China to Audit Foreign and Domestic Drug Makers on Accounting Compliance

In an effort to drive down medical costs, the PRC Ministry of Finance has announced it will audit 77 randomly selected drug makers in China in order to examine the companies’ costs and profits and determine the reasonableness of their drug pricing mechanisms.

The Ministry of Finance (MOF) of the People’s Republic of China released the Notification on Carrying Out Accounting Information Quality Inspection in Pharmaceutical Industry in 2019 (Circular 18) on June 4, weeks after the Shanghai-listed Kangmei Pharmaceutical was found to have overstated its cash position by about 30 billion RMB (approximately $4.3 billion). According to Circular 18, the MOF will collaborate with the National Healthcare Security Administration in the special audit of 77 pharmaceutical companies in June and July 2019, as listed therein, and the local counterparts of these two authorities will report their findings to the MOF before August 30, 2019. MOF states in Circular 18 that it intends to examine the companies’ costs and profits and to determine the reasonableness of drug pricing mechanisms in a bid to drive down medical costs.

The list covers some of the largest domestic drug makers and also includes the Chinese subsidiaries of three international pharmaceutical conglomerates. MOF mentioned that the companies were randomly selected, and the audit may extend to their affiliates, distributors, and third-party service providers, and to medical institutions when necessary.

Key Areas of Audit

The audit will focus on the authenticity and compliance of a company’s reported sales expenses. Circular 18 sets forth four specific areas of scrutiny in detail:

1. Authenticity of reported sales expenses

• Whether reported sales expenses are genuine
• Whether large sums of cash have been exchanged in the form of consultancy commissions, conference fees, or accommodation and transportation costs
• Whether the frequency and number of fapiao (an official invoice issued by the Chinese Tax Bureau for any goods or services purchased within the country) received from any single supplier is unreasonable
• Whether fapiao issued for conference fees match with the corresponding conference itineraries
• Whether the company has assumed the office operations and equipment purchase costs of medical institutions
• Whether the company has paid kickbacks to healthcare providers (HCPs) in the forms of consultancy commissions, R&D expenses, or publicity fees

2. Authenticity of cost

• Whether the costs of raw materials have been artificially inflated
• Whether the allocation of production costs among different drugs is reasonable

3. Authenticity of income

• Whether income has been inflated by increasing sale prices on output VAT fapiao
• Whether such inflated income has been rebated to medical institutions in the form of service fees
• Whether the inflated income has been used for the development, systematic maintenance, or academic promotion of a hospital

4. Miscellaneous

• Whether the company has set up off-the-book accounts
• Whether the company has paid kickbacks to medical institutions or HCPs based on the quantities of drugs purchased
• Whether internal controls on inventory management, contract execution, sales delivery, and payment collection are effective

Observations

This initiative is the first time that the MOF has launched a nationwide audit specifically targeting pharmaceutical companies. The audit may allow the MOF to detect irregularities or other issues that other industry regulators may miss. Circular 18 provides that the MOF may report its findings to other regulators if the issues identified during the audit are within their scope of authority, and it is possible that the MOF may expand this audit to other drug makers or players in the Chinese medical industry if the spotted issues are seen as prevalent in the industry. As such, we recommend that businesses operating in the Chinese medical industry closely monitor this special audit and any consequent sanctions, and take the following remedial actions:

• Conduct a thorough assessment of product costs, and verify whether the costs are reasonable and market determined
• Review sales and marketing practices, and examine the reasonableness of product sales prices, profit margins, and marketing expenses
• Review sales and marketing policies, and tighten up bookkeeping and documentation of sales and marketing expenses
• Review agreements with medical institutions, HCPs, and third-party service providers, and examine the acceptability and necessity of collaborative relationships with them
• Conduct compliance audits of engaged third parties, and terminate engagements with those found to have any irregularities
• Emphasize compliance, rectify any weaknesses in internal controls, and provide periodic trainings to employees

Contact

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact the author, Todd Liao.