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Accounting for revenue impact on life sciences

RFP
With a global accounting standard for revenue recognition now issued (also known as ASU 2014-09), many life sciences companies are wondering how their businesses will be affected. Grant Thornton’s Steven Perkins, Technology practice leader, and Lynne Triplett, Accounting Principles partner, explain what changes life sciences companies can expect.

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ASC 605-25, Revenue Recognition: Multiple Element Arrangements; ASC 605-28, Revenue Recognition: Milestone Method, and ASC 605-30; Revenue Recognition: Rights to Use, which are commonly used guidance for life science industry revenue recognition, are superseded and replaced by ASC 606.
 
Multiple-element arrangements
Contracts that include promises to sell multiple goods and/or services may be complex. For example, a contract for a medical device may include embedded software, replacement parts and other components, installation, training, service and warranty for the device. Historically, these arrangements have required careful consideration of multiple standards under current revenue recognition guidance. ASC 606 replaces all those separate standards and requires an entity to identify “distinct” performance obligations, which may result in the identification of different performance obligations than those identified using the standalone value criteria in the current multiple-element arrangement guidance.

An entity will allocate the transaction price among all performance obligations on a relative standalone selling price basis, which is similar to existing U.S. GAAP. However, the strict hierarchy of vendor-specific objective evidence, third-party evidence and management’s best estimate for determining standalone selling price in existing guidance is superseded. Under ASC 606, an entity will first look to the observable selling price of a performance obligation, and if the standalone selling price of a performance obligation can’t be observed, an entity must estimate it. A residual approach to estimate a standalone selling price may be applied in limited circumstances.

Collaborative research arrangements
Collaborative arrangements are common in the life sciences industry and can take many forms.  ASC 606 applies to a contract only if the counterparty is a customer. A counterparty to a collaborative arrangement that does not receive goods or services that are an output of the entity’s ordinary activities would not be considered a customer.    

While many collaborative arrangements are excluded from the scope of the new standard, judgment is required in determining whether a transaction, in effect, is with a customer.

Collaborative arrangements under the scope of ASC 606 that grant a license, along with a promise for R&D services should be evaluated to determine whether these activities are separate performance obligations or should be combined into a single performance obligation.

Entities with contracts that are outside the scope of ASC 606 should continue to follow other existing guidance, such as for R&D arrangements.

Variable consideration
Milestone payments: Under ASC 606, variable consideration, such as milestone payments, is included in the transaction price using a probability-weighted or most-likely-amount approach. Estimated amounts are included in the transaction price only to the extent that it is probable that a significant revenue reversal will not occur. In some situations, revenue may be recognized earlier than under current guidance, which requires excluding milestone payments from the consideration until the contingency resulting in the milestone payment is resolved.

The new standard may also create more complexity and the need for more judgment, for example, when estimating revenue at contract inception for amounts due from a customer as a product progresses through various development stages, such as milestone payments awarded on an all-or-none basis on successfully passing a research phase. High failure rates for product development projects may make it difficult to evaluate the probability of success for an individual project.

Volume discount incentives: An entity should evaluate volume discounts as variable consideration and estimate the amounts in determining the transaction price.

Additional purchase options: Contracts that include the right to purchase additional goods or services at a discount, or even at no charge, should be considered a separate performance obligation if the option represents a material right that the customer would not receive without entering into the contract. These purchase options may result in the customer effectively making an advance payment for future goods or services. This portion should be deferred and recognized when the performance obligation for the additional goods or services is satisfied or the option expires.

Royalty arrangements: An entity should recognize revenue for a sales-based or usage-based royalty promised in exchange for a license of intellectual property only when (or as) the later of the following events occurs:
  • The subsequent sale or usage occurs
  • The performance obligation to which some or all of the sales/usage-based royalty was allocated has been satisfied (or partially satisfied)

License rights
Right to access versus right of use: Except for certain industry-specific guidance, U.S. GAAP does not include direct guidance on accounting for licenses of intellectual property. ASC 606 provides a single model for recognizing license revenue, which will improve consistency and comparability in accounting for licenses. Under ASC 606, the timing of revenue recognition for a license to a customer — assuming the license is a distinct and separate performance obligation — depends on whether the customer has a right to access or simply a right to use the entity’s intellectual property.  

If the license provides a right to use the entity’s intellectual property as it exists at the time the license is granted, revenue is recognized when the license is transferred and the customer can use the license. This contrasts with the recognition over time for a license right to access the entity’s intellectual property as it exists throughout the license period.

Right of return     
Pharmaceutical and medical device companies commonly provide customers (distributors) with a right of return if the product is unsold within a specific period of time or expires.  

The new standard does not change the requirement that revenue be recognized only for amounts not expected to be returned. However, the right of return makes the amount of consideration variable and subject to the constraint. This might result in a difference in timing of revenue recognized to the extent an entity concludes that the estimated amount differs from the estimate under existing U.S. GAAP.  Consistent with existing GAAP, rights of return can be contractual or based on common practice.  

ASC 606 requires an entity to recognize estimated returns to be accounted for as a refund liability (equivalent to the sales amount of the product estimated to be returned), as well as a corresponding asset (carrying amount of the product estimated to be returned less expected costs to recover) separate from inventory. The return asset is assessed for impairment and not subject to the lower of cost or market testing, as is inventory. For pharmaceutical companies, limited value may be attributed to any asset recorded, because products returned are typically expired and have no value.

Under ASC 606, an assessment of the estimated liability and asset amounts should be updated at the end of each reporting period, and any changes are recognized as an increase or decrease in revenue.

Disclosures
All entities, especially those with contracts longer than one year, will be required to provide more disclosures than currently required.

This Grant Thornton LLP document provides information and comments on current accounting and tax issues and developments. It is not a comprehensive analysis of the subject matter covered and is not intended to provide accounting, tax, or other advice or guidance with respect to the matters addressed in the document. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this document.

Moreover, nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

For additional information on topics covered in this document, contact your Grant Thornton LLP adviser.


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