FASB Emerging Issues Task Force

Transcription

1 EITF Issue No FASB Emerging Issues Task Force Issue No Title: Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property Document: Issue Summary No. 1 Date prepared: February 26, 2007 FASB Staff: Bolash (ext. 358)/Beswick (ext. 453) EITF Liaison: Matthew Schroeder Date previously discussed: None Previously distributed EITF materials: Working Group Report No. 1 (distributed concurrently as Exhibit 07-1C) References: FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (CON 5) FASB Statement No. 154, Accounting Changes and Error Corrections (FAS 154) APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (APB 18) AICPA Statement of Position 78-9, Accounting for Investments in Real Estate Joint Ventures (SOP 78-9) AICPA Accounting Interpretation 2, Investments in Partnerships and Ventures, of APB Opinion No. 18 (AIN APB 18) The alternative views presented in this Issue Summary are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination, exposes it for public comment, and it is ratified by the Board. EITF Issue No Issue Summary No. 1, p. 1

2 SEC Regulation S-X, Rule 4-08(g) (SEC Regulation S-X, Rule 4-08(g)) EITF Issue No , "Sales of Future Revenues" (Issue 88-18) EITF Issue No , "Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights" (Issue 96-16) EITF Issue No , "Reporting Revenue Gross as a Principal versus Net as an Agent" (Issue 99-19) EITF Issue No. 00-1, "Investor Balance Sheet and Income Statement Display under the Equity Method for Investments in Certain Partnerships and Other Ventures" (Issue 00-1) EITF Issue No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products)" (Issue 01-9) EITF Issue No , "Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor" (Issue 02-16) EITF Issue No Issue Summary No. 1, p. 2

3 Background 1. In several industries, entities may seek partners to jointly develop and commercialize intellectual property of some type, for example, a pharmaceutical product, motion picture, video game, or computer hardware and software. In the biotechnology and pharmaceutical industries, the time required to develop a drug candidate into a commercially viable product can take many years (it is not uncommon for the research and development stage to last between 7 and 10 years). During that stage, the development activities generate significant costs but generally do not generate product revenues. Due to the uncertainties inherent in the development process, many drug candidates are discontinued for various reasons including the failure to satisfy the safety or efficacy requirements of the United States Food and Drug Administration (FDA). As such, many drug candidates never generate product revenues. 2. Additionally, during the early commercialization periods of those drug candidates that are approved for sale, pharmaceutical and biotechnology companies may experience losses because, in many cases, the introductory marketing costs and continued development costs for other uses of the product may exceed the product revenues. For example, a drug candidate may only receive approval from the FDA for a narrowly defined use, and, as a result, the partners will continue to develop the drug candidate (and incur additional development costs) to support a wider application of the drug. These additional development costs may significantly outweigh the product revenues on sales of the drug for the narrowly defined use. However, companies invest in research and development activities in the biotechnology or pharmaceutical industries with the expectation that a successful product could ultimately enjoy a substantial revenue stream and operating profits. 3. Because of the considerable amount of resources required to develop a product and the financial risks involved, companies in the biotechnology or pharmaceutical industries often enter into arrangements with other companies to jointly develop, manufacture, distribute, and market a drug candidate. In some cases, these arrangements are entered into between a small biotechnology or pharmaceutical company that is conducting research and development activities on a particular drug candidate and a large, established pharmaceutical company. In other cases, two established pharmaceutical companies will enter into an arrangement to share funding of EITF Issue No Issue Summary No. 1, p. 3

4 research and development to mitigate the risk of development of a new drug or to combine two existing drugs into a new single drug. 4. Predominantly, the activities associated with these arrangements are conducted by the partners without the creation of a separate legal entity (that is, the arrangement is operated as a "virtual joint venture"). Even in arrangements that utilize a legal structure, much of the arrangement may be "virtual," such that, for example, the legal entity will not have employees, fixed assets, or any intellectual property of its own since the partners are responsible for performing all of the activities under the arrangement. The arrangements generally provide that the partners will share, based on contractually defined calculations, the profits or losses from the associated activities. These arrangements typically also involve the licensing of a specific technology, a drug candidate, or a molecule by the partners for the length of the arrangement. The license frequently requires upfront payments and additional subsequent payments based on the achievement of certain milestones. The licensor typically maintains the ownership of the drug candidate; however, any new products that are co-developed as part of the arrangement are cross-licensed between the partners. 5. The types of activities conducted under such arrangements may include research and development, marketing (including promotional activities and physician detailing), general and administrative, manufacturing, and distribution. The arrangement may provide that one partner has sole or primary responsibility for certain activities, or that one or more partners have shared responsibility for certain activities. For example, a typical arrangement may provide for one partner to have primary responsibility to perform research and development related to the drug candidate, while the other partner has primary responsibility for commercialization of the drug candidate. 6. Typically, the arrangement establishes a steering committee that is responsible for the oversight of the activities conducted by the partners. There is also a set of procedures established in the arrangement to escalate issues to the senior management of the partners if the steering committee is unable to reach a decision on an issue. In other arrangements, one party EITF Issue No Issue Summary No. 1, p. 4

