Revenue Recognition Developments and How They Will Affect Biopharmaceutical Companies in 2010
Revenue recognition continues to be a point of contention in the biopharmaceutical industry, internally within company management as well as between company management and their auditors. Due to the novel and incentivized structure of arrangements, recognition of revenue remains challenging and the level of complexity associated with certain accounting rules can be overwhelming. Multiple-element arrangements are commonplace in the biopharmaceutical industry with varying licensing agreements, where companies will license compounds or products, provide for clinical support agreements, and provide for a royalty stream once approved for commercialization. Such arrangements give rise to unique revenue recognition issues and significant industry and transaction-specific guidance that companies must address in order to properly recognize of revenue. Accounting rules continue to evolve, and the standard setters have revised, amended and superseded a number of pronouncements that will impact the biopharmaceutical industry.
Areas the standard setters are developing new rules in, which continue to challenge biopharmaceuticals companies and relate to revenue recognition, include:
- Multiple element and collaborative arrangements
- Upfront fees
- Milestone payments
- Providing documentation of the fair value of these deliverables
Under U.S. GAAP, revenue is recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the price is fixed and determinable and (4) collectability is reasonably assured. In the bio/pharmaceutical industry, once delivery has occurred or when a price is fixed and determinable, it’s not so black and white.
With collaborative and joint arrangements, numerous deliverables potentially exist and determining how these deliverables are “separable” creates revenue recognition issues. Also common in these arrangements are one-time, non-refundable, upfront fees and additional milestone fees that are contingent upon successful clinical outcomes. These upfront and milestone fees may have to be amortized over a short period (in the case of specific development activity), upon receipt or over the entire expected life of the program. When to recognize the related revenue depends on the features imbedded in the agreements and the company’s ability to separate and determine the fair value of the deliverables. Due to the differentiation and complexity of these agreements, there have been, and continue to be, divergent methodologies used in practice.
In light of the issues that continue to stem from multiple element arrangements, the Emerging Issues Task Force (EITF) and Financial Accounting Standards Board (FASB) have recently issued guidance that supersedes current revenue recognition literature. This is expected to impact the biopharmaceutical industry’s accounting for revenue.
Most recently, a revised model has been created with the issuance of Accounting Standards Update (ASU) No. 2009-13, Revenue Recognition (Topic 605) – Multiple-Deliverable Revenue Arrangements (a consensus of the FASB Emerging Issues Task Force). ASU 2009-13 continues to require companies to bifurcate and determine the fair value of deliverables included in an agreement. However, the new “separable” rules are not as stringent. Currently, companies have difficulty separating deliverables due to the high threshold of vendor-specific objective evidence (VSOE) or “third-party” evidence of selling price of the undelivered items. This ASU allows, in the absence of VSOE, an allocation of the overall consideration to each deliverable using a best estimate of the selling price. Previous guidance required a residual method when certain VSOE was not available which often resulted in the deferral of revenue recognition and was at times punitive based on current economic factors. This ASU removes the “residual” method altogether.
The new guidance also requires additional qualitative and quantitative disclosures by similar type of arrangement, disclosure of significant judgments made and changes to those judgments, and how those judgments may significantly impact the timing and amount of recognized revenue.
ASU 2009-13 is effective for fiscal years that begin on or after June 15, 2010, either prospectively or retrospectively, and early adoption is permitted on either basis. If a company elects to early adopt in other than the beginning of its fiscal year, then retrospective application is required from the beginning of the fiscal year. If adoption is on a prospective basis, then the update requires transitional qualitative and quantitative disclosures for the impact of adoption.
If retrospective adoption is chosen, then the company must make additional disclosures for all previously reported interim periods in the fiscal year of adoption for revenue, income before taxes, net income, earnings per share and the effect of the change for the captions presented.
