US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 6

Chapter 6: Revenue Recognition

US GAAP landing page

6-1 Scope considerations when accounting for collaboration agreements

Background

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.

Question: Is this arrangement within the scope of ASC 606?

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.

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).

6-2 Receipts for out-licensing of IP

Background

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.

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

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.

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).

6-3 Contract term

Background

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.

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

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.

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.

6-4 Determine the transaction price

Background

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.

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

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.

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.

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

Background

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.

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

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.

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...

6-6 Assessing distinct promises (license and manufacturing)

Background

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.

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

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.

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

6-7 Significant financing component

Background

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.

Question: Does a significant financing component exist?

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.

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).

6-8 Determining standalone selling price

Background

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.

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

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.

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...

6-9 Accounting for options to additional IP

Background

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.

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

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.

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...

6-10 Accounting for modifications

Background

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.

Question: How should Company A account for the modification?

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.

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.

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

Background

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.

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

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.

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.

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

Background

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.

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

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.

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.

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

Background

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.

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

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.

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.

6-13A Determine who the customer is when a Manufacturer sells product to a Wholesaler

Background

Company A, a pharmaceutical company, enters into an arrangement with Wholesaler X, whereby Wholesaler X can purchase drug tablets for list price (often referred to as Average Wholesale Price or AWP), less 3%. Wholesaler X can only return drug tablets to Pharma six months prior to expiry. Wholesaler X enters into a contract with Hospital Y to sell the drug for list price plus 2%. Hospital Y does not need to buy from Wholesaler X; it can negotiate pricing for drug tablets with multiple wholesalers to obtain the cheapest price. Wholesaler X has the ability to sell the drug tablet to any customer at any price and can decide whether to sell the drug to Hospital Y or another entity (e.g., another hospital or pharmacy). Company A’s sales team is actively marketing the drug to Wholesaler X’s customers, including Hospital Y.

On January 1, 20X2, Wholesaler X orders 100,000 tablets (expiry is June 30, 20X6) from Company A. Company A delivers the units to Wholesaler X’s warehouse. On February 20, 20X2, Hospital Y orders 25,000 tablets from Wholesaler X. Wholesaler X delivers the drugs to Hospital Y. Company A is responsible for the acceptability of the drug such that Hospital Y directs any quality issues to Company A.

Question: Who is Company A’s customer and how should Company A account for this transaction?

Solution

Company A would assess the transactions (sale of drug) between Company A and Wholesaler X to determine whether Wholesaler X is a principal or an agent. If Company A transfers control of the drug tablets to Wholesaler X, Wholesaler X is a principal, in which case revenue is recognized upon transfer. Otherwise, Wholesaler X is acting as Company A’s agent, in which case Company A would recognize revenue upon control of the drug tablets transferring to Hospital Y. 

Company A would consider the indicators of whether Wholesaler X controls the goods (drug tablets) before they are transferred to Hospital Y. Hospital Y can negotiate the price with Wholesaler X and Hospital Y can choose to contract with a different wholesaler to obtain the cheapest price. Wholesaler X has the ability to sell the drug tablet to any customer and can decide whether to sell the drug to Hospital Y or another entity (e.g., another hospital or pharmacy). Wholesaler X has inventory risk because Wholesaler X obtained control of drug tablets before obtaining a contract with Hospital Y and has the ability to direct the use of and obtain substantially all of the benefits of transferring the drug tablets to its customers. 

There are also indicators present that could point to Wholesaler X being Company A’s agent. Company A is responsible for the acceptability of the drugs and Wholesaler X has the right to return the product in four years. This does not, however, mitigate Wholesaler X’s inventory risk. 

In this example, the indicators appear to support a conclusion that Wholesaler X is the principal in the sale of the drugs to Hospital Y. Therefore, Wholesaler X is Company A’s customer for the order of 100,000 tablets. 

Because Wholesaler X is Company A’s customer, Company A should record revenue, net of variable consideration for any estimated discounts, rebates, or contractual allowances that will become due and payable once the drug is sold on to Wholesaler X’s customers, when control of the 100,000 tablets transfers to Wholesaler X. 