5 may have the final decision in the event of a dispute, or the dispute may be resolved through binding arbitration. 7. The activities under most arrangements of this nature in the biotechnology and pharmaceutical industries are accounted for on either a gross or net basis in the respective partner's income statement. Some partners report revenues generated and costs incurred on a gross basis within their respective financial statements for these types of arrangements. Other partners report the net of amount of revenue and expenses in the revenue line item, for example, as "alliance revenue." There are circumstances, however, in which the partners will report the activities of the arrangement as a joint venture (that is, using equity method accounting under APB 18 and related literature). Periodically, the partners share financial information related to product revenues generated (if any) and costs incurred that may trigger a payment from one partner to the other partner depending upon the contractual terms for sharing the combined profits or losses related to the arrangement. Questions have arisen in practice as to the appropriate income statement presentation and classification for these activities and payments between the partners. For example, should the activities under the arrangement be presented on a gross or net basis in the respective partner's income statement based on that partner's role in the given activity? With respect to payments between the partners, current authoritative literature does not adequately address whether these payments should be reflected in revenue, operating expenses, or a combination of both. There is also a question in practice with respect to the scope of these issues, that is, what are the characteristics of the arrangements (herein referred to as "Collaborative Arrangements") for which these issues need to be addressed? 8. At the 2005 AICPA National Conference on Current SEC and PCAOB Developments, the SEC staff cited research and development reimbursements as one area that registrants have not consistently and transparently presented and disclosed. Some registrants have presented research and development reimbursements in revenue while others have accounted for such payments as a contra research and development expense. The SEC staff also observed that some registrants may be "cherry picking" when determining how to present research and development reimbursements. That is, those registrants might include research and development reimbursements with a net debit (the amount of research and development expenditures less the EITF Issue No Issue Summary No. 1, p. 5

6 amount of reimbursements) as a reduction of research and development expense, while research and development reimbursements with a net credit are grossed up to show revenue for the reimbursement and research and development expense for the costs. 9. Users of financial statements have also commented on the lack of transparency in the financial statements of the partners in these arrangements. Entities vary significantly with respect to the quality of the disclosures related to these arrangements. While many users of financial statements have found ways to use the information provided for their analyses, they believe that a standardized presentation and/or disclosure would significantly improve financial reporting in this area. 10. As discussed above, these types of joint development and commercialization arrangements are not limited to the biotechnology and pharmaceutical industries. For example, the motion picture industry also utilizes a similar structure with respect to the production of motion pictures. Two or more studios may jointly fund the production of a motion picture, jointly distribute the motion picture, and share in the resulting net proceeds. Participation by the Working Group 11. A Working Group was formed to assist the Task Force in addressing these issues by providing background information on these arrangements including the industries that use these types of structures and their related operation. The Working Group included representatives from the pharmaceutical, biotechnology, and motion picture industries, public accounting, the FASB staff, and an observer from the SEC. The Working Group discussed the definition of a Collaborative Arrangement at meetings held on October 20 and December 6, 2006, in addition to certain related accounting and reporting issues that will be addressed by the Task Force. Working Group Report No. 1 has been included in Exhibit 07-1C. 12. The Working Group observed that there are many forms and structures for collaborative arrangements. These may include structures that vary with respect to cost and revenue sharing arrangements between the partners and structures that may or may not use a separate legal entity. EITF Issue No Issue Summary No. 1, p. 6

7 The Working Group discussed the scenarios that were included in the EITF Agenda Committee Report and observed that while the scenarios in the EITF Agenda Committee Report were an accurate representation of the facts of each scenario, they were overly simplistic. The Working Group indicated that the arrangements in practice vary significantly, which may make it difficult to determine the definition of a Collaborative Arrangement and the scope of this Issue. Some variations discussed by the Working Group included: a. One partner may perform and be solely responsible for research and development, while the other partner may be solely responsible for commercialization efforts b. One partner may take the lead in the sales/distribution of the product in certain jurisdictions, for example, in the U.S., while the other partner may take the lead outside the U.S. c. Revenue sharing may vary in different jurisdictions, (for example, 50 percent/50 percent in the U.S., but 70 percent/30 percent internationally) d. Costs of research and development efforts may be borne 60 percent/40 percent prior to FDA approval, then 50 percent/50 percent thereafter e. One partner may enter the arrangement at a later stage of development and, in most situations, the arrangement will not be in place at the inception of the research f. A legal entity may exist in some jurisdictions (for example a low-tax jurisdiction), while other jurisdictions may not include a legal entity even though the entire arrangement is under the same governance structure. 13. The Working Group's recommendations on Issue 1 and Issue 2 are included below. Accounting Issues and Alternatives Issue 1: How to determine whether an arrangement constitutes a Collaborative Arrangement within the scope of this Issue. 14. The Working Group discussed its recommendations for determining whether a Collaborative Arrangement exists and observed that these arrangements can take many forms. As a result, the Working Group recommended that a collaborative arrangement be identified through a series of indicators since a scope that is overly specific may not capture all EITF Issue No Issue Summary No. 1, p. 7

