In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, later codified as Accounting Standards Codification (ASC) Topic 606. This major overhaul of revenue recognition (effective for fiscal years starting after December 15, 2017 for public companies) affects almost every industry, and life sciences is no exception. The complex arrangements between life science companies, customers, and collaborating parties pose some of the most difficult issues under ASC 606. Due to the frequency of performance-based contracts, licensing agreements, and the numerous services that may be involved in a single contract, application of the five-step revenue-recognition model can be particularly complicated.
In this article, we provide a brief explanation of the key issues the life sciences industry faces when applying ASC 606, drawing on the following helpful guides published by the AICPA and the major accounting firms.
- AICPA: Revenue Recognition: Audit and Accounting Guide
- Deloitte: Life Sciences Accounting and Financial Reporting – Interpretive Guidance on Revenue Recognition Under ASC 606
- EY: Technical Line: How the Revenue Standard Affects Life Sciences Entities
- KPMG: Financial Reporting View: Revenue for the life sciences industry
- PwC: In Depth: New Revenue Guidance Implementation in the Pharmaceutical and Life Sciences Industry
We also point you to other RevenueHub articles that contain more detailed explanations of ASC 606 topics throughout the article.
There are eight issues that companies in the life sciences industry commonly face:
1. Identifying the performance obligations in the contract
Within the life sciences industry, contracts commonly include multiple performance obligations. In contracts with multiple commitments, it is important for companies to determine whether certain performance obligations are distinct or should be bundled in order to properly allocate the transaction price and recognize revenue.
Under ASC 606, a good or service is distinct if it is both (1) capable of being distinct, and (2) distinct within the context of the contract. The first criterion is satisfied if the customer can benefit from the good or service on its own or with readily available resources. The second criterion is satisfied if the benefit the customer can derive from the good or service is not dependent on or interrelated with the other goods and services within the contract. If a promised good or service is not distinct within the contract, the entity should combine it with other goods or services in the contract until a distinct performance obligation is formed.
For example, companies that sell medical devices often enter into contracts with multiple performance obligations. In addition to the device itself, other such performance obligations may include a warranty, on-going maintenance, and initial training on the device as part of a single contract. In this example, it may be reasonable to determine that the device on its own provides value to the customer independent of the other goods or services and is, therefore, distinct.
2. Determining the transaction price
Under ASC 606, the transaction price should be the amount of consideration a company expects to receive in exchange for its goods or services. When a company enters into an agreement in which all or a portion of the consideration varies based on the quality of performance or the occurrence of an event, determining the transaction price can be difficult. This type of arrangement is common in the life sciences industry. A licensing arrangement that includes milestones is an example of this type of contract.
If variable consideration exists, companies are required to estimate the amount they expect to receive and include that amount of variable consideration in the transaction price. The FASB provides two methods that companies should use when estimating variable consideration: the most likely amount and the expected value approach. When deciding which method is most appropriate, companies should consider the structure of the agreement in the contract. If the variable consideration is based on milestones, thresholds, or event occurrence, the most likely amount is generally more appropriate because the nature of these conditions is binary; the event will either occur or it will not. In these situations, the most likely amount is either the entire amount of variable consideration or no variable consideration.
On the other hand, the expected value approach assigns probabilities to each condition and estimates the weighted average amount of variable consideration that will be received based on these probabilities. This may lead to estimating amounts of variable consideration that are not possible under the terms of the contract. Therefore, the expected value approach is most appropriate when the outcome includes many possible amounts. Pay-for-performance arrangements often fall into this category. For example, a drug manufacturer may be required to reimburse a portion, or all, of the consideration received from the sale of a drug depending on the drug’s success.
Regardless of the method used to estimate variable consideration, companies should only recognize variable consideration to the extent they are confident a significant reversal of revenue will not occur.
3. Significant financing component
Life science companies commonly have contracts that include extended payment terms. Under ASC 606, certain extended payment terms qualify as significant financing components. ASC 606-10-32-16 provides factors that companies should consider when determining if a significant financing component exists:
- The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services.
- The combined effect of both of the following:
- The expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services.
- The prevailing interest rates in the relevant market.
While these factors help to establish whether a significant financing component exists, their existence does not always mean that a contract contains a significant financing component, and the company must consider all the facts and circumstances of the contract. The FASB outlined three scenarios in which a significant financing component does not exist: (1) the timing of the transaction is at the discretion of the customer, (2) a substantial portion of the consideration is variable and not under the control of the entity or customer, and (3) the difference between the promised consideration and the cash selling price of the goods or services is due to something other than financing.
If a significant financing component exists, companies are required to recognize interest income or expense apart from revenue from the contract. However, the standard does provide a practical expedient that allows companies to not impute interest income and expense if the difference between payment and performance is less than one year.
Relevant RevenueHub Articles: Significant Financing Component
4. Recognizing revenue over time or at a point in time
ASC 606 requires that companies recognize revenue at either a point in time (when the good or service is delivered) or over time (as the good or service is being completed). Life science companies may be required to recognize revenue over time when the good or service they are providing is customized to the point that it cannot be used by any other customer and takes a significant amount of time to develop. For example, if a company is being paid $1,000,000 to develop a drug as specified by a pharmaceutical company, and the project will take five years, then the company might recognize revenue over time of $200,000 each year, assuming the passage of time is an accurate measure of progress. On the other hand, if the drug could be used by any pharmaceutical company for its own development, then the company would recognize all $1,000,000 at the time it sells the drug.
