US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences

This publication highlights industry-specific factors to be considered and provides guidance on the most pertinent accounting solutions for the pharmaceutical, life sciences and medical device industry. Because each company deals with accounting issues in ways that should reflect the facts and circumstances of its particular situation, we cannot address every nuance in this publication. For example, the structure in licensing, manufacturing, and research and development arrangements lead to variations in contracts, corporate structures, and accounting requirements. Therefore, the solutions we present are meant to provide a framework for determining the appropriate accounting answer for general situations; however, individual facts and circumstances may give rise to a different answer. The contents of this publication are based on guidance that is effective or could be early adopted as of January 1, 2019, including ASC 842 on Leases. Therefore, whenever considering the solutions contained in the publication in future periods, it is important to keep in mind that the accounting guidance may be superseded as new guidance and interpretations emerge.

Chapter 1: Capitalization and Impairment

1-1 Capitalization of internal development costs: timing – Scenario 1

Background / Question

Company A is developing a vaccine for HIV that was successful during Phases I and II testing. The drug is now in Phase III of testing. Management still has concerns about securing regulatory approval and has not started manufacturing or marketing the vaccine.

How should management account for research and development costs incurred related to this project?

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Solution

Costs to perform research and development, including internal development costs, should be expensed as incurred.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

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1-2 Capitalization of internal development costs: timing – Scenario 2

Background /Question

A pharmaceutical entity is developing a vaccine for HIV that was successful during Phases I and II of testing. The drug is now in the late stages of Phase III testing. It is structurally similar to drugs the entity has successfully developed in the past with very low levels of side effects, and management believes it will be favorably treated by the regulatory authority because it meets a currently unmet clinical need.

Should management start capitalizing the development costs?

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Solution

No. Costs to perform research and development, including internal development costs, should be expensed as incurred, regardless of past history with similar drugs or regulatory approval expectations.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

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1-3 Capitalization of internal development costs when regulatory approval has been obtained in a similar market

Background /Question

An entity has obtained regulatory approval for a new respiratory drug in Country A. It is now progressing through the additional development procedures necessary to gain approval in Country B.

Management believes that achieving regulatory approval in Country B is a formality. Mutual recognition treaties and past experience show that Country B’s authorities rarely refuse approval for a new drug that has been approved in Country A.

Should the development costs associated with the additional development procedures necessary to gain approval in Country B be capitalized?

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Solution

No. The development costs should be expensed as incurred, regardless of the probability of success and history.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred…

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1-4 Capitalization of development costs for generics

Background / Question

An entity is developing a generic version of a painkiller that has been sold in the market by another company for many years. The technological feasibility of the drug has already been established because it is a generic version of a product that has already been approved, and its chemical equivalence has been demonstrated. The lawyers advising the entity do not anticipate any significant difficulties in obtaining commercial regulatory approval.

Should management capitalize the development costs at this point?

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Solution

No. Research and development costs should be expensed when incurred.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

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1-5 Development expenditure once capitalization criteria are met—Scenario 1

Background / Question

Company A has obtained regulatory approval for a new respiratory drug and is now incurring costs to educate its sales force and perform market research.

Should Company A capitalize these costs?

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Solution

No. Company A should expense sales and marketing expenditures, such as training a sales force or performing market research, as incurred.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

Statements of Financial Concepts 6, paragraph 80: Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

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1-6 Development expenditure once capitalization criteria are met—Scenario 2

Background / Question

Company A has developed a vaccine delivery device that has received regulatory approval. Company A is incurring costs to add new functionality to the existing device. The additional functionality will require Company A to receive regulatory approval prior to selling the enhanced device.

Should Company A capitalize these development costs?

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Solution

No. Company A should expense the costs of adding new functionality as incurred as these costs are research and development expenditures.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

Statements of Financial Concepts 6, paragraph 80: Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

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1-7 Development of alternative indications

Background / Question

Company A markets a drug approved for use as a painkiller. Recent information shows the drug may also be effective in the treatment of rheumatoid arthritis. Company A has commenced additional development procedures necessary to gain approval to market the drug for this indication.

Should Company A capitalize the development costs relating to alternative indications?

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Solution

No. The internal development costs are research and development costs that should be expensed as incurred.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

Statements of Financial Concepts 6, paragraph 80: Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

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1-8 Cost that qualify as research and development costs

Background / Question

Company A is developing a new compound for the treatment of pancreatic cancer. Company A is incurring costs to identify a new formulation and make a routine update to an existing manufacturing line that will be used to make the clinical trial product.

Do the additional expenditures incurred by Company A qualify as research and development costs?

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Solution

The cost associated with the identification of a new formulation would be expensed as research and development costs.  Research and development costs could include materials, equipment or facility charges, compensation and benefits for personnel, intangible assets purchased from others (if they do not have alternative use or have not achieved technological feasibility), the cost of contract services performed by others and a reasonable allocation of indirect costs.

The cost associated with the routine update to the manufacturing line would ultimately be expensed to cost of sales.

 

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

ASC 730-10-55-1: The following activities typically would be considered research and development within the scope of this Topic (unless conducted for others under a contractual arrangement…):

a.   Laboratory research aimed at discovery of new knowledge

b.   Searching for applications of new research findings or other knowledge

c.   Conceptual formulation and design of possible product or process alternatives

d.   Testing in search for or evaluation of product or process alternatives

e.   Modification of the formulation or design of a product or process

...

h.   Design, construction, and operation of a pilot plant that is not of a scale economically feasible to the entity for commercial production

i.    Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture

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1-9 Asset acquisition of a compound

Background / Question

Company A acquired a license to the intellectual property (IP) rights to a compound for $5 million on January 1, 20X7. There is no alternative future use for the IP and the acquired asset does not constitute a business. Company A expects to receive regulatory and marketing approval on March 1, 20X8 and plans to start using the compound in its production process on June 1, 20X8.

How should Company A account for the acquisition of the compound?

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Solution

Because the license to the compound was acquired prior to regulatory approval, the payment would be expensed as research and development costs (since there is no alternative future use and the acquired asset does not constitute a business).

If the license to the compound had been acquired after regulatory approval, Company A would have capitalized the intangible asset and began amortizing it on the date it was available for its expected use. This would generally be the acquisition date for an approved compound.

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Relevant guidance

ASC 730-10-25-2(c): Intangible assets purchased from others. The costs of intangible assets that are purchased from others for use in research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be accounted for in accordance with Topic 350 [Intangibles – Goodwill and Other]. The amortization of those intangible assets used in research and development activities is a research and development cost. However, the costs of intangibles that are purchased from others for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred.

ASC 350-30-35-2: The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity...

ASC 350-30-35-6: ...The method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be readily determined, a straight-line amortization method shall be used.

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1-10 Accounting for a sales-based milestone payment

Background / Question

Company A acquires the intellectual property rights to one of Company B’s approved compounds for an upfront cash payment of $15 million and agrees to make an additional one-time sales-based milestone payment of $10 million if and when sales for the related product in any one year reach a specified sales target. Company A has determined that the transaction does not constitute a business and, therefore, will account for it as an asset acquisition. The sales-based milestone payment, if made, does not entitle Company A to additional intellectual property rights beyond those already obtained in the initial asset acquisition.

Company A capitalizes the $15 million payment made to acquire the IP rights since the rights relate to an approved compound and the cost is considered recoverable based on expected future cash flows. The useful life of the intellectual property rights is 15 years and Company A begins amortizing $1 million per year. At the end of the third year, following a significant uptick in sales of the product, it becomes probable that the specified sales level will be met the following year.

How should Company A account for the $10 million sales-based milestone payment?

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Solution

Company A should accrue the milestone payment when the achievement of the milestone is probable. The obligation to make the milestone payment, while contingent on the company reaching a specified sales level, is considered to be established on the date the agreement to make the payment is entered into. Accordingly, at that date, it is a contractual contingent obligation, based on having received the intellectual property license rights. Company A would accrue the $10 million sales-based milestone when the obligation is no longer contingent. In this case, Company A would accrue the milestone obligation when it becomes probable that the payment will be made. The amount of the payment is reasonably estimable, as it is a fixed amount under the terms of the arrangement once the sales target has been achieved.

After it is accrued, Company A will need to consider the economics of the arrangement to determine the expense recognition pattern. Because $25 million is the total consideration paid for the intellectual property rights, it would be appropriate to adjust the carrying value of the intellectual property rights on a cumulative catch-up basis as if the additional amount that is no longer contingent had been accrued from the outset of the arrangement. Accordingly, Company A would immediately expense 20% (3 out of 15 years) or $2 million of the $10 million sales-based milestone and capitalize the remainder of the payment. At the end of the third year, Company A would have expensed an aggregate of $5 million, with $20 million remaining capitalized on the balance sheet.

Alternatively, if the economics of the arrangement were such that the payment appeared to be the equivalent of an additional royalty that is paid annually, it may be appropriate to expense the entire $10 million over a 1-year period. This might be the case, for example, if there were similar sales-based milestone targets in each year of the arrangement.

Amortizing the $10 million payment prospectively over the 12 remaining years in the  life of the IP would only potentially be supportable if the payment was in exchange for additional intellectual property rights under the arrangement.

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Relevant guidance

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...
  • The amount of loss can be reasonably estimated...

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1-11 Indefinite-lived intangible assets

Background / Question

Management of a pharmaceutical entity has acquired an intangible asset that it believes to have an indefinite useful life.

How should management account for the acquired intangible asset?

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Solution

If none of the factors in ASC 350-30-35-4 limit its useful life, the asset should be considered to have an indefinite life. The asset would not be amortized, but would be tested for impairment annually and whenever there is an indication that the intangible asset may be impaired.

Pharmaceutical intangible assets that might be regarded as having an indefinite life could include acquired brands (e.g., over-the-counter products) or generic products. The limited life of patents means that prescription pharmaceutical products and medical devices generally would not have indefinite lives.

 

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Relevant guidance

ASC 350-30-35-4: If no legal, regulatory, contractual, competitive, economic or other factors limit the useful life of an intangible asset to the reporting entity, the useful life of the asset shall be considered to be indefinite. The term indefinite does not mean the same as infinite or indeterminate. The useful life of an intangible asset is indefinite if that life extends beyond the foreseeable horizon—that is, there is no foreseeable limit on the period of time over which it is expected to contribute to the cash flows of the reporting entity...

ASC 350-30-35-15: If an intangible asset is determined to have an indefinite useful life, it shall not be amortized until its useful life is determined to be no longer indefinite.

ASC 350-30-35-16: An entity shall evaluate the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether events and circumstances continue to support an indefinite useful life.

ASC 350-30-35-18: An intangible asset that is not subject to amortization shall be tested for impairment annually and more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired.

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1-12 Indicators of impairment for intangibles

Background / Question

Company A has capitalized the cost of acquiring the license rights to a product that has recently received regulatory approval on November 30, 20x9. Company A has plans to begin selling this product in six months, and as such, is not amortizing the asset since it is not available for use.

What indicators of impairment should management consider at December 31, 20x9?

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Solution

ASC 360-10-35-21 provides several examples of events or changes in circumstances that management should consider when assessing whether an intangible asset should be tested for impairment. Some of the events or changes in circumstances include: a significant decrease in the market price of the long-lived asset, a significant adverse change in the manner in which the asset is used or a significant adverse legal event.

Management of pharmaceutical and life sciences entities should also consider the following common industry-specific indicators, including:

  • Development of a competing drug
  • Changes in the legal framework covering patents, rights or licenses
  • Failure of the drug’s efficacy
  • Advances in medicine and/or technology that affect the medical treatments
  • A pattern of lower than predicted sales
  • A change in the economic lives of similar assets
  • Relationship with other intangible or tangible assets
  • Changes or anticipated changes in participation rates or reimbursement policies of insurance companies, Medicare or the government

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Relevant guidance

ASC 350-30-35-14: An intangible asset that is subject to amortization shall be reviewed for impairment in accordance with the Impairment or Disposal of Long-Lived Assets Subsections of Subtopic ASC 360-10 by applying the recognition and measurement provisions in paragraphs 360-10-35-17 through 35-35...

ASC 360-10-35-17: An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). That assessment shall be based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use... or under development... An impairment loss shall be measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value.

ASC 360-10-35-21: A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable...

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1-13 Indicators of impairment – Property, plant and equipment

Background / Question

Company A announced a withdrawal of a marketed product due to unfavorable post-approval Phase IV study results. Company A informed healthcare authorities that patients should no longer be treated with this product. Company A has property, plant and equipment that is dedicated to the production of the terminated product and has no future alternative use.

What impairment indicators should Company A consider?

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Solution

Company A should consider the general indicators given in ASC 360-10-35-21 when assessing whether there is an impairment of property, plant and equipment. In addition, pharmaceutical and life sciences entities should consider the following common industry-specific factors:

  • Patent expiry date
  • Failure of the machinery to meet regulatory requirements
  • Technical obsolescence of the property, plant and equipment (for example, because it cannot accommodate new market preferences)
  • Changes in medical treatments
  • Market entrance of competitive products
  • Declining sales (e.g., due to market demand, a product recall)
  • Changes or anticipated changes in third-party reimbursement policies that will impact the price received for the sale of product manufactured by the property, plant and equipment.

Based on Company A’s determination that the property, plant and equipment dedicated to the production of the terminated product cannot be repurposed for other use,  the long-lived asset group is likely impaired.

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Relevant guidance

ASC 360-10-35-21: A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable...

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1-14 Single market impairment

Background / Question

Company A acquired the rights to market a topical fungicide cream in Europe. The acquired rights apply broadly to the entire territory and, as such, Company A determined that it would account for the acquired right as one unit of account. For unknown reasons, patients in Country X prove far more likely to develop blisters from use of the cream, causing Company A to withdraw the product from that country. As fungicide sales in Country X were not expected to be significant, the loss of the territory, taken in isolation, does not cause the overall value from sales of the drug to be less than its carrying value.

What is the impact of the withdrawal from Country X on Company A’s impairment analysis?

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Solution

Company A acquired the rights to market the fungicide cream over a broad territory and not specifically in Country X. Because Company A determined the European territory as a whole represented one unit of account the entire territory would likely represent the lowest level of identifiable cash flows for testing impairment of the marketing rights. Because revenues from product sales in Country X were not significant, the withdrawal of the product from Country X would generally not be considered an event that would trigger the need for an interim impairment analysis. However, Company A should carefully consider whether the development of blisters in patients in Country X is indicative of potential problems in other territories. If the issue cannot be isolated, the withdrawal in Country X could be a triggering event and a broader impairment analysis should be performed, including the consideration of the potential for more wide-ranging decreases in sales.

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Relevant guidance

ASC 360-10-35-21: A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable...

ASC 360-10-35-17: An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). That assessment shall be based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use... or under development... An impairment loss shall be measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value.

ASC 360-10-35-23: For purposes of recognition and measurement of an impairment loss, long-lived asset or assets shall be grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities...

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1-15 Impairment testing and useful life

Background / Question

Company A has a major production line that produces its blockbuster antidepressant. The production line has no alternative use. A competitor launches a new antidepressant with better efficacy. Company A expects sales of its drug to drop rapidly and significantly. Although positive margins are forecasted to continue, Company A identifies this as an indicator of impairment. As a result of the new competition, Company A may exit the market for this drug.

How should Company A assess the impairment and useful lives of long-lived assets when impairment indicators have been identified?

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Solution

Assuming that the antidepressant asset group represents the lowest level of identifiable cash flows, Company A should evaluate the carrying amount of the antidepressant’s asset group (including the production line) relative to its future undiscounted cash flows. An impairment loss should be recognized if the carrying amount of the antidepressant’s asset group exceeds the future undiscounted cash flows. The resulting impairment would be based on the difference between the carrying amount of the unit and its fair value.

Company A should revise the estimated useful life of the affected assets after the impairment analysis is performed based on the estimated period it expects to obtain economic benefit from the assets. After recognizing the impairment and revising the estimated useful life for the affected assets, Company A would continue to amortize the remainder of the asset over its expected useful life. However, regardless of whether there is an impairment recognized as a result of the impairment analysis, Company A should assess the useful life of the assets based on the estimated period it expects to obtain economic benefit from the assets and revise the useful life as necessary.

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Relevant guidance

ASC 360-10-35-21: A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable...

ASC 360-10-35-17: An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). That assessment shall be based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use... or under development... An impairment loss shall be measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value.

ASC 360-10-35-22: When a long-lived asset (asset group) is tested for recoverability, it also may be necessary to review depreciation estimates and method… or the amortization period… Any revision to the remaining useful life of a long-lived asset resulting from that review also shall be considered in developing estimates of future cash flows used to test the asset (asset group) for recoverability…

ASC 360-10-35-20: If an impairment loss is recognized, the adjusted carrying amount of a long-lived asset shall be its new cost basis. For a depreciable long-lived asset, the new cost basis shall be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited.

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1-16 Exchange of intangible assets when control is transferred

Background / Question

Company A is developing a hepatitis vaccine compound. Company B is developing a measles vaccine compound. Company A and Company B enter into an agreement to exchange the two products. The exchange of products will not involve the transfer of legal entity ownership interests. Company A will lose and Company B will gain control of the hepatitis vaccine compound. The fair value at contract inception of Company B’s compound was $3 million. The carrying value of Company A’s compound was zero, as it was internally developed.

How should Company A account for the swap of vaccine products?

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Solution

To determine the accounting for the exchange transaction, Company A would first determine whether it qualifies for derecognition of a nonfinancial asset (i.e., the vaccine). The accounting guidance for the derecognition of nonfinancial assets refers to certain provisions in ASC 606, Revenue from Contracts with Customers, to assess the appropriate accounting for these types of transactions, including whether or not a contract exists, identifying each distinct nonfinancial asset and determining when control has transferred. After assessing the control criteria in ASC 606, Company A concluded that it has transferred control of the hepatitis compound to Company B. Company A would derecognize the carrying value of the hepatitis compound (for internally-developed IPR&D assets, the carrying value would typically be zero).

Company A would recognize $3 million for the measles compound as this represents the fair value, at contract inception, of the noncash consideration received by Company A. The fair value at contract inception may be different than the fair value on the date when the noncash consideration is received. Company A would recognize a gain on the exchange of $3 million ($3 million value of the noncash consideration received less zero book value for the compound Company A gave up).

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Relevant guidance

ASC 610-20-25-6: Once a contract meets all of the criteria in paragraph 606-10-25-1, an entity shall identify each distinct nonfinancial asset and distinct in substance nonfinancial asset promised to a counterparty in accordance with the guidance in paragraphs 606-10-25-19 through 25-22. An entity shall derecognize each distinct asset when it transfers control of the asset in accordance with paragraph 606-10-25-30.

ASC 606-10-32-21: To determine the transaction price for contracts in which a customer promises consideration in a form other than cash, an entity shall measure the estimated fair value of the noncash consideration at contract inception.

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1-17 Exchange of intangible assets when control of the nonfinancial asset is not transferred

Background / Question

Company A is developing a hepatitis vaccine compound. Company B is developing a measles vaccine compound. Company A and Company B enter into an agreement to exchange the two products. The exchange of products will not involve the transfer of legal entity ownership interests. Company A retains an option to repurchase the hepatitis vaccine. As such, Company A will not lose and Company B will not gain control of the hepatitis vaccine compound. The fair value at contract inception of Company B’s compound is $3 million. The carrying value of Company A’s compound was zero, as it was internally developed.

How should Company A account for the swap of vaccine compounds, assuming that the transaction has commercial substance?

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Solution

Given Company A can repurchase the hepatitis vaccine (i.e., via the call option), Company A would not recognize a gain or loss on the transaction as control has not transferred to Company B (as defined in ASC 606-10-25-30(c)).

Company A would evaluate the exercise price for the option to determine the accounting treatment. If the exercise price is greater than or equal to the original consideration received for the hepatitis vaccine (i.e., the $3 million fair value of the measles vaccine), Company A would recognize a financing arrangement. If the exercise price was less than the original consideration, Company A would recognize the arrangement as a lease under ASC 840 (or ASC 842 as applicable). The accounting for repurchase arrangements associated with transfers of nonfinancial assets can be complex. Refer to PwC’s Property, plant and equipment guide, Section 5.4.4.3 for further details.

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Relevant guidance

ASC 610-20-25-6: Once a contract meets all of the criteria in paragraph 606-10-25-1, an entity shall identify each distinct nonfinancial asset and distinct in substance nonfinancial asset promised to a counterparty in accordance with the guidance in paragraphs 606-10-25-19 through 25-22. An entity shall derecognize each distinct asset when it transfers control of the asset in accordance with paragraph 606-10-25-30.

ASC 606-10-32-21: To determine the transaction price for contracts in which a customer promises consideration in a form other than cash, an entity shall measure the estimated fair value of the noncash consideration at contract inception.

ASC 606-10-25-30: If a performance obligation is not satisfied over time in accordance with paragraphs 606-10-25-27 through 25-29, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and the entity satisfies a performance obligation, the entity shall consider the guidance on control in paragraphs 606-10-25-23 through 25-26. In addition, an entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

c.   The entity has transferred physical possession of the asset—The customer’s physical possession of an asset may indicate that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or to restrict the access of other entities to those benefits. However, physical possession may not coincide with control of an asset. For example, in some repurchase agreements and in some consignment arrangements, a customer or consignee may have physical possession of an asset that the entity controls. Conversely, in some bill-and-hold arrangements, the entity may have physical possession of an asset that the customer controls. Paragraphs 606-10-55-66 through 55-78, 606-10-55-79 through 55-80, and 606-10-55-81 through 55-84 provide guidance on accounting for repurchase agreements, consignment arrangements, and bill-and-hold arrangements, respectively.

ASC 606-10-55-66: A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase the asset. The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component.

A 606-10-55-68: If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset. Consequently, the entity should account for the contract as either of the following:

a.   A lease in accordance with Topic 840 on leases, if the entity can or must repurchase the asset for an amount that is less than the original selling price of the asset unless the contract is part of a sale-leaseback transaction. If the contract is part of a sale-leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale-leaseback in accordance with Subtopic 840-40.

b.   A financing arrangement in accordance with paragraph 606-10-55-70, if the entity can or must repurchase the asset for an amount that is equal to or more than the original selling price of the asset.

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1-18 Accounting for receipt of listed shares in exchange for a patent

Background / Question

Company A agrees to acquire a patent from Company B in order to develop a drug. Company A will pay for the right it acquires by giving Company B 5% of its shares (which are listed and not subject to any restrictions). Company B is in the business of licensing and selling patents in its patent portfolio; therefore, Company A is considered a customer. The listed shares are considered to be equal in value to the patent. If Company A is successful in developing a drug and bringing it to the market, Company B will receive a 5% royalty on all sales.

How should Company B account for this transaction?

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Solution

Company B should initially recognize the shares received as equity securities. Assuming that the equity security has a readily determinable fair value, subsequent changes in the fair value should be recognized in earnings. Company B should derecognize the patent transferred to Company A to the extent an asset has been previously recorded.

Company B concluded that Company A is a customer. In accordance with ASC 606, Company B should initially recognize as revenue the estimated fair value of the shares received at contract inception (i.e., the noncash consideration).

To the extent Company B can estimate a minimum amount of royalties it expects to receive and it is probable that the amount will not result in a significant reversal of cumulative revenue in the future, such estimated amounts are included in the transaction price at the time of sale. Company B should update its assessment of these royalties at each reporting date. Since the transaction is a sale of IP and not a license, the sales- and usage-based royalty exception in ASC 606 does not apply.

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Relevant guidance

ASC 321-10-20: Readily determinable fair value - An equity security has a readily determinable fair value if it meets any of the following conditions:

a.      The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by OTC Markets Group Inc. Restricted stock meets that definition if the restriction terminates within one year.

b.      The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparable to one of the U.S. markets referred to above...