8 arrangements and may allow an opportunity for an entity to structure an arrangement to achieve a specific accounting result. 15. The Working Group recommended that a Collaborative Arrangement is one in which the parties share in the risks and rewards of the arrangement's operations from inception through termination. A collaborative arrangement may be characterized by one or more of the following indicators. None of the indicators should be considered presumptive or determinative; however, the relative strength of each indicator should be considered. a. The partners are active participants to the arrangement. That is, the partners are not solely financial investors but, rather, they make significant contributions to directing and carrying out the joint operating activities. b. The partners are exposed to significant risks and rewards that are dependent on the ultimate commercial success of the endeavor. 1 c. While all partners need not be present at the inception of the research effort, the partners financially participate in the arrangement through its eventual termination or commercialization. d. Through the arrangement the partners have a contractual or other legal right to the underlying intellectual property, for example, by holding the patent or a related license. e. There is a Steering Committee or other mechanism to provide participating rights 2 to the partners. 16. The Working Group believes that the indicators in paragraph 15 characterize the principle of a Collaborative Arrangement (that is, parties sharing the risks and rewards of an arrangement's operations from the inception of the arrangement through termination) and provide differentiation from situations addressed by other authoritative literature. For example, an 1 For example, the "endeavor" in a biotechnology or pharmaceutical environment would be a drug candidate. In the entertainment industry, it would be a motion picture. 2 Participating rights are described in Issue as rights that allow a minority shareholder to effectively participate in decisions that occur as part of the ordinary course of an investee's business and are significant factors in directing and carrying out the activities of the business. EITF Issue No Issue Summary No. 1, p. 8

9 arrangement involving a purely financial investor may be appropriately accounted for under Issue depending on the terms of the arrangement. An arrangement in which the partners are not exposed to "risks and rewards and related variability dependent on the ultimate commercial success of the endeavor" (for example, services being performed for fees paid in cash at fair market value rates), may indicate a simple executory contact subject to other authoritative literature. 17. The Working Group also discussed whether to include the existence of a separate legal entity established by the partners to the arrangement as an indicator. However, the Working Group felt this indicator should be excluded on the basis that the accounting should follow the substance of the arrangement rather than its legal form. The Working Group believes that excluding this indicator may also limit the potential for structuring arrangements for a desired accounting treatment. They noted that risks and rewards are often not shared equally in such arrangements and should therefore not be used as indicators. Finally, the Working Group believes that entities that were not present at the inception of development could be participants in Collaborative Arrangements, provided that they participated in the arrangement through its conclusion (that is, through the termination or commercialization of the underlying drug candidate). In fact, many such arrangements begin after the initial research begins. 18. The scope of this Issue is not intended to include arrangements for which the accounting is specifically addressed within the scope of other authoritative literature. To the extent that guidance in this Issue conflicts with other authoritative literature, the arrangement should be accounted for in accordance with the relevant provisions of that literature rather than the guidance in this Issue. In addition, this Issue does not address revenue recognition matters related to these arrangements (for example, determining the appropriate units of accounting; when the criteria for revenue recognition are met; or the appropriate revenue recognition convention for a given unit of accounting). 19. At the March 15, 2007 EITF meeting, the staff will ask the Task Force to affirm the recommendation of the Working Group. EITF Issue No Issue Summary No. 1, p. 9

10 Exhibit 07-1A includes several illustrations of arrangements found in the biotechnology and pharmaceutical industries that demonstrate the application of these indicators in order to determine whether a Collaborative Arrangement exists. Issue 2: How costs incurred and revenue generated on sales to third parties should be reported by the partners to a Collaborative Arrangement in each of their respective income statements. Exhibit 07-1B includes example income statements illustrating the activities of the partners to a sample Collaborative Arrangement discussed in Issue 2 and the application of various views under Issue 2. This example is presented over four fiscal quarters, as well as the related fiscal year. 19. The following fact pattern will be used to illustrate the reporting of the alternative views under Issue 2: Big Pharma and Biotech have entered into a joint development agreement that is considered to be a Collaborative Arrangement. The partners agree to equally participate in the research and development activities for a drug candidate and in the commercialization of the drug candidate if it is approved for sale. Big Pharma and Biotech both agree to provide resources during the research and development and commercialization activities. Under the Collaborative Arrangement, they will share costs incurred and revenue generated on sales to third parties on a 50 percent/50 percent basis. On a quarterly basis, Big Pharma and Biotech share financial information about the expenditures for research and development and commercialization activities under the Collaborative Arrangement. One partner is required to make a payment to the other partner for a proportionate share of the excess of the companies' combined expenditures pursuant to the Collaborative Arrangement. EITF Issue No Issue Summary No. 1, p. 10