Another development in the area of revenue recognition which impacts the biopharmaceutical industry is EITF Issue No. 08-9, Milestone Method of Revenue Recognition (contained in the FASB Accounting Standards Codification (ASC) 605-25, Revenue Recognition – Multiple Element Arrangements), which defines a milestone and clarifies whether a vendor may recognize arrangement consideration earned from the achievement of a milestone in its entirety in the period in which the milestone is achieved. A milestone is defined as an event for which there is “substantial” uncertainty at the date the arrangement is entered into that the event will be achieved. The determination of whether a milestone is substantive is a matter of judgment however, in order to be substantive, the consideration earned from the achievement of a milestone is commensurate with either the vendor’s performance to achieve the milestone or the enhancement of the value of the delivered item and relates solely to past performance and is reasonable relative to the deliverables and payment terms within the arrangement. The guidance in this accounting policy does not require use of the milestone method, and instead provides guidance on one method of accounting that could be used to account for the arrangements that fall within its scope.
The effective date of this consensus is for fiscal years beginning after December 15, 2009 with early adoption permitted.
The accounting guidance surrounding revenue recognition continues to be debated and with arrangements becoming more complex with the inclusion of many terms specific to a product or service, management and the analysis they provide their auditors requires diligent and careful analysis. Organizational management, including non-accounting personnel, should periodically review revenue recognition policies internally in conjunction with the provisions of the recently issued guidance and potential licensing transactions to ensure continuing compliance. It is also advised to consult with external accountants to review new contractual arrangements and modifications to existing arrangements to ensure proper revenue recognition prior to signing and accepting those terms and conditions.
Bonus! : Developments with Acquired Defensive Intangible Assets and In-Process Research and Development Costs
A competitive strategy that is employed by the purchaser in an acquisition may involve buying intangible assets (i.e., intellectual property, technology, customer lists) when it has no intention at all of using those assets, to prevent and protect other parties from having access to it. Those assets are commonly referred to as “defensive intangible assets.” It used to be that an amount less than fair value was assigned to such assets when the buyer intended to keep them out of the hands of competitors and do nothing else with them. As a result, more value would be ascribed to goodwill, if any.
After December 15, 2008, however, this was no longer is acceptable. The current rules state that a value must be ascribed to defensive intangible assets based on the amount that a market participant would pay for them - even when the buyer intends to just hold onto them, or utilize them in ways that vary from how other market participants would use them. An estimated useful life would then be assigned to the defensive intangible asset based upon how long the buyer would benefit from acquiring the alternative technology, and the cost of those assets would be amortized over that life. However, if no estimated useful life can be assigned based on legal, contractual, competitive or economic factors, then the useful life is considered to be indefinite, and evaluated for impairment annually. (Note that the general consensus is that it is rare that these assets would have indefinite lives.) This now poses additional work for companies that used to provide for no or insignificant value to defensive assets and then call it a day, in that they have to grapple with fair value and economic life determination, and, potentially, impairment testing.
Another development for biopharmaceutical companies involved in acquisitions relates to the recognition of in-process research and development or “IPR&D.” Under previous rules, such amounts were expensed immediately upon acquisition. However, under the new rules now, acquired IPR&D are to be recorded at fair value and then expensed immediately at the date of acquisition. The new rules also change prior rules in that they call for an intangible asset used in research and development activities recognized in a business combination to be accounted for as an indefinite-lived asset until the research and development efforts are completed or abandoned. While recognized as an indefinite-lived asset, the acquired IPR&D is subject to impairment testing annually. The acquirer would then determine the useful life of the intangible asset at the completion or abandonment stage of the associated research and development efforts.
John Pennett is an audit partner and director of the Life Sciences Practice at EisnerAmper LLP. He is the publisher of Catalyst, a magazine focused solely on issues facing life sciences and pharmaceutical companies. He can be reached at 732-287-1000 ext. 1392 or via e-mail.
For more information on Revenue Recognition and it affects Biopharmaceutical companies, contact our Life Sciences group.