Companies in the Life Sciences industry will need to exercise more judgment in their revenue recognition practices as the new revenue recognition standard becomes effective for public entities with years beginning after December 15, 2017 and all other entities with years beginning after December 15, 2018. The new standard supersedes all revenue recognition guidance including industry-specific guidance. The new standard applies to nearly all contracts with customers. A customer, is a party that has contracted with a company to obtain goods or services for which the company has generated from its normal operating activities in exchange for consideration. This standard will not apply to parties that share in the risks and benefits that result from the activities or processes of the company. As an example, if a biotechnology company and a pharmaceutical company share the risks and benefits associated with developing a drug but do not have a vendor-customer relationship, this would likely not fall with the scope of the new standard. However, if the biotechnology company licensed its intellectual property to the pharmaceutical company and/or provided research and development services, it would likely be in the scope of the new standard.
There are two key considerations companies will need to make to their processes and controls for making estimates and possibly recognizing revenue earlier than they currently are today. The first is identifying separate contracts or possibly combining contracts as they represent a common commercial objective over their individual form. The other key consideration is determining if there are separate performance obligations for complex arrangements with multiple goods and services such as licensing a product, combining research and development services, or a selling a medical device with installations services and a maintenance agreement. Careful consideration will need to be taken to evaluate contracts to determine the revenue to be allocated amongst different performance obligations. The new standard has five steps in recognizing revenue as follows:
- Identify the contract(s) with a customer
- Identify performance obligations (promises) in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the reporting organization satisfies a performance obligation
Estimating Variable Consideration
Under today’s revenue guidance, a company cannot recognize revenue on an uncertain future event, such as a milestone payment until that event occurs. However, under the new revenue guidance life science companies will have to estimate the consideration they expect to receive from milestone payments. Once a life sciences company considers the constraint of the possibility of meeting their milestone they may be able to recognize a portion of these payments before they actually achieve the milestone.
Companies will also need to estimate the right of return on products and factor this into the transaction price. Based on the estimated consideration expected to be returned they would only recognize the amount they expect to be entitled. Life sciences companies would recognize the amount of expected returns as a refund liability, which would represent the obligation the company has to return the customer’s consideration. Correspondingly, the new standard requires the return asset to be recognized for the right to recover the product. Entities must present the return asset separately from both the refund liability and inventory. Companies may want to implement a process to update these estimates as time passes over each reporting period.
Overall, the inclusion of variable consideration into the transaction price is further constrained to the probable amount that would not result in a significant reversal of revenue.
Collaboration and Licensing Arrangements
Life sciences companies consistently partner with other parties and share the risks and benefits of developing their products. Companies may find it challenging to conclude whether these partnerships are in the scope of the new revenue standard. Two key issues should be considered: identify whether the agreement falls within the scope of the new standard and identify the separate performance obligations and determine how to account for them. Companies will need to assess whether the counterparty in the arrangement is either a customer or a collaborator sharing in the risks and benefits of the arrangement. The arrangement may be outside the scope of the revenue standard in which case the collaboration could result in a reduction of R&D expense or as other income.
Reseller and Distributor Arrangements
Under the new standard, life sciences companies that sell their product using the “sell-through” approach with their distributors may be able recognize revenue sooner than they currently do. Under current GAAP, companies that have elected the “sell-through” approach generally wait until the product is sold by the distributor to the end customer to recognize revenue because they do not meet all the criteria to recognize revenue when they deliver the product to the reseller. Once enough experience is obtained on returns and chargebacks, a company can switch to recognizing revenue when they transfer the products to the reseller provided the transfer of control of the inventory is with the distributor and it is probable of not resulting in a significant reversal of cumulative revenue in the future. If the distributor has control of the product, including the right but not the obligation to return the product to the seller at its discretion and the customer does not have a significant economic incentive to exercise the right feature, control is considered transferred when the product is delivered to the distributor. Considerable judgment will be required when applying this new guidance and companies may need to change their processes and information systems to account for this change, as an adoption of this new guidance would likely expedite the revenue recognition process with life sciences companies that utilize resellers and distributors to take their products to market.
Licenses of Intellectual Property
Companies in the life sciences industry typically have arrangements that include licensing of intellectual property (IP) with other goods and services such as research and development or manufacturing services. Companies will need to determine if they should recognize revenue at a point in time or over a period of time. One example is whether the IP license is a right to access the IP or a right to use the IP. The right to access the IP will be recognized over the licensed period agreed upon, whereas the right to use will be recognized when the license is provided. Determination will be based on the facts and circumstances of the contracts.
Along with the new revenue standard comes extensive disclosure requirements to communicate to users the amount, timing and judgments related to the revenue recognition and cash flows arising from contracts with customers. The additional disclosure requirements focus on the estimates used and significant judgments made in applying the guidance such as establishing stand-alone selling price for certain deliverables or expected timing of the satisfaction of certain performance obligations for contracts greater than one year.
The Following are Steps to Consider:
Companies should begin to perform a preliminary assessment on how they will be affected by the changes as soon as possible to determine how best to prepare for the new standard. All entities will need to evaluate the requirements and make sure they have the processes and systems in place to collect the necessary information to implement the standard, even if their accounting results won’t change significantly or at all. This would include evaluating significant revenue streams and identifying key contracts to see if there are specific lines of business that may have a greater impact than others. It would also include consideration and preparation to the two different adoption methods through a retrospective approach or through a cumulative effect adjustment in the first period of adoption.
If you have any questions about the standard, or how you can apply this guidance, contact Scott Taylor at firstname.lastname@example.org or (650) 855-6882 or Eric Borr at email@example.com or (650) 815-7814.
BPM for Life Sciences
BPM is one of the largest California-based public accounting and advisory firms, ranking in the top 50 in the country. With six offices across the Bay Area – as well as offices in Oregon, Hong Kong and the Cayman Islands – we serve emerging, mid-cap, and closely-held businesses as well as high-net-worth individuals since 1986. Our Life Sciences Industry Group represents over 250 companies from early stage research ventures to public healthcare companies in fields ranging from biopharmaceuticals and medical devices to health diagnostics. Our goal in partnering with our clients is to provide financial clarity and guidance to help with their strategic planning, preparing for capital raises/liquidity events and regulatory compliance. For more information, visit us at bpmcpa.com/lifescience.