11 When the drug candidate is commercialized, the partners share equally in the combined results of manufacturing and marketing the drug, as well the expenditures of any continued research and development activities. For example, if in the first annual period of the Collaborative Arrangement, Biotech incurred research and development expenses of $10 million and Big Pharma had sales of $50 million and related manufacturing expenses of $20 million and marketing expenses of $10 million, Big Pharma would make a payment to Biotech of $15 million, such that each partner realizes $5 million, net (sales of $50 million in total, less total expenses of $40 million, divided by 2), from sales of the drug. See Exhibit 07-1B for a table summarizing the activities of the partners by quarter and for a fiscal year. View A: Costs incurred and revenue generated by partners to a Collaborative Arrangement to third parties should be reported on the appropriate line item in each company's respective financial statement pursuant to Issue Proponents of View A believe that Issue addresses the question of whether to report revenue or expenses on a gross or net basis depending on whether the entity is a principal or agent and that in the context of this Issue, an entity should refer to that guidance in making a determination of whether they are a principal or an agent. Issue concluded that the principal for a given activity should report revenues and expenses gross because that presentation represents the substance of the arrangement, that is, the principal is primarily responsible for the given activity. For example, Biotech is primarily responsible for the research and development activities, while Big Pharma is primarily responsible for the commercialization efforts. Proponents of View A observe that the application of Issue is consistent with industry practice. 21. Opponents of View A believe that since partners to a Collaborative Arrangement frequently share the risks and rewards associated with the arrangement's activities, it may be difficult to determine who the principal is. Those opponents believe that the application of the indicators to EITF Issue No Issue Summary No. 1, p. 11

12 this fact pattern ignores the economic reality of a Collaborative Arrangement, which is more akin to a joint venture than a principal-agent relationship. 22. The income statements of Biotech and Big Pharma resulting from the application of View A to the fact pattern above are included in Exhibit 07-1B (excluding the net sharing payment between the partners, which is addressed in Issue 3). View B: A Collaborative Arrangement should be considered a "virtual" joint venture and accounted for pursuant to APB 18 and related guidance for joint ventures. This will typically result in the application of equity method accounting in accordance with APB Proponents of View B believe that a Collaborative Arrangement is economically similar to a joint venture and, therefore, should be accounted for in a similar manner. In a traditional joint venture, a separate legal entity is formed for the joint venture's operations. Proponents of View B do not believe that the lack of a legal entity in a Collaborative Arrangement should result in different accounting. View B proponents observe that the indicators of a Collaborative Arrangement recommended by the Working Group in Issue 1 are similar to APB 18's description of "corporate joint ventures." 3 These supporters believe that applying APB 18 to these types of collaborative arrangements will improve comparability among entities with both types of arrangements (that is, virtual joint ventures through Collaborative Arrangements and the traditional joint venture), as well as reduced structuring opportunities. Since entities are required to apply APB 18 if a legal entity exists, entities may achieve a different accounting result by including or not including a legal entity in a Collaborative Arrangement, although the underlying economics will not differ. View B proponents believe that View B will eliminate this kind of structuring opportunity and further ensure that similar arrangements are accounted for similarly. 3 The definition of "corporate joint venture" in APB 18, paragraph 3(d), includes the following: "Corporate joint venture" refers to a corporation owned and operated by a small group of businesses (the "joint venturers") as a separate and specific business or project for the mutual benefit of the members of the group... The purpose of a corporate joint venture frequently is to share risks and rewards in developing a new market, product or technology; to combine complementary technological knowledge; or to pool resources in developing production or other facilities. A corporate joint venture also usually provides an arrangement under which each joint venturer may participate, directly or indirectly, in the overall management of the joint venture. Joint venturers thus have an interest or relationship other than as passive investors. EITF Issue No Issue Summary No. 1, p. 12

