service provider direct costs) because the required variables are straightforward. Every site contract includes specific detailed budgets for every patient visit, so combining these with patient visit data from the EDC or IRT for each respective site can provide excellent accrual results. For companies with fewer and smaller clinical studies, manual Excel-based models that track patient activity and budgets by respective investigator sites may be sufficient. For companies conducting multiple larger, more complex studies, they can either develop shortcut “aggregation” models (ones that combine all sites in a country or region using an average cost, for instance) or engage third-party service providers who specialize in managing site activities for accruals and making investigator payments.

The one site cost area that requires extra attention pertains to “invoiceable” expenses. These are items that are not part of the main patient visit budgets and are separately invoiced by investigator sites after they occur. These include items such as incremental medical procedures ordered by investigators (additional MRIs or blood draws, for example); site-specific costs, such as pharmacy fees, storage fees, advertising fees; and patient pass-through expenses, such as hotel and transportation expenses for patients. While these costs are usually detailed in the site contract budgets, sponsor companies and CROs often do not know if or when they occur until the site invoices the sponsor (hence the term “invoiceable”). Unfortunately, it is common for sites to invoice these items very late, even as big “catch-up” lump sums at the end of studies. The values associated with these invoiceable items are generally small relative to the primary patient visit costs, and companies often make a conscientious decision not to accrue for them due to low materiality and difficult obtainment. However, in some circumstances, they can collectively add up to material amounts, and not accounting for them becomes quite problematic.

Despite the opaque nature of these invoiceable items, there are ways to mitigate risk. One methodology is to accrue an estimated amount every period based on a reasonable assumption. For example, based on trends observed in past studies, clinical personnel may estimate that every third patient will be given an out-of-scope ECG or MRI, or incur a certain amount of out-of-scope pass-through expenses per period. These estimates can then be adjusted based on progressive study experience and observation. Additionally, some site invoiceable expenses can be accrued based on anticipated timing. For instance, annual fees such as pharmacy, advertising, and IRB renewal fees can be accrued every January regardless of when the sites decide to invoice. Finally, as a general practice, sponsor companies should actively communicate with their CROs and investigator sites to solicit updates on these activities and encourage prompt notification and invoicing.

Accruing For CRO (Service Provider) Direct Fees

The most sensible way to calculate accruals for any CRO or service provider direct fee (defined as those fees the CRO directly charges for work it performs on your behalf, as opposed to pass-through expenses) would be to obtain accrual estimates directly from the CRO… seemingly. While straightforward in theory, experience shows that accruals data provided by CROs are often less than stellar. It turns out that, like sponsor companies, CROs also find it challenging to corral expense estimates for the myriad activities under their management for a given point in time. Imagine overseeing a temporary staffing agency that employs hundreds of contractors who work anywhere from one hour to 60 hours per week on multiple client assignments, then imagine the difficulty of generating a precise accrual estimate if those temporary workers all turn in their time sheets inconsistently. In practice, CROs do a lot of estimating (including straight-line assumptions for certain categories!) when they calculate client accruals. This is why sponsors often marvel at the imprecision of accruals that CROs generate for their own work. Furthermore, some CRO personnel can be unclear on the accruals concept. For instance, sometimes when they provide an alleged accruals summary, they are actually providing a “cash flow” of activities with no analyses or understanding of prepayments or payments for past liabilities.

In addition, sponsors often contract with many service providers. In these circumstances, not only are sponsors dependent on multiple vendors’ accruals quality and knowledge but also on the timeliness of their report deliveries. May Buddha grant patience and mercy to the souls responsible for corralling these cattle on a regular basis.

What are alternatives to CRO-provided accruals? As mentioned previously, sponsors can generate in-house models that allocate CRO direct expenses based on rational cost drivers, such as patient enrollment, site initiations, and other variable units. To understand what units to use, examine the CRO’s work orders’ budget details and see which variable units constitute the biggest budget dollars. Although the types and quantity of variables to use in a model are flexible, keep in mind that increasing the number of variables in hopes of achieving higher precision results in more complex and time-consuming accruals. If you build a model that requires 10 variables, you will need to gather data on all 10 variables every time you calculate accruals. On the other hand, using a low quantity of variables increases imprecision risk. For instance, if the only cost driver variable is patient enrollment, misstatement risk increases because many direct costs are not necessarily correlated to patient activities. All that said, you should try to take advantage of the inherent flexibility and contemplate a model that is most suitable for your specific circumstances.

Other ways to generate CRO direct cost accruals include utilizing specialized third-party software, using simple straight-line methodology, or establishing a hybrid combination of different methodologies. For example, in one previous company, we established a process in which all service provider contracts over $1 million would be accrued through a combination of CRO-provided reports and in-house models, while all contracts under or at $1 million would be accrued on a straight-line basis. To get the company’s finance leaders and external auditors comfortable with the process, we generated pro forma accruals for prior years using the new proposed methodologies and compared them to those prior years’ actual accrued expenses. Because the comparisons showed minimal variance, the stakeholders comfortably supported adoption of the new more efficient process.

In Conclusion

Financially accruing for clinical trials continues to be a vexing endeavor, but it does not have to be as painful and labyrinthian as returning a ring to Mordor. For clinical professionals, the first step to mitigating the challenge is to understand the concepts and nuances involved in clinical accruals. The second step is to understand the current accrual methodologies used in your organization, assess the pros and cons associated with these methodologies, and determine the risk tolerance of your company’s leadership.

Finally, you can consolidate these concepts and knowledge to help determine the most feasible accruals methodologies for your company’s particular circumstances, whether that’s using sophisticated third-party tools to accrue for a high number of large complex studies to reduce risk, using simple home-generated Excel-based models to accrue for smaller less complex studies to reduce cost, or something in between. You can partner with your finance colleagues (many of whom are less sullen than they appear and want to be your friend) to discover and propose a Goldilocks accruals process that is not too risky and not too burdensome, but is just right for your organization. Hopefully, this article provides some guidance and motivation toward this quest.

About The Author:

Growing up, Chris Chan wanted to be Bruce Lee or a Jedi Knight. He wound up doing the next closest thing and became a biotech finance professional. Over a span of three decades (or approximately four times Al Capone’s total prison tenure), Chris has worked in biopharmaceutical companies of various shapes and sizes, primarily in the areas of corporate FP&A and clinical/R&D finance. He has given numerous conference presentations and written multiple articles on drug development budgeting, financial accruals, and outsourcing. He currently crunches numbers as a clinical finance consultant at Danforth Advisors.