The determination often requires judgment and impacts both the timing and amount of revenue ultimately recognized. Companies should carefully assess the facts and circumstances when making the principal vs. agent assessment.

Relevant guidance

ASC 606-10-55-36: When another party is involved in providing goods or services to a customer, the entity should determine whether the nature of its promise is a performance obligation to provide the specified goods or services itself (that is, the entity is a principal) or to arrange for those goods or services to be provided by the other party (that is, the entity is an agent). An entity determines whether it is a principal or an agent for each specified good or service promised to the customer. A specified good or service is a distinct good or service (or a distinct bundle of goods or services) to be provided to the customer (see paragraphs 606-10-25-19 through 25-22). If a contract with a customer includes more than one specified good or service, an entity could be a principal for some specified goods or services and an agent for others.

ASC 606-10-55-36A: To determine the nature of its promise (as described in paragraph 606-10-55-36), the entity should:

a. Identify the specified goods or services to be provided to the customer (which, for example, could be a right to a good or service to be provided by another party [see paragraph 606-10-25-18])

b. Assess whether it controls (as described in paragraph 606-10-25-25) each specified good or service before that good or service is transferred to the customer.

 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 606-10-55-38: An entity is an agent if the entity’s performance obligation is to arrange for the provision of the specified good or service by another party. An entity that is an agent does not control the specified good or service provided by another party before that good or service is transferred to the customer. When (or as) an entity that is an agent satisfies a performance obligation, the entity recognizes revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the specified goods or services to be provided by the other party. An entity’s fee or commission might be the net amount of consideration that the entity retains after paying the other party the consideration received in exchange for the goods or services to be provided by that party.

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.

ASC 606-10-55-39A: The indicators in paragraph 606-10-55-39 may be more or less relevant to the assessment of control depending on the nature of the specified good or service and the terms and conditions of the contract. In addition, different indicators may provide more persuasive evidence in different contracts.

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). Consideration payable to a customer also includes equity instruments (liability or equity classified) granted in conjunction with selling goods or services (for example, shares, share options, or other equity instruments). 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.

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

Background

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.

Question: Does the royalty exception apply to this arrangement?

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.

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).

6-15 Sales-based milestones

Background

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.

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

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).

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).

6-16 Milestone payments based on first commercial sale

Background

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.

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

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.

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).

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

Background

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.

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

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.

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

6-18 Distributor arrangement in new territory

Background

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.

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

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.

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.

6-19 Right of return

Background

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.

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

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).

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)...

6-20 Price appreciation rights

Background

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.

Question: How should Company A account for December 20X0 sales?

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.

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.

6-21 Rebates paid to a customer’s customer

Background

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.

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

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.

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.

6-22 Price protection clauses

Background

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.

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

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.

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.

6-23 Accounting for retroactive rebates

Background

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.

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.

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

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.

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)...

6-24 Volume purchase arrangements

Background

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.

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

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:

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.

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).

6-25 Medicare Part D coverage gap

Background

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.

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

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.

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.

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.

6-26 Pay-for-performance arrangements

Background

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.

Question: How should Company A account for this arrangement?

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.

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.

6-27 Synthetic FOB destination

Background

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.

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

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.

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...

6-28 Bill-and-hold arrangements

Background

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.

Question: When should Company A recognize revenue on this transaction?

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.

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.

6-29 Government vaccine stockpile arrangements

Background

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.

Question: How should Company A account for this arrangement?

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.

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.

6-30 Contract manufacturing

Background

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.

Question: When and how should Vendor recognize revenue?

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)).

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).

6-31 Installation obligation – Separate performance obligations

Background

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.

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

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.

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).

6-32 Medical device sale with optional warranty

Background

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.

Question: How should MedTech account for the warranty?

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.

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...

6-33 Accounting for upgrades and enhancements

Background

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.

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

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.

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).

6-34 Future discount on next-generation equipment

Background

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.

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

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.

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...

6-35 Accounting for payments to a customer

Background

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.

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

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.

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.

6-36 Gross vs. net arrangements

Background

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.

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

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.

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.

Contact us

Josh Herron

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

Follow us