13 24. Proponents of View B believe that View B avoids having to identify the principal and agent, which can be difficult in many of these arrangements since some activities may be shared by the partners. Proponents also point out that paragraph 11 of SOP 78-9 requires equity method accounting even though the arrangement does not include a legal entity. 25. Opponents to View B believe that because the arrangements lack a legal entity, they should not apply APB 18. They believe APB 18 is only appropriate in a joint venture when there is ownership of equity interests. AIN APB 18 specifically states that "APB Opinion No. 18 applies only to investments in common stock of corporations and does not cover investments in partnerships and unincorporated joint ventures..." (emphasis added). Opponents of View B do not believe that reporting under View B would produce high-quality financial information for users of financial statements because, pursuant to the requirements of APB 18, the significant financial results of the joint venture would be shown in a single line item and in the footnotes. It would likely be difficult for preparers to make meaningful distinctions between costs attributable to the virtual joint venture and those attributable to other operations of the individual partners not related to the Collaborative Arrangement because the joint venture is, as discussed, virtual. There are no separate facilities, plant and equipment, or employees. Any allocations made to the joint venture would be arbitrary. 26. Proponents of View B counter that while AIN APB 18 does state that APB 18 only applies to investments in common stock of corporations, it continues to state that "many of the provisions of [APB 18] would be appropriate in accounting for investments in... unincorporated entities," such as presenting profits and losses as a single amount in the income statement. 27. The income statements of Biotech and Big Pharma resulting from the application of View B to the fact pattern above are included in Exhibit 07-1B. Opponents of View B note the lack of decision-useful information that is included in that disclosure. Proponents of View B counter that disclosure consistent with SEC Regulation S-X, Rule 4-08(g), and related disclosure about the material terms of the Collaborative Arrangement, would provide useful information to users of financial statements. EITF Issue No Issue Summary No. 1, p. 13

14 Working Group Recommendation: 28. The Working Group supports View A. The Working Group observed that it may be difficult for preparers to make meaningful distinctions between costs attributable to the virtual joint venture and those attributable to other operations, because the Collaborative arrangement is a virtual joint venture. There are no separate facilities, plant and equipment, or employees. Thus, any allocations made to the joint venture would be arbitrary. Issue 3: If the Task Force reaches a consensus on View A of Issue 2, how sharing payments made to or received by a partner pursuant to a Collaborative Arrangement should be presented in the income statement. Exhibit 07-1B includes example income statements illustrating the activities of the partners to a sample Collaborative Arrangement as outlined in Issue 2 and the application of various views under this Issue 3. This example is presented over four fiscal quarters, as well as the related fiscal year. View A: Sharing payments received from or made to a partner pursuant to a Collaborative Arrangement should be reflected as a component of revenue in the income statement. That is, payments received from a partner should be reflected as an addition to revenue and payments made to a partner should be reflected as a reduction of revenue unless such payments represent a cumulative payment to the other partner. 29. Proponents of View A believe that payments made to a partner generally should be recorded on the same line item as payments received from that partner and should be characterized as a reduction of revenue, unless such payments represent a cumulative payment to the other partner (that is, if the amounts paid after commercialization is achieved and sales begin to exceed the amounts received from the other partner on a cumulative basis). In such cases, they believe that the amount of the cumulative shortfall of payments made versus received should be classified as an expense. EITF Issue No Issue Summary No. 1, p. 14

15 30. Proponents of View A reference paragraph 83 of CON 5, which states that "an entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations " (footnote reference omitted). They believe that an earnings process commences as the partners begin to realize sales upon the commercialization of the drug candidate. That process, which will be conducted pursuant to the terms of the Collaborative Arrangement, will generally be a central part of the companies' ongoing operations. Accordingly, supporters believe that the presentation of payments made to or received from the partner pursuant to a Collaborative Arrangement as a component of revenues is appropriate. 31. Proponents of this view also believe that the accounting for the net profits sharing payment within a single line item in the income statement is analogous to the presentation required by paragraph 19(c) of APB 18, which provides that an investor's share of an investee's earnings or losses be displayed as a single amount in the investor's income statement when the investment is accounted for using the equity method of accounting. Supporters note that although the activities conducted by partners pursuant to a Collaborative Arrangement may not be conducted through a legal entity, payments made or received are generally computed as if the company holds an equity interest in a joint venture conducted through a legal entity. Supporters also note that these arrangements are generally significantly integral to the operations of partners so to allow for classification of the net profits-sharing payment within operations, similar to how a public registrant may present income from equity investees that are operationally integral to its operations. 32. Supporters also note that expense classification for the excess cumulative payments made over payments received is analogous to the accounting for payments made by a vendor to a reseller pursuant to the consensuses for Issues 1 and 2 of Issue Paragraph 17 of Issue 01-9 states that if a vendor demonstrates that characterization of amounts paid to a reseller as a reduction of revenue would result in "negative revenue for a specific customer on a cumulative basis (that is, since the inception of the overall relationship between the vendor and the customer), then the amount of the cumulative shortfall may be recharacterized as an expense." EITF Issue No Issue Summary No. 1, p. 15

