In recent years, auditors have increased the amount of attention they give to nonfinancial measures because these measures can be very helpful in assessing the risk of revenue frauds. Most frauds of this nature involve accounting personnel falsifying financial information with the intent of materially misstating the financial statements. Nonfinancial measures are much more difficult for accounting personnel to manipulate, especially those produced independently; therefore, auditors have increasingly used these nonfinancial measures to help them detect fraud. In order to utilize the nonfinancial information of a company for auditing purposes, auditors must select Key Performance Indicators (KPIs) for the company or industry. By compiling KPIs for a company and its competitor(s), the audit team can compare the nonfinancial measures and the effects they might have on the financial statements. The purpose of this paper is to identify three KPIs for Pfizer, Inc. and compare these measures with those of Merck & Company, Inc. Both of these companies focus mainly on the development and sale of pharmaceutical drugs. The success of companies in this industry relies greatly on research and development of new drugs. New drugs stay in the research and development phase until they are granted FDA approval. For this reason, we have selected number of FDA approvals as a KPI for Pfizer and Merck. The pharmaceutical industry is fiercely competitive. Manufacturers of drugs are constantly coming out with new drugs that compete with existing drugs on the market. This makes it very difficult for company’s drugs to maintain their market share from year to year. For this reason, we have decided our second KPI will be the ratio of drugs that have increased in sales over the last year to drugs that have decreased in sales over the year. Finally, we selected number of employees as the last KPI to compare between Pfizer and Merck. Both of these organizations are global companies with many subsidiaries and employees, and each company has its own plan in place to continue to reduce its number of employees globally. We expect the number of employees to have a direct impact on total revenues but a larger effect on the reduction of wage expense.
FDA Approvals
In order for a pharmaceutical company to release a new drug to the market, it must first gain FDA approval. There is an extensive process that each drug must go through before it can gain this approval. There are six stages of research and development that must be completed before the drug can go to clinical trials. These stages are: 1. Discovery, 2. Product Characterization, 3. Formulation, Delivery, and Packaging development, 4. Pharmacokinetics and Drug Disposition, 5. Preclinical Toxicology Testing and IND Application, and 6. Bioanalytical Testing. The details of these stages are outside the scope of this paper; however, it should be noted that there are significant costs associated with each of these stages. After completing these six stages, a drug can then move to the clinical trial stages. There are three phases of clinical trials a drug must go through before it can gain FDA approval: 1. Human Pharmacology, 2. Therapeutic Exploration, and 3. Therapeutic Confirmatory. The details of these phases are also outside the scope of this paper; however, it should be noted that there are also significant costs associated with each phase as well. With a brief understanding of the extensive journey a drug makes on its way to FDA approval, it becomes clear how important those approvals are to the continuing success of a pharmaceutical company. In 2011, Pfizer was granted approval by the FDA for four new pharmaceutical medications: Prevnar 13 Adult, Xalkori, Oxecta and Sutent. Pfizer’s main competitor, Merck, gained approval on three drugs: Juvisync, Zoely, and Victrelis. In 2012, Pfizer gained FDA approval on six pharmaceutical medications: Eliquis, Xeljanz, Bosulif, Lyrica Capsules CV, Elelyso, and Inlyta; while Merck had three FDA approvals in 2012 covering the drugs: Zioptan, Janumet XR, and Cosopt PF. This list was compiled using information from each company’s 10-K for 2011 and 2012. We confirmed these approvals by cross-checking them with the FDA’s website. The lists given in each 10-K are accurate and complete.
(Pfiizer & Merck 2011, 2012) This information can be made useful to an auditor in two ways. First, the auditor should expect to see an increase in R&D expenses related to these drugs. This is because the clinical trials associated with gaining FDA approval can be very costly because they are human trials and come with significant risks. Next, the auditor can match the newly released drugs to the new revenue stream they create. This will increase the validity of the new revenue. If the auditor chooses to make further use of this KPI, it would be advisable to find the frequency of the ailments in the population that each new drug treats as well as a list of competing drugs. This would give the auditor a better idea of how much new income should be generated from the newly released drug.
