US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 9

Chapter 9: Other Areas

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9-1 Advertising and promotional expenditure

Background

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.

Question: How should these costs be accounted for and presented in the financial statements?

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.

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...

9-2 Product Recall

Background

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.

Question: How should Company A account for the costs associated with the product recall?

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.

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.

9-3 Accounting for the annual pharmaceutical manufacturers fee

Background

The Patient Protection and Affordable Care Act imposes an annual fee on pharmaceutical companies that manufacture or import branded prescription drugs. The determination of an entity’s relative portion of the fee is based on the entity’s branded prescription drug sales for the current year as a percentage of the industry’s branded prescription drug sales for the same year.

Question: How should a company account for its allocation of the annual fee in its financial statements?

Solution:

A company incurs a liability for the annual fee in the period in which the underlying sale occurs. As a result, the liability related to the annual fee should be estimated and recorded in full upon the first qualifying sale in the applicable calendar year in which the fee is payable. A corresponding deferred cost should be amortized to expense using a straight-line method of allocation, unless another method better allocates the fee over the calendar year in which it is payable. Since the annual fee is based on a company’s market share each year, it is important to consider whether there could be significant changes to a company’s market share from one year to the next, which should be estimated each reporting period. This might be the case, for example, if a company has a branded product coming off patent that could reduce their market share. Alternatively, if a competitor has a “blockbuster” drug coming off patent, a company might project an increase in market share.

Companies should reflect this cost as an operating expense.

Guidance

ASC 720-50-05-1: This Subtopic provides guidance on the annual fees paid by pharmaceutical manufacturers and health insurers to the U.S. Treasury in accordance with the Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act (the Acts).

ASC 720-50-05-2: The Acts impose annual fees on the pharmaceutical manufacturing industry for each calendar year beginning on or after January 1, 2011, and on the health insurance industry for each calendar year beginning on or after January 1, 2014. An entity’s portion of the annual fee is payable no later than September 30 of the applicable calendar year and is not tax deductible.

ASC 720-50-05-3: For the pharmaceutical manufacturing industry, the annual fee will be allocated to individual pharmaceutical manufacturers on the basis of the amount of their branded prescription drug sales for the preceding year as a percentage of the industry’s branded prescription drug sales for the same period. A pharmaceutical manufacturing entity’s portion of the annual fee becomes payable to the U.S. Treasury once the entity has a gross receipt from branded prescription drug sales to any specified government program or in accordance with coverage under any government program for each calendar year beginning on or after January 1, 2011.

ASC 720-50-05-4: For the health insurance industry, the annual fee will be allocated to individual health insurers based on the ratio of the amount of an entity’s net premiums written during the preceding calendar year to the amount of health insurance for any U.S. health risk that is written during the preceding calendar year. A health insurance entity’s portion of the annual fee becomes payable to the U.S. Treasury once the entity provides health insurance for any U.S. health risk for each calendar year beginning on or after January 1, 2014.

ASC 720-50-25-1: The liability related to the annual fee described in paragraphs 720-50-05-1 through 05-4 shall be estimated and recorded in full upon the first qualifying sale for pharmaceutical manufacturers or once the entity provides qualifying health insurance for health insurers in the applicable calendar year in which the fee is payable with a corresponding deferred cost that is amortized to expense using a straight-line method of allocation unless another method better allocates the fee over the calendar year that it is payable. The annual fee imposed on health insurers does not represent a cost related to the acquisition of policies that is consistent with the definition of an acquisition cost in Subtopic 944-30.

ASC 720-50-45-1: The annual fee described in paragraphs 720-50-05-1 through 05-4 shall be presented as an operating expense.

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Josh Herron

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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