ASC 321-10-35-1: Except as provided in paragraph 321-10-35-2 [equity securities without readily determinable fair values], investments in equity securities shall be measured subsequently at fair value in the statement of financial position. Unrealized holding gains and losses for equity securities shall be included in earnings.

ASC 606-10-32-21: To determine the transaction price for contracts in which a customer promises consideration in a form other than cash, an entity shall measure the estimated fair value of the noncash consideration at contract inception...

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration estimated only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

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Chapter 2: Intellectual Property

2-1 Accounting for a loss contingency when a settlement offer has been made in a lawsuit

Background / Question

Company A is the defendant in a patent infringement case. Company B (the plaintiff) alleges that Company A owes it $10 million for use of a specific patent and an additional $25 million for revenue lost because of competition. The trial has gone through the discovery phase, and as of December 31, 20X2, Company A has offered $15 million to settle both issues.

Company A has not received a response from the plaintiff as of December 31, 20X2. Therefore, Company A believes that the case may still be going to trial. Company A believes it is probable that a loss has been incurred, and the loss amount was estimated in the range of $15 million (the amount of its settlement offer) to $35 million (the maximum estimated loss in the event the case goes to trial). Company A does not believe there is a best estimate within this range.

What amount should Company A accrue as of December 31, 20X2?

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Solution

As the contingent loss related to an event that had already occurred as of the balance sheet date, and a loss is probable, Company A should accrue its best estimate of the contingency as of December 31, 20X2. A settlement offer is generally presumed to establish a minimum “probable loss.” This presumption could be overcome based on the specific facts and circumstances. As no estimate within the range represents a better estimate than any other, Company A should generally accrue the minimum amount in the range ($15 million). Company A should also disclose the nature and amount of the accrual.

If it is reasonably possible that an estimate of a contingent loss on the financial statements will change in the near term due to one or more future confirming events and the effect of the change would be material to the financial statements, disclosure of the nature and potential change in the accrual is also required.

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Relevant guidance

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...
  • The amount of the loss can be reasonably estimated...

ASC 450-20-50-1: Disclosure of the nature of an accrual made pursuant to the provisions of paragraph 450-20-25-2, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading. Terminology used shall be descriptive of the nature of the accrual, such as estimated liability or liability of an estimated amount. The term reserve shall not be used for an accrual made pursuant to paragraph 450-20-25-2; that term is limited to an amount of unidentified or unsegregated assets held or retained for a specific purpose. Examples 1 (see paragraph 450-20-55-18) and 2, Cases A, B, and D (see paragraphs 450-20-55-23, 450-20-55-27, and 450-20-55-32) illustrate the application of these disclosure standards.

ASC 450-20-50-2: If the criteria in paragraph 275-10-50-8 are met, paragraph 275-10-50-9 requires disclosure of an indication that it is at least reasonably possible that a change in an entity's estimate of its probable liability could occur in the near term. Example 3 (see paragraph 450-20-55-36) illustrates this disclosure for an entity involved in litigation.

ASC 275-10-50-8: Disclosure regarding an estimate shall be made when known information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that both of the following criteria are met:

a.  It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation, or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events.

b.  The effect of the change would be material to the financial statements.

ASC 275-10-50-9: The disclosure shall indicate the nature of the uncertainty and include an indication that it is at least reasonably possible that a change in the estimate will occur in the near term. If the estimate involves a loss contingency covered by Subtopic 450-20, the disclosure also shall include an estimate of the possible loss or range of loss, or state that such an estimate cannot be made. Disclosure of the factors that cause the estimate to be sensitive to change is encouraged but not required. The words reasonably possible need not be used in the disclosures required by this Subtopic.

ASC 450-20-30-1: If some amount within a range of loss appears at the time to be a better estimate than any other amount within the range, that amount shall be accrued. When no amount within the range is a better estimate than any other amount, however, the minimum amount in the range shall be accrued. Even though the minimum amount in the range is not necessarily the amount of loss that will ultimately be determined, it is not likely that the ultimate loss will be less than the minimum amount...

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2-2 Accounting for legal costs incurred in connection with a loss contingency

Background / Question

Company A is the defendant in a patent infringement case. The case was still in discovery as of December 31, 20X2 (Company A’s year-end), and there have been no discussions of possible settlement. Company A believes it will incur at least $2 million in litigation costs based on a case with similar facts for which it reached a settlement; however, it cannot make a determination of what the legal costs may be if the case goes to trial. A trial is scheduled to commence in the first quarter of 20X3 should a settlement not be reached.

Should Company A accrue legal costs it expects to incur in connection with a loss contingency?

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Solution

In the absence of authoritative guidance, Company A should make an accounting policy election with regard to the accounting for such litigation costs and disclose such policy, if material. Acceptable accounting policies include: (1) accrue the costs when they are probable and reasonably estimable and (2) expense such costs as incurred.

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Relevant guidance

As discussed in ASC 450-20-S99-2, there is no definitive guidance on whether an accrual must be made for legal costs that the entity expects to incur in connection with a loss contingency. ASC 450-20-S99-2 also states: The SEC Observer noted that the SEC staff would expect a registrant's accounting policy to be applied consistently and that APB Opinion No. 22, Disclosure of Accounting Policies, requires disclosure of material accounting policies and the methods of applying those policies.

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Chapter 3: Manufacturing & Supply

3-1 Treatment of validation batches

Background / Question

A laboratory has just completed the development of a new machine to mix components at a specified temperature to create a new formulation of aspirin. The laboratory produces several batches of the aspirin using the new machinery in order to obtain validation (an approval for the use of the machine) from the relevant regulatory authorities. The validation of the machinery is a separate process from the regulatory approval of the new formulation of aspirin.

Should expenditures to validate machinery be capitalized?

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Solution

Because validation is required to bring the machinery to its working condition, the laboratory should capitalize the costs incurred (including materials, labor, and applicable overhead) to obtain the necessary validation, together with the cost of the machinery. However, management should exclude abnormal validation costs caused by errors or rework during the validation process (such as wasted material, labor, or other resources). If later the machinery requires revalidation (after the initial validation and subsequent use), the costs related to this would be expensed as incurred as the asset had already been prepared for its original intended use.

Generally, any costs associated with validation batches that can be sold after the machinery is approved, should be accounted for as part of inventory.

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Relevant guidance

CON 5, par. 67(a): Property, plant, and equipment is reported at historical cost which is the amount of cash, or its equivalent, paid to acquire an asset, commonly adjusted after acquisition for amortization or other allocations…

ASC 835-20-05-1: ...The historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. If an asset requires a period of time in which to carry out the activities necessary to bring it to that condition and location, the interest cost incurred during that period as a result of expenditures for the asset is a part of the historical cost of acquiring the asset.

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3-2 Treatment and presentation of development supplies

Background / Question

Company A, a laboratory, has purchased 10,000 batches of saline solution. These batches are used in trials on patients during various Phase III clinical tests. They can also be used as supplies for other testing purposes, but have no other uses (i.e., Company A has no intention to sell the batches in the future). Management is considering whether the batches should be recorded as an asset.

Should costs associated with supplies used in clinical testing be accounted for as inventory?

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Solution

The batches do not meet the definition of inventory in ASC 330-10-20 because they are not held for sale, or consumed in the production of goods to be sold. However, the batches meet the definition of an asset (other current asset or prepaid asset) since they have alternative future uses in other development projects. They should therefore be recorded at cost and accounted for as supplies used in the development process. When supplies are used, the associated cost forms part of research and development expense.

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Relevant guidance

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale…

ASC 730-10-25-2-(a): …The costs of materials (whether from the entity's normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment or facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred…

CON 6, par. 26: An asset has three essential characteristics: (a) it emodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others’ access to it, and (c) the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred…

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3-3 Accounting for demonstration equipment

Background / Question

Company A produces manufacturing equipment. It provides its sales representatives with demonstration equipment that can be loaned to potential customers for a period of time before sale to the customer or return to Company A.

How should Company A account for demonstration equipment?

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Solution

Demonstration equipment is classified as inventory or fixed assets depending on a number of factors, including the nature of the equipment, the length of time it remains in the field prior to being sold, and management’s intent (i.e., to sell, place with another customer, continue to  loan). The longer a unit remains in the field before being sold or if it is used by sales representatives to demonstrate the equipment to multiple potential customers, the more likely it is that the equipment is a productive asset of the company. It should then be classified as a fixed asset and depreciated over its estimated useful life down to its estimated recoverable value. Equipment that remains in the field for a relatively short period prior to sale are generally classified as inventory and are not depreciated like a fixed asset.

Equipment that can be readily repaired or restored is more likely to be inventory than is a product that cannot. The need for a reserve to write the units down to their lower of cost or net realizable value (if classified as inventory) or their fair value (if classified as fixed assets) as a result of technological advances or physical wear and tear should be considered. The cash flow presentation of the purchases of such equipment should generally be consistent with the balance sheet classification (i.e., investing for fixed assets, operating for inventory).

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Relevant guidance

Con 6, par 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale…

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3-4 Pre-launch inventory – Treatment of “in-development” drugs

Background / Question

Company A developed a new drug and needs to have sufficient quantities of inventory on hand in anticipation of commercial launch once regulatory approval to market the product has been obtained. Company A has filed for regulatory approval and is currently awaiting a decision. Company A believes that final regulatory approval is probable.

Company A produced 15,000 doses following submission of the filing for regulatory approval. If regulatory approval is not obtained, the inventory has no alternative use. Company A measures inventory using FIFO.

How should the costs associated with the production of pre-launch inventory for drugs in-development be accounted for?

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Solution

Pre-launch inventory can be capitalized if it has probable future economic benefit, which is assessed based on the individual facts and circumstances. Factors to consider include whether key safety, efficacy, and feasibility issues have been resolved, the status of any advisory committee reviews, and an understanding of any potential hurdles to regulatory approval or product reimbursement.

Company A has filed for regulatory approval and believes future economic benefit is probable. Accordingly, the pre-launch inventory can be capitalized at the lower of cost or net realizable value. Periodic reassessments should be made to determine whether the inventory continues to have a probable future economic benefit (e.g., whether regulatory approval is still probable and whether the product will be sold prior to its expiration). If at any time regulatory approval is not deemed to be probable, the inventory should be written down to its net realizable value, which is presumably zero as it must be assumed that the product cannot be sold.  If the value of inventory is written down, the reduced amount is the new cost basis (i.e., if regulatory approval is ultimately obtained, the inventory is not written back up).

Companies should consider whether additional financial statement disclosures are necessary related to the capitalization of pre-launch inventory, including the judgments around the probable future benefit and total amount capitalized.

Further, if inventory that had previously been written down is ultimately sold, companies should consider disclosing the impact on margins.

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Relevant guidance

CON 6, par. 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale…

ASC 330-10-30-1: The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean acquisition and production cost, and its determination involves many considerations.

ASC 330-10-35-1B: Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out (FIFO) or average cost) shall be measured at the lower of cost and net realizable value. When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs. That loss may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes.

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3-5 Recognition of raw materials as inventory

Background / Question

Company A buys bulk materials used for manufacturing a variety of drugs. The materials are used for marketed drugs, samples, and drugs in development. The materials are warehoused in a common facility and released to production based upon orders from the manufacturing and development departments.

How should purchased materials be accounted for when their ultimate use is not known?

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Solution

Raw material costs can be capitalized to the extent the inventory has probable future economic benefit. Therefore, Company A should account for the raw materials that can be used in the production of marketed drugs as inventory.

When the material is consumed in the production of sample products, Company A should account for the sample product to be given away as an expense in accordance with its policy, which would generally be either when the product is packaged as sample product or the sample is distributed. When the materials are released to production for use in the manufacturing of drugs in development, the cost of the materials should be accounted for as research and development expense.

Alternatively, if the bulk materials were only able to be used for a particular research and development project, and did not have alternative future uses, the costs would be recognized as research and development expense when incurred, which would typically be when the bulk material is received by Company A.

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Relevant guidance

ASC 330-10-20: Inventory: The aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale.

ASC 730-10-25-2]: …The costs of materials (whether from the entity’s normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment of facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred…

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3-6 Indicators of impairment – Inventory

Background / Question

Company A has decided to temporarily suspend all operations at a certain production site due to identified quality issues. Company A initiated a recall of products manufactured at that site to be destroyed upon return. Company A carries a significant amount of raw material inventory used in the manufacturing of the recalled product. There is no work-in-process on hand at the time operations are suspended.

How should Company A assess if an impairment may exist?

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Solution

Company A would need to consider all available evidence to determine if there is an impairment. Suspending production and recalling the product are indicators that the carrying value of raw material inventory used to manufacture the drug, as well as any related finished goods on hand, may not be recoverable. Company A would need to evaluate the reason for the recall, its history with past recalls, the likelihood that the quality issue could be fixed, and if the raw materials have an alternative use.

In addition to product recalls, the following events are typical indicators within the pharmaceutical and life sciences industry that may trigger the need for an impairment test:

  • Patent expiration

  • Failure to meet regulatory or internal quality requirements

  • Product or material obsolescence

  • Market entrance of competitor products

  • Changes or anticipated changes in third-party reimbursement policies that will impact the selling price of the inventory

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Relevant guidance

ASC 330-10-35-1B: Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out (FIFO) or average cost) shall be measured at the lower of cost and net realizable value. When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs. That loss may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes.

ASC 330-10-35-1C: A departure from the cost basis of pricing inventory measured using LIFO or the retail inventory method is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to damage, physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.

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3-7 Accounting for patent-related costs

Background / Question

Company A has filed a number of patent applications and has incurred external legal and related costs in connection with the applications. Company A has also incurred legal costs in defense of its patents.

Should legal costs relating to the defense of patents be capitalized?

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Solution

Determining whether to capitalize or expense patent application costs involves judgment. To capitalize patent application costs, there must be probable future economic benefit, otherwise, the costs would need to be expensed. For example, if Company A’s product is in the research and development phase and has not yet been approved for commercialization, the costs incurred in connection with the patent application should generally be expensed in the income statement because there is uncertainty as to the product’s future economic benefit. If, on the other hand, a future economic benefit is probable, or it has an alternate future use, the application costs could be capitalized and amortized over the expected life of the patent.

Company A can also capitalize external legal costs incurred in the defense of its patents when a successful defense is probable and the future economic benefit of the patent is expected to increase as a result. Capitalized patent defense costs are amortized over the remaining life of the related patent. When the defense of the patent only maintains (rather than increases) its expected future economic benefit, the costs would generally be expensed as incurred. Losses to defend allegations of infringement against other parties’ patents are generally not in the defense of a company’s own patents.

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Relevant guidance

CON 6, par 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

CON 6, par 247: ...the legal and other costs of successfully defending a patent from infringement are “deferred legal costs” only in the sense that they are part of the cost of retaining and obtaining the future economic benefit of the patent.

AICPA Technical Practice Aids, Technical Questions and Answers Section 2260: If defense of the patent lawsuit is successful, costs may be capitalized to the extent of an evident increase in the value of the patent. Legal costs which relate to an unsuccessful outcome should be expensed.

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3-8 Accounting for contingent insurance proceeds

Background / Question

Company A is waiting to hear from Company B, an insurance company, with respect to a claim that was filed in the second quarter of 20X8. The claim was filed as a result of an accident at one of Company A’s production facilities that occurred late in the first quarter of 20X8, resulting in a period of business interruption.

The accident involved a production machine, which is an important component of one of Company A’s production lines. The machine will need to be completely refurbished at a cost of $5 million and will not be available for use until the fourth quarter of 20X8. Company A asserts it will lose $10 million in sales while the machine is out of service.

Company A’s insurance policy covers the full amount of the claim ($15 million). Company A believes it is clear the insurance policy covers its claim and does not anticipate coverage disputes by its carrier.

How should Company A analyze the components of the insurance claim?

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Solution

Company A should analyze the two components of this insurance claim separately.

The claim for lost revenues (business interruption) should be assessed using a gain contingency model under ASC 450–30 because of the inherent judgment involved in determining allowable claims and their amounts, and because no accounting loss was recorded. Therefore, recognition of the gain would likely not be appropriate prior to the carrier acknowledging that the claim is covered under the insurance policy and the amount to be paid to Company A. At that point, the carrier’s ability to pay the amount would need to be validated (at which point the gain would be considered realizable) before a receivable was recorded.

The damage to the equipment meets the ASC 610-30-25-3 definition of an involuntary conversion of a nonmonetary asset (machinery) to a monetary asset (insurance proceeds). If Company A believes that recovery of these losses from the insurer is probable, it should recognize an asset representing its best estimate of the amount it will recover. This amount should not exceed the amount of actual accounting loss to which the recovery relates (e.g., the impairment of the cost of the machine in this case). This accounting treatment is consistent with the guidance in ASC 410–30–35 (recoveries related to environmental remediation liabilities). In performing this probability assessment, Company A would likely consider (among other things) the terms and clarity of the existing agreement with Company B, the viability of Company B, and whether Company A has an established history of prior claims with Company B. Any potential proceeds in excess of the loss recorded on the asset for accounting purposes (i.e., if the asset was destroyed and the claim was for its fair value, which exceeded its book value) are considered a gain contingency and should be assessed as such as discussed for the business interruption claim.

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Relevant guidance

ASC 610-30-25-3: Involuntary conversions of nonmonetary assets to monetary assets are monetary transactions for which gain or loss shall be recognized even though an entity reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets...

ASC 450-30-25-1: A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements…

  • The amount of the loss can be reasonably estimated.

The purpose of those conditions is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period...

ASC 410-30-35-8: … An asset relating to the recovery shall be recognized only when realization of the claim for recovery is deemed probable…

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3-9 Selling raw materials to and purchasing finished goods from a subcontractor

Background / Question

Company A outsources the manufacturing of certain products to Company B. Company A purchases and then sells the raw materials to Company B, which processes the raw materials into finished goods. Company A is then obligated to repurchase the finished goods from Company B.

At the time of sale of the raw materials (at which point transfer of control passes), Company A invoices Company B and executes a purchase order to purchase from Company B a specific quantity of finished goods. Company B invoices Company A for the finished goods when delivered to Company A. Company B has physical risk of loss associated with the raw materials once received. The price of the finished goods purchased by Company A far exceeds the price Company B pays to buy the raw materials from Company A.

How should Company A record the sale of raw materials to Company B?

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Solution

Although not explicitly in its scope, in this example, it is appropriate to analogize to the guidance in ASC 470-40-25-2(a). Consistent with ASC 470–40–25–2(a) and ASC 606-10-55-66, Company A should retain the raw materials on its books (effectively, as consigned inventory) when they are “sold” to Company B. Any consideration received from Company B in advance of Company A’s repurchase of the finished goods should be accounted for as a financial liability. The liability would be relieved upon payment to Company B for the finished goods.

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Relevant guidance

ASC 470-40-05-2: Product financing arrangements include agreements in which a sponsor (the entity seeking to finance product pending its future use or resale) does any of the following: (a) Sells the product to another entity (the entity through which the financing flows), and in a related transaction agrees to repurchase the product (or a substantially identical product)...

ASC 470-40-05-3:... For an arrangement described in 2(a), see topic 606 revenue from contracts with customers for guidance on repurchase agreements in paragraphs 606-10-55-66 through 55-78 and an illustration on repurchase agreements in Example 62, Case A, paragraphs 606-10-55-401 through 55-404.

ASC 470-40-25-2(a):  If a sponsor sells a product to another entity and, in a related transaction, agrees to repurchase the product (or a substantially identical product) or processed goods of which the product is a component, the sponsor shall record a liability at the time the proceeds are received from the other entity to the extent that the product is covered by the financing arrangement. The sponsor shall not record the transaction as a sale and shall not remove the covered product from its balance sheet.

ASC 606-10-55-66: A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase the asset.  The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component.

ASC 606-10-55-70: If the repurchase agreement is a financing arrangement, the entity should continue to recognize the asset and also recognize a financial liability for any consideration received from the customer...

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Chapter 4: Business Combinations & Asset Acquisitions

4-1 Asset acquisition versus business combination – Scenario 1

Background / Question

Company A owns the rights to several drug compound candidates that are currently in Phase I of development. Other than the stage of development, the compounds have no other similarities and are designed to treat disparate conditions. Company A’s activities primarily consist of research and development (R&D) on these compounds. Company A employs management and administrative personnel as well as scientists, who are vital to the R&D.

Company B acquires the rights to the drug compound candidates along with Company A’s workforce composed primarily of scientists. None of the acquired drug compounds are similar. Two of the compounds are the predominant assets acquired.

Should Company B account for the transaction as a business combination or an asset acquisition?

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Solution

Company B should perform the screen test and consider whether substantially all of the purchase price is concentrated in a single identifiable asset or a group of similar identifiable assets.Based on the fact that none of the acquired compounds are similar, and two of the compounds are the predominant assets acquired, the screen test is likely not met and a full assessment must be performed. In the full assessment, Company B will need to consider whether it has acquired inputs, substantive processes, and outputs. Company B would likely conclude that there are no outputs acquired because the compounds are in early stage of development. Company B would need to consider whether the scientists hired by Company B through the transaction would meet the definition of an organized workforce that can be combined with an input and process to convert or develop an output. Factors to consider may include: the employees’ roles, whether the workforce is subject to contracts with employers or service organizations, as well as the nature and stage of the assets acquired. A conclusion that an organized workforce was acquired would result in Company B acquiring a business as opposed to assets.

This example assumes adoption of Accounting Standards Update 2017-01, Clarifying the Definition of a Business. Non-public business entities that have not yet adopted this guidance must make an assessment under the previous guidance.

ASU 2017-1 is effective for non-public business entities for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted, including adoption in an interim period.  Prospective application is required.

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Relevant guidance

ASC 805-10-55-3A defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. Further, to be capable of this, a business must have, at a minimum, an input and a substantive process that together significantly contribute to the ability to create an output.

ASC 805-10-55-5A through 55-5C introduce a screen test to be performed prior to the full assessment. The screen test states that if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not considered a business and no further analysis is required.

If the screen test is not met, then a company must perform further assessment. The framework for this assessment is discussed in ASC 805-10-55-5D through 55-9.

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4-2 Asset acquisition versus business combination – Scenario 2

Background / Question

Company A purchases a legal entity from Company B that contains the rights to a Phase 3 (in the clinical research phase) compound being developed to treat diabetes, or the in-process research and development (IPR&D) project. Included in the IPR&D project is the historical know-how, formula protocols, designs, and procedures expected to be needed to complete Phase 3. The legal entity also holds an at-market clinical research organization contract and an at-market clinical manufacturing organization contract. No employees, other assets, or other activities are transferred.

Should Company A account for the transaction as a business combination or an asset acquisition?

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Solution

Company A should perform the screen test and consider whether substantially all of the purchase price is concentrated in a single identifiable asset. The clinical research organization contract and the clinical manufacturing organization contract are at market rates and could be provided by multiple vendors in the marketplace. Therefore, there is no fair value associated with these arrangements. As a result, all of the consideration will be allocated to the IPR&D project. As such, Company A should account for the transaction as an asset acquisition.

This example assumes adoption of Accounting Standards Update 2017-01, Clarifying the Definition of a Business. Non-public business entities who have not yet adopted this guidance must make an assessment under the previous guidance.

ASU 2017-1 is effective for non-public business entities for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted, including adoption in an interim period.  Prospective application is required.

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Relevant guidance

ASC 805-10-55-3A defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. Further, to be capable of this, a business must have, at a minimum, an input and a substantive process that together significantly contribute to the ability to create an output.

ASC 805-10-55-5A through 55-5C introduce a screen test to be performed prior to the full assessment. The screen test states that if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not considered a business and no further analysis is required.

