ASC 606 and the Challenges for the Life Sciences

Upon initial adoption of Accounting Standards Codification (“ASC” or “Codification”) 606, Revenue from Contracts with Customers (“ASC 606”), companies within the life sciences industry have faced certain unique challenges.

In this article, we will explore two specific challenges faced by life science companies upon and post- adoption of ASC 606: (1) assessment of collaborative-type arrangements to determine if they are within the scope of ASC 606; and (2) if the contract is within the scope of ASC 606, how to identify and account for variable consideration.

Collaborative-Type Arrangements

One of the more common businesses within the life sciences sector is biopharmaceuticals. Biopharmaceutical companies are primarily engaged in researching and developing medical treatments from living cells and organisms. A common way of performing these activities is through collaborative arrangements with, for example, other research & development (“R&D”) companies or Big Pharma. As defined by the Codification, collaborative arrangements involve joint operating activities by all parties involved. All parties must be actively involved in the activity and exposed to both the risks and rewards surrounding the success of the activity to be considered a collaborative arrangement.

With the aforementioned information in mind, the following is an example of a collaborative arrangement for a biopharmaceutical company, Company B, to determine whether a contract falls within the scope of ASC 606 or ASC 808, Collaborative . The ASC “Master Glossary” states that in order to meet the definition of a collaborative arrangement, there must be active participants in the activity, and both must be exposed to significant risks and reward based on the results of the activity. Company A and Company B entered into a collaboration agreement for clinical activities related to the development of a vaccine. Company A will supply doses of the vaccine at no charge to Company B. Company B will handle, store and ship or dispose of materials provided to study sites. Company B is responsible for making sure that the study is conducted in accordance with the terms of the agreement and at the approval of a steering committee formed by both companies. The results of the study are jointly owned by Company A and Company B. The two companies are working together to develop the drug, and no compensation or services are being provided by one company to the other.

Consideration of Applicable Authoritative Guidance – Circumstance I

Initially one would expect this type of contract to fall squarely within the guidance of ASC 808, as, based on the terms of this agreement, both companies are active participants as they direct and carry out the activities jointly and have a steering committee composed of representatives from each company to provide oversight. From Company B’s perspective, for example, there is no monetary compensation for completion of the activities, and Company B bears all the costs of the activities being performed; therefore, it is exposed to the risks and rewards. As both points of the definition are met, this agreement meets the definition of a collaborative agreement and would be within the scope of ASC 808, Collaborative .

Collaboration Arrangements with a Twist          

Let’s look at another example. Using our previously established collaborative arrangement, we will add some updated terms. Instead of both companies working together to develop a drug, Company B is providing research and development activities for Company A. Company B receives consideration from Company A when it reaches certain milestones within the clinical development process. Company B is responsible for the performance of R&D services, while Company A is responsible for the costs relating to the R&D and clinical trials. In addition, a non-refundable upfront payment by Company A was provided to Company B in exchange for Company B granting Company A an exclusive license to its intellectual property to perform clinical studies, regulatory and other activities.

Consideration of Applicable Authoritative – Circumstance II

In order to determine whether the arrangement as a whole, or a portion of the arrangement, falls within the scope of ASC 606, Company B must determine whether the relationship is strictly a collaboration or if there is a customer relationship present. If the relationship is a contract with a customer, it would fall within the guidance of ASC 606. By definition per ASC 606, 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.” In the original example, no party is considered a customer as the parties are working together on the clinical activities, and a contract, as defined under ASC 606, does not exist, as no consideration will be transferred in exchange for materials and activities provided by/performed by each of the parties. In the updated example, however, Company A would be deemed a customer, as it is receiving the benefits of the out-licensing and R&D activities performed by Company B, and Company A is providing consideration for the R&D services to Company B. Licensing of its intellectual property and R&D services are considered Company B’s ordinary business activity. As such, this collaboration arrangement would fall within the scope of ASC 606, and Company B would recognize the consideration received from Company A for its licensing and services as revenue.

Variable Consideration

Identifying Common Forms of Variable Consideration

An issue unique to the pharmaceutical companies is the presentation of their revenue related to sales of pharmaceutical products due to the various potential reductions to the amount of transaction consideration to which a company will be entitled. These potential reductions include discounts, rebates, chargebacks and coupons, as well as product returns. These post-sale adjustments to transaction price create an accounting challenge, as they represent estimates of amounts that a pharmaceutical company expects it will ultimately owe to its customers. Pharmaceutical companies need to assess the accuracy of their estimates each reporting period based on actual reductions to transaction consideration incurred.  Standard sales contracts often provide for prompt payment discounts and the right to return a product within a predetermined number of months of expiry. Both the prompt payment discount and the product right of return represent variable consideration, which is defined within ASC 606-10-32-3 as an element that affects transaction price. Under ASC 606, companies must now estimate and recognize the expected amount of variable consideration, such prompt payment discounts and product returns at the time the associated revenue is recognized and record such amounts as a reduction to the total amount of revenue recognized.

Estimation of Variable Consideration

ASC 606 provides two methods companies can use to estimate variable consideration: the expected value method, which uses historical data as the basis to estimate the potential future outcome; and the most likely amount method, which is the single most likely outcome from a range of possible outcomes and is more appropriate when there are only two possible outcomes. For example, applying an expected product return rate to current sales based on historical actual returns would generally be the more appropriate method to estimate the variable consideration related to product returns. Regardless of the methodology selected, it must be applied consistently, and the estimated value of the variable consideration must be recorded at the time of sale.

Allocation of Variable Consideration to Multiple Performance Obligations

The guidance under ASC 606 indicates that, in instances of contracts which contain multiple performance obligations, it is possible to allocate variable consideration to only one of the performance obligations to which the variable consideration specifically relates or amongst all performance obligations, in which case it follows the same guidance as the transaction price allocation. Using our example from above, if there were additional performance obligations within the contract unrelated to the delivery of pharmaceutical products, the variable consideration for product returns would not be allocated amongst all performance obligations, as it relates only to the product delivery performance obligation. However, if variable consideration was recognized for prompt payment discounts, that likely should be allocated amongst all identified performance obligations, as it relates to the sale transaction as a whole.

Key Takeaways

The application of ASC 606 can add complexity to accounting for many companies within the life sciences industry. The complexity of contracts typically entered into by life sciences companies often results in the ongoing application of the standard being more challenging, as highlighted in our discussion here.  Life companies must exercise judgment in determining if their contracts fall within the scope of ASC 606, as well as their selection and application of methods to estimate variable consideration. These are just a couple of the examples of complexities that may be encountered when applying ASC 606 to contracts by life sciences companies; there are many more circumstances that could create potential pain points. It is advisable to identify potential issues or uncertainties early and engage a trusted advisor to assist, when necessary, in navigating the provisions of the standard.