Ratio of Drugs Increasing vs. Decreasing in Sales Revenue As we can see from the previous section, the pharmaceutical industry is driven by innovation. After FDA approval, newly released drugs begin to compete with existing drugs that treat the same ailment. This has an adverse effect on the sales of these pre-existing drugs. For this reason, drug manufacturers can expect to see erratic sales patterns for many of their products. Another contributing factor to this sales trend is the fact that drug patents expire allowing other manufacturers to make identical compounds that compete with the original. In 2012, Pfizer experienced this when their patent for Lipitor expired. The expiration of this patent caused Lipitor’s sales figures to fall drastically despite the constant growth it had enjoyed in previous years. In an effort to measure how innovative a company is in the pharmaceutical industry, we decided to find the ratio of drugs that increased in sales revenue compared to drugs that decreased in sales revenue and use the ratio as a KPI. Data concerning the changes in sales for individual drugs manufactured by Pfizer and Merck is summarized in the table below.
|Ratio of # of Products that Increased vs. Decreased in Sales* |
| |2012 |2011 |
|Company |Increase |Decrease |Ratio |Increase |Decrease |Ratio |
|Pfizer |21 |22 |1:1.05 |23 |20 |1.15:1 |
|Merck |18 |24 |3:4 |27 |18 |3:2 |
*Per 2011 and 2012 10-K filings for Pfizer and Merck
The main application of this KPI in an audit would be to validate any change in total revenue from year to year. For instance, in 2011, Pfizer had a ratio of 1.15:1; therefore, it is reasonable to expect that Pfizer’s total revenue for 2011 increased slightly compared to 2010. We can see on Pfizer’s income statement that there was a slight increase in total revenue between these two years. In 2012, the ratio for the KPI is 1:1.05 so it is reasonable to expect the total revenue for 2012 to be slightly less than that of 2011. Again, we can see from Pfizer’s income statement that there was a decrease in revenue in 2012 compared with 2011. While this KPI is useful, it is not without its limitations. As noted earlier, patent expirations can have a significant impact on revenue. Factors such as this can create outliers in the data if a company is too reliant on one particular drug. If significant outliers exist, a comparison of this KPI and total revenue may not be appropriate. The auditor should consider factors like patent expiration before relying heavily on this KPI.
Number of Employees
Both Pfizer and Merck are multinational corporations with locations around the world. In order to facilitate manufacturing and sales on this scale, these companies must employ tens of thousands of people. Both companies have a plan (detailed in their 10-K) to reduce the number of employees to save costs, and it is reasonable to think that a reduction in the number of employees would lead to a reduction in total revenue on the short term. Using the number of employees as a KPI is useful when accounting for changes in total revenue and SG&A expenses between years. While this KPI may seem overly simple, it is incredibly difficult for a company to manipulate. Pfizer saw its workforce reduced to 91,500 in 2012 from 103,700 in 2011. Similarly, Merck saw a reduction in its workforce from 86,000 in 2011 to 83,000 in 2012. The income statements from the two companies show that there was a reduction in total revenue as well as a reduction in SG&A expenses across the two years.
Conclusion
There are many ways to gain an understanding of how a company is performing as well as how it will perform in the future, but because KPI’s of non-financial measurements of a company are very difficult to manipulate by management, they prove to be a reliable source of information to auditors in locating and evaluating misstatements due to error or fraud. The three Key Performance Indicators that have been chosen are clear examples of situations where the data is very hard to manipulate and it proves to correlate with the company’s success (revenues, profits, etc.) to a reasonable degree that an auditor could use this information as a tool in detecting misstatements. As explained before, no KPI should be completely relied on, as they are always possibilities for outliers in data or legitimate circumstances unusual to an auditor’s experience. However, KPI’s should serve as a means of detecting discrepancies within accounts across years.