If the screen test is not met, then a company must perform further assessment. The framework for this assessment is discussed in ASC 805-10-55-5D through 55-9.

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4-3 Accounting for acquired IPR&D

Background / Question

Company A is in the pharmaceutical industry and owns the rights to several product (drug compound) candidates. Company A also has a product candidate that received FDA approval, but for which it has not yet started production. Company A’s activities only consist of R&D on these product candidates.

Company B, also in the pharmaceutical industry, acquires Company A, including the rights to all of Company A’s product candidates, testing and development equipment. Company B also hires all of the scientists formerly employed by Company A, who are integral to developing the acquired product candidates. Company B accounts for this transaction as an acquisition of a business.

How should Company B account for the acquired IPR&D?

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Solution

Company B should measure the acquired IPR&D at its acquisition date fair value and record it as an indefinite-lived IPR&D intangible asset. Subsequent to the acquisition, the acquired IPR&D would be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. To do so, Company B may elect to perform a qualitative impairment assessment under ASC 350-30-35-18A. If the qualitative assessment either failed or was not used, Company B would perform a quantitative assessment comparing the fair value of the IPR&D asset to its carrying value.

Incremental R&D costs subsequent to the acquisition would be expensed. Once the IPR&D asset becomes available for use, it should be amortized over its estimated useful life.

Company A’s product candidate that has received FDA approval (it is no longer “in-process”) would be recognized as a finite-lived intangible asset at the date of acquisition, separate from the acquired IPR&D, and amortized over its estimated useful life. The production, testing and developing equipment would generally be separately recognized as tangible assets, measured at fair value, and depreciated over their estimated useful lives.

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Relevant guidance

Under ASC 805, acquired IPR&D continues to be measured at its acquisition date fair value but is accounted for initially as an indefinite-lived intangible asset (i.e., not subject to amortization).

Post-acquisition, acquired IPR&D is subject to impairment testing, as required by ASC 350-30-35, until the completion or abandonment of the associated R&D efforts. If abandoned, the carrying value of the IPR&D asset is written off. Once the associated R&D efforts are completed, the carrying value of the acquired IPR&D is reclassified as a finite-lived asset and amortized over its useful life.

Incremental costs incurred on IPR&D after the acquisition date are expensed as incurred, unless there is an alternative future use, under ASC 730-10-25.

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4-4 Unit of account – IPR&D

Background / Question

Company A acquires Company B, a small pharma company, in a transaction accounted for as an acquisition of a business under ASC 805. Company B is developing a drug compound that is expected to become a leading product for its therapeutic indication. The project reached market approval in Canada, the US, and Europe just prior to acquisition, and regulatory approval is currently being pursued in Japan and Brazil. The project has been scaled to allow for additional trials to meet the regulatory requirements in each future jurisdiction.

What is the unit of account for the acquired IPR&D asset?

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Solution

It depends. Industry practice would suggest that Company A may recognize at least two, and potentially up to five, separate assets: one intangible asset representing the rights to the compound in all market-approved jurisdictions (or a separate asset for each of the three market approved jurisdictions) and one IPR&D asset for the portion still being developed (or two, if separated by jurisdiction). The late stage of development combined with the plan to scale trials to meet regulatory requirements in each future jurisdiction may suggest that disaggregation by jurisdiction of the intellectual property being developed is warranted. However, the specific facts and circumstances would need to be assessed to determine if the risk of further development, along with the associated costs would be different in the two jurisdictions.

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Relevant guidance

ASC 350-30-35 provides factors to consider in determining the appropriate unit of accounting both for recognition and subsequent impairment assessments of intangible assets. This determination for acquired IPR&D can be complex when an approved drug may ultimately benefit various jurisdictions. One approach is to record separate jurisdictional assets for each jurisdictions. Another approach is to record a single global asset. When making the unit of account determination, companies may consider, among other things, the following factors:

  • Phase of development of the related IPR&D project
  • Nature of the activities and costs necessary to further develop the related IPR&D project
  • Risks associated with the further development of the related IPR&D project;
  • Amount and timing of benefits expected to be derived from the developed asset
  • Expected economic life of the developed asset
  • Whether there is an intent to manage advertising and selling costs for the developed asset separately or on a combined basis
  • Once completed, whether the product would be transferred as a single asset or multiple assets

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4-5 Core or base technology

Background / Question

Company A acquired Company B, which is accounted for as an acquisition of a business under ASC 805. At the acquisition date, Company B produced and sold a medical scanner that includes Version 1.0 of its proprietary software. Company B was also conducting R&D related to significant improvements to Version 1.0 (Version 1.0 was being modified and would be partly reused in Version 2.0) that Company B expects to sell in their new scanner. Company B believes there is potential for additional enhancements that may be included in the next generation scanner, including new software Version 3.0. Version 3.0 was not yet under development at the date of the acquisition.

How should Company A account for the various versions of the technology?

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Solution

The fully developed and commercialized technology present in Version 1.0 would be recognized as a separate software technology asset and amortized over its useful life. The IPR&D activities related to the new technology to be included in Version 2.0 would be recognized as an indefinite-lived IPR&D asset. As Version 3.0 is not yet under development, and, therefore, lacks any substance as IPR&D, there would not be an asset recognized for Version 3.0.

Company A would also consider whether a separate enabling technology asset should be recognized for Version 1.0. The IPR&D guide indicates that the enabling technology, in order to be separately identifiable, should exhibit the same characteristics between the various products in which it is used.  If the enabling technology shares the same useful life, growth risk, and profitability of the products in which it is used, a separate asset would likely not be recognized. Company A would likely not record a separate enabling technology as the design and technology of Version 1.0 is not used in the same form in the later versions (i.e., it is further enhanced and altered). As a result, the value of the Version 1.0 technology that is able to be reused in later versions would be included as part of the Version 1.0 intangible asset as it is not considered to be a separate enabling technology asset.

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Relevant guidance

When IPRD involves enhancements to existing technologies, the allocation of value between a proven technology and an unproven (incomplete) research project can be difficult to measure. The AICPA’s Accounting and Valuation Guide on acquired intangible assets used in research and development activities (the IPR&D Guide) notes that value should be allocated to all identifiable assets, which could include IPR&D.

As described in section 8.2.4.1 in PwC’s Business Combinations guide, “[The IPR&D Guide] also eliminated the concept of core technology and introduces the concept of enabling technology which is intended to have a narrower definition. Enabling technology is…underlying technology that has value through its combined use or reuse across many product or product families. Examples of enabling technology provided in the IPR&D Guide include a portfolio of patents, a software object library, or an underlying form of drug delivery technology. If enabling technology meets the criteria for recognition as an intangible asset, it could be a separate unit of account if it does not share the useful life, growth, risk, and profitability of the products in which it is used. The IPR&D Guide indicates that enabling technology will be recognized as a separate asset less frequently than core technology had previously been recognized, and that the introduction of enabling technology is not expected to significantly contribute to the amount of recognized goodwill. As a result, elements of value previously included in core technology likely will be recognized separately as identifiable intangible assets that increase the value of developed technology and/or an IPR&D asset.”

While the IPR&D Guide is non-authoritative, it reflects the input of financial statement preparers, auditors, and regulators and serves as a US GAAP accounting and reporting resource for entities that acquire IPR&D.

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4-6 Assets acquired in a business combination to be used in commercial products and R&D

Background / Question

Company A is the owner of patented intellectual property used in medical devices that it currently markets and sells to customers. Company A is also using the intellectual property in certain ongoing R&D activities.

Company B acquires Company A in a business combination. Company B expects to continue to use the intellectual property in the sale of currently marketed products as well as in identified future R&D activities.

How should Company B account for the acquisition of the patented intellectual property?

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Solution

Company B would not assign the acquired patent an indefinite life upon acquisition because it is not solely being used for the purpose of an ongoing R&D. The patent would be accounted for under ASC 350-30-25 and treated as a single intangible asset or grouped with other intangible assets associated with the currently marketed product and would be amortized over a finite life.

If the patent was solely used in ongoing R&D, the AICPA concluded that it may be appropriate to aggregate the patent with other intangible assets used in the R&D activities and capitalize it as an indefinite lived IPR&D asset.

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Relevant guidance

ASC 350-30-35-17A: Intangible assets acquired in a business combination... that are used in research and development activities (regardless of whether they have an alternative future use) shall be considered indefinite lived until the completion or abandonment of the associated research and development efforts...

The AICPA’s Accounting and Valuation Guide on acquired intangible assets used in R&D activities a makes a distinction between complete and incomplete intangible assets used in R&D. Completed intangible assets acquired in a business combination to be used in R&D activities lack the necessary characteristic of being incomplete to be recorded as IPR&D. As a result, the AICPA concluded that these assets should be accounted for in accordance with their nature (e.g., market-related, technology-based). Only intangible assets that are incomplete and used in R&D activities should be accounted for in accordance with ASC 350-30-35-17A (that is, assigned an indefinite useful life upon acquisition).

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4-7 Amortization of acquired intellectual property

Background / Question

Company A acquires Company B in a business combination accounted for under ASC 805. As part of the business combination, Company A acquires the intellectual property of Company B that meets the criteria for separate recognition of an intangible asset apart from goodwill. The intellectual property acquired by Company A does not represent IPR&D.

When should Company A begin amortizing the acquired intellectual property, what factors should be considered in determining the amortization period, and how should the costs be classified in the income statement?

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Solution

Amortization of intangible assets should begin on the date the asset is available for its intended use, which is generally the acquisition date.

To determine the useful life, in addition to the factors in ASC 730-30-35-3, Company A should consider industry-specific factors, such as the following:

a.    Duration of the patent right or license of the product

b.    Redundancy of a similar medication/device due to changes in market preferences

c.    Unfavorable court decisions on claims related to product liability or patent ownership

d.    Regulatory decisions over patent rights or licenses

e.    Development of new drugs treating the same disease

f.     Changes in the environment that make the product ineffective (e.g., a mutation in the virus that is causing a disease, which renders it stronger)

g.    Changes or anticipated changes in participation rates or reimbursement policies of insurance companies

h.    Changes in government reimbursement or policies (e.g., Medicare, Medicaid) for drugs and other medical products

None of the above factors should be considered more presumptive than any other, and companies should consider all the facts and circumstances when estimating an asset’s useful life. Companies should also evaluate the remaining useful lives of their intangible assets each reporting period to determine whether events and circumstances warrant revisions to the estimated useful lives. A change in the estimated useful lives of intangible assets is considered a change in an accounting estimate and should be accounted for prospectively in the period of change and future periods.

Income statement classification of an intangible asset’s amortization expense should reflect the nature of the asset. If Company A expects to utilize the technology to support the commercialization process or to manufacture goods, the presumption is that amortization would be recorded as part of cost of goods sold.

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Relevant guidance

Pursuant to ASC 805-20-55-2 through 55-4, an intangible asset that meets the contractual-legal criterion or separability criterion is considered identifiable and is recognized at fair value using the market participant framework contained in ASC 820, Fair Value Measurement. Intangible assets are amortized over their estimated useful lives. If the precise length is unknown, intangible assets should be amortized over a company’s best estimate of the assets’ useful life.

ASC 350-30-35-2: The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity...

ASC 350-30-35-3: The estimate of the useful life of an intangible asset to an entity shall be based on an analysis of all pertinent factors, in particular, all of the following factors with no one factor being more presumptive than the other:

a.      The expected use of the asset by the entity.

b.      The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate.

c.      Any legal, regulatory, or contractual provisions that may limit the useful life. The cash flows and useful lives of intangible assets that are based on legal rights are constrained by the duration of those legal rights. Thus, the useful lives of such intangible assets cannot exceed the length of their legal rights and may be shorter.

d.      The entity’s own historical experience in renewing or extending similar arrangements, consistent with the intended use of the asset by the entity, regardless of whether those arrangements have explicit renewal or extension provisions. In the absence of that experience, the entity shall consider the assumptions that market participants would use about renewal or extension, consistent with the highest and best use of the asset by market participants, adjusted for entity-specific factors in this paragraph.

e.      The effects of obsolescence, demand, competition, and other economic factors (such as the stability of the industry, known technical advances, legislative action that results in an uncertainty or changing regulatory environment, and expected changes in distribution channels)

f.       The level of maintenance expenditures required to obtain the expected future economic benefits from the asset (for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life). As in determining the useful life of depreciable tangible assets, regular maintenance may be assumed but enhancements may not.

If an income approach is used to measure the fair value of an intangible asset, Company A should consider the period of expected cash flows used to measure fair value adjusted as appropriate for the entity-specific factors noted above.

The classification of amortization expense should generally be determined based on the asset’s intended use and recorded in the income statement accordingly.

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4-8 Cash flow presentation of up-front licensing fee

Background / Question

Company A and Company B enter into an agreement in which Company A will license Company B’s know-how and technology related to a compound in the research stage. The agreement stipulates that Company A will make a non-refundable payment of $3 million to Company B for access to the technology.

Company A determines that this meets the definition of an asset acquisition and the license has no alternative future use. Company A expenses the $3 million as incurred as R&D costs.

What is the appropriate presentation of up-front licensing fees on the statement of cash flows?

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Solution

Company A should consider the nature of the underlying cash flow in determining its classification. Although the acquisition of an asset is often an investing activity, R&D costs are generally operating expenditures. In this case, Company A determined the upfront license fee was R&D expense, and because of this, the payment would generally be considered an operating cash outflow, which is the predominant nature of the expenditure.

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Relevant guidance

ASC 230-10-45-22: In the absence of specific guidance, a reporting entity shall determine each separately identifiable source or each separately identifiable use within the cash receipts and cash payments on the basis of the nature of the underlying cash flows, including when judgment is necessary to estimate the amount of each separately identifiable source or use. A reporting entity shall then classify each separately identifiable source or use within the cash receipts and payments on the basis of their nature in financing, investing, or operating activities.

ASC 230-10-45-22A: In situations in which cash receipts and payments have aspects of more than one class of cash flows and cannot be separated by source or use... the appropriate classification shall depend on the activity that is likely to be the predominant source or use of cash flows for the item.

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Chapter 5: Leases

Accounting for leases – Lessee section

5-1 Identifying a lease - Scenario 1

Background / Question

Company A, a biotech company, enters into an arrangement with Company B, a contract manufacturing organization, to produce medical equipment and disposables (“the Products”) that Company A then sells to outside customers. Company B has multiple production lines that it uses to fulfill orders for multiple customers. The arrangement allows Company B to choose the production line used to fulfill Company A’s orders. Even after the production of the Products commences on a product line, Company B can easily change to a different production line with minimal transfer costs. Company A submits legally-binding purchase orders quarterly to Company B and is contractually required to provide an annual non-binding production forecast. The products are generic, can easily be stored and Company B has full discretion over the operating process, including the selection of materials to use in production.

Does this arrangement contain a lease?

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Solution

This arrangement likely does not contain a lease under ASC 842. While the use of an asset, the production line, is implicit in the contract, there is likely no identified asset because substantive substitution rights exist. Also, there is likely not a lease because Company B has the right to change the operating process and decide when the output is produced.

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Relevant guidance

The right to control the use of an asset may not necessarily be documented, in form, as a lease agreement. Often, the right to use an identified asset is embedded in an arrangement that may appear to be a supply arrangement or service contract. Therefore, a reporting entity should consider all of the terms of an arrangement to determine whether it contains a lease.

ASC 842-10-15-3: A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).

ASC 842-10-15-10: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:

a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).

b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

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5-2 Identifying a lease - Scenario 2

Background / Question

Company A, a biotech company, enters into an arrangement with Company B, a contract manufacturing organization, to produce medical equipment and disposables (“the Products”) that Company A then sells to outside customers. The Products are highly specialized, there is a dedicated production line for the Products and Company B is contractually restricted from using any other production line to fulfill its obligations under the arrangement. Purchase orders are very frequent and key operating decisions are predetermined by Company A and any changes are subject to approval by Company A.

Question #1: Does this arrangement contain a lease?

Question #2: How should Company A account for this embedded lease under ASC 842?  

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Solution

Question #1: Does this arrangement contain a lease?

There is an identified asset explicit in the contract (that is, the production line) and there are no substitution rights.

Company A has the right to obtain substantially all of the economic benefit from the use of the identified asset. Company A also directs the use of the identified asset because Company B does not have the right to change the operating instructions, including types of  materials/components, overall production process, and other decisions related to the output, without prior authorization by Company A. Further, Company A is also directing the use of the production line through frequent purchase orders, which, consequently, determine whether and when the equipment is used.

Company A controls the use of the identified asset because Company A (1) has the right to obtain substantially all of the economic benefit from the use of the identified asset and (2) has the right to direct the use of the identified asset and therefore, this arrangement is likely to contain a lease under ASC 842.

Question #2: How should Company A account for this embedded lease under ASC 842?

Company A should allocate the expected consideration between the leased production line (lease component) and the services to produce the drug product (non-lease component) based on their relative standalone selling prices at contract inception. If the arrangement contains fixed consideration, (or if Company A is required to purchase minimum volumes, which would establish fixed minimum consideration) then Company A would record a lease liability on its balance sheet at the present value of the amount of fixed consideration allocated to the lease, and a corresponding right-of-use (ROU) asset.

If the contract contains no minimum monthly volume, the arrangement would continue to contain an embedded lease; however, the consideration would be 100% variable. Because variable consideration is excluded from the measurement of the lease liability, there would be no initial accounting for this agreement. Instead, Company A would allocate and record a portion of each payment as variable lease expense for the embedded lease component and a portion as the cost of the contract manufacturing. Alternatively, under ASC 842, Company A can elect not to separate lease components from non-lease components and instead disclose the consideration in the arrangement entirely as lease expense.

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Relevant guidance

ASC 842-10-15-3: A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).

ASC 842-10-15-10: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive if both of the following conditions exist:

a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).

b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

ASC 842-10-15-4: To determine whether a contract conveys the right to control the use of an identified asset (see paragraphs 842-10-15-17 through 15-26) for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

a. The right to obtain substantially all of the economic benefits from use of the identified asset (see paragraphs 842-10-15-17 through 15-19)

b. The right to direct the use of the identified asset (see paragraphs 842-10-15-20 through 15-26).

If the customer in the contract is a joint operation or a joint arrangement, an entity shall consider whether the joint operation or joint arrangement has the right to control the use of an identified asset throughout the period of use.

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5-3 Identifying components in an arrangement

Background / Question

Company A, a biotech company leases a biotech lab facility, including the land on which the building is situated, and laboratory equipment, from Company B, the lessor. Company B does not lease or sell the equipment separately, but other suppliers do. The laboratory equipment can be used in other facilities. The monthly payment to the lessor includes (a) fixed rent for the building, land, and laboratory equipment; (b) a fixed amount for property taxes and insurance; (c) a fixed amount for maintenance related to the laboratory equipment; and (d) a fixed amount related to the maintenance of building and land. The accounting effect of treating the right to use land as a separate lease component is insignificant because doing so would not have an impact on the classification of any lease component.

What are the lease components in this arrangement?

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Solution

The lease components in the arrangement are the building (including land) and laboratory equipment. The nonlease components are the maintenance services for the building (including land) and maintenance services for the laboratory equipment. The lease of the laboratory equipment is considered a separate component from the lease of the building and land as it is neither dependent on, nor highly interrelated with the building or land since the equipment could be sourced from other providers and be used in other facilities.

Maintenance services for the building (including land) and equipment involve the provision of separate services to Company A and are considered separate nonlease components.

Real estate taxes and insurance do not represent separate goods or services and therefore are not contract components. Any payments related to those amounts would be included in the overall contract consideration to be allocated to the identified contract components.

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Relevant guidance

ASC 842-10-15-28: After determining that a contract contains a lease in accordance with paragraphs 842-10-15-2 through 15-27, an entity shall identify the separate lease components within the contract. An entity shall consider the right to use an underlying asset to be a separate lease component (that is, separate from any other lease components of the contract) if both of the following criteria are met:

a. The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).

b. The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.

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5-4 Build-to-suit

Background / Question

Company A, a pharmaceutical company, enters into an arrangement with a real estate company, Company B (landlord), for the lease of a building that will house biotech labs once constructed. Company B hires a construction company to build the building. Company A is required to provide the design for the building and to reimburse Company B for the construction to modify rooms to create labs and for Company B’s purchase of the related equipment. The equipment will remain in the building at the end of the lease term, can be utilized by a subsequent tenant, and are considered Company B’s assets. Company B holds legal title to the land on which the building will be built as well as the legal title to the building under construction. Company B does not have an enforceable right to payment for its performance to date. Company A does not have the right to buy the partially-constructed building at any point during the construction period.

How should Company A account for the above construction?

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Solution

Company A does not control the building under construction because (a) the building is legally owned by Company B; (b) Company B does not have an enforceable right to payment for its performance to date; (c) Company B owns the land on which the building will be constructed and Company A does not control or lease the land; and (d) Company A does not have the right to buy the partially constructed building at any point during the construction period. Company A would record the costs incurred relating to the design of the building, the construction of the labs, and purchase of the related equipment as lease payments because they are costs incurred in connection with the completion of lessor assets and do not represent payment for goods or services provided to Company A. Company A would recognize such costs as prepaid rent (and reclassify the prepaid rent to the right-of-use asset upon commencement of the lease).

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Relevant guidance

ASC 842-40-55-5: If the lessee controls the underlying asset being constructed before the commencement date, the transaction is accounted for in accordance with this Subtopic. Any one (or more) of the following would demonstrate that the lessee controls an underlying asset that is under construction before the commencement date:

a. The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor).

b. The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.

c. The lessee legally owns either:

1. Both the land and the property improvements (for example, a building) that are under construction.

2. The non-real-estate asset (for example, a ship or an airplane) that is under construction.

d. The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements.

e. The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements, and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.

The list of circumstances in ASC 842-40-55-5 indicting a lessee controls an underlying asset that is under construction before the commencement date is not all inclusive. There may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset that is under construction before the commencement date.

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5-5 Accounting for modification – separate lease

Background / Question

Company A, a life sciences company, enters into a 5-year lease for 2,000 square feet of warehouse space with Company B, a landlord, for $10,000 per month.

At the end of year one, Company A and Company B agree to amend their lease contract to include an additional 1,000 square feet of warehouse space in the same building for the remaining four years of the lease. Company A pays an additional $6,000 per month for the additional space. The additional $6,000 is in line with the current market rate to lease 1,000 square feet of warehouse space in that particular building at the date that the modification is agreed to. Company A will make monthly payments of $16,000 per month after the modification.

How should Company A account for this lease modification?

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Solution

Company A should account for the lease modification as a separate lease because the modification granted Company A an additional right of use at a price that is commensurate with the standalone price for the additional space. Therefore, on the new lease commencement date, Company A would have two separate leases:

  • The original lease for 2,000 square feet for five years

  • A new lease for the additional 1,000 square feet for four years

The accounting for the original lease is not impacted by the modification.

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Relevant guidance

ASC 842-10-25-8: An entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present:

a. The modification grants the lessee an additional right of use not included in the original lease (for example, the right to use an additional asset).

b. The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract.  For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee.

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5-6 Accounting for a sub-lease

Background / Question

Company A, a biotech company, enters into a building lease with a 25 year term. The building has a depreciable life of 40 years. At the end of year 3, Company A enters into an agreement with Company B to sublease the building to Company B for the remaining 22 years. Company A is not relieved of its obligations under the original head lease.

How should Company A account for its sublease with Company B?

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Solution

Company A would account for the sublease to Company B as an operating lease because the term of the sublease is not for a major part of the remaining life of the underlying asset of the sublease (i.e., the sublease term of 22 years represents only 59% of the remaining 37-year life of the building) and Company A has concluded that no other classification criteria in ASC 842-10-25-2 would result in a sales-type lease.

