In May 2014, the Financial Accounting Standards Board (FASB) issued the long-awaited standard on revenue recognition, ASU 2014-09, Revenue from Contracts with Customers. This standard was a converged effort with the International Accounting Standard Board (IASB) issuance of IFRS 15, Revenue from Contracts with Customers.
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. Due to a one-year deferral, the US GAAP standard is effective for public entities for fiscal years beginning after December 15, 2017 and for interim periods therein. Nonpublic entities are required to adopt the new guidance for fiscal years beginning after December 15, 2018 and interim periods within fiscal years beginning after December 15, 2019.
While this may seem some time away, the new principles-based model will require important decisions and actions by life sciences companies that may affect your financial statements and business practices, as well as have potential tax implications.
For life sciences companies, the new revenue model may have the greatest impact on collaboration and licensing arrangements. Yet, as discussed below, reseller and distributor arrangements for medical device manufacturers may also be impacted.
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 US GAAP. Current US GAAP requires recognition to be deferred until that contingent event occurs.
Examples 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. In 2015, the FASB discussed 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 (i.e., 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 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 will require significant judgment.
Sales to distributors and resellers
Some pharmaceutical and medical device life sciences 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).
In addition, as part of its 2015 proposed amendments, the FASB voted to clarify that there will be a sales and usage-based royalty exception applied to the overall royalty stream when the sole item to which the royalty relates is a license of IP.
Another item discussed includes the pattern of revenue recognition for a combined performance obligation that includes a license. The FASB highlighted that for licenses, the restrictions of time, geographical region, or use do not define whether a performance obligation is satisfied at a point in time or over time.
Life sciences companies should perform a preliminary assessment of how the company will be impacted by the new principles-based standard. In addition, companies should continue to monitor the discussions and communications from the FASB, the IASB, and groups such as the Joint Transition Resource Group for Revenue Recognition (TRG) 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.