US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 8

Chapter 8: Research & Development

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8-1 In-licensing agreements

Background

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.

Question: How should Company A account for the in-licensing agreement?

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.

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.

8-2 Non-refundable upfront payments to conduct research

Background

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.

Question: How should Company A account for the upfront payment made to the CRO?

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.

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.

8-3 Payments made to conduct research

Background

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.

Question: How should Company A account for clinical trial payments?

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.

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.

8-4 Fixed-fee contract research arrangements

Background

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.

Question: How should Company A account for the contract research arrangement?

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.

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.

8-5 Third-party development of intellectual property

Background

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.

Question: How should Company A account for the upfront and subsequent milestone payments?

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.

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.

8-6 Recording a milestone payment due to a counterparty

Background

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.

Question: When should Company A record the milestone payment due to Company B?

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.

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

8-7 External development of intellectual property with buy-back options

Background

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.

Question: How should Company A account for payments in an arrangement in which a third party develops its intellectual property?

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.

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.

8-8 Donation payment for research

Background

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.

Question: How should Company A recognize the donation?

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.

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.

8-9 Capitalization of interest incurred on loans received to fund research and development

Background

Company A has obtained a loan from Company B, another pharmaceutical company, to finance the late-stage development of a drug to treat cancer.

Question: Can Company A capitalize the interest incurred for borrowings obtained to finance research and development activities?

Solution

Borrowing costs associated with research and development projects should be expensed as incurred as they do not qualify for capitalization.

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.

8-10 Treatment of trial batches in development

Background

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.

Question: How should Company A account for the raw materials and trial batches?

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.

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.

8-11 Fixed asset purchases used in research and development

Background

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.

Question: Should Company A expense costs associated with the construction of tangible assets as incurred, or is there a basis for capitalization of those expenditures?

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.

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.

8-12 Accounting for funded research and development arrangements

Background

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.

Question: What factors should Company A consider to determine the most appropriate accounting model for the research and development funding?

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.

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.)

8-13 Research and development reimbursed by a third party

Background

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.

Question: How should Company A report the research and development funding it receives from Company B?

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).

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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Josh Herron

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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