Authors: Peter McElwain and Mike McKee
The Financial Accounting Standards Board’s (FASB) new standard on revenue recognition, ASC 606, Revenue from Contracts with Customers, must be adopted by public companies in 2018. Although originally issued as a converged standard, the FASB and the International Accounting Standard Board (IASB) have made slightly different amendments, so the application of the guidance could differ under U.S. GAAP and IFRS.
The standard will improve the financial reporting of revenue and the transparency and comparability of revenue in financial statements globally.
The new revenue recognition standard is more principles-based than current revenue guidance. The U.S. GAAP standard is effective for public entities for fiscal years beginning after Dec.15, 2017 and for interim periods therein. Nonpublic entities are required to adopt the new guidance for fiscal years beginning after Dec. 15, 2018 and interim periods within fiscal years beginning after Dec. 15, 2019.
The new principles-based model will require important decisions and actions by life sciences companies that will likely affect your financial statements and business practices, as well as have potential tax implications.
The Revenue Recognition Transition Resource Group (TRG) has contemplated various implementation issues in a variety of industries.
For life sciences companies, the new revenue model will have the greatest impact on collaboration and licensing arrangements and sales to resellers and distributors.
Overview of standard
The standard developed a five-step model to determine when revenue from customer contracts should be recognized:
Step 1: Identify the contract with a customer
Step 2: Identify the performance obligations in the contract
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the performance obligations
Step 5: Recognize revenue when (or as) each performance obligation is satisfied
In addition, under the new standard, life sciences companies will have to estimate the consideration to which they expect to be entitled from the arrangement. An element of variable consideration (e.g., price concessions) may be recognized earlier than under current U.S. GAAP. Current U.S. GAAP requires recognition to be deferred until that contingent event occurs.
The new standard will have the greatest impact on the following areas within the life sciences industry
License of intellectual property
Many life sciences companies will enter into Intellectual Property (IP) licensing arrangements with larger pharmaceutical companies. The FASB made amendments to the revenue standard that would clarify how an entity evaluates the nature of the promise to grant an IP license. IP will be classified as either functional or symbolic, and this classification will dictate the timing of the revenue.
If the license is deemed in the functional category, and thus has “standalone” functionality when the license was entered into, the life sciences company may recognize the revenue at that point in time.
Should the IP be deemed more symbolic, thus no standalone functionality and requiring ongoing and significant support from the life sciences company (e.g., activities that support the brand, trademark or logo), the revenue would be recognized over the period the performance obligation is being satisfied (e.g., over the term of the license).
Thus, life sciences companies will need to evaluate each of their IP arrangements prior to adoption of the standard to determine the proper timing of revenue recognition.
Pharmaceutical and life sciences companies often enter into strategic collaborations and licensing arrangements. Companies must assess initially whether these arrangements should fall into the new revenue standard with the establishment of a vendor-customer relationship, as opposed to arrangements outside the standard that might require accounting for the transaction, such as a reduction of R&D expense.
Should the company conclude the arrangement represents a vendor-customer relationship, then the revenue standard will apply and the company must assess the performance obligations of the revenue arrangement. Identification of the individual performance obligations, the types of services being provided (e.g., the complexity of R&D services) and the resulting accounting will be complex and require significant judgment.
Sales to distributors and resellers
Some pharmaceutical and medical device companies recognize revenue using the “sell-through” approach with their relationships with distributors and resellers. Under the current sell-through approach, revenue is not recognized until the product is sold to the end customer.
Under the new standard, revenue is recognized upon transfer of control to the customer, which may result in earlier revenue recognition for those companies previously recognizing revenue based on the sell-through method. The standard will require companies to estimate the variable consideration based on the information available as it relates to return rights and pricing uncertainty versus delaying revenue recognition until the risks and rewards have transferred to the customer (based on the old standard).
Life sciences companies should perform an assessment of how the new standard will impact the company’s financial statements and disclosures. In addition, companies should continue to monitor the discussions and communications from the FASB, the IASB and groups such as the Revenue Recognition Transition Resource Group for updated information and amendments for applying the standard.
For more information on this topic, or to learn how Baker Tilly life science specialists can help, contact our team.