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Relevant guidance

In a sublease, an entity is both a lessee and a lessor for the same underlying asset. In a sublease, a lessee subleases the underlying asset to a sublessee; the entity is then referred to as the intermediate lessor (or sublessor). In a sublease transaction, the lease between the original lessee and lessor (referred to as the head lease) remains in effect.

ASC 842-10-25-2: A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

a.  The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

b.  The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

c.  The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

d.  The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.

e.  The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

ASC 842-10-25-6: When classifying a sublease, an entity shall classify the sublease with reference to the underlying asset (for example, the item of property, plant, or equipment that is the subject of the lease) rather than with reference to the right-of-use asset.

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Accounting for leases – Lessor section

5-7 Substitution rights

Background / Question

Company A, a medical device company,  enters into an arrangement with Company B, a hospital, to provide a medical imaging scanner and supply medical imaging consumables (cartridges) for five years. Upon executing the arrangement, Company A installs a medical imaging scanner at Company B’s premises that requires the use of Company A’s consumables. The scanner has been customized to run Company B’s proprietary software. Company A provides the scanner free of charge to Company B; however, Company A expects to recover the scanner cost through Company B’s purchase of consumables. Legal title to the scanner remains with Company A. The contract permits Company A to substitute the scanner. However, due to the potential disruption substitution would have on Company B’s activities, the contract includes a significant penalty in the event of downtime above a specified threshold. Therefore, it is expected that Company A will not substitute the equipment, except in the case of malfunction. Company A also provides maintenance services.

Does the arrangement contain a lease?

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Solution

Yes, the arrangement contains a lease. Although the contract does not explicitly specify the scanner, it is on site and customized for Company B. As a result, it is implicitly identified. While Company A has the legal right of substitution, this right is not substantive due to the significant disruption and potential downtime penalty if the equipment was to be substituted (substitution for maintenance or malfunction is not considered a substantive right to substitute). Therefore, the arrangement contains an identified asset, i.e., the scanner.

Company B has the right to control the use of the equipment throughout the period of use because:

a. Company B has the right to obtain substantially all of the economic benefits from the use of the identified equipment based on its exclusive access and use of the equipment during the five-year term; and

b. Company B makes the relevant decisions about how and when the equipment is operated by the hospital staff in their practice of medicine throughout the period of use.

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Relevant guidance

ASC 842-10-15-4: To determine whether a contract conveys the right to control the use of an identified asset … for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

a. The right to obtain substantially all of the economic benefits from use of the identified asset ...

b. The right to direct the use of the identified asset ...

ASC 842-10-15-10: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive if both of the following conditions exist:

a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).

b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

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5-8 Lease classification

Background / Question

Company A, a medical device manufacturer, leases specialized medical imaging equipment to Company B, a hospital, designed and customized to work with Company B’s proprietary software. Given the age and customization of the equipment for Company B, Company A would incur significant costs to modify the equipment for use with another lessee or to facilitate its sale. The costs exceed the expected benefit resulting from any such sale. The arrangement is a lease of the equipment with the following additional facts:

Lease term

4.5 years with no renewal option

Purchase option

None

Present value of lease payments

$200,000

Fair value of the equipment

$200,000

Remaining economic life of equipment         

5 years

Title to the asset remains with Company A upon lease expiration

How should Company A classify the lease?

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Solution

Since the equipment is of such a specialized nature that it is expected to have no alternative use to Company A at the end of the lease term, Company A would classify the lease as a sales-type lease. In this example, Company B has effectively obtained control of the underlying asset, which is economically similar to Company A selling the asset to Company B. Therefore, upfront profit recognition would be appropriate assuming collectibility of the lease payments is probable.

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Relevant guidance

ASC 842-10-25-2: A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

a.  The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

b.  The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

c.  The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

d.  The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.

e.  The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

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5-9 Allocation of consideration to components of lease contract

Background / Question

Company A, a medical device manufacturer, enters into an arrangement to lease medical equipment to Company B, a hospital, for a five-year period and to sell 4,500 disposable units per year to be used in the operation of the equipment. Disposables used for other medical equipment owned by Company B can be used in the medical equipment leased from Company A. Similarly, disposables purchased from Company A can be used in operating either the leased medical equipment or other medical equipment owned by Company B; therefore, the amount of disposables purchased by Company B is unrelated to the usage of the leased medical equipment. In addition, under the terms of the arrangement, Company A will provide maintenance services (similar maintenance services are sold separately by Company A for $10,000) and training (sold separately by Company A for $5,000) for no additional consideration. Company B will pay Company A $4.00 per disposable purchased.

The medical equipment has a useful life of five years and is not expected to have any residual value at the end of the lease term. Company A’s cost of the medical equipment is $14,000. At the lease commencement date, the standalone selling price of the equipment lease component is $15,000 and the standalone selling price of each disposable is $3.50.

Company A determines that the arrangement has one lease component - the lease of medical equipment, and three nonlease components - disposables, maintenance, and training. Total contract consideration is $90,000 (4,500 disposable units per year x 5 years x $4.00/unit). Any purchases above 4,500 units are considered optional purchases and therefore the right to purchase excess units is not considered a separate component. Company A has not elected to utilize the practical expedient described in ASC 842-10-15-42A, which would allow lease and nonlease components to be accounted for as a single component if certain criteria are met.

How should Company A allocate contract consideration among the various lease and nonlease components at lease commencement?

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Solution

The lease and nonlease components represent separate performance obligations under the revenue guidance in ASC 606. The $90,000 contract consideration would be allocated to lease and nonlease components based on their relative standalone selling price at lease commencement as follows:

 

Standalone price 

Allocation %

Allocation of contract consideration

 

(A)

(A/$108,750) = (B)   

(B*$90,000)          

Leased equipment

$15,000             

14%                    

$12,600                     

Disposables

78,750*

72%

64,800

Maintenance            

10,000

9%

8,100

Training

5,000

5%

4,500

Total

$108,750     

100%

$90,000      

 

*4,500 disposable units per year x 5 years x $3.50 standalone price/unit

At the commencement date, Company A would classify the lease as a sales-type lease because the lease term (5 years) is for the major part of the remaining economic life of the medical equipment (5 years) and collectibility of lease payments is probable at commencement date. Based on the allocation of transaction consideration, Company A would record $12,600 in revenue and net investment in the lease. It would also remove the equipment (carrying value $14,000) from its balance sheet; and record $14,000 cost of goods sold, resulting in a day-1 loss of $1,400 at the commencement date.*4,500 disposable units per year x 5 years x $3.50 standalone price/unit

Note - This example ignores any initial direct costs as well as the effect of discounting. ASC 842 requires lessors to discount lease payments using the rate implicit in the lease.

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Relevant guidance

ASC 842-10-15-38: A lessor shall allocate the consideration in the contract to the separate lease components and the nonlease components using the requirements in ASC 606-10-32-28 through 32-41...

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Chapter 6: Revenue Recognition

6-1 Scope considerations when accounting for collaboration agreements

Background / Question

Company A grants an IP license to a drug compound to Company B and will perform manufacturing services on the compound. Company A receives an upfront payment of $40 million, per-unit payments for manufacturing services performed, and a milestone payment of $150 million upon regulatory approval. Consideration payable under this arrangement is at market rates and all payments received by Company A are non-refundable.

Is this arrangement within the scope of ASC 606?

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Solution

Determining whether an arrangement is within the scope of ASC 606 can be a difficult judgment at times. In this case, the arrangement appears to be in the scope of the revenue standard as Company A and Company B appear to have a vendor-customer relationship. Company A is providing a license and manufacturing services to Company B and those goods and services are the outputs of Company A’s ordinary activities. The fees paid are at market rates and payments received are non-refundable. Also, the two companies do not appear to share in the risks and rewards that result from the activities under the arrangement.

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Relevant guidance

ASC 606-10-15-3: An entity shall apply the guidance in this Topic to a contract…only if the counterparty to the contract is a customer. A customer is a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration...

ASC 808-10-20: Collaborative arrangement: A contractual arrangement that involves a joint operating activity (see paragraph 808-10-15-7). These arrangements involve two (or more) parties that meet both of the following requirements:

a.  They are active participants in the activity (see paragraphs 808-10-15-8 through 15-9).

b.  They are exposed to significant risks and rewards dependent on the commercial success of the activity (see paragraphs 808-10-15-10 through 15-13).

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6-2 Receipts for out-licensing of IP

Background / Question

Company A and Company B enter into an agreement in which Company A will license Company B’s IP related to a compound for HIV. Company B will not undertake any other activities under the contract. Company A will use Company B’s IP for a period of three years. Company B obtains a non-refundable upfront payment of $30 million for access to the IP. Company B will also receive a royalty of 20% from sales of the HIV compound if Company A successfully develops a marketable drug.

How should Company B account for the receipts for the out-license of its IP?

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Solution

Given the IP relates to a drug compound, has standalone functionality and Company B will not perform any further activities that affect that functionality. As such, Company B would conclude that it has granted a “right to use” license to functional IP. As a result, the non-refundable upfront payment of $30 million would be recognized at the point in time that the license is granted to Company A.

Company B applies the exception for variable consideration related to sales- or usage-based royalties received in exchange for licenses of IP, therefore the royalties would not be included in the transaction price until Company A sells the product, regardless of whether or not Company B has predictive experience with similar arrangements.

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Relevant guidance

ASC 606-10-55-62: A license to functional intellectual property grants a right to use the entity’s intellectual property as it exists at the point in time at which the license is granted unless both of the following criteria are met:

a.      The functionality of the intellectual property to which the customer has rights is expected to substantively change during the license period as a result of activities of the entity that do not transfer a promised good or service to the customer... Additional promised goods or services (for example, intellectual property upgrade rights or rights to use or access additional intellectual property) are not considered in assessing this criterion.

b.      The customer is contractually or practically required to use the updated intellectual property resulting from the activities in criterion (a)...

ASC 606-10-55-65: ...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:

a.      The subsequent sale or usage occurs.

b.      The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

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6-3 Contract term

Background / Question

Biotech enters into a ten-year term license arrangement with Pharma under which Biotech transfers to Pharma the exclusive rights to sell product using its intellectual property (IP) in a particular territory. The IP is considered “functional” (as defined) and there are no other performance obligations in the arrangement. Pharma makes an upfront non-refundable payment of $25 million and is obligated to pay an additional $1 million at the end of each year throughout the stated term.

Pharma can cancel the contract for convenience at any time, but must return its rights to the licensed IP to Biotech upon cancellation. Pharma does not receive any refund of amounts previously paid upon cancellation.

What is the contract term for purposes of applying the revenue standard?

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Solution

Biotech would likely conclude that the contract term is ten years because Pharma cannot cancel the contract without incurring a substantive termination penalty. The substantive termination penalty in this arrangement is Pharma’s obligation to transfer an asset to Biotech through the return of its exclusive rights to the licensed IP without a refund of amounts paid. Also, since the additional annual payments are due over a ten year period, Biotech would likely conclude that the arrangement contains a significant financing component. Therefore, Biotech would record $25 million plus the present value of the 10 $1 million payments due at the end of each year through the stated term upon transferring control of the license.

Entities should consider termination clauses when assessing contract duration. If a contract can be terminated early for no compensation, enforceable rights and obligations would likely not exist for the entire stated term. The contract may, in substance, be a shorter-term contract with a right to renew. In contrast, a contract that can be terminated early, but requires payment of a substantive termination penalty, is likely to have a contract term equal to the stated term. This is because enforceable rights and obligations exist throughout the stated contract period.

The assessment of whether a substantive termination penalty is incurred upon cancellation could require significant judgment for arrangements that include a license of IP. Factors to consider include the nature of the license, the payment terms (for example, how much of the consideration is paid upfront), the business purpose of contract terms that include termination rights, and the impact of contract cancellation on other performance obligations, if any, in the contract. If management concludes that a termination right creates a contract term shorter than the stated term, management should assess whether the arrangement contains a renewal option that provides the customer with a material right.

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Relevant guidance

ASC 606-10-25-3: Some contracts with customers may have no fixed duration and can be terminated or modified by either party at any time. Other contracts may automatically renew on a periodic basis that is specified in the contract. An entity shall apply the guidance in this Topic to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations…

ASC 606 Basis of Conclusion 50: The Boards decided that Topic 606 should not apply to wholly unperformed contracts if each party to the contract has the unilateral enforceable right to terminate the contract without penalty. Those contracts would not affect an entity’s financial position or performance until either party performs. In contrast, there could be an effect on an entity’s financial position and performance if only one party could terminate a wholly unperformed contract without penalty. For instance, if only the customer could terminate the wholly unperformed contract without penalty, the entity is obliged to stand ready to perform at the discretion of the customer. Similarly, if only the entity could terminate the wholly unperformed contract without penalty, it has an enforceable right to payment from the customer if it chooses to perform.

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6-4 Determine the transaction price

Background / Question

Company A, a biotechnology company, enters into a license arrangement with Company B, a pharmaceutical company, to jointly develop a potential drug that is currently in Phase II clinical trials. As part of the arrangement, Company A agrees to provide Company B a perpetual license to Company A’s proprietary intellectual property. Company A also agrees to provide research and development (R&D) services in the form of clinical trials to Company B to develop the potential drug. Company A receives an upfront payment of $20 million at the inception of the arrangement and is eligible to receive a milestone payment of $25 million upon regulatory approval.

How should Company A determine the transaction price for this arrangement?

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Solution

Company A will receive a fixed amount of $20 million upfront and may receive a variable amount of $25 million if the drug receives regulatory approval. In this case, Company A would use the “most likely amount” method since the outcome is binary (i.e., either regulatory approval is granted or it is not).

At contract inception, Company A may not be able to assert that it is likely the regulatory approval will be granted and that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. This is due to the current stage of development and the fact that regulatory approval (i.e., judgments and actions of third parties) cause the underlying consideration to be highly susceptible to factors outside of the Company’s influence.

Therefore, at contract inception, Company A’s total transaction price would be $20 million, consisting of just the upfront payment. Company A will update its estimate at each reporting date until the uncertainty is resolved.

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Relevant guidance

ASC 606-10-32-2: An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer... The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.

ASC 606-10-32-8: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a. The expected value—The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.

b. The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 606-10-32-8 only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

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6-5 Assessing distinct promises (license and R&D services)

Background / Question

Company A, a biotechnology company, enters into an arrangement to provide Company B with a license to manufacture and commercialize an early-stage drug compound as well as perform ongoing R&D services on Company B’s behalf to continue to develop the compound. The compound is currently in Phase II clinical trials. The license is delivered to Company B in the first quarter and the R&D services will be provided over time.

What factors should Company A consider when assessing whether the license is a separate performance obligation in this arrangement?

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Solution

Significant judgment is required when identifying the number of performance obligations in an arrangement that includes a license to IP as well as R&D services performed by the licensor. In determining whether the license is distinct, Company A should consider whether the license is capable of being distinct and whether the promise to transfer the license is distinct in the context of the contract.

Capable of being distinct

This criterion is met if Company B can benefit from the license on its own or with other readily available resources. The license may not be capable of being distinct if the R&D services are so specialized that the services could only be performed by Company A as opposed to Company B or another qualified third party.

Distinct in the context of the contract

This criterion is met if the promise to transfer the license is separately identifiable from the R&D services. The license may be separately identifiable from the R&D services if the R&D services are not expected to significantly modify or customize the initial IP. This is often the case with clinical trials when the purpose is to validate the usage and efficacy of a drug versus significantly modifying or customizing the initial IP (e.g., the drug compound).

Conversely, in the case of very early stage IP (e.g., within the drug discovery cycle) whereby the R&D services are expected to involve significant further development of the drug formula or biological compound, Company A might conclude that the license is not separately identifiable from the R&D services.

Company A should also evaluate if the R&D services are optional; that is, could the customer decide to cancel at any time with no penalty or hire another vendor or biotech to perform the services. Optional services may indicate that the only enforceable rights and obligations relate to the license of IP. In that circumstance, Company A would need to assess if a material right exists with regard to future optional R&D services, which may be the case, for example, if the R&D services were priced at an amount below standalone selling price.

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Relevant guidance

ASC 606-10-25-19: A good or service that is promised to a customer is distinct if both of the following criteria are met:

  • The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

  • The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

ASC 606-10-25-20: A customer can benefit from a good or service... if it can be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits. For some goods or services, a customer may be able to benefit from a good or service on its own. For other goods or services, a customer may be able to benefit from the good or service only in conjunction with other readily available resources. A readily available resource is a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. Various factors may provide evidence that the customer can benefit from a good or service either on its own or in conjunction with other readily available resources. For example, the fact that the entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources.

ASC 606-10-55-56: ...Examples of licenses that are not distinct from other goods or services promised in the contract include the following:

a. A license that forms a component of a tangible good and that is integral to the functionality of the good

b. A license that the customer can benefit from only in conjunction with a related service...

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6-6 Assessing distinct promises (license and manufacturing)

Background / Question

Company A, a pharmaceutical company, enters into an agreement with Company B to provide them with a license related to a mature product for a period of 10 years. For the first 5 years, Company A will continue to manufacture the drug while Company B is developing their manufacturing facilities. As the license is related to a mature product, it is not expected that the underlying product will change over the license period.

What factors should Company A consider when assessing whether the license is a separate performance obligation in this arrangement?

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Solution

Determining whether the license is distinct in this scenario will depend upon the facts and circumstances surrounding the license and the related manufacturing services. Company A will need to determine whether the customer can benefit from the license on its own, as well as whether the license is separately identifiable from the manufacturing services. For example, if the manufacturing process is highly specialized and only Company A has the knowledge and expertise to perform the manufacturing services, the license may not be distinct as Company B cannot benefit from the license on its own but rather requires the ongoing involvement of Company A to continue the manufacturing. If that were the case, the license may not be separately identifiable as Company B has contracted with Company A for the license as well as the manufacturing of the product for the first 5 years. In other words, Company B can only benefit from the license in conjunction with the related manufacturing services and therefore the license is not considered distinct and the license and manufacturing services would be accounted for as a single performance obligation.

Conversely, if Company B could contract with another company to perform the manufacturing services (for example, a contract manufacturing organization), the license may be distinct as the customer can benefit from the license on its own without Company A’s ongoing involvement. This would be the case even if Company B is contractually required to use Company A to manufacture the product for the defined period. Additionally, the license may be separately identifiable as Company B is not contracting for the combined output of the license and manufacture of product, and Company A could fulfill its promise to deliver the license independent of fulfilling the promise to provide manufacturing services. In this instance, the entity may be able to conclude that the license is distinct.

Finally, in a scenario in which the license Company B obtained was solely limited to a right to distribute Company A’s product, the arrangement may not constitute a distinct license to use IP under ASC 606 and would function only as a mechanism for Company B to sell what they purchased from Company A.

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Relevant guidance

ASC 606-10-25-19: A good or service that is promised to a customer is distinct if both of the following criteria are met:

a. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

b. The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

ASC 606-10-25-20: A customer can benefit from a good or service... if it can be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits. For some goods or services, a customer may be able to benefit from a good or service on its own. For other goods or services, a customer may be able to benefit from the good or service only in conjunction with other readily available resources. A readily available resource is a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. Various factors may provide evidence that the customer can benefit from a good or service either on its own or in conjunction with other readily available resources. For example, the fact that the entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources.

ASC 606-10-55-56: ...Examples of licenses that are not distinct from other goods or services promised in the contract include the following:

  1. A license that forms a component of a tangible good and that is integral to the functionality of the good.

  2. A license that the customer can benefit from only in conjunction with a related service...

ASC 606 Example 56 – Identifying a distinct license

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6-7 Significant financing component

Background / Question

On January 1, 20X9, Company A entered into a six-year arrangement to transfer a license of functional intellectual property (IP) in exchange for a nonrefundable upfront fee of $500 million and an additional $200 million ($40 million per year) payable in five equal, annual installments from 2020 through 2024. As such, Company A transferred control of the license to Company B at that time. There are no other performance obligations in the contract and Company A has concluded (1) collection of the consideration is probable and (2) there is a substantive termination penalty in the event the customer cancels the contract.

Does a significant financing component exist?

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Solution

A significant financing component exists at the inception of the arrangement because Company A provides Company B with a significant financing benefit in that Company A transferred control of the license at the inception of the arrangement but Company B is effectively paying in arrears over a five year period. As such, Company A would present value the five annual installments of $40 million at the Company B’s borrowing rate, which at an assumed rate for this example of 5%, would equal $173 million. Company A would recognize the $173 million as revenue on January 1, 20X9, when Company A transferred control of the license to functional IP to Company B. Company A would also recognize $27 million of interest income over the remainder of the contract term.

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Relevant guidance

ASC 606-10-32-15: In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.

ASC 606-10-32-19: To meet the objective in paragraph 606-10-32-16 when adjusting the promised amount of consideration for a significant financing component, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract, as well as any collateral or security provided by the customer or the entity, including assets transferred in the contract. An entity may be able to determine that rate by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer. After contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk).

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6-8 Determining standalone selling price

Background / Question

Company A enters into an arrangement that includes the transfer of a license along with ongoing R&D services for one fixed price. The license is delivered to the customer in the first quarter, and the R&D services will be provided over a three year period. Company A has assessed the nature of the arrangement and determined that both the license and R&D services are distinct and, therefore, Company A needs to allocate the total transaction price between them. Company A has not previously sold either the license or R&D services individually.

How would Company A determine the standalone selling price of each performance obligation?

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Solution

The standalone selling prices are not directly observable as Company A does not sell the license or R&D services on a standalone basis. Therefore, Company A will need to estimate the standalone selling price of each performance obligation in order to allocate the transaction price.

Under ASC 606, there is not a particular estimation method that is prescribed nor prohibited as long as the method results in an estimate that fairly represents the price the entity may charge for the goods or services if they were sold separately. Additionally, there is not a prescribed hierarchy to be used in order to determine the standalone selling price; however, the entity should maximize the use of observable inputs in determining the estimated standalone selling price.

Company A may consider using the following methods to estimate the standalone selling price of each performance obligation:

  • Adjusted market assessment approach - A market assessment approach considers the market in which the good or service is sold and estimates the price that a customer in that market would be willing to pay. This approach would consider competitor’s pricing for similar goods or services adjusted for specific factors such as position in the market, expected profit margin and customer or geographic segments. Company A would need to also consider the exact rights associated with the license, the stage of development of the underlying product and the projected cash flows over the license period. Related to the R&D services, Company A may consider prices of similar services offered in the marketplace.

  • Expected cost plus a margin - Under this method, an entity estimates the standalone selling price by considering the costs incurred to produce the product or service plus an adjustment for the expected margin expected on the sale. This method may be more appropriate if the license is in an early stage of development or forecasted revenues and cash flows do not exist. This method may also be appropriate to determine the selling price of R&D services by considering the level of effort necessary to perform the services.

  • Residual approach - Under this approach, the estimated standalone selling price of other goods and services in the contract with known selling prices are deducted from the total transaction price in order to determine the standalone selling price for the remaining goods and services. In limited circumstances, the residual approach may be used in order to determine the estimated standalone selling price of a good or service. However, this approach may only be used if the entity sells the same good or service to different customers for a broad range of amounts OR the entity has not yet established a price for that good or service and the good or service has not previously been sold on a standalone basis.

Company A should use judgment in order to determine which method will best estimate the price that would be paid if the license and services were sold on a standalone basis.

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Relevant guidance

ASC 606-10-32-29: To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with paragraphs 606-10-32-31 through 32-35, except as specified in paragraphs 606-10-32-36 through 32-38 (for allocating discounts) and paragraphs 606-10-32-39 through 32-41 (for allocating consideration that includes variable amounts).