16 33. Some opponents to View A question whether an earnings process had been completed prior to commercialization of the endeavor. Sharing payments between the parties may be exchanged prior to generating sales from third-parties, so they do not believe that it is appropriate for parties to report revenue related to these arrangements. 34. Opponents to View A also counter that View A's approach could result in negative revenue (other than cumulative negative revenue amounts discussed above) in certain periods of the Collaborative Arrangement. In the illustration of the application of View A to Big Pharma and Biotech in Exhibit 07-1B, Big Pharma has negative revenue in the first quarter and in the first six months of that arrangement. These opponents do not believe that Big Pharma's reporting negative revenue is an accurate reflection of the substance of the arrangement, which is that Big Pharma is funding another party's research and development efforts. View B: All payments received from a partner pursuant to a Collaborative Arrangement should be reported as revenue and payments made to a partner should be presented as expenses. 35. Supporters of this view believe that this presentation best reflects the substance of the Collaborative Arrangement between the partners. That is, proponents of View B believe that all receipts from a partner under a Collaborative Arrangement represent revenue earned for a service performed, while payments made to the partner represent costs incurred for services received from the partner and should be reflected in the income statement accordingly. For example, Biotech's cash receipts represent revenue related to research and development services provided to Big Pharma, and Big Pharma's payment represents its funding of research and development. Even in the commercialization phase, Biotech's cash receipts represent revenue generated from its previous development of intellectual property. 36. Opponents of this view disagree with the assertion that this represents the substance of the Collaborative Arrangement. They believe that determining presentation based on the results of operations for one period will provide financial reporting that could be misleading because it does not represent the substance of the entire arrangement. They point out that in some situations, an entity may make a payment in one period and receive a payment in another. These EITF Issue No Issue Summary No. 1, p. 16

17 opponents also point out that the results of the combined Collaborative Arrangement may be overstated (see below). 37. Opponents of this view also reference by analogy the guidance in Issue They believe that View B's approach mischaracterizes the nature of the cash payments received, for example, by Biotech. Issue 02-16's presumption is that cash consideration received from a vendor should be a reduction of the prices of the products and services, and, therefore, should be characterized as a reduction of cost of sales in the vendor's income statement. The payments received by Biotech were intended to reduce its research and development expenditures and should not be reflected as revenues by Biotech but, rather, as a reduction of research and development expenses. In addition, opponents point to the illustrations in Exhibit 07-1B, noting that Big Pharma records revenue of $1 million under this view in advance of the recognition of any sales to third parties. View C: All payments either made to or received from a partner should be recorded as an adjustment to expense(s) incurred, and no payments should be classified as revenues. 38. Those holding this view believe that the payments are not a component of the company's revenue generating operations and, thus, should not be included in revenues. As discussed above, the payments received by Biotech will, in many periods, result from financial support by Big Pharma for the research and development activities performed. It would be inappropriate to characterize these amounts as revenue, since the payments are intended to reduce Biotech's research and development expenditures. In addition, proponents note that Big Pharma should also reflect its share of research and development expenses from the net payments that it makes to Biotech. 39. Opponents of this view believe that this presentation would not adequately take into consideration the earnings process resulting from the delivery of a commercialized product, as discussed above, and believe that it would not transparently report the continuing rate of the company's underlying expenses. They also note that it is possible that this presentation could lead to a negative expense presentation net of revenues in certain periods (as noted in Biotech's EITF Issue No Issue Summary No. 1, p. 17

18 results for the fiscal year in Exhibit 07-1B), which could be misleading and confusing to users of the financial statements. View D: All payments either made to or received from a partner should be recorded either as revenue or as expense based on the nature of the respective payments. 40. Proponents of View D believe that a "one-size-fits-all" approach to this Issue is not adequate. Sharing payments between the partners will result from both revenue and expense related activities, and the income statement classification should reflect that fact. Payments and receipts should be allocated to the various income statement line items based on the nature of the payment and the related terms of the Collaborative Arrangement. Supporters note that View D combined with appropriate disclosure, will produce the most faithful representation of the impact of these arrangements on an entity's financial statements. 41. Opponents of this view believe that this presentation would be too operationally complex for preparers and not sufficiently transparent for users of financial statements. Such an approach would effectively result in a presentation similar to proportional consolidation, which is generally only acceptable when an undivided interest in assets and liabilities exists, as discussed in Issue In Collaborative Arrangements, there is likely not an undivided interest present, as one party clearly owns the underlying intellectual property. In addition, it does not accurately reflect the activities of the respective partners to the arrangement. Based on the illustration in Exhibit 07-1B, Biotech would reflect cost of goods sold, sales, and general and administrative expenses when it did not necessarily participate in those activities and incur those types of expenses itself related to this Collaborative Arrangement. 42. Opponents of View D note that the illustration in Exhibit 07-1B is based on a very simple structure. View D's approach would become too complex in more complex arrangements that had different percentages of revenue and expense sharing by activity, geography, stage of development, etc., for example. Proponents of View D counter that preparers must develop this information by contract in order to determine the periodic payments between the parties. EITF Issue No Issue Summary No. 1, p. 18

