The life sciences sector, covering pharmaceuticals, biotechnology, and medical devices, is known for its diversity and complexity. Managing complex contracts, including collaboration arrangements, licensing agreements, and research projects, is crucial for seamless business operations. This complexity gives rise to accounting challenges, especially in applying the revenue standard. Hence, life sciences companies must deeply understand the nuances involved in correctly applying the revenue recognition principles outlined in the standard.
The 5-step model, At a Glance
ASC 606, Revenue from Contracts with Customers, provides a robust framework for recognizing revenue from contracts with customers. The core principle is that a seller should recognize revenue when the customer obtains control of a good or service in an amount the seller expects to be entitled to in exchange for those goods or services. To apply this principle, ASC 606 provides more specific guidance, a five-step model that companies should follow when recognizing revenue from customer contracts:
1. Identify the contract with the customer.
2. Determine the company’s performance obligations as outlined within each contract.
3. Determine the transaction price from the agreement, breaking down the individual revenue streams (some may be upfront, while others will occur over time) and identifying any variable considerations, non-cash considerations, or financing components.
4. Allocate the transaction price, assigning revenue to every performance obligation in the contract.
5. Recognize the revenue at the point that the company meets the contracted performance obligations or over the period the company performs the contracted obligation.
Where the revenue standard has the greatest impact
Some of the more common challenges that life sciences entities encounter when applying the revenue standard are discussed below.
Collaborative arrangements
Biotechnology and pharmaceutical companies often form collaborative agreements with partners for drug research, development, and commercialization, sharing risks and potential rewards. If the relationship is solely based on a collaboration arrangement as governed by ASC 808, it’s straightforward. However, some contracts stipulate that once a finished product is developed, it will be sold to one of the collaborators for commercial distribution. ASC 606 requires a careful assessment of such agreements, which may be considered vendor-customer relationships. Once it’s determined that a contract falls into this category, it should be accounted for under the revenue standard.
Medical device sales and arrangements
Most entities selling medical devices and equipment also grant customers the right to use these devices for a specific period (i.e., a lease) and offer the option to purchase auxiliaries and consumables required for their operation. ASC 606 mandates that entities initially determine whether these agreements qualify as leases, falling under the scope of ASC 842, Leases.
If the contract contains a lease, ASC 606 requires the entity to identify and separate lease and non-lease components based on their standalone selling prices. The entity should then apply the rules and principles of ASC 842 to the lease component and ASC 606 to the non-lease component. If the arrangement doesn’t meet the definition of a lease, and no other standard is directly applicable, the entire contract would be accounted for using the revenue standard.
Identifying separate performance obligations
Contracts in the life sciences industry often include multiple promised goods or services, such as intellectual property licenses, contract research services, and contract manufacturing services. Identifying all promises and assessing whether they qualify as performance obligations is critical to properly applying the revenue standard. However, the identification process can be complex, especially when certain promises are not explicitly stated in the contract. For instance, some goods or services accompanying the sale of medical equipment, such as training or consumable supplies, may not be explicitly stated in the contract, instead being part of an entity’s customary business practices, Administrative activities to fulfill the contract, such as medical equipment setup, do not transfer a good or service to the customer and, therefore, are not considered performance obligations. In addition, promises that are considered immaterial in the context of the contract may be disregarded.
To be considered a performance obligation, the good or service must be capable of being distinct, and the promise to transfer the good or service must be distinct in the context of the contract. Life sciences entities might have to exercise considerable judgment when determining if a promised good or service is separately identifiable. This process necessitates a comprehensive understanding of each contract’s specific details and conditions.
Customer options for additional goods or services
Certain contracts entered by life sciences entities include an option to purchase additional goods or services, which could be offered at a reduced price or potentially provided without any cost. Such an option is treated as a performance obligation only if it provides a material right to the customer that it would not have received without entering into the contract. For instance, when the reduction in rates upon renewal is relatively more significant than that typically provided under similar circumstances.
Determining whether an option for additional goods or services constitutes a material right, a variable consideration, or a separate contract upon exercise requires significant judgment.
Contracts with variable consideration
Life science entities may enter into contracts with customers involving variable considerations, such as milestone payments, outcomes-based pricing, price concessions, discounts, rebates, and performance bonuses. For instance, payments tied to achieving specific goals, like reaching a particular phase in a clinical trial or obtaining regulatory approval, are typical.
