A shift in the top line A new global standard on accounting for revenue The FASB, along with the IASB, has finally issued ASU 2014-09, Revenue from Contracts with Customers, its new standard on revenue. This bulletin summarizes the new requirements and what they will mean for the life sciences industry. The new standard at a glance The new standard replaces virtually all U.S. GAAP revenue guidance (including industry-specific), with a single model. It is codified in a new Topic 606 in the FASB Accounting Standards Codification (ASC) and is based on the following: The 5-step model for the new revenue recognition standard (ASU 2014-09) Step 1: Identify a contract with a customer Step 2: Identify performance obligations Step 3: Determine the transaction price Step 4: Allocate the transaction price to the performance obligations Step 5: Recognize revenue when/as performance obligation(s) are satisfied Timing of revenue ASC 606 requires revenue to be recognized as the work is performed if, and only if, control over the promised goods or services is transferred to the customer over time. Broadly, this occurs if one of the following conditions applies: Variable pricing If pricing is variable or contingent (for instance, performance-based fees), revenue is recognized on a best-estimate basis. This may be the single most likely amount or an expected (probability-weighted) value. Variable revenue is also subject to a constraint aimed at ensuring that the amount recognized will not later be subject to a significant reversal because of a change in estimates. Credit risk Collectibility of the expected amount of revenue must be considered probable before revenue is recognized.
Time value The contract price must be adjusted for the effects of the time value of money if the contract contains a significant financing component. As a practical expedient, the financing component can be considered not significant if the time between performance and payment is one year or less. Contract costs Contract fulfillment costs are recognized as assets if they are expected to be recovered and other conditions are met. Incremental costs of obtaining a contract must be capitalized if similar conditions are met. Specific issues ASC 606 also provides specific guidance on various other transaction types, including: Noncash consideration Rights of return and other customer options Supplier repurchase options Warranties Principal versus agent (gross versus net) Licensing intellectual property Breakage Nonrefundable upfront fees Consignment and bill-and-hold arrangements CONTRACT Disclosures ASC 606 will require considerably more disclosure about revenue, including information regarding: Customer contracts, such as the remaining performance obligations (backlog) Key judgments made Contract costs recognized as assets The customer simultaneously receives and consumes the benefits The customer controls the asset as it is created or enhanced The asset has no alternative use, and the supplier is entitled to payment for performance-to-date and expects to fulfill the contract Multiple-element arrangements A customer contract may cover a bundle of goods or services. ASC 606 requires performance obligations to be accounted for separately if distinct. For example: The customer benefits from the item on its own or