19 View D's approach would simply use that same reporting for financial statement presentation purposes. 43. Proponents of View D counter that AIN APB 18 notes that a partner in an unincorporated joint venture "may account in its financial statements for its pro rata share of the assets, liabilities, revenues, and expenses of the venture" in certain industries. Proponents of View D believe that Collaborative Arrangements could be accounted for similarly to those arrangements, even though they may not meet all of the criteria discussed therein (for example, an undivided interest in each asset and being proportionately liable for its share of each liability). Disclosure 44. To the extent that sales and expenses associated with a Collaborative Arrangement are significant to a company, the pertinent terms of the Collaborative Arrangement, the amounts of and the accounting policies applied with respect to costs incurred and sales to third-parties, and payments made or received pursuant to such agreements, should be disclosed in the footnotes to interim and annual financial statements. Transition and Effective Date 45. The FASB staff believes that entities should recognize the consensus on this Issue as a change in accounting principle through retrospective application to all periods. Upon application of the consensus, comparative financial statements for prior periods should be reclassified to comply with the classification guidelines of this Issue. If it is impracticable to reclassify priorperiod financial statements, disclosure should be made of both the reasons why reclassification was not made and the effect of the reclassification on the current period pursuant to the guidelines in paragraph 9 of Statement The consensus on this Issue shall be effective for annual periods beginning after December 15, Early adoption is encouraged. The FASB staff believes that the application of this consensus may result in a significant change in accounting and financial reporting for certain entities that have not accounted for Collaborative Arrangements in a manner that is consistent with the consensuses on this Issue. Accordingly, the FASB staff believes that the EITF Issue No Issue Summary No. 1, p. 19

20 timing of the recommended effective date would allow entities ample time to prepare for the implementation of this consensus. 47. Upon application of this consensus, the FASB staff believes that the following disclosures should be made: a. A description of the prior-period information that has been retrospectively adjusted, if any. b. The effect of the change on revenue and operating expenses (or other appropriate captions of changes in the applicable net assets or performance indicator), and on any other affected financial statement line item. EITF Issue No Issue Summary No. 1, p. 20

21 Exhibit 07-1A EXAMPLES ILLUSTRATING THE APPLICATION OF THE INDICATORS OF A COLLABORATIVE ARRANGEMENT IN THE EITF CONSENSUS ON ISSUE 1 OF ISSUE 07-1 The following examples illustrate the application of the indicators of a Collaborative Arrangement discussed in Issue 1. The application of the indicators depends on the relative facts and circumstances and requires significant judgment. The assessment below reflects those judgments in the given fact pattern based on the assumed facts; however, those judgments will vary in differing fact patterns. Scenario 1 Big Pharma and Biotech agree to equally participate in the results of research and development activities for a drug candidate and in the commercialization if and when the drug candidate is approved for sale, pursuant to a joint development and marketing agreement (a 50 percent/50 percent arrangement). Further, assume that Big Pharma and Biotech both agree to provide resources during the research and development and commercialization activities. A steering committee made up equally of representatives of Big Pharma and Biotech is established to direct and approve the activities under the joint development and marketing agreement. On a quarterly basis, Big Pharma and Biotech provide financial information about the research and development and commercialization activities under the joint development and marketing agreement and one partner is required to make a payment to the other partner for a proportionate share of the excess of the companies' combined operating results pursuant to their joint development and marketing agreement. Evaluation: Many of the indicators of a Collaborative Arrangement are present in this fact pattern, and this arrangement would be considered a Collaborative Arrangement. Scenario 2 Big Pharma and Biotech agree to equally participate in the results of research and development activities for a drug candidate, and in the commercialization if and when the drug candidate is approved for sale, pursuant to a joint development and marketing agreement (a 50 percent/50 EITF Issue No Issue Summary No. 1, p. 21