ASC 606-10-32-32: The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. The best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers...

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6-9 Accounting for options to additional IP

Background / Question

Company A enters into an arrangement to provide Company B with a license to use its IP for a single indication. Company A also provides Company B with an option during the term of the arrangement to add additional indications if the IP is proven effective for those other indications.

How should Company A evaluate the option it provided to Company B?

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Solution

Company A should consider whether the option provided to Company B offers a future discount that is incremental to the range of discounts typically given to the same class of customer.

If the option provides a material right to Company B, there are two performance obligations in the arrangement: the license to use Company A’s IP for a single indication and the right to licenses for additional indications in the future. In this scenario, Company A would need to allocate a portion of the transaction price to both the current license and the right to future licenses based on the standalone selling price of each performance obligation. If the standalone selling price for Company B’s option is not directly observable, Company A should estimate it. That estimate should reflect the discount that Company B would obtain when exercising the option, adjusted for (1) any discount that would otherwise be available and (2) the likelihood that the option will be exercised. The amount allocated to the material right would be recognized when the future licenses transfer to Company B or when the option expires.

If the option to obtain additional licenses are at a price that reflects the standalone selling price for the additional license, the option does not provide Company B with a material right even if the option can only be exercised because of the previous contract. In this scenario, Company A should not assign any portion of the transaction price of the initial contract to the option and instead account for the exercise of the right if and when Company B choses to purchase the additional licenses.

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Relevant guidance

ASC 606-10-55-42: If, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

ASC 606-10-55-45: If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration...

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6-10 Accounting for modifications

Background / Question

Company A provided a license to Company B to its oncology drug and is performing R&D services. Company A received a large upfront payment of $50 million and receives reimbursement at cost for R&D services throughout the contract term up to a specified budget of $30 million. Company A is recording revenue over time in a cost-to-cost model as a single performance obligation because it concluded the license and R&D services are not distinct.

Company A and Company B enter into an amendment to increase the budget for R&D on the oncology drug to $40 million. As a result, Company A now expects to incur $10 million of additional R&D costs and to be reimbursed an additional $10 million by Company B. No other changes were made as part of this amendment.

How should Company A account for the modification?

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Solution

The pricing on the extension (i.e., zero margin) would not appear to represent the stand-alone selling price for the additional R&D efforts. As a result, the contract modification would not meet the conditions to be accounted as a separate contract as per ASC 606-10-25-12.  Company A is merely extending the existing oncology program and, therefore, the modification would likely not constitute a separate performance obligation in the context of the contract.

Company A would (1) adjust the measure of progress by reflecting the additional costs it expects in the denominator of the cost-to-cost model, (2) increase the transaction price by the additional consideration it now expects to receive, subject to the constraint, and (3) reflect the impact as a cumulative catch up adjustment to revenue.

In a scenario when the modification relates to an entirely new R&D program that was completely separate from the oncology program and the economics represented the stand-alone selling price, the modification could potentially be accounted for as a separate contract.

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Relevant guidance

ASC 606-10-25-11: A contract modification may exist even though the parties to the contract have a dispute about the scope or price (or both) of the modification or the parties have approved a change in the scope of the contract but have not yet determined the corresponding change in price. In determining whether the rights and obligations that are created or changed by a modification are enforceable, an entity shall consider all relevant facts and circumstances including the terms of the contract and other evidence. If the parties to a contract have approved a change in the scope of the contract but have not yet determined the corresponding change in price, an entity shall estimate the change to the transaction price arising from the modification in accordance with paragraphs 606-10-32-5 through 32-9 on estimating variable consideration and paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration.

ASC 606-10-25-12: An entity shall account for a contract modification as a separate contract if both of the following conditions are present:

a.  The scope of the contract increases because of the addition of promised goods or services that are distinct (in accordance with paragraphs 606-10-25-18 through 25-22).

b.  The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract...

ASC 606-10-25-13: If a contract modification is not accounted for as a separate contract, an entity shall account for the promised goods or services not yet transferred at the date of the contract modification (that is, the remaining promised goods or services) in whichever of the following ways is applicable:

a.  An entity shall account for the contract modification as if it were a termination of the existing contract, and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. The amount of consideration to be allocated to the remaining performance obligations (or to the remaining distinct goods or services in a single performance obligation identified in accordance with paragraph 606-10-25-14(b)) is the sum of:

  1. The consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of the transaction price and that had not been recognized as revenue and
  2. The consideration promised as part of the contract modification.

b.  An entity shall account for the contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. The effect that the contract modification has on the transaction price, and on the entity’s measure of progress toward complete satisfaction of the performance obligation, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) at the date of the contract modification (that is, the adjustment to revenue is made on a cumulative catch-up basis).

c.  If the remaining goods or services are a combination of items (a) and (b), then the entity shall account for the effects of the modification on the unsatisfied (including partially unsatisfied) performance obligations in the modified contract in a manner that is consistent with the objectives of this paragraph.

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6-11 Estimating variable consideration when there are contingent bonus payments

Background / Question

Company A, a contract research organization, enters into an arrangement with Company B, a pharmaceutical company, to perform a clinical trial on a Phase III drug candidate. Company A will receive fixed consideration of $20 million plus an additional milestone or bonus payment of $2 million if it screens 100 patients to enroll in the clinical trial in the first two months of the contract term. Company A has extensive experience enrolling patients and completing similar types of trials in the same field Company B’s drug candidate is targeting. Company A believes (1) there is a large population of patients to potentially screen for the clinical trial and (2) its past experience of screening patients has significant predictive value.

At the inception of the arrangement, should Company A include the bonus payment in the transaction price?

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Solution

Since there is a binary outcome as it relates to the bonus (that is, Company A either will or will not screen 100 patients in the first two months), it would generally be expected to use the most likely amount method to estimate variable consideration.

In this case, Company has extensive experience that it believes has predictive value. In addition, screening patients is largely in its control and the contingency is expected to be resolved in a relatively short period of time. Therefore, Company A would likely include the $2 million bonus as variable consideration in the transaction price at inception. It would then consider the variable consideration constraint and is likely to conclude that it is probable there will not be a significant reversal of cumulative revenue due to the large upfront payment ($20 million) coupled with the expected stage of completion at the two-month mark when the contingency is expected to be resolved.

Assuming the performance obligation is satisfied over time, the entire $22 million would be subject to recognition from inception. Said differently, no revenue needs to be “held back” due to the constraint.

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Relevant guidance

ASC 606-10-32-2: An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer... The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.

ASC 606-10-32-8: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a.      The expected value—The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.

b.      The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).

ASC 606-10-32-12: ...Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:

1.      The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.

2.      The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

3.      The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.

4.      The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.

5.      The contract has a large number and broad range of possible consideration amounts.

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6-12 Applying the variable consideration constraint to milestone payments when using a cost-to-cost measure of progress

Background / Question

Company A enters into a license arrangement with Company B to develop a potential drug currently in a Phase I clinical trial. As part of the arrangement, Company A agrees to provide Company B a perpetual license to Company A’s proprietary IP. Company A also agrees to provide R&D services to Company B in the form of completing clinical trials to develop the potential drug. In this case, due to the early stage of development, Company A determined the license to the proprietary IP and R&D services are not distinct and thus are accounted for as a single performance obligation that is satisfied over time. Company A receives an upfront payment of $40 million at the inception of the arrangement and is eligible to receive a milestone payment of $10 million upon the completion of the phase I clinical trial (“Phase I milestone”).

Company A uses a cost-to-cost input method to measure progress as that method best depicts its performance under the agreement. At the inception of the arrangement, the cumulative percentage complete in the cost-to-cost input method at the end of phase I is estimated to be approximately 75%. Company A concludes that the most likely amount approach is the most predictive to estimate the variable consideration associated with the milestone payment. In this case, Company A believes the most likely amount for the Phase I milestone would include the full $10 million payment.

How should Company A apply the constraint in this fact pattern?

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Solution

The assessment of whether a significant reversal could occur should be done at the contract level. In this arrangement, if the $10 million milestone was included in the transaction price (assuming completion of Phase I), this would result in $37.5 million ($50 million x 75% complete) of cumulative revenue recorded at the completion of the Phase I clinical trial. If the Phase I milestone was not achieved, the potential adjustment to revenue would be an additional recognition of $2.5 million ($40 million compared to $37.5 million). This is because even though Company A would not receive the $10 million milestone payment in the event the milestone was not achieved, the entire $40 million upfront payment would be recognized as the contract would then be 100% complete.

Company A should therefore include the Phase I milestone in the transaction price at contract inception because (1) Company A has estimated variable consideration of $10 million using the “most likely amount” approach and (2) if the milestone was not achieved, it would not result in a significant reversal of cumulative revenue at the contract level.

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Relevant guidance

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration, only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

ASC 606-10-32-12:...Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:

1.      The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.

2.      The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

3.      The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.

4.      The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.

5.      The contract has a large number and broad range of possible consideration amounts.

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6-13 Accounting for reimbursement of costs when using cost-to-cost measure of progress

Background / Question

Company A, a biotechnology company, enters into a license arrangement with Company B, a pharmaceutical company, to develop a potential drug currently in the pre-clinical stage. Company A agrees to provide Company B a perpetual license to Company A’s proprietary IP and perform R&D services for Company B in the form of completing clinical trials to develop the potential drug. In this case, due to the early stage of development, Company A determined the license to the proprietary IP and R&D services are not distinct and thus are accounted for as a single performance obligation that is satisfied over time. Company A uses a cost-to-cost input method to measure progress as that method best depicts its performance under the agreement. Company A receives an upfront payment of $100 million at the inception of the arrangement and receives 100% reimbursement for all R&D costs incurred.

At the inception of the arrangement, should Company A include an estimate of cost reimbursement for the R&D in the transaction price?

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Solution

Company A should typically include a best estimate of R&D reimbursements in the transaction price at the inception of the arrangement. In other words, if Company A expects to incur total R&D costs of $60 million to fulfill the performance obligation (and will use that estimate for purposes of measuring progress), it should also include $60 million of estimated reimbursements in the transaction price, assuming it is contractually entitled to a dollar-for-dollar reimbursement.  Company A is also required to consider the constraint on variable consideration; however, since the related R&D services revenue would only be recognized as the costs are incurred, typically at no time would Company A be exposed to a significant reversal of cumulative revenue under the arrangement. Company A would update the R&D reimbursements estimate to include in the transaction price each reporting period to reflect the best and most current information available.

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Relevant guidance

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration, only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

ASC 606-10-32-12:... Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:

1.      The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.

2.      The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

3.      The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.

4.      The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.

5.      The contract has a large number and broad range of possible consideration amounts.

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6-14 Determining whether a license of IP is “predominant”

Background / Question

Pharma licenses its patent rights to an approved, mature drug compound to Customer for a license term of 10 years. Pharma also promises to provide training and transition services relating to the manufacturing of the drug for a period not to exceed three months. The manufacturing process is not unique or specialized, and the services are intended to help Customer maximize the efficiency of its manufacturing process. Pharma concludes that the license and services are distinct. The only compensation for Pharma in this arrangement is a percentage of Customer’s sales of the product.

Does the royalty exception apply to this arrangement?

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Solution

The sales- and usage-based royalty exception (the “royalty exception”) applies since the license of IP is predominant in the arrangement. This is because Customer would presumably ascribe significantly more value to the license than to the three months of training and transition services. Following the exception, Pharma would recognize revenue as the customer’s sales occur, assuming this approach does not accelerate revenue ahead of performance.

In other scenarios where the vendor provides more substantive manufacturing services in addition to a license of IP in exchange for sales-based royalty, it may be challenging to assert that the license of IP is predominant. In those fact patterns, companies will apply the general variable consideration guidance (including the variable consideration constraint) to estimate the transaction price, and allocate the transaction price between the license and manufacturing, assuming each is a distinct promise. The portion attributed to the license will be recognized when control of the IP has been transferred and the customer is able to use and benefit from the license. The remaining transaction price will be allocated to the manufacturing and recognized when (or as) control of the product is transferred to the customer.

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Relevant guidance

ASC 606-10-32-5: If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

ASC 606-10-55-65: Notwithstanding the guidance in paragraphs 606-10-32-11 through 32-14, an entity should recognize revenue for a sales-based or usage-based royalty promised in exchange for a license of IP only when (or as) the later of the following events occurs:

a.      The subsequent sale or usage occurs.

b.      The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

ASC 606-10-55-65A: The guidance for a sales-based or usage-based royalty in paragraph 606-10-55-65 applies when the royalty relates only to a license of IP or when a license of IP is the predominant item to which the royalty relates (for example, the license of IP may be the predominant item to which the royalty relates when the entity has a reasonable expectation that the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty relates).

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6-15 Sales-based milestones

Background / Question

Company A entered into an arrangement with Company B, whereby Company A has agreed to provide to Company B a license to its IP. The license was transferred to Company B at contract inception. In return, Company B has paid Company A an up-front payment of $10 million and will pay Company A an additional $20 million in the event Company B’s annual sales of products associated with this licensed IP exceed $250 million.

How should Company A account for the contingent sales-based milestone?

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Solution

We believe the $20 million sales-based milestone would be viewed as a sales-based royalty given it is based on Company B’s subsequent sales of product. Because this example relates to the license of IP and the milestone is tied to sales, the royalty exception applies.

Under the royalty exception, the milestone is recognized at the later of (1) when the subsequent sales or usage occurs or (2) full or partial satisfaction of the performance obligation to which some or all of the sales-based milestone has been allocated.

Company A would recognize the $20 million sales-based milestone as revenue when the subsequent sales mandating payment occur because this is the latter of when the subsequent sales occurs and when the performance obligation was satisfied (control of the license transferred at the beginning of the contract).

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Relevant guidance

ASC 606-10-32-5: If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

ASC 606-10-32-6: An amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.

ASC 606-10-55-65: Notwithstanding the guidance in paragraphs 606-10-32-11 through 32-14, an entity should recognize revenue for a sales-based or usage-based royalty promised in exchange for a license of IP only when (or as) the later of the following events occurs:

a.      The subsequent sale or usage occurs.

b.      The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

ASC 606-10-55-65A: The guidance for a sales-based or usage-based royalty in paragraph 606-10-55-65 applies when the royalty relates only to a license of intellectual property or when a license of intellectual property is the predominant item to which the royalty relates (for example, the license of intellectual property may be the predominant item to which the royalty relates when the entity has a reasonable expectation that the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty relates).

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6-16 Milestone payments based on first commercial sale

Background / Question

In June 20X7, Company A enters into an arrangement to license functional IP to Company B. The IP relates to an unapproved drug that will be further developed by Company B. The license is transferred at contract inception and there are no other performance obligations in the contract. In exchange for the license, Company A will receive

  • An upfront payment of $50 million

  • A milestone payment of $30 million upon first commercial sale of a product by Company B

In December 20X8, the drug is approved by the FDA, and the first commercial sale occurs in February 20X9. As of December 31, 20X8, it is probable that a commercial sale will occur.

How should Company A account for the milestone payment triggered upon first commercial sale?

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Solution

We believe a reasonable interpretation of the guidance is that the royalty exception would apply to the $30 million milestone payment given it is in exchange for a license of IP and is based on Company B’s subsequent sale of the drug.

Under the royalty exception, the milestone is recognized at the later of (1) when the subsequent sales or usage occurs or (2) full or partial satisfaction of the performance obligation to which some or all of the sales-based royalty has been allocated.

The milestone payment should be recognized as revenue in the period that the first commercial sale occurs (i.e., in February 20X9). Company A should consider providing disclosure about the milestone and the related accounting policies in the December 20X8 financial statements, if material.

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Relevant guidance

ASC 606-10-55-65: Notwithstanding the guidance in paragraphs 606-10-32-11 through 32-14, 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:

a.      The subsequent sale or usage occurs.

b.      The performance obligation to which some or all of the sales-based or usage- based royalty has been allocated has been satisfied (or partially satisfied).

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6-17 Revenue recognition for customers with a history of long delays in payment

Background / Question

Company A, a pharmaceutical company, sells prescription drugs to a governmental entity in Country X. Company A has historically experienced long delays in payment for sales to this entity due to slow economic growth and high debt levels in Country X. Company A currently has outstanding receivables from sales to this entity over the last three years and continues to sell product at its normal market price. The receivables are non-interest bearing.

How should Company A account for the outstanding receivables and future sales to Country X?

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Solution

At the inception of each arrangement, Company A will need to evaluate its contract with the governmental entity to determine if it is probable that it will collect the amounts to which it is entitled in exchange for the prescription drugs. ASC 606 indicates that for purposes of determining the transaction price, the entity should consider the variable consideration guidance, including the possibility of price concessions. If, based on its historical experience, Company A expects to ultimately provide a price concession to collect its receivable, then the transaction price would be reduced by the amount of the expected price concession. Company A would then evaluate whether it is probable it will collect the adjusted transaction price. Assuming the collectibility hurdle is met, the transaction price will be recognized as Company A satisfies its performance obligation of delivering the drugs.

Additionally, if by agreement or based on past experience with the governmental entity, the amount of time expected between the sale of the prescription drug and expected payment from the governmental entity exceeds one year, before concluding on the final amount of the transaction price, Company A will need to consider if there is a significant financing element in the arrangement.

Company A will need to continually evaluate its outstanding receivables for impairment relating to the customer’s credit risk. Company A needs to consider whether any subsequent billing adjustments are concessions granted to the customer (i.e., a modification to the transaction price) or a credit adjustment (i.e., a write-off of an uncollectible amount from the governmental entity). A modification of the transaction price reduces the amount of revenue recognized, while a credit adjustment is an impairment assessed under ASC 310, Receivables, and recognized as a bad debt expense. The facts and circumstances specific to the adjustment should be considered, including the entity’s past business practices and ongoing relationship with the customer, to make this determination.

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Relevant guidance

ASC 606-10-25-1: An entity shall account for a contract with a customer that is within the scope of this Topic only when all of the following criteria are met… (e) It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer... In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession...

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration…only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

ASC 606-10-32-15: In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.

ASC 606-10-32-18: As a practical expedient, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to the customer and when the customer pays for that good or service will be one year or less.

ASC 606 Example 1 – Collectibility of the consideration

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6-18 Distributor arrangement in new territory

Background / Question

Company A is a manufacturer of laboratory instruments and related consumables. It recently entered into a new distribution agreement with Company B, which will undertake the distribution of Company A’s consumable products in a new geographic territory. Title to the consumables passes to Company B upon delivery, and Company B assumes full risk of loss on any inventory that is damaged or destroyed.

Company A completed a credit assessment of Company B at the outset of the arrangement. Company B is an established distributor in the territory and has been in operation for decades and generates substantial revenues from the sale of other companies’ products.

Company A’s products have never been sold in this new territory before, and there is some question as to how successful the new market will be. As a result, Company B insisted on having a right to return any consumable products that expire prior to sale to an end user. Company A also provided price protection to Company B for any unsold inventory on hand.

Company B will be selling the consumables to a mix of private physician practices and government-owned hospitals. In this territory, it is common that end users have payment terms between 90 and 180 days. Company B insisted on 240-day payment terms.

When should Company A record revenue upon sale of its instruments and consumables to Company B?

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Solution

Under ASC 606, Company A would record revenue upon transfer of control. The consideration recorded should include an estimate of variable consideration (to reflect the impact of refunds for potential returns and price protection adjustments) using either the expected value or most likely amount method (whichever is more predictive of the amount Company A expects to receive), subject to the constraint described in ASC 606-10-32-11. Although there are a number of factors that may make it difficult to estimate the variable consideration, Company A should consider if there is at least a minimum amount of revenue to record when products are delivered to the distributor. This estimate would then be updated at the end of every reporting period based on the most current information.

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Relevant guidance

ASC 606-10-25-1: An entity shall account for a contract with a customer that is within the scope of this Topic only when all of the following criteria are met:… (e) It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer (see paragraphs 606-10-55-3A through 55-3C)....

ASC 606-10-25-30: An entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

a.      The entity has a present right to payment for the asset...

b.      The customer has legal title to the asset...

c.      The entity has transferred physical possession of the asset...

d.      The customer has the significant risks and rewards of ownership of the asset...

e.      The customer has accepted the asset...

606-10-32-5: If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

ASC 606-10-32-6: An amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 606-10-32-8 only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

ASC 606-10-32-12: In assessing whether it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur once the uncertainty related to the variable consideration is subsequently resolved, an entity shall consider both the likelihood and the magnitude of the revenue reversal. Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:

a.  The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.

b.  The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

c.  The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.

d.  The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.

e.  The contract has a large number and broad range of possible consideration amounts.

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6-19 Right of return

Background / Question

Company A sells cardiac drugs through a number of wholesale and retail customers. The drugs have a shelf life of 24 months from the date manufactured. Both wholesalers and retailers can return the drugs from six months before to six months after the expiration date, subject to compliance with other provisions in Company A’s returns policy.

Company A has sold these drugs for the past two years. Through December 31, 20X9, 3% of the drugs have been returned in accordance with policy.

On December 31, 20X9, Company A delivered 100 units to Distributor Z for $200 each, for a total sale of $20,000.

How much revenue can Company A recognize on December 31, 20X9?

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Solution

Company A would not be able to recognize the full $20,000 as revenue at December 31, 20X9.

Instead, Company A will need to utilize judgment to determine the exact amount of revenue to recognize on December 31, 20X9. Company A will first need to determine the level of sales for which it is probable there will be no significant revenue reversal due to product returns. Company A will need to analyze its return volume, return patterns, current demand levels, the level of inventory currently in the distribution channel, and any new or upcoming Company A or competitor products that may render the product obsolete or otherwise impact product demand.

Although Company A has sold the product for 2 years and has a history of returns experience, because of the extended nature of the return policy, it should assess whether the returns experience is sufficient to develop its returns estimate. However, even in a circumstance where a company has a limited history to draw upon to determine its estimate of returns, it would nonetheless need to determine if there is a minimum level of sales for which it is probable that a change in estimate would not cause a significant reversal of revenue, and record revenue for those sales.  

To the extent Company A is able to determine that it is probable there will not be a significant reversal of cumulative revenue recognized in the future, it should reduce the revenue recognized as of December 31, 20X9 by the amount of the estimated returns. For example, if Company A estimates a 3% return rate (using the expected value approach for measuring variable consideration), it would recognize net revenue of $19,400 ($20,000 total order - (3% x $20,000 product sales)) at December 31, 20X9, a refund liability of $600 (3% x $20,000 product sales), and an asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability. The asset would be measured at the carrying amount of goods at the time of the sale, net of any impairment for expected costs to recover the products or decreases in the value of returned products (e.g., due to the limited remaining shelf life of returned products).

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Relevant guidance

ASC 606–10–55-22: In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receive any combination of the following:

  • A full or partial refund of any consideration paid

  • A credit that can be applied against amounts owed, or that will be owed, to the entity

  • Another product in exchange.

ASC 606-10-55-23: To account for the transfer of products with the right of return..., an entity should recognize all of the following:

  • Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for products expected to be returned)

  • A refund liability

  • An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.

ASC 606-10-55-25: An entity should apply the guidance in paragraphs 606-10-32-2 through 32-27 (including the guidance on constraining estimates of variable consideration in paragraphs 606-10-32-11 through 32-13) to determine the amount of consideration to which the entity expects to be entitled (that is, excluding the products expected to be returned)...

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6-20 Price appreciation rights

Background / Question

Company A, a pharmaceutical company, manufactures prescription drug B (the product) and sells the product to Company B, a wholesaler, at wholesaler acquisition cost (WAC). Company B obtains control of the product before selling it to a retailer at a price determined by Company B.