Relevant RevenueHub Articles: Determining the Transfer of Control
5. Licenses and revenue recognition effects
Licensing intellectual property (IP) is an integral part of the life sciences industry. Compared to ASC 605, ASC 606 may create significant differences in revenue recognition when accounting for licenses. To properly recognize revenue, companies must determine whether the license provides the customer with a right to use the IP, or simply the right to access the IP. If a customer has the right to the IP as it exists at the start of the contract, then the company has provided the right to use. Right to use licenses should be recognized when the license is transferred, while right to access licenses should be recognized over the life of the contract.
To assist companies in determining whether they have granted a customer the right to use or the right to access a company’s intellectual property, ASC 606 distinguishes between functional IP and symbolic IP. Functional IP has significant standalone functionality and derives a substantial amount of its value from its standalone functionality. All IP that is not classified as functional is symbolic IP. According to ASC 606-10-55-62,
A license to functional intellectual property grants a right to use the entity’s intellectual property as it exists at the point in time at which the license is granted unless both of the following criteria are met:
- The functionality of the intellectual property to which the customer has rights is expected to substantively change during the license period as a result of activities of the entity that do not transfer a promised good or service to the customer…
- The customer is contractually or practically required to use the updated intellectual property resulting from criterion (a).
If both of those criteria are met, then the license grants a right to access the entity’s intellectual property.
Therefore, if a company is licensing functional IP, aside from the exception mentioned above, the license should be accounted for as a right-to-use license. In contrast, symbolic IP and functional IP that meet the exception above are accounted for as right-to-access licenses.
The life sciences industry frequently uses both functional and symbolic IP. For example, drug compounds or formulas, software, or completed media content are generally considered functional IP. Therefore, if a company were to license a drug formula it created, it would recognize the revenue from that contract when it transferred the formula. Examples of symbolic IP in the life sciences industry include brands and logos.
Relevant RevenueHub Articles: Licenses for Intellectual Property
6. Collaborative arrangements
Collaborative arrangements, such as the combined efforts of two companies working to develop a new product or conduct a marketing effort, are common in the life sciences industry. In ASU 2018-18, the FASB clarified the interaction between ASC 808, Collaborative Arrangements and ASC 606. If a customer-vendor relationship exists between participants of a collaborative arrangement (i.e., one of the participants meets the definition of a customer in ASC 606), consideration exchanged for distinct goods or services within the customer-vendor relationship should be accounted for under ASC 606. Otherwise, consideration should be presented separately from revenue from contracts with customers.
For example, a biotech company and a pharmaceutical company may enter into an agreement where the biotech company will create a drug that the pharmaceutical company will then commercialize. Both parties will share all the risks and rewards of the arrangement. In this collaborative arrangement, as long as consideration is exchanged between collaborators for distinct goods or services that are an output of the party’s ordinary activities, the transaction is within the scope of ASC 606.
Relevant RevenueHub Article: Revenue from Collaborative Arrangements
7. Collectibility issues
Per ASC 606, entities may only account for contracts with customers “when it is probable the company will collect substantially all of the consideration.” For US GAAP purposes, probable generally means between 75 percent and 80 percent likely to occur. If it is not probable that a company will collect substantially all of the consideration in a given contract, then it may only recognize revenue as it delivers the goods or services to the customer and receives payment. When accounting for a contract that includes a price concession, companies must first adjust the amount of consideration to be included in the transaction price, after which they will assess collectibility. Price concessions are considered variable consideration and therefore factor into the transaction price of the contract but not the likelihood of collectibility.
8. Contract costs
ASC 606 directs entities to follow the guidance in ASC 340-40 when accounting for incremental costs incurred to obtain and fulfill a contract (i.e., contract costs).
Contract costs to obtain a contract (i.e., sales commissions) should be capitalized if (1) the costs are incremental to successfully obtaining the contract (i.e., the costs are incurred only if the contract is actually obtained), and (2) the entity expects to recover the costs over the life of the contract, including expected contract renewals. Capitalized costs are then amortized as the provider transfers the related goods or services to the customer. In determining the period over which to amortize these costs, judgment is often necessary. For example, if a renewal is expected, the amortization period may extend beyond the original contract period if the provider does not pay a commensurate commission for the renewal. As a practical expedient, companies may immediately expense costs to obtain a contract if they will be fully amortized in one year or less.
Contract costs to fulfill a contract (i.e., set-up costs) should only be capitalized if the costs are (1) not within the scope of other guidance, (2) related directly to a specific contract, (3) used to generate or enhance resources that will be used to satisfy performance obligations in the future, and (4) expected to be recovered. Capitalized costs should be amortized as the provider transfers the related goods or services to the customer. Capitalized contract costs should be monitored and tested for impairment as necessary.
Many additional issues and questions will likely arise for entities in the life sciences industry as they adopt ASC 606. However, this article serves as a reference point for some of the focal issues anticipated by industry experts. Similar industry-specific issues, discussions, and resources are available on RevenueHub for other major industries identified by the AICPA. These articles can be found under Industry-specific Issues.