22 percent arrangement). Further assume that Biotech is responsible for conducting research and development activities relating to the drug candidate and Big Pharma is responsible for the commercialization activities if and when the drug candidate is approved for sale. A steering committee made up equally of representatives of Big Pharma and Biotech is established to direct and approve the activities under the joint development and marketing agreement. On a quarterly basis, Big Pharma and Biotech provide financial information about the research and development and commercialization activities under the joint development and marketing agreement and one partner is required to make a payment to the other partner for a proportionate share of the excess of the companies' combined expenditures pursuant to their joint development and marketing agreement. Evaluation: While each partner is solely responsible for different activities in this arrangement, this arrangement would be considered a Collaborative Arrangement. The partners will participate in the remainder of the project; they have established a mechanism for providing participating rights; and they have assumed more risk and are entitled to more reward than a normal marketplace participant. Scenario 3 Big Pharma contracts with Biotech to perform research and development on a drug candidate. Biotech is paid a specified rate per full-time employee assigned to the arrangement, and payments are not dependent on a successful development of a drug. The rate per full-time employee is below fair market value. Big Pharma is responsible for directing and approving the activities of Biotech during the research and development phase. During the research and development phase, Biotech has an option to buy into the arrangement to share expenses for the remaining research and development and commercialization if and when the drug candidate is approved for sale. Biotech's purchase into the joint development and marketing agreement is in a form that surrenders the right to the license milestone payments of the drug candidate from Big Pharma for the remaining part of the arrangement. If the option is excercised, Big Pharma is responsible for the commercialization of the drug candidate and pays Biotech a royalty on the product revenues of the drug candidate. Evaluation: The Working Group concluded that options should be considered in the initial evaluation of an arrangement. If the arrangement post-exercise would be considered a EITF Issue No Issue Summary No. 1, p. 22

23 Collaborative Arrangement, then the arrangement should be considered a Collaborative Arrangement from inception. By contrast, an option at fair value that could be exercised by any party (for example a party without an existing contractual or legal relationship to the underlying intellectual property) would not be indicative of a Collaborative Arrangement. Under this view, the arrangement would be a Collaborative Arrangement because, subsequent to the exercise of the option, Biotech's future income will no longer be fixed but, rather, dependent on the commercial success of the endeavor. In addition, the exercise of the option will cause Biotech to financially participate in the endeavor through its eventual termination or eventual commercialization. Scenario 4 Big Pharma outsources research and development and clinical trials on a drug candidate to an unrelated entity. Biotech is paid a specified fair market rate per full-time employee assigned to the arrangement and payments are not dependent on a successful development of a drug. Big Pharma is responsible for directing and approving the activities of the unrelated entity during the research and development phase. Evaluation: This arrangement is not a Collaborative Arrangement. Although the partners are active participants in the arrangement, the unrelated entity is not exposed to variability dependent on the ultimate commercial success of the effort, because they are being compensated at market rates for services performed, and there is no mechanism to provide participating rights to the parties. Scenario 5 Biotech provides a license for the drug candidate to Big Pharma. Big Pharma contracts with Biotech to perform research and development on the drug candidate and contract manufacturing for Big Pharma. Biotech is paid a specified fair market rate per full time employee that is assigned to the research and development activities and payments for these activities are not dependent on a successful development of a drug. Biotech will be paid cost plus for any contract manufacturing that is performed on a successful drug candidate (also at a fair market rate), as well as a royalty on the future sales of the product. EITF Issue No Issue Summary No. 1, p. 23

24 Evaluation: Although Biotech would be involved in the remainder of the project through the manufacturing arrangement and license royalties, its fees are similar to those that would be obtained by any other market participant, so it is not exposed to risks based on its precommercialization involvement in the effort. It also does not direct any of the joint operating activities and there is no mechanism for Biotech to have any participating rights in the effort. As a result, this arrangement is not a Collaborative Arrangement. Scenario 6 Big Pharma hires Biotech to perform research and development and clinical trials for a drug candidate. Biotech was previously not involved in the development of the drug candidate. Big Pharma directs the research and clinical trial activities. Biotech is paid a specified below fair market rate for its services that is not dependent on successful commercialization of the drug. If the drug is approved and successfully commercialized, Biotech will receive a royalty on future sales of the drug. Evaluation: Biotech is exposed to some risk through the fee and royalty terms of the arrangement. However, the lack of a contractual link to the underlying intellectual property and participating rights lead to the conclusion that this arrangement is not a Collaborative Arrangement. Scenario 7 Biotech completes pre-clinical research independently. After Biotech receives approval to begin clinical trials, Biotech and Big Pharma enter into an arrangement whereby they will equally participate in the results of the remaining research and development activities for the drug candidate and in the commercialization, if and when the drug candidate is approved for sale, pursuant to a joint development and marketing agreement (a 50 percent/50 percent arrangement, before considering license payments from Big Pharma to Biotech). Big Pharma and Biotech both agree to provide resources during the research and development and commercialization activities. A steering committee made up equally of representatives of Big Pharma and Biotech is established to direct and approve the activities under the joint development and marketing agreement. On a quarterly basis, Big Pharma and Biotech provide financial information about the research and development and commercialization activities under the joint development and EITF Issue No Issue Summary No. 1, p. 24