Company A and Company B are parties to a distribution services agreement (DSA) under which Company A is due price appreciation credits to the extent it increases WAC on the product. That is, Company B will owe Company A for the difference between the old price and the new price for any product that Company B has on hand when the new pricing goes effective.  Company A approves a price increase for the product on December 1, 20X0, which becomes effective on January 1, 20X1.

Company A observes that historically there have not been significant adjustments to a planned price increase between the approval date and the date upon which it becomes effective and that Company B consistently maintains an inventory level of one month demand for the product based on periodic inventory reports it provides Company A.

How should Company A account for December 20X0 sales?

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Solution

Under the variable consideration guidance, Company A would need to determine if including the expected impact of the price appreciation credits in estimating the transaction price of the December sales will result in a significant reversal in the amount of cumulative revenue recognized once the uncertainty associated with the price increase is subsequently resolved. If a significant reversal is not expected, Company A would adjust all December 20X0 sales of the product to reflect the effect of the new price, given that all sales made during December 20X0 are expected to remain on hand in Company B’s inventory as of January 1, 20X1 (the effective date of the price increase).

Company A would also record the corresponding impact of the various “gross-to-net” revenue deductions that will correspondingly increase as a result of the increase in WAC.

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Relevant guidance

ASC 606-10-32-8: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled.

a. The expected value—The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.

b. The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 606-10-32-8 only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

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6-21 Rebates paid to a customer’s customer

Background / Question

Company A enters into an arrangement with Distributor X for the sale of pharmaceutical drugs. Distributor X then sells the product to Customer B. Customer B is entitled to a sales rebate from Company A of 25% of the sales price of the first 100 units if 1,000 units are purchased.

Company A has developed a relationship with Customer B after selling pharmaceutical drugs for a number of years. Further, Company A has offered a similar sales arrangement to Customer B in prior years.

The unit selling price for each product is $100. Company A believes that it has sufficient basis to estimate that the end customer will purchase exactly 1,000 units during the year and earn the full rebate.

How should Company A account for rebates to be paid to its customer’s customer?

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Solution

The performance obligation in the contract is the promise to deliver individual units of the pharmaceutical drugs to Distributor X as requested over the term of the sales arrangement. To determine the transaction price, Company A will need to estimate the effects of the rebates offered to Distributor X’s customer. Since Company A estimates that 1,000 units will be delivered to Customer B, the total rebate will be $2,500 (i.e., 25% rebate x 100 units x $100 price per unit). The estimated rebate serves as a reduction from the contractual sales price.

To determine the amount of rebate to recognize upon each product sale, Company A would take the full estimated rebate ($2,500) and divide it by the sales price of the 1,000 units (Company A’s expected sales). As each of the units are shipped, Company A would recognize a rebate accrual of 2.5% ($2,500 total rebate/$100,000 anticipated sales). The rebate would be accrued as an offset to revenue. Company A would record sales to Distributor X at a transaction price of $97.50 ($100 less 2.5% discount). At the end of each quarter, Company A would revise the estimate of sales and true up the calculation and rebate that will be due at the end of the arrangement. This true up would include a cumulative adjustment on shipments through that date.

Even though the product is sold to Distributor X and the rebates are paid to Customer B, the classification of the payment is treated as a reduction of revenue.

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Relevant guidance

ASC 606-10-32-25: Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer). An entity shall account for consideration payable to a customer as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service (as described in paragraphs 606-10-25-18 through 25-22) that the customer transfers to the entity. If the consideration payable to a customer includes a variable amount, an entity shall estimate the transaction price (including assessing whether the estimate of variable consideration is constrained) in accordance with paragraphs 606-10-32-5 through 32-13.

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6-22 Price protection clauses

Background / Question

Company A, a pharmaceutical drug manufacturer, enters into a sales arrangement with a group purchasing organization (GPO). Included in the agreement is a price protection clause that guarantees that the GPO will receive Company A’s lowest selling price. If Company A sells its products to another customer at a lower price, the GPO will receive the lower price on all future purchases. Company A is not obligated to, and has no history of, providing retroactive price adjustments to its customers.

Does inclusion of this price protection clause impact the current sales to the GPO?

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Solution

It depends. Company A will need to assess whether it has conveyed a material right to the GPO to buy products at a lower price in the future. In this determination, Company A would consider, among other things, whether the right is incremental to those received by other similar classes of customers in the same market.

In this case, it does not appear to be a material right as the GPO is not receiving the right to the future discount as a result of current purchases (e.g., achieving a specified volume of purchases). That is, the GPO is not paying in advance for the right to a potential discount on future purchases. Further, at the time the GPO receives the lower pricing, it will be the same pricing charged to similar customers. As such, there would be no accounting impact on the current sales, and future sales will be accounted for at the established prices.

In situations where the price protection clause could require Company A to provide the GPO a retroactive price concession if it lowered its prices in the future (or Company A has a history of providing such a concession), this uncertainty would be evaluated as variable consideration in the existing contracts and depending on the facts, a portion of the transaction price might need to be allocated to a refund liability.

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Relevant guidance

ASC 606-10-55-42: If, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

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6-23 Accounting for retroactive rebates

Background / Question

Company A has a multi-year contract with Company B to sell pharmaceutical drugs and agrees to pay Company B an annual rebate if Company B completes a specified cumulative level of purchases during any year of the contract period. The amount of rebate varies based on the following tiered structure. Based on its historical experience of rebates due to Company B, Company A has assigned probabilities to each possible outcome.

Purchases

Rebate        

Probability   

1-1,000 units

0%

15%

1,001-2,000 units

2%

60%

Greater than 2,000 units       

5%

25%

The unit price for each product is $100. Company A has determined that the “expected value” method better predicts the amount of consideration to which it will be entitled. Company A concludes that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty is resolved.

How should Company A account for the rebate expected to be paid to the customer at the end of the year?

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Solution

Under the expected value approach, Company A would estimate the rebate to be 2.45% based on a probability-weighted assessment of each possible scenario (i.e., (0% rebate x 15% likelihood) + (2% rebate x 60% likelihood) + (5% rebate x 25% likelihood)). Therefore, as each unit is shipped during the year, Company A would recognize a rebate accrual of $2.45 and revenue of $97.55 under this approach. At the end of each quarter, Company A would revise the estimate of sales and true up the calculation and rebate that will be due at the end of the arrangement. This true up would include a cumulative adjustment on shipments through that date.

The same guidance would generally apply in cases when the customer is a government health system.

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Relevant guidance

ASC 606-10-32-25: Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer). An entity shall account for consideration payable to a customer as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service (as described in paragraphs 606-10-25-18 through 25-22) that the customer transfers to the entity. If the consideration payable to a customer includes a variable amount, an entity shall estimate the transaction price (including assessing whether the estimate of variable consideration is constrained) in accordance with paragraphs 606-10-32-5 through 32-13.

ASC 606-10-32-8: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a.      The expected value -The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts...

b.      The most likely amount - The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract)...

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6-24 Volume purchase arrangements

Background / Question

Company A enters into a two-year arrangement with Company B for the sale of pharmaceutical drugs on January 1, 20X8. The terms of the agreement do not specify any contractual minimum purchases by Company B. However, once the number of purchases exceeds 1,000 units of the drug, the price per unit decreases from $12 per unit (which represents the “list” price for this drug) to $8 per unit for each unit purchased thereafter (often referred to as a volume purchase arrangement). Company A routinely offers other similarly-sized customers a 5% discount.

As of December 31, 20X8, Company B has ordered 1,000 units of the drug and Company A expects that another 1,000 units will be sold throughout 20X9. Based on its forecast, Company A does not expect Company B to issue any additional purchase orders under the two-year arrangement.

How should Company A account for the sale of the first 1,000 units of the drug?

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Solution

Company A needs to evaluate whether the volume purchase arrangement represents a material right.

Company A offers Company B a 33.3% discount ($4 discount off of the $12 per unit price, or $8 per unit) on all purchases after the first 1,000 units. They routinely offer other similar-sized customers a 5% discount on such purchases, resulting in a standalone selling price of $11.40 per unit. Therefore, the volume purchase arrangement represents a material right provided to Company B. Company A must calculate the value of the material right and allocate the total transaction price based on relative standalone selling prices. Alternatively, in this case, Company A meets the requirements to use the practical alternative in ASC 606-10-55-45.

Allocation based on relative standalone selling price

Company A needs to determine the standalone selling price of the option to purchase additional units at the discounted price. This is calculated as:

Standalone selling price of 1,000 units (assuming the “normal” 5% discount)     

$11,400   

Actual purchase price of 1,000 additional units (at the 33% discount)

$8,000

Intrinsic value of option

$3,400

Multiplied by: the likelihood of exercise

100%

Standalone selling price of the option   

$3,400

Standalone selling price of 1,000 units  

$11,400

Combined stand-alone selling price   

$14,800

When Company A sells the first 1,000 units to Company B, it will receive $12,000 (1,000 units x $12). Company A would allocate $2,757 ($12,000 consideration x ($3,400/$14,800 total stand-alone selling price)) of the consideration to the material right (i.e., as a contract liability) and the remaining $9,243 would be recognized as revenue. The transaction price allocated to the material right, based on the relative standalone selling price, will be recognized upon exercise (that is, purchase of additional product) or expiry.

When Company A sells the second 1,000 units to Company B, it will receive $8,000 (1,000 units x $8). Company A would recognize the $8,000 received as well as the $2,757 allocated to the material right. By purchasing the second 1,000 units, Company B has fully exercised its option to purchase products at the discounted price since Company A does not expect Company B to purchase any additional units under the contract. Accordingly, the full value allocated to the material right should be recognized.

In this case, Company A would report $9,243 of revenue associated with the first 1,000 units of product and $10,757 ($8,000 plus $2,757) related to the second 1,000 units.

Practical alternative (ASC 606-10-55-45)

Since it has a sufficient basis to estimate that 2,000 units will be purchased, Company A could estimate the total consideration that Company B will pay under the volume purchase arrangement and allocate it to the expected total purchase of 2,000 units. The transaction price per unit on 2,000 units would be $10 ((1,000 units x $12 plus 1,000 units x $8)/2,000 total units). As each unit is shipped, Company would recognize revenue of $10. At the end of each quarter, it would revise the estimate of sales under the volume purchase arrangement and record a true-up to reflect the cumulative adjustment on shipments through that date.

As demonstrated above, the practical alternative will often result in a different allocation of revenue than allocating revenue on a relative selling price basis between the initial units and the option.

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Relevant guidance

ASC 606-10-55-42: If, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

ASC 606-10-55-44: ...If the standalone selling price for a customer’s option to acquire additional goods or services is not directly observable, an entity should estimate it. That estimate should reflect the discount that the customer would obtain when exercising the option, adjusted for both of the following:

a. Any discount that the customer could receive without exercising the option

b. The likelihood that the option will be exercised.

ASC 606-10-55-45: If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may... allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration.

ASC 606-10-32-29: To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with paragraphs 606-10-32-31 through 32-35, except as specified in paragraphs 606-10-32-36 through 32-38 (for allocating discounts) and paragraphs 606-10-32-39 through 32-41 (for allocating consideration that includes variable amounts).

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6-25 Medicare Part D coverage gap

Background / Question

Pharma currently has one marketed product that is impacted by the Medicare coverage gap provision. Gross revenue of $500 million is earned every quarter. Pharma’s full year estimate of coverage gap subsidies (i.e., reimbursements to the Federal government) is $400 million. Pharma’s inventory does not sit in the channel at the end of a particular quarter (i.e., product sold in Q2 will be sold through to the end customer in Q2). Pharma’s customers primarily enter and exit the Medicare coverage gap in the third and fourth quarters. Pharma’s quarterly revenues, net of coverage gap subsidies, are included in the table below.

In millions

 Q1      

 Q2      

 Q3      

 Q4      

 Total      

Gross sales per quarter

 $500  

 $500  

 $500  

 $500  

 $2,000  

Coverage gap subsidy

 $0

 $0

 $250

 $150

 $400

Actual sales per quarter, net of subsidies   

 $500

 $500

 $250

 $350

 $1,600

How should Pharma account for its coverage gap obligations throughout the year?

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Solution

We believe companies can make a policy election between two acceptable methods – a “spreading” approach or a “point-of-sale” approach (sometimes referred to as a “specific identification” approach).

Under the “spreading” approach, the estimated impact of the rebate expected to be incurred for the annual period is recognized ratably using an estimated, effective rebate rate for all of a company’s projected sales to Medicare patients throughout the year. This method appears to be broadly consistent with the accounting for an option (i.e., a material right) provided to a customer.

Companies following this approach will allocate a portion of the transaction price between current sales and the material right, which represents the discount to be provided on future sales to any Medicare-eligible patient within the coverage gap, and recognize the value of the material right into revenue when the coverage gap subsidies are utilized.

However, some companies may experience higher coverage gap liabilities earlier in the year (e.g., with certain more expensive drugs) with sales reverting back to list price in subsequent periods. In these cases, it would not be appropriate to follow a spreading approach that results in a contract asset on the balance sheet as that would, in effect, be inappropriately pulling revenue forward for optional purchases.

If Pharma accounts for coverage gap subsidies as a material right, it would recognize a contract liability at each quarter end for the cumulative year-to-date difference (see chart below) between the actual sales and the amount that should be recognized based on the average selling price for the year.   

In millions 

  Q1      

  Q2      

 Q3      

 Q4      

 Total      

Actual sales per quarter, net of subsidies  

 $500 

 $500 

 $250

 $350 

 $1,600 

Spread basis

 $400

 $400

 $400

 $400 

 $1,600 

Quarterly difference

 $100

 $100

 ($150) 

 ($50) 

   -

Cumulative year-to-date difference

 $100

 $200

 $50

 $0

   -

The contract liability could be calculated in accordance with the practical alternative described in ASC 606-10-55-45. Under that alternative, a company would include the total number of estimated drugs to be sold during the year in the initial measurement of the transaction price of each drug. In other words, all sales of drugs before, during, and after the incurrence of coverage gap liabilities would be recognized, priced at a level discount to reflect the reduced transaction price for drugs sold during the period in which Pharma is liable to fund a portion of patient costs through this program.

It should be noted; however, that some companies may experience higher coverage gap liabilities earlier in the year (e.g., with certain more expensive drugs) with sales reverting back to list price in subsequent periods. In these cases, it would not be appropriate to follow a spreading approach that results in a contract asset on the balance sheet as that would, in effect, be inappropriately pulling revenue forward for optional purchases.

Under the “point-of-sale” method, the rebate is recognized at the time a company recognizes revenue on sales of drugs into the channel that are expected to be resold to Medicare patients who are in the coverage gap. This method is premised on the fact that the Federal government is technically not the customer in the transaction and that each individual sale to an end customer stands on its own. If Pharma accounts for coverage gap subsidies using this approach, it would recognize the subsidies as a reduction of revenue in the periods they are incurred. Therefore, Pharma would record no reduction in revenue in either Q1 or Q2 and would instead reflect a reduction of revenue of $250 and $150 in Q3 and Q4, respectively.

Whichever method is applied would need to be applied on a consistent basis for similar arrangements.

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Relevant guidance

ASC 606-10-55-44:... If the standalone selling price for a customer’s option to acquire additional goods or services is not directly observable, an entity should estimate it. That estimate should reflect the discount that the customer would obtain when exercising the option, adjusted for both of the following:

a. Any discount that the customer could receive without exercising the option

b. The likelihood that the option will be exercised.

ASC 606-10-55-45: If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration. Typically, those types of options are for contract renewals.

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6-26 Pay-for-performance arrangements

Background / Question

Company A manufactures, markets, and sells Drug B to a hospital. The hospital administers Drug B to its patients. Under the terms of their arrangement, if after three months of treatment, patients’ test results do not meet the predetermined objective criteria, the hospital is eligible for a full refund of the price paid for the administered product from Company A. The hospital has two months after the treatment period to process the request for refund (i.e., a total of five months after the initial treatment).

Company A obtained FDA approval for Drug B two years ago, and began selling Drug B immediately to the hospital. Over the past two years, Company A and the hospital have been tracking the number of patients whose post-treatment test results did not meet the predetermined criteria, and it has consistently ranged from 6-7% on a monthly and annual basis. Based on the nature of this drug and the relatively consistent patient results over the past two years, Company A expects future refunds to be consistent with historical results.

How should Company A account for this arrangement?

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Solution

This arrangement includes a contingent refund, which represents a form of variable consideration. Company A will need to estimate the total transaction price at contract inception using either the expected value method or most likely amount method, whichever it deems to be most predictive. Given its historical experience with a fairly large number of previous transactions, Company A would likely conclude the expected value approach based on its historical experience is most predictive for estimating variable consideration. Company A would then need to evaluate the variable consideration constraint and include an amount of variable consideration in the transaction price to the extent that it is probable that doing so would not subject the Company to a significant revenue reversal when the uncertainty is subsequently resolved.

However, even in a circumstance when Company A has a limited history to draw upon, it would need to determine if there is a minimum level of estimated sales for which it is probable that a change in estimate would not cause a significant reversal of revenue, and record revenue for those sales.

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Relevant guidance

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration... only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

ASC 606-10-32-12: ... Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:

a.     The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.

b.     The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

c.     The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.

d.     The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.

e.     The contract has a large number and broad range of possible consideration amounts.

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6-27 Synthetic FOB destination

Background / Question

Company A, a pharmaceutical drug manufacturer, sells pharmaceutical drugs to its customers. Company A’s standard sales contracts contain “free on board” (FOB) shipping point terms, and it is clear that title legally transfers at the time the product is provided to the common carrier to be shipped to the customer. At the same time, Company A has a history of replacing or crediting lost or damaged shipments. When a customer indicates that a product has been lost or damaged, Company A provides the customer with a credit to their account or replaces the damaged product at no cost to the customer.

Upon shipment, Company A issues the invoice to the customer using customary payment terms. Over the last three years, customer claims averaged less than 0.2% of total orders and 0.1% of total revenues. Company A has reimbursed all claims for each of the last three years.

When should Company A recognize revenue from the sale of the products?

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Solution

Under ASC 606, companies should carefully consider the indicators in ASC 606-10-25-30 as to when control transfers. There is judgment in determining when control transfers, and specific facts and circumstances to a transaction could impact this determination.

In this case, while there are mixed indicators as to when control transfers to the customer, it would appear that transfer of control occurs at the point of shipment. Company A would need to evaluate whether its past practice of replacing lost or damaged product represents a separate performance obligation or possibly a guarantee, if material.

If it concludes that control of the product transfers at the point of shipment, Company A would also need to consider whether there is a separate promise related to providing or arranging for the shipping service. If Company A concluded control transferred at shipping point, Company A could elect an accounting policy to treat shipping and handling as activities to fulfill the promise to transfer the good. Companies applying that election would include any fee received for shipping and handling as part of the transaction price and recognize revenue when control of the good transfers. Costs related to providing the shipping service would be accrued at the time revenue is recognized.

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Relevant guidance

ASC 606-10-25-30:...An entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

  • The entity has a present right to payment for
    the asset...

  • The customer has legal title to the asset...

  • The entity has transferred physical possession of the asset...

  • The customer has the significant risks and rewards of ownership of the asset...

  • The customer has accepted the asset...

ASC 606-10-25-18B: If shipping and handling activities are performed after a customer obtains control of the good, then the entity may elect to account for shipping and handling as activities to fulfill the promise to transfer the good...

ASC 606-10-25-16A: An entity is not required to assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer...

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6-28 Bill-and-hold arrangements

Background / Question

A customer issues a purchase order on November 15, 20X8 to Company A, a medical equipment company, for a large standard product that requires installation at the customer site. Company A will also perform the installation. The order requests a delivery and installation date of December 28, 20X8. On December 21, 20X8, the customer requests that Company A defer the planned delivery and segregate the product because the customer’s facility modifications that will enable the installation and operation of the equipment have been unexpectedly delayed. As of December 31, 20X8, Company A is able to identify and segregate the product for the customer in its warehouse and it is ready for transfer to the customer. At this stage, Company A is unable to use the equipment or direct it to another customer due to certain specifications. Additionally, after inspecting the equipment and accepting the purchase, the customer has taken title to the equipment, has insured its purchase, and will take delivery on January 25, 20X9 when the facility modifications are expected to be completed.

As of December 31, 20X8, Company A has invoiced the customer with payment terms that are consistent with its normal practices when shipping goods to customers.

When should Company A recognize revenue on this transaction?

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Solution

This is a very facts-and-circumstances based analysis. First, an analysis will need to be made as to whether the medical equipment and the installation are distinct promises. Assuming that they are, Company A would then need to determine whether it has satisfied the criteria under the bill and hold guidance in order to conclude that the customer has obtained control of the product. Typically, Company A recognizes revenue upon delivery, which is when control has transferred, using the guidance included in ASC 606-10-25-30. In this example, the indicators for transfer of control have been met, with the exception of the customer taking physical possession:

  • Company A has a present right to payment for the asset (invoiced the customer with normal payment terms).

  • The customer has legal title to the asset.

  • The customer has the significant risks and rewards of ownership of the asset.

  • The customer has accepted the asset.

Based on an analysis of these indicators, Company A would likely conclude that transfer of control has occurred for the product. In this situation, Company A can recognize revenue from the equipment portion associated with the sale to the customer at December 31, 20X8, assuming all of the additional criteria to recognize revenue in a bill and hold arrangement have been met:

  • The customer has requested the bill and hold arrangement (and therefore, the arrangement must be substantive).

  • The product is segregated and identified as belonging to the customer.

  • The product is ready for physical transfer to the customer.

  • Company A is not able to use the product or to direct it to another customer.

In the fact pattern above, all the criteria have been met for the arrangement to qualify as a sale under the bill and hold guidance. Company A would therefore recognize revenue for the equipment as of December 31, 20X8. Company A should also consider whether it has a remaining performance obligation for custodial services (in addition to the installation services). If so, unless the custodial services are considered an immaterial promise in the context of the contract, Company A will need to allocate a portion of the transaction price to this additional performance obligation and recognize the related revenue as the services are being performed.

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Relevant guidance

ASC 606 includes specific guidance around bill-and-hold arrangements. As defined in ASC 606, a bill-and-hold arrangement is a contract under which an entity bills a customer for a product but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future.

ASC 606-10-25-30:...An entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

  • The entity has a present right to payment for the asset...

  • The customer has legal title to the asset...

  • The entity has transferred physical possession of the asset...

  • The customer has the significant risks and rewards of ownership of the asset...

  • The customer has accepted the asset...

ASC 606-10-55-83: In addition to applying the guidance in paragraph 606-10-25-30, for a customer to have obtained control of a product in a bill-and-hold arrangement, all of the following criteria must be met:

  • The reason for the bill-and-hold arrangement must be substantive (for example, the customer has requested the arrangement).

  • The product must be identified separately as belonging to the customer.

  • The product currently must be ready for physical transfer to the customer.

  • The entity cannot have the ability to use the product or to direct it to another customer.

ASC 606-10-55-84: If an entity recognizes revenue for the sale of a product on a bill-and-hold basis, the entity should consider whether it has remaining performance obligations (for example, for custodial services) in accordance with paragraphs 606-10-25-14 through 25-22 to which the entity should allocate a portion of the transaction price in accordance with paragraphs 606-10-32-28 through 32-41.

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6-29 Government vaccine stockpile arrangements

Background / Question

Company A, a pharmaceutical company and public registrant, sells 1 million influenza vaccines to the United States government for placement into a stockpile. In December 20X1, Company A segregates the vaccines in its facility. The influenza vaccines are identified separately as belonging to the United States government. Company A does not have the ability to use the influenza vaccines or to direct them to another customer.

How should Company A account for this arrangement?

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Solution

Company A should recognize revenue in December 20X1 when the 1,000 influenza vaccines are placed into US Government stockpile because it qualifies under the August 2017 SEC interpretive guidance, control of the vaccines has transferred to the customer, and the criteria in ASC 606 for recognizing revenue in a bill-and-hold arrangement are satisfied.

Companies that participate in government vaccine stockpile programs that do not meet the scope of the interpretive guidance will need to assess whether control of the product has transferred to the government prior to delivery. ASC 606 does not require a fixed delivery schedule to recognize revenue, but the requirement for transfer of control may not be met if the stockpile inventory is not separately identified as belonging to the customer and is subject to rotation. Even if a company concludes that the bill and hold requirements of ASC 606 are met for certain of these arrangements, to the extent a company is replacing or rotating expired and soon-to-be-expired vaccines for fresh product, ASC 606 requires that replacement or rotation rights be accounted for as a return right, subject to the variable consideration constraint.

In addition, all companies will need to consider their performance obligations under the arrangement. For example, companies need to assess if the storage of stockpile product, the maintenance and rotation of stockpile product, and the shipping of product are separate performance obligations.

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Relevant guidance

ASC 606-10-55-81: A bill-and hold arrangement is a contract under which an entity bills a customer for a product but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future...

ASC 606-10-55-83: In addition to applying the guidance in paragraph 606-10-25-30, for a customer to have obtained control of a product in a bill-and-hold arrangement, all of the following criteria must be met:

a.      The reason for the bill-and-hold arrangement must be substantive (for example, the customer requested the arrangement).

b.      The product must be identified separately as belonging to the customer.

c.      The product currently must be ready for physical transfer to the customer.

d.      The entity cannot have the ability to use the product or to direct it to another customer.

In August 2017, the SEC updated its interpretation on vaccine stockpile programs to conform to the guidance in ASC 606. The updated interpretation states that vaccine manufacturers should recognize revenue and provide the appropriate disclosures when vaccines are placed into US government stockpile programs because control of the vaccines has transferred to the customer (the government) and the criteria in ASC 606 for recognizing revenue in a bill-and-hold arrangement are satisfied. This interpretation is only applicable to childhood disease vaccines, influenza vaccines, and other vaccines and countermeasures sold to the US government for placement in the Strategic National Stockpile.

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6-30 Contract manufacturing

Background / Question

Vendor is hired by Customer to manufacture a batch of 100,000 units of a drug with specific package labelling. The initial contract term is six months. Once bottled and labelled, there are significant practical limitations that preclude Vendor from redirecting the product to another customer. Vendor has an enforceable right to payment for performance completed to date if the contract is cancelled for any reason other than a breach or non-performance.

When and how should Vendor recognize revenue?

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Solution

In accordance with ASC 606-10-25-27(c), Vendor should recognize revenue upon transfer of control of the product to the distributor, which in this case would be over time as the units are being manufactured. This is because (a) the drug to be manufactured by Vendor has no alternative use to Vendor (that is, the bottled and labelled product imposes a practical limitation that precludes Vendor from redirecting it to another customer) and (b) Vendor has an enforceable right to demand payment for any work in process if Customer cancels the contract.

In a scenario when Customer maintains legal title to the raw materials throughout the contract manufacturing process, Vendor would also recognize revenue over time as the units are manufactured. In that instance, the drug to be manufactured by Vendor is legally owned by Customer throughout the manufacturing process; therefore, Vendor’s performance enhances Customer’s asset that Customer controls throughout the manufacturing process (as described in ASC 606-10-25-27(b)).

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Relevant guidance

ASC 606-10-25-27: An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met:

a.     The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs (see paragraphs (606-10-55-5 through 55-6).

b.     The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced (see paragraph 606-10-55-7).

c.     The entity’s performance does not create an asset with an alternative use to the entity … and the entity has an enforceable right to payment for performance completed to date (see paragraph 606-10-25-29).

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6-31 Installation obligation – Separate performance obligations

Background / Question

A customer issues a purchase order to Company A, a medical equipment company, for equipment and installation services. Company A will install the equipment at the customer site shortly after delivery and does not expect to have any sales returns. The installation services typically occur consistently over a two month period. Consideration for the equipment and installation services is fixed (i.e., the arrangement does not include any variable consideration or discounts) and the total contract transaction price amounted to $500.

The installation services are relatively routine in nature and Company A is not the only party capable of performing the services. As such, the customer can benefit from the equipment on its own or together with other resources that are readily available (e.g., can engage another party to perform the installation services) and the equipment and installation services are distinct and separately identifiable from one another. Based on this evaluation, Company A concluded the contract included two separate performance obligations to the customer (the equipment and installation services).

Company A has established a standalone selling price of $450 and $150 for the equipment and installation services performance obligations, respectively.

How should Company A recognize revenue for the sale of the equipment and installation services?

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Solution

Company A would first allocate the total transaction price of $500 to each performance obligation identified in the contract based on their relative standalone selling price. Based on their standalone selling prices ($450 and $150), this results in 75% ($375) being allocated to the equipment performance obligation and 25% ($125) being allocated to the installation services performance obligation.

The $375 amount allocated to the equipment performance obligation would be recognized as revenue at the point in time at which the customer obtains control of the equipment. The $125 allocated to the installation services performance obligation would be recognized as revenue over the two month period the services are performed by Company A using a measure of progress that depicts Company A’s performance in satisfying the performance obligation.

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Relevant guidance

ASC 606-10-25-14: At contract inception, an entity assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: (a) a good or service (or a bundle of goods or services) that is distinct (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer...

ASC 606-10-32-29: To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with paragraphs 606-10-32-31 through 32-35, except as specified in paragraphs 606-10-32-36 through 32-38 (for allocating discounts) and paragraphs 606-10-32-39 through 32-41 (for allocating consideration that includes variable amounts).

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6-32 Medical device sale with optional warranty

Background / Question

MedTech, a medical device company, sells a piece of equipment to its customer, Hospital.  MedTech warranties the equipment for a period of three months from purchase; however, for an additional fee, the customer can elect to obtain an extended warranty that provides full protection for a period of two years beyond the original warranty period. Hospital decides to purchase the extended coverage.

How should MedTech account for the warranty?

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Solution

MedTech is required to account for the two year extended warranty as a separate performance obligation.  This is because customers have the option of purchasing or declining the additional service, which demonstrates that that a service is being provided beyond ensuring that the medical device will function as intended.

MedTech would allocate a portion of the transaction price to the warranty based on its relative standalone selling price. The amount of revenue allocated to the warranty could therefore differ from the stated price of the warranty in the contract. MedTech will need to assess the measure of progress for the promise to provide the warranty to determine when the revenue allocated to the warranty should be recognized (that is, ratably over the warranty period or some other pattern).

If the two-year warranty was not optional, MedTech would need to assess whether the warranty only provides Hospital with assurance that the related product complies with agreed-upon specifications (that is, not a separate performance obligation) or provides a service that is a separate performance obligation. If not a separate performance obligation, MedTech would need to evaluate and accrue for the expected costs of satisfying the warranty.

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Relevant guidance

ASC 606-10-25-14: At contract inception, an entity shall assess the goods or services promised in a contract with a customer and identify as a performance obligation each promise to transfer to the customer either: (a) A good or service (or a bundle of goods or services) that is distinct (b) A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer...

ASC 606-10-32-29: To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with paragraphs 606-10-32-31 through 32-35, except as specified in paragraphs 606-10-32-36 through 32-38 (for allocating discounts) and paragraphs 606-10-32-39 through 32-41 (for allocating consideration that includes variable amounts).

ASC 460-10-25-5: Because of the uncertainty surrounding claims that may be made under warranties, warranty obligations fall within the definition of a contingency. Losses from warranty obligations shall be accrued when the conditions in paragraph 450-20-25-2 are met.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

  • The amount of loss can be reasonably estimated...

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6-33 Accounting for upgrades and enhancements

Background / Question

Pursuant to a sales agreement, Company A is selling a medical device and is also obligated under the arrangement to deliver specified future upgrades/enhancements to the medical devices sold. The sales terms also require that Company A provide unspecified, “when-and-if-available” upgrades/enhancements of its medical devices during the three-year term of the arrangement. Company A is paid in full under the contract at the inception of the arrangement. Company A expects to deliver the specified upgrades shortly after the initial sale. The arrangement does not contain any general or specific rights of return.

Are obligations to deliver future upgrades or enhancements of a product considered separate performance obligations?

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Solution

Both the specified and the unspecified upgrades/enhancements in a contract are promises under ASC 606-10-25 and should be evaluated to determine if they are separate performance obligations that necessitate separate accounting, as defined in ASC 606-10-25-19.

Company A would need to determine if the delivered product is distinct from the specified and unspecified upgrades/enhancements in order to separate the contract into multiple performance obligations. The unspecified upgrades/enhancements in this example would most likely be a separate performance obligation. Company A would also need to determine if the delivered product and specified upgrades are separate performance obligations.

Assuming Company A determined the contract had three separate performance obligations, revenue recognition for the allocated amounts would occur upon transfer of control for the sale of the medical device and specified upgrade. The unspecified upgrades/enhancements would be recognized over the three-year term of the contract.

If one or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract, this is an indicator that the good or service is not distinct. For Company A, a critical evaluation would need to be performed to determine if the specified upgrade may significantly modify the medical device and reflects (together with the original device) the combined product that the customer is actually purchasing. On the other hand, if the medical device is fully functional upon delivery and that functionality is not expected to be significantly modified by future upgrades, this would indicate that the medical device is distinct from the promised upgrades.

To the extent that Company A concluded that the delivered medical device is not distinct, the delivered medical device would be bundled with one or more of the other distinct goods or services in the contract and recognized as revenue using an appropriate pattern, based on the guidance in ASC 606-10-25-23. For example, if the initial medical device and the specified upgrades were not considered distinct, revenue would likely be recognized upon the transfer of control of the specified upgrade for the amount allocated to this combined performance obligation, and over the three-year term of the contract for the amount allocated to the unspecified upgrades/enhancements.

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Relevant guidance

A contract includes promises to transfer goods or services to a customer. If those goods or services are distinct, the promises are performance obligations and are accounted for separately. A good or service is distinct if the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer and the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. Paragraphs 606-10-25-14 through 25-22 further discuss identification of performance obligations.

ASC 606-10-25-18: Depending on the contract, promised goods or services may include, but are not limited to, the following:… e. Providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when-and-if-available basis) or of making goods or services available for a customer to use as and when the customer decides...

ASC 606-10-25-19: A good or service that is promised to a customer is distinct if both of the following criteria are met:

a. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

b. The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

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6-34 Future discount on next-generation equipment

Background / Question

Company A sells a medical equipment device to Company B and there is no right of return. Company A is currently developing the next-generation product, which it expects to release in six months. As an incentive for Company B to purchase the current model, Company A offers a 40% discount on the next-generation model when it is released. Management has not determined what the selling price of the next-generation model will be.

How should Company A account for the sale of the medical device?

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Solution

The option provides a material right to the customer. Company A should therefore use one of the suitable methods to determine standalone selling prices of the medical device and the option.

Assume that Company A sells the current model for $100 and uses the “cost plus” margin approach to determine that the standalone selling price of the future model is $110. Under this scenario, Company A would determine the amount of revenue to defer from the sale of the current model by multiplying the estimated future standalone selling price of $110 by the 40% discount, and then allocating this amount between the two performance obligations based on their relative standalone selling price, as described in ASC 606-10-32-29.

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Relevant guidance

ASC 606-10-55-42: If … an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract. ... If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

ASC 606-10-55-44: ...If the standalone selling price for a customer’s option to acquire additional goods or services is not directly observable, an entity should estimate it. That estimate should reflect the discount that the customer would obtain when exercising the option, adjusted for both of the following:

a.   Any discount that the customer could receive without exercising the option

b.   The likelihood that the option will be exercised.

ASC 606-10-32-34: Suitable methods for estimating the standalone selling price of a good or service include, but are not limited to, the following:

c.      Adjusted market assessment approach—An entity could evaluate the market in which it sells goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. That approach also might include referring to prices from the entity’s competitors for similar goods or services and adjusting those prices as necessary to reflect the entity’s costs and margins.

d.      Expected cost plus a margin approach—An entity could forecast its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service.

e.      Residual approach—An entity may estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract...

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6-35 Accounting for payments to a customer

Background / Question

Company A, a medical device manufacturer, sells products to doctors and hospitals for use in performing certain medical procedures. The Company separately enters into contracts with the doctors to obtain information regarding the use of the products in surgery and postoperative information regarding patient recovery.

Company A concluded it was not possible to obtain this information from someone other than the doctors who perform the procedure and manage the postoperative care.

The doctors collect and maintain the information in a patient registry, which is made available to Company A on an exclusive and controlled basis. Company A pays the doctors a fee in exchange for the registry management service.

How should Company A account for the registry management service payments?

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Solution

Because Company A cannot receive registry management service from parties other than the purchasers of its products, it would be unable to conclude that the service it receives is capable of being distinct. As such, Company A should characterize the registry management service payments as a reduction of the transaction price and, therefore, of revenue.

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Relevant guidance

ASC 606–10–32–26: If consideration payable to a customer is a payment for a distinct good or service from the customer, then an entity shall account for the purchase of the good or service in the same way that it accounts for other purchases from suppliers. If the amount of consideration payable to the customer exceeds the fair value of the distinct good or service that the entity receives from the customer, then the entity shall account for such an excess as a reduction of the transaction price. If the entity cannot reasonably estimate the fair value of the good or service received from the customer, it shall account for all of the consideration payable to the customer as a reduction of the transaction price.

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6-36 Gross vs. net arrangements

Background / Question

Company A manufactures and sells a surgical instrument. The instrument requires a disposable that is manufactured and sold by Company B. In order to facilitate sales to its customers, Company A maintains an inventory of disposables, and offers for sale both the surgical instrument and the disposables to its customers. If the disposables are not sold, Company A does not have a right of return to Company B.

Company A guarantees the performance of the disposables and offers a full refund to its customers on nonconforming parts. For nonconforming parts, Company A has a right to return the disposables for returns made by customers to Company A for a replacement or a full refund from Company B.

While Company A has agreed with Company B not to sell the disposables for less than Company B’s list price, Company A can charge any price at or above list price for its disposable sales. Company A receives a 10% discount off the list price when it purchases disposables from Company B.

Should Company A record revenue from the sale of disposables on a gross or net basis?

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Solution

The transaction should be first evaluated against the principles of control in ASC 606-10-55-36 through 55-38, supplemented, as necessary, by the indicators detailed in ASC 606-10-55-39, to determine whether Company A has control over the disposables before they are transferred to the customer. In this example, Company A is primarily responsible for fulfilling disposables and the customer will look to Company A first to resolve any issues with the disposables. Company A also has inventory risk in the transaction and though Company A has agreed not to sell the disposables below Company B’s list price, it still has some discretion in establishing the price. While significant judgment is required, the information above includes several indicators that Company A controls the disposables before they are transferred to the customer and would indicate that it is the principal in the transaction.

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Relevant guidance

ASC 606-10-55-37: An entity is a principal if it controls the specified good or service before that good or service is transferred to a customer. However, an entity does not necessarily control a specified good if the entity obtains legal title to that good only momentarily before legal title is transferred to a customer. An entity that is a principal may satisfy its performance obligation to provide the specified good or service itself or it may engage another party (for example, a subcontractor) to satisfy some or all of the performance obligation on its behalf.

ASC 606-10-55-39: Indicators that an entity controls the specified good or service before it is transferred to the customer (and is therefore a principal [see paragraph 606-10-55-37]) include, but are not limited to, the following:

a.  The entity is primarily responsible for fulfilling the promise to provide the specified good or service.This typically includes responsibility for the acceptability of the specified good or service (for example, primary responsibility for the good or service meeting customer specifications). If the entity is primarily responsible for fulfilling the promise to provide the specified good or service, this may indicate that the other party involved in providing the specified good or service is acting on the entity’s behalf.

b. The entity has inventory risk before the specified good or service has been transferred to a customer or after transfer of control to the customer (for example, if the customer has a right of return). For example, if the entity obtains, or commits to obtain, the specified good or service before obtaining a contract with a customer, that may indicate that the entity has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the good or service before it is transferred to the customer.

c. The entity has discretion in establishing the price for the specified good or service. Establishing the price that the customer pays for the specified good or service may indicate that the entity has the ability to direct the use of that good or service and obtain substantially all of the remaining benefits. However, an agent can have discretion in establishing prices in some cases. For example, an agent may have some flexibility in setting prices in order to generate additional revenue from its service of arranging for goods or services to be provided by other parties to customers.

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Chapter 7: Warranty

7-1 Accounting for new product warranty

Background / Question

Company A offers a standard warranty on a newly-launched medical device. Customers do not have the option to purchase the warranty separately. Company A has determined the standard warranty does not provide the customer a service in addition to the assurance that the product complies with agreed-upon specifications. Company A has no historical experience selling a similar medical device and has not offered a similar warranty on a different product in the past.

How should Company A account for the standard warranty?

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Solution

Company A would account for the warranty in accordance with ASC 460 by considering the two conditions in ASC 450-20-25-2. Company A would first assess whether it is probable that a liability was incurred in connection with the warranty. If it is probably that a liability has been incurred, satisfaction of the second condition in ASC 450-20-25-2 (the amount can be reasonably estimated) will normally depend on the experience of the company or other available information. Because Company A has no experience of its own, reference to the experience of other companies in a comparable business may be appropriate.

If a customer has the option to purchase the warranty separately, or the warranty provides the customer with a service (e.g., repairing or replacing the device following damage caused by the customer) in addition to the assurance that the product complies with agreed-upon specifications, the warranty should be accounted for as a distinct performance obligation and a portion of the transaction price would be allocated to the warranty related performance obligation under ASC 606. If Company A cannot reasonably separate the service component from a standard warranty, it should be accounted for together as one performance obligation under ASC 606.

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Relevant guidance

ASC 606-10-55-31: If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity should account for the promised warranty as a performance obligation in accordance with paragraphs 606-10-25-14 through 25-22 and allocate a portion of the transaction price to that performance obligation in accordance with paragraphs 606-10-32-28 through 32-41.

ASC 606-10-55-32: If a customer does not have the option to purchase a warranty separately, an entity should account for the warranty in accordance with the guidance on product warranties in Subtopic 460-10 on guarantees, unless the promised warranty, or a part of the promised warranty, provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

ASC 606-10-55-33: In assessing whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, an entity should consider factors such as:

a.   Whether the warranty is required by law—If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.

b.   The length of the warranty coverage period—The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.

c.   The nature of the tasks that the entity promises to perform—If it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.

ASC 460-10-25-5: Because of the uncertainty surrounding claims that may be made under warranties, warranty obligations fall within the definition of a contingency. Losses from warranty obligations shall be accrued when the conditions in paragraph 450-20-25-2 are met.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

b. The amount of loss can be reasonably estimated...

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7-2 Recognition of warranty-related costs absorbed by manufacturer

Background / Question

Company A purchases components from various manufacturers and integrates them into a single medical equipment solution that is sold to end users. Company A accounts for the sale of equipment in accordance with ASC 606. Company A has concluded that it is the principal in the transactions with its customers. As part of its normal sales terms, Company A offers its customers a standard warranty that ensures the product will be free from defects and will operate in accordance with its published specifications. The warranty is not sold separately and is not considered to provide a distinct service.

The sale of equipment includes a manufacturer’s standard warranty, such that in the event there is a defect with the equipment, Company A will submit a warranty claim to the manufacturer, which will either replace or repair the defective product. Company A has concluded that it is contractually responsible for the warranty to all of its customers who purchase the equipment.

How should Company A account for the standard warranty to its customers?

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Solution

Company A should accrue warranty costs in accordance with ASC 450–20-25-2. Although the manufacturer is expected to ultimately fulfil the standard warranty claims, Company A is liable to its customers based on its contractual sales terms. A corresponding asset may be recorded for the portion covered by the manufacturer’s warranty. Company A is not permitted to offset the recorded liability with the asset. The warranty accrual and asset would be reversed in the period in which the manufacturer completes the repair, replaces the product or when the warranty expires. This accounting would be different for resellers that do not provide a warranty to the customer. In this situation, the customer would be required to file any warranty claims to repair or replace the product directly with the manufacturer. No warranty expense would be recorded because the reseller is not offering a warranty to the customer.

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Relevant guidance

ASC 606-10-55-32: If a customer does not have the option to purchase a warranty separately, an entity should account for the warranty in accordance with the guidance on product warranties in Subtopic 460-10 on guarantees, unless the promised warranty, or a part of the promised warranty, provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

ASC 460-10-25-5: Because of the uncertainty surrounding claims that may be made under warranties, warranty obligations fall within the definition of a contingency. Losses from warranty obligations shall be accrued when the conditions in paragraph 450-20-25-2 are met.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

b. The amount of loss can be reasonably estimated.

ASC 410-30-35-8: … An asset relating to the recovery shall be recognized only when realization of the claim for recovery is deemed probable… 

 

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7-3 Standard product warranty vs. an extended product warranty

Background / Question

Company A, a manufacturer of medical devices, includes a standard product warranty as part of its standard sales contract terms. The standard product warranty is an agreement to provide warranty protection by the manufacturer for a specific period of time and is included in the price of the product.

Company A offers customers the option to purchase an extended warranty in addition to the scope of coverage of the original standard warranty. Customers also have the option of purchasing a product maintenance contract, under which Company A will perform certain agreed-upon services to maintain its product for a specific period of time.

Does the existence of an extended warranty or a product maintenance contract constitute a performance obligation in the arrangement?

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Solution

Yes. Extended product warranties and product maintenance contracts that are sold separately provide customers with a service and would represent a distinct performance obligation under ASC 606. Company A should allocate the transaction price to the product and the services following the guidance in ASC 606-10-32-28 through 32-41. If Company A cannot reasonably account for the standard and extended warranty separately and/or the extended warranty and the product maintenance contract separately, the warranty/extended warranty and/or the extended warranty/product maintenance contract should be accounted for together as a single performance obligation under ASC 606.

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Relevant guidance

ASC 606-10-55-31: If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity should account for the promised warranty as a performance obligation in accordance with paragraphs 606-10-25-14 through 25-22 and allocate a portion of the transaction price to that performance obligation in accordance with paragraphs 606-10-32-28 through 32-41.

ASC 606-10-55-34: If a warranty, or a part of a warranty, provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, the promised service is a performance obligation. Therefore, an entity should allocate the transaction price to the product and the service. If an entity promises both an assurance-type warranty and a service-type warranty but cannot reasonably account for them separately, the entity should account for both of the warranties together as a single performance obligation.

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7-4 Allocating consideration for an extended warranty

Background / Question

Company A, a manufacturer of medical devices, includes a standard product warranty as part of its standard sales contract terms. The standard product warranty is an agreement to provide warranty protection by the manufacturer for one-year and is included in the price of the product.

Company A runs a promotion by selling a medical device for $1,800 (its regular price) with a “free” extended three-year warranty (which is regularly sold for a separate price of $300). Customers must take the extended warranty. Company A has concluded the extended warranty provides a service to the customer beyond the assurance that the product complies with agreed-upon specifications and, therefore, the service represents a separate performance obligation.

How should Company A allocate the consideration to the performance obligations in this arrangement?

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Solution

Under ASC 606, Company A should allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with ASC 606-10-32-28 through 32-41. This applies whether or not the extended warranty is priced separately as part of the transaction.

While the extended warranty is not being sold separately and is not optional to the customer under the promotion, Company A has concluded it provides the customer with a service. In accordance with ASC 606-10-32-36, Company A would likely allocate a discount proportionately to all performance obligations in the contract. As such, the $1,800 total consideration would be allocated to each performance obligations based on its relative selling prices, resulting in an allocation of $257 to the warranty ($1,800 x ($300/$2,100)) and an allocation of $1,543 to the medical equipment ($1,800 x ($1,800/$2,100)).

