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 for the new standard. 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: Audit & Accounting Guide—Revenue
- 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, Executive Accounting Update: Life Science Companies
- 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.
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 the new revenue recognition standard, 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 met 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. Medical device companies commonly sell a device, 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 their goods or services. When a company enters into an agreement in which all or a portion of the consideration varies based on 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 method and the expected value method. When deciding whether the most likely amount method or the expected value method is most appropriate, companies should consider the structure of the variable consideration milestones contained in the contract. Generally, if the variable consideration in the contract is based on milestones, thresholds, or event occurrence, the most likely amount method is generally most appropriate. The nature of these conditions is binary: the event will either occur or it will not. Therefore, it is more appropriate for the company to estimate whether or not the condition will be met and either include the entire amount of variable consideration or no variable consideration. On the other hand, the expected value method would assign probabilities to each condition and estimate the weighted average amount of variable consideration that will be received based on those probabilities. However, this may lead to estimating amounts of variable consideration that are not actually possible because the company will either receive 100% or 0% of the variable consideration, not a weighted amount in between. Therefore, while it may be appropriate to use the expected value method under specific circumstances, generally, it is more appropriate to apply the most likely amount method. It is also important to note that companies should only recognize variable consideration to the extent that they are confident a significant reversal of revenue will not occur.
Pay-for-performance arrangements are an example of contracts within the life sciences industry that include variable consideration. In these arrangements, a drug manufacturer is required to reimburse a portion or all of the consideration received from the sale of a drug if it does not produce the intended benefits. Under ASC 606, the amount of variable consideration included in the transaction price would be the estimated amount of consideration the manufacturer expects to receive taking into account the amount of consideration it may have to return based on the drug’s expected performance.
3. Significant financing component
Life science companies commonly have contracts that include extended payment terms. Under the new revenue standard, certain extended payment terms qualify as significant financing components. ASC 606-10-32-16 provides factors 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 do help to establish if a significant financing component exists, the existence of these factors does not always indicate there is a significant financing component and the company must still use judgment in their determination. 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 the revenue from the contract. However, there is a practical expedient allowing companies not to impute interest income and expense if there is less than a one-year difference between payment and performance.
Relevant RevenueHub Articles: Significant Financing Component
4. Recognizing revenue over time or at a point in time
The new standard requires that companies either recognize revenue at 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 using particular specifications for a pharmaceutical company and the project will take five years, then the company might recognize revenue over time of $200,000 each year. On the other hand, if the drug is one that 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. Under the new revenue standard, changes related to accounting for licenses may create significant differences in revenue recognition for some companies. To properly recognize revenue, companies must determine whether the license provides the customer with a right to use the IP, or just access rights to 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 606-1055-62,
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.
There are examples of both functional and symbolic IP in the life sciences industry. For example, drug compounds or formulas, software, or completed media content are all 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. Collaborative arrangements are not ordinarily contracts with customers and generally fall under the scope of ASC 808. However, there are certain circumstances where a collaborative arrangement may be within the scope of ASC 606. ASC 606 defines a customer as,
“…a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.” But it also states that a “counterparty to the contract would not be a customer if, for example, the counterparty has contracted with the entity to participate in an activity or process in which the parties to the contract share in the risks and benefits that result from the activity or process (such as developing an asset in a collaboration arrangement) rather than to obtain the output of the entity’s ordinary activities.”
The FASB believes that generally, collaborative arrangements are not considered customer-vendor relationships; however, depending on the industry, certain circumstances may require companies to account for these arrangements as contracts with customers under ASC 606. It is important for companies to consider all the relevant facts and circumstances when determining if a collaborative arrangement falls under the scope of ASC 606.
ASC 606 specifically gives the example of “collaborative research and development efforts between biotechnology and pharmaceutical entities” as an example of an arrangement that may fall within the scope of ASC 606. If, for example, a biotech company and a pharmaceutical company enter into an agreement where the biotech company will create a drug that the pharma company will sell, and both parties will share all the risks and rewards of the arrangement, then the arrangement would qualify as a collaborative arrangement. However, if the two companies have other contracts that establish a customer-vendor relationship, they should account for the parts of their collaborative arrangement that are related to their customer-vendor relationship under ASC 606.
7. Collectability 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% and 80% 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 will first adjust the amount of consideration to be included in the transaction price, after which they will assess collectability. Price concessions are considered variable consideration and therefore factor into the transaction price of the contract, but not the likelihood of collectibility.
Related RevenueHub Articles: Collectibility of Consideration
8. Contract costs
Under the new standard, companies will be required to capitalize and amortize the incremental costs they incur to obtain (e.g., sales commissions) and fulfill a contract. The costs of obtaining a contract are recognized as an asset if the company expects to recover them. As a practical expedient, companies may immediately expense the costs if they would have been fully amortized in one year or less. The company should only capitalize and amortize the costs to fulfill a contract if (1) the costs relate directly to a specific contract, (2) the costs generate or enhance resources that will be used to satisfy performance obligations in the future, and (3) the provider expects to recover the costs. The costs capitalized by the company should be amortized as the provider transfers the goods or services designated in the contract to the customer.
For example, if a pharmaceutical company pays one of its salespeople a commission of $12,000 on a three-year contract, the $12,000 sales commission costs would be capitalized and amortized over the three-year period. However, if the commission was related to a six-month contract, then the company would apply the practical expedient and recognize the entire $12,000 commission expense at the time of the sale.