US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 1

Chapter 1: Capitalization and Impairment

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

Background

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.

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

Solution

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

Relevant guidance

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

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

Background

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.

Question: Should management start capitalizing the development costs?

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.

Relevant guidance

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

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

Background

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.

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

Solution

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

Relevant guidance

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

1-4 Capitalization of development costs for generics

Background

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.

Question: Should management capitalize the development costs at this point?

Solution

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

Relevant guidance

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

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

Background

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.

Question: Should Company A capitalize these costs?

Solution

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

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.

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

Background

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.

Question: Should Company A capitalize these development costs?

Solution

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

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.

1-7 Development of alternative indications

Background

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.

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

Solution

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

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.

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.

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

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.

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

1-9 Asset acquisition of a compound

Background

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.

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

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.

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.

1-9A: Accounting for a payment upon regulatory approval (added August 2019)

Background

Company A acquired IP rights to a drug compound for an upfront cash payment of $25 million and agrees to make a one-time payment of $20 million if and when regulatory approval is obtained. There are no alternative future uses for the IP and the acquired asset does not constitute a business. Because the drug compound was acquired prior to regulatory approval, the upfront cash payment of $25 million is expensed as research and development costs.

Question: How should Company A account for the $20 million approval payment?

Solution

Assuming the cost is recoverable based on expected future cash flows, Company A would capitalize the $20 million payment upon regulatory approval as an intangible asset because the payment relates to what is now an approved compound. Company A would amortize the intangible assets over the useful life of the IP beginning on the date the asset is available for its intended use, which would generally be the regulatory approval date.

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]. 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 350-30-20: Intangible Assets - Assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.)

ASC 350-30-35-1: The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life shall be amortized; an intangible asset with an indefinite useful life shall not be amortized.

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...

1-10 Accounting for a sales-based milestone payment

Background

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.

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

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.

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...

1-11 Indefinite-lived intangible assets

Background

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

Question: How should management account for the acquired intangible asset?

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.

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.

1-12 Indicators of impairment for intangibles

Background

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.

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

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

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...

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

Background

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.

Question: What impairment indicators should Company A consider?

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.

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...

1-14 Single market impairment

Background

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.

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

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.

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...

1-15 Impairment testing and useful life

Background

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.

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

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.

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.

1-16 Exchange of intangible assets when control is transferred

Background

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.

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

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).

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.

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

Background

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.

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

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.

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.

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

Background

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.

Question: How should Company B account for this transaction?

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.

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.

1-19: Accounting for priority review vouchers (added August 2019)

Background

Under the priority review voucher (PRV) program, developers are “rewarded” for treatments for certain neglected or rare pediatric diseases. Following the treatment’s approval by the Food and Drug Administration (FDA), the developer receives a voucher for priority review for a future drug candidate, which is freely transferable to third parties.

On January 1, 20X9, Company A acquires a PRV from Company B for $250 million.

Question: How should Company A account for the purchase of the PRV from Company B?

Solution

On January 1, 20X9, Company A should capitalize the $250 million paid for the PRV because it has alternative future uses; specifically Company A can realize the benefit by selling it to a third party. Subsequent to the acquisition, the PRV would be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the indefinite lived asset might be impaired.

At the time Company A commits to using the PRV with the FDA to accelerate the review of its drug application, the $250 million should be expensed as research and development costs because at that point the PRV no longer has an alternative use (i.e., the PRV is no longer available to be sold to another party). Alternatively, if the PRV is sold, the capitalized asset of $250 million would be derecognized from the balance sheet. Any difference between the $250 million cost paid to obtain the PRV and the proceeds received from its sale would be recognized in the income statement.

Relevant guidance

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.

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 350-30-20: Intangible Assets - Assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.)

ASC 350-30-35-1: The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life shall be amortized; an intangible asset with an indefinite useful life shall not be amortized.

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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Josh Herron

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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