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Relevant guidance

ASC 606-10-32-28 through 32-41 provides guidance on the allocation of the transaction price to each performance obligation.

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Chapter 8: Research & Development

8-1 In-licensing agreements

Background / Question

Company A and Company B enter into an agreement in which Company A will in-license Company B’s technology to manufacture a compound to treat HIV. Company A cannot use the technology for any other project or otherwise assign or transfer the technology. Company A has not yet concluded if economic benefits are likely to flow from the compound or if relevant regulatory approval will be granted.

The agreement stipulates that Company A will be permitted to use Company B’s technology in its own facilities for a period of three years. Company A will make a non-refundable payment of $3 million to Company B for access to the technology. Company B will also receive a 20% royalty from any future sales of the compound.

How should Company A account for the in-licensing agreement?

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Solution

Company A should expense the $3 million when incurred (normally when paid) as research and development costs since the technology have no alternative future uses.

If there are subsequent sales of the compound, the royalty payments of 20% would generally be presented in the income statement within cost of sales as incurred.

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

ASC 730-10-25-2(c): ...the costs of intangible assets that are purchased from others for a particular research and development project and that have no alternative future uses and thus have no separate economic values are research and development costs at the time the costs are incurred.

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8-2 Non-refundable upfront payments to conduct research

Background / Question

Company A engages a contract research organization (CRO) to perform research activities for a period of two years in connection with a drug compound related to the treatment of HIV. The CRO is well known in the industry for having modern facilities and good practitioners dedicated to investigation. Company A pays the CRO a non-refundable, upfront payment of $3 million in order to carry out the research under the agreement. The CRO will have to present a quarterly report to Company A with the results of its research. Company A has full rights to the research performed, including the ability to control the research undertaken on the potential cure for HIV. The CRO has no rights to use the results of the research for its own purposes.

How should Company A account for the upfront payment made to the CRO?

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Solution

Although the payment is non-refundable, Company A will receive a future benefit (the rights to the research) as the CRO performs the research services over the two-year period. Therefore, the upfront payment should be capitalized as a prepayment and recognized in the income statement (as research and development expense) based upon the pattern of performance of the CRO in order to properly expense the costs under the arrangement based upon the level of effort necessary to perform the research services. Company A should continue to evaluate whether it expects the goods to be delivered or services to be rendered each reporting period to assess recoverability.

If the payment from Company A to the CRO (or a portion thereof) represents an advance payment for specific materials, equipment or facilities that do not have an alternative future use, it would be recognized in the income statement as research and development expense at the time of payment.

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Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred.

ASC 730-20-25-13: Non-refundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized.

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8-3 Payments made to conduct research

Background / Question

Company A needs to conduct clinical trials to obtain regulatory approvals for its products. Substantial portions of the company’s clinical trials are contracted with third parties, such as CROs. The financial terms of these contracts are subject to negotiations, may vary from contract to contract and may result in uneven payment flows and timing of expense recognition. For example, CROs commonly require payments in advance of performing clinical trial management services. These advance payments are commonly nonrefundable and made three to six months prior to the start of the research and development activity.

How should Company A account for clinical trial payments?

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Solution

Company A should record clinical trial expense for work performed by CROs in the period when services are performed, not necessarily when payments are made. An accrual should be recorded based on estimates of services received and efforts expended pursuant to agreements established with CROs and other outside service providers. These estimates are typically based on contracted amounts applied to the number of patients enrolled, the number of active clinical sites, the duration for which the patients will be enrolled in the study and the percentage of work completed to date.

Nonrefundable advance payments for future clinical trial management services should initially be capitalized and then expensed as the related services are performed. Company A should continue to evaluate whether it expects the services to be rendered. If services are not expected to be rendered, the capitalized advance payment should be charged to expense in the period in which this determination is made.

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Relevant guidance

Statement of Financial Accounting Concepts No. 6, paragraph 139: Accrual accounting attempts to record the financial effects of transactions and other events and circumstances that have cash consequences for an entity in the periods in which those transactions, events, and circumstances occur rather than only in the periods in which cash is received or paid by the entity.

ASC 730-20-25-13: Nonrefundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized.

ASC 730-20-35-1: Nonrefundable advance payments... shall be recognized as an expense as the related goods are delivered or the related services are performed.

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8-4 Fixed-fee contract research arrangements

Background / Question

Company A enters into a contract research arrangement with Company B. Company B will perform research on a library of molecules and will catalogue the research results in a database.

Company A will pay Company B $3 million only upon completion of the contracted work. The payment is based on delivery of the research services. There are no success-based contingencies.

How should Company A account for the contract research arrangement?

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Solution

Company A should accrue a liability for the costs of the contract research arrangement (with an offset to research expenses) as Company B performs the services. Company A will need some visibility into Company B’s pattern of performance in order to properly expense the contract research costs under the arrangement based upon the level of effort necessary to perform the research services. The timing of the payment does not alter the timing of the expense recognition.

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Relevant guidance

ASC 730-10-25-2(d): Contract services. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others [on] behalf of the entity, shall be included in research and development costs.

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8-5 Third-party development of intellectual property

Background / Question

Company A has appointed Company B, an independent third party, to develop an existing compound owned by Company A on its behalf. Company B will act purely as a service provider without taking any risks during the development phase and will have no further involvement after regulatory approval. Company A will retain full ownership of the compound. Company B will not participate in any marketing or production arrangements. Company A will make a $2 million non-refundable payments to Company B on signing the agreement, and an additional payment of $3 million on successful completion of Phase II testing.

How should Company A account for the upfront and subsequent milestone payments?

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Solution

The initial upfront payment represents a prepayment for future development by a third party and should be capitalized and then amortized as Company B performs the research using a pattern that accurately depicts performance. Company A should expense the milestone payment when it is probable the payment will be made unless the milestone payment is intended to compensate Company B for future development services. In such instance, Company A should capitalize the milestone payment and amortize it over the performance period in a pattern consistent with the pattern of underlying performance.

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Relevant guidance

ASC 730-10-25-1: Research and development costs... shall be charged to expense when incurred.

ASC 730-20-25-13: Nonrefundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized.

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8-6 Recording a milestone payment due to a counterparty

Background / Question

Company A entered into a collaboration arrangement with Company B. Company A paid Company B an upfront fee upon signing the arrangement and will pay Company B a discrete milestone payment of $2 million upon FDA approval.

When should Company A record the milestone payment due to Company B?

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Solution

Under the contractual terms of the agreement, the milestone payment becomes payable upon the resolution of a contingency. Company A should accrue the milestone payment when the achievement of the milestone is probable (the amount of the payment is reasonably estimable, as it is a fixed amount under the terms of the arrangement).

Due to the uncertainties associated with the FDA approval process, it may be difficult for Company A to conclude that achievement of the milestone is probable prior to notification of FDA approval. All facts and circumstances regarding the nature of the milestone should be considered when evaluating when the achievement of a milestone is probable.

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Relevant guidance

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  1. Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

  2. The amount of the loss can be reasonably estimated.

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8-7 External development of intellectual property with buy-back options

Background / Question

Company A has out-licensed the development of an existing compound to Company B, an independent third party, multi-national public company. There was no upfront consideration paid between the parties. Company A will neither retain any involvement in the development of its compound nor participate in the funding of the development. The out-license agreement includes the following terms:

  • If the development fails, Company B bears all the costs it incurred without any compensation.

  • If the development is successful, Company A can elect to buy-back the rights to the compound and pay Company B an agreed fixed buy-back payment.

  • If the development is successful and Company A does not buy back the compound, Company B can commercialize the compound on its own.

How should Company A account for payments in an arrangement in which a third party develops its intellectual property?

 

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Solution

Company A effectively removes its exposure to failure of the development of its compound, having transferred all development risks to Company B. In this case, there are no indicators that would lead to a presumption that the buyback will occur and that a liability should be recognized before any decision to reacquire the rights occurs.

If  Company A  exercised the buy-back option, it would reacquire the rights to commercialize the intangible asset. Since exercisability of the buy-back option is only triggered upon regulatory approval, the payment made by Company A to reacquire the rights would be capitalized when the option is exercised and then amortized over the useful life of the right.

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Relevant guidance

ASC 730-20-25-3: If the entity is obligated to repay any of the funds provided by the other parties regardless of the outcome of the research and development, the entity shall estimate and recognize that liability. This requirement applies whether the entity may settle the liability by paying cash, by issuing securities, or by some other means.

ASC 730-20-25-4: To conclude that a liability does not exist, the transfer of the financial risk involved with research and development from the entity to the other parties must be substantive and genuine. To the extent that the entity is committed to repay any of the funds provided by the other parties regardless of the outcome of the research and development, all or part of the risk has not been transferred...

ASC 730-20-25-6: Examples of conditions leading to the presumption that the entity will repay the other parties include any of the following:

  1. The entity has indicated an intent to repay all or a portion of the funds provided regardless of the outcome of the research and development.

  2. The entity would suffer a severe economic penalty if it failed to repay any of the funds provided to it regardless of the outcome of the research and development...

  3. A significant related party relationship between the entity and the parties funding the research and development exists at the time the entity enters into the arrangement.

  4. The entity has essentially completed the project before entering into the arrangement.

ASC 730-20-25-9: If the entity’s obligation is to perform research and development for others and the entity subsequently decides to exercise an option to purchase the other parties’ interests in the research and development arrangement or to obtain the exclusive rights to the results of the research and development, the nature of those results and their future use shall determine the accounting for the purchase transaction or business combination…

ASC 730-10-25-2(d): Contract services. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others [on] behalf of the entity, shall be included in research and development costs.

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8-8 Donation payment for research

Background / Question

Company A has made a non-refundable gift of $3 million to a university. The donation must be used to fund research activities in the area of infectious diseases over a two-year period. Company A has no right to access the research findings.

How should Company A recognize the donation?

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Solution

Company A should expense the donation (generally as selling, general and administrative expense) when incurred (normally when paid) or at the time an unconditional promise to give cash is made, whichever is sooner.

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Relevant guidance

ASC 720-25-25-1: Contributions shall be recognized as expenses in the period made and as decreases of assets or increases of liabilities depending on the form of benefits given. For example...unconditional promises to give cash are recognized as payables and contribution expenses...

ASC 958-720-25-2: Unconditional promises to give shall be recognized at the time the donor has an obligation to transfer the promised assets in the future, which generally occurs when the donor approves a specific grant or when the recipient of the promise is notified...If payments of the unconditional promise to give are to be made to a recipient over several fiscal periods and the recipient is subject only to routine performance requirements, a liability and an expense for the entire amount payable shall be recognized.

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8-9 Capitalization of interest incurred on loans received to fund research and development

Background / Question

Company A has obtained a loan from Company B, another pharmaceutical company, to finance the late-stage development of a drug to treat cancer.

Can Company A capitalize the interest incurred for borrowings obtained to finance research and development activities?

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Solution

Borrowing costs associated with research and development projects should be expensed as incurred as they do not qualify for capitalization.

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Relevant guidance

ASC 835-20-15-5: Interest shall be capitalized for the following types of assets (qualifying assets):

  1. Assets that are constructed or otherwise produced for an entity’s own use, including assets constructed or produced for the entity by others for which deposits or progress payments have been made.

  2. Assets intended for sale or lease that are constructed or otherwise produced as discrete projects (for example ships or real estate developments).

  3. Investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations provided that the investee’s activities include the use of funds to acquire qualifying assets for its operations. The investor’s investment in the investee, not the individual assets or projects of the investee, is the qualifying asset for purposes of interest capitalization.

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8-10 Treatment of trial batches in development

Background / Question

Company A, a commercial laboratory, is manufacturing a stock of 20,000 doses (trial batches) of a newly-developed drug using various raw materials. The doses can only be used in patient trials during Phase III clinical testing, and cannot be used for any other purpose. The raw materials can be used in the production of other approved drugs.

How should Company A account for the raw materials and trial batches?

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Solution

Company A should initially recognize the raw materials acquired for the production of trial batches as inventory since the raw materials have alternative future use in the production of other approved drugs. As the trial batches do not have any alternative future use and the technical feasibility of the drug is not proven (the drug is in Phase III), the cost of the trial batches (including the cost of the raw materials used in their production) should be charged to research and development expense as they are produced.

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Relevant guidance

ASC 730-10-25-2(a): Materials, equipment, and facilities. The costs of materials (whether from the entity’s normal inventory or acquired specially for research and development activities) and equipment or facilities, that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed…

However, the cost of materials, equipment or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred.

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8-11 Fixed asset purchases used in research and development

Background / Question

Company A incurs costs to construct the plant and facility that will be used to produce a medical device that has not yet received FDA approval. The plant and facility will be used to produce the device, at commercially viable levels, once regulatory approval has been obtained.

The project is in an advanced stage and Company A believes regulatory approval will be obtained and that recovery of the costs to construct the plant and facility via future cash flows is probable.

Should Company A expense costs associated with the construction of tangible assets as incurred, or is there a basis for capitalization of those expenditures?

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Solution

The important distinction is whether the construction costs represent research and development costs subject to the guidance in ASC 730. Because the construction activities pertain to tangible assets that will be used to produce the end product at commercially viable levels, rather than costs associated with testing the product or the construction of a pilot facility or pre-production prototype not involving a scale that is economically feasible for commercial production, the costs of construction would not be considered research and development cost as contemplated in ASC 730.

The costs would be subject to the more general concepts of fixed asset accounting and the related impairment considerations. Company A should capitalize the construction costs incurred as plant and equipment. The assets would be subject to impairment testing based on the expected future cash flows of the assets, which would consider the various potential outcomes of the regulatory approval process and their associated likelihoods.

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Relevant guidance

ASC 730–10–20, Research and development: Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service (referred to as product) or a new process or technique (referred to as process) or in bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants.

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8-12 Accounting for funded research and development arrangements

Background / Question

Company A partners with Investor B, an unrelated financial investor, for the development of selected compounds that are in Phase II development. Investor B commits a specified dollar amount to fund the research and development of the selected compounds. In exchange for the funding, Investor B will receive royalties on future sales of product resulting from the compounds being developed. Investor B will not be repaid if the compounds are not successfully developed (i.e., the transfer of financial risk for the research and development is substantive). Investor B does not participate in any of the development or commercialization activities.

What factors should Company A consider to determine the most appropriate accounting model for the research and development funding?

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Solution

While ASC 730–20 only relates to research and development funding, ASC 470–10–25 does not specifically exclude research and development funding arrangements from its scope. If the research and development risk is substantive, such that it is not yet probable the development will be successful, the guidance in ASC 730-20 would generally be followed. However, if the successful completion of the research and development is already probable at the time the funding is received, the guidance in ASC 470-10-25 is applicable.

Company A should assess whether the contractual arrangement with Investor B meets all of the characteristics of a derivative, and if so, whether any of the scope exceptions to derivative accounting are applicable. Since Investor B would only receive royalties on future sales (assuming the development is successful), the settlement provisions under this contract are based on specified volumes of items sold. Therefore, the royalty exception would apply and Company A would not account for this arrangement as a derivative.

To conclude that a liability does not exist, the transfer of financial risk involved with the research and development from Company A to Investor B must be substantive and genuine. When assessing the substance of the transfer of financial risk, Company A should consider any explicit or implicit obligations to repay any or all of the funding and consider the examples in ASC 730-20-25-6.

If Company A determines that there is significant risk associated with the research and development and that successful development is not probable, Company A would apply the guidance in ASC 730-20 to evaluate whether the research and development funding is a liability to repay the funding party or an obligation to perform contractual services.

In this example, Company A has no explicit or implicit obligation to repay any of the funds and therefore determines that the arrangement is an obligation to perform contractual research and development services.

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Relevant guidance

ASC 730-20-05, Research and development arrangements, this subtopic provides guidance on research and development arrangements.  Research and development arrangements have been used to finance the research and development of a variety of new products, such as…medical technology, experimental drugs…

ASC 730-20-25-1: This Subtopic deals with transactions in which the issue is whether, at the time an entity enters into a research and development arrangement:

  1. The entity is committed to repay any of the funds provided by the other parties regardless of the outcome of the research and development.

  2. Existing conditions indicate that it is likely that the entity will repay the other parties regardless of the outcome.

  3. The entity is obligated only to perform research and development work for others.

ASC 470-10-25-1: An entity receives cash from an investor and agrees to pay to the investor for a defined period a specified percentage or amount of the revenue or of a measure of income (for example, gross margin, operating income, or pretax income) of a particular product line, business segment, trademark, patent, or contractual right.  It is assumed that immediate income recognition is not appropriate due to the facts and circumstances.

ASC 815-10-15-59(d): Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following… Specified volumes of sales or service revenues of one of the parties to the contract. (This scope exception applies to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.)

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8-13 Research and development reimbursed by a third party

Background / Question

Company A is a medical diagnostics company that is conducting research and development for a new diagnostic test. The research and development activities are funded by Company B. If the research and development activities are not successful, Company A is not obligated to refund any payment previously received from Company B. Any intellectual property developed under this arrangement would belong to Company B.

How should Company A report the research and development funding it receives from Company B?

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Solution

Guidance related to determining whether a liability exists for research and development funding arrangements is provided in ASC 730–20, Research and Development Arrangements.

Company A should consider that the financial risk associated with the research and development remains with Company B. Therefore, Company A should not recognize a liability associated with this funding. Company A should record contract revenue as it performs the contractual research and development services.

This scenario assumes the research and development is the only performance obligation in the arrangement. If there were other performance obligations, revenue would be allocated to each based on relative standalone selling price (ASC 606-10-65-1).

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Relevant guidance

ASC 730-20-05, Research and development arrangements, this subtopic provides guidance on research and development arrangements.  Research and development arrangements have been used to finance the research and development of a variety of new products, such as…medical technology, experimental drugs…

ASC 730-20-25-1: This Subtopic deals with transactions in which the issue is whether, at the time an entity enters into a research and development arrangement:

  1. The entity is committed to repay any of the funds provided by the other parties regardless of the outcome of the research and development.

  2. Existing conditions indicate that it is likely that the entity will repay the other parties regardless of the outcome.

  3. The entity is obligated only to perform research and development work for others.

ASC 808, Collaborative Arrangements, provides guidance on reporting requirements and income statement classification for transactions between participants in a collaborative arrangement.

For government-sponsored research and development grants, the AICPA industry guide, Audits of Federal Government Contractors, addresses the accounting for certain best-efforts research and development cost-sharing arrangements.

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Chapter 9: Other Areas

9-1 Advertising and promotional expenditure

Background / Question

Company A has developed a new drug that simplifies the long-term treatment of kidney disease. Company A’s commercial department has incurred significant costs on a promotional campaign, including television commercials, presentations in conferences and seminars for doctors.

How should these costs be accounted for and presented in the financial statements?

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Solution

Company A should not recognize its advertising and promotional costs as an intangible asset, even though the expenditure incurred may provide future economic benefits.

Advertising and promotional costs should be included within sales and marketing expenses. Depending on the accounting policy it selected, Company A should charge all promotional costs (i.e. costs to create a television commercial) to the income statement as the costs are incurred or the first time the advertising takes place, however the costs of television airtime and print media space should not be expensed before it is aired or printed, respectively.

The notes to the financial statements should disclose (1) the accounting policy selected from the two alternatives allowed for reporting advertising costs and (2) the amount charged to advertising expense for each income statement presented.

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Relevant guidance

ASC 720-35-25-1: The costs of advertising… shall be expensed either as incurred or the first time the advertising takes place. Deferring the costs of advertising until the advertising takes place assumes that the costs have been incurred for advertising that will occur. Such costs shall be expensed immediately if such advertising is not expected to occur. Examples of the first time advertising takes place include the first public showing of a television commercial for its intended purpose and the first appearance of a magazine advertisement for its intended purpose.

ASC 720-35-25-2: ...costs incurred to produce film or audio and video tape to be used to communicate advertising do not create tangible assets.

ASC 720-35-25-5: Costs of communicating advertising are not incurred until the item or service has been received and shall not be reported as expenses before the item or service has been received. For example: (a) The costs of television airtime shall not be reported as advertising expense before the airtime is used...

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9-2 Product Recall

Background / Question

Company A manufactures and sells pharmaceutical products. Company A identifies a manufacturing defect in a particular product and subsequently issues a recall. The recalled product will be destroyed when it is returned and the customer will either be offered replacement product or a credit that can be applied towards any future purchases by the customer.

How should Company A account for the costs associated with the product recall?

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Solution

A probable loss is deemed to have occurred whenever the determination is made by Company A that a recall is necessary. If that determination was made after the balance sheet date of the Company A’s financial statements, but before the issuance of its financial statements, the liability related to the product recall should generally be recorded in Company A’s financial statements to the extent it relates to sales made prior to the balance sheet date.

The classification of the cost of the recall in the income statement depends on the nature of the recall. If Company A offers to replace the recalled product, it should account for the costs of the replacement similar to the accounting for warranties (ASC 606-10-55-29). Such amounts would generally be expected to be charged to cost of goods sold. If Company A offers the customer a cash refund or credit, it should recognize the amount expected to be refunded as a reduction of revenue similar to the accounting for a right of return (ASC 606-10-32-10).

In this example, since Company A gives the customer the option to obtain a credit, which can be applied towards any future purchases, or receive a replacement product, Company A will need to use a reasonable basis to estimate which option the customer will elect, and account for each option as described above. Company A will also need to consider the need to adjust the carrying value of inventory on hand related to the recalled product, which would result in an incremental charge to cost of goods sold. In this example, as the product will be destroyed upon receipt, no asset for the returned item should be recorded. The product recall may also trigger other impairment assessments (e.g., goodwill, intangible assets, deferred taxes), as well as potentially a going concern evaluation. Additionally, Company A may need to consider the possibility of any legal claims associated with injury or damage caused by a product.

Finally, depending on its significance, consideration should be given to providing clear disclosure of the nature of the recall and its impact on Company A’s business and financial results.

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Relevant guidance

ASC 450–20–25–2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

  • The amount of the loss can be reasonably estimated.

ASC 606-10-32-10: An entity shall recognize a refund liability if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer. ASC 606-10-55-25: …For any amounts received (or receivable) for which an entity does not expect to be entitled, the entity should not recognize revenue when it transfers products to customers but should recognize those amounts received (or receivable) as a refund liability. Subsequently, at the end of each reporting period, the entity should update its assessment of amounts for which it expects to be entitled in exchange for the transferred products and make a corresponding change to the transaction price and, therefore, in the amount of revenue recognized.

ASC 606-10-55-26: An entity should update the measurement of the refund liability at the end of each reporting period for changes in expectations about the amount of refunds. An entity should recognize corresponding adjustments as revenue (or reductions of revenue).

ASC 606-10-55-29: Contracts in which a customer may return a defective product in exchange for a functioning product should be evaluated in accordance with the guidance on warranties in paragraphs 606-10-55-30 through 55-35.

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PwC Pharmaceutical and Life Sciences Practice

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Copyright:

This publication has been prepared for general informational purposes, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this publication was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PricewaterhouseCoopers LLP, its members, employees, and agents shall not be responsible for any loss sustained by any person or entity that relies on the information contained in this publication. Certain aspects of this publication may be superseded as new guidance or interpretations emerge. Financial statement preparers and other users of this publication are therefore cautioned to stay abreast of and carefully evaluate subsequent authoritative and interpretative guidance.

The FASB Accounting Standards Codification® material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, and is reproduced with permission.

Questions

PwC clients that have questions about this US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences Guide should contact their engagement partners. Engagement teams that have questions should contact: Laura Robinette, Brett Cohen, Mark Barsanti, Jeroen van Paassen or Holly Reeves.

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Laura Robinette

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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