ASC 606 mandates that companies include the consideration to which they expect to be entitled (i.e., the variable consideration) in the transaction price. Accordingly, in a distributor and reseller arrangement, it is no longer acceptable for a life science entity to delay revenue recognition until the distributor or reseller sells the product to the end consumer.
In most cases, a life science entity must estimate the variable consideration based on information available at contract inception and determine if it is “probable” that a significant reversal of the cumulative revenues recognized under the contract will not occur in future periods when the uncertainty related to the variable consideration is resolved. Estimating the amount of variable consideration can be made using the expected value method or the most likely amount method. The choice depends on which method better predicts the amount of variable consideration in the particular set of facts and circumstances.
For instance, the life science entity may conclude that the milestone payment contingent on regulatory approval should be recognized once it becomes probable that the Food and Drug Administration (FDA) will approve the product. If there are only a limited number of outcomes (i.e., a specified milestone payment will be paid if approval is sought and nothing will be paid if approval is not sought), the entity may deem the most likely amount method to be best suited for estimating the expected amount of variable consideration. In turn, this requires identifying the amount that is most likely to occur and applying the variable consideration constraint to the estimate.
Rights of return
If the contract grants the customer the right to return products, particularly for new product launches, within a specified period after the sale, the life science entity should recognize revenue only at the amount of consideration to which the entity expects to be entitled. Accordingly, the estimate excludes consideration for products expected to be returned, which should be recognized as a refund liability. A corresponding adjustment to the asset representing the right to receive future inventory returns and the cost of sales for the estimated returns should likewise be recognized. At the end of each reporting period, the entity should subsequently update its assessment of returns and adjust the related amounts recognized.
Consideration paid or payable to a customer
Payments made or expected to be made to any purchaser of the entity’s products or services, such as its customers and the customers of its resellers or distributors, should be accounted for as a reduction of the transaction price, and thus revenue, only if no distinct good or service is received in exchange for the payment. Otherwise, such payments result in the recognition of an asset or expense. This includes rebates paid to Medicaid, Medicare, and other government entities and health insurers, patient assistance programs, as well as service fees, chargebacks, and discounts paid to wholesalers and/or other entities.
License of intellectual property
Life science companies frequently engage in arrangements with customers involving the licensing of intellectual property, such as licenses for product candidates or patented drug formulas, in exchange for future milestone payments or royalties.
The accounting treatment for each performance obligation may differ depending on the distinctness of the licenses and contractual restrictions. In addition, there is specific guidance for recognizing revenue from licenses and sales-based royalties. Determining the appropriate accounting model to apply to these arrangements requires significant judgment based on the facts, types, and circumstances of each contract.
For instance, consider a license contract between a biotechnology and a pharmaceutical company involving the use of a patented drug compound, where the latter must pay the former a royalty based on a percentage of the sales of specified prescription drugs that incorporate the licensed drug compound. In that case, the biotechnology company may conclude that the royalty revenue should be recognized until the later of either the subsequent sales of prescription drugs or the satisfaction of the related performance obligation (i.e., the grant of a license to use the patented drug compound). Should the sales data necessary to calculate the sales-based royalty remain unavailable before the financial statements are issued, the biotechnology company would need to make revenue estimations from the sales-based royalty as of the end of a given period. This is because the related performance obligation, which is considered a right to use intellectual property, is deemed satisfied at the point in time when control of the licensed patented drug compound is transferred.
Navigating revenue recognition can be challenging for life sciences entities, given the distinct nature of their operations. Accordingly, these entities must exercise thorough diligence in reviewing their contracts, identifying nuanced provisions, and recognizing the potential impacts on revenue. A meticulous approach is needed to ensure accurate and compliant financial reporting in accordance with ASC 606.
How Scrubbed can help
Revenue recognition is a complex accounting topic that demands deep understanding and experience to accurately apply its underlying concepts. The Technical Accounting Group at Scrubbed can provide hands-on assistance and expert technical consultations to help ensure that the accounting standards are applied appropriately.
Contact Scrubbed to learn how the experts in our Technical Accounting Group can help your business apply the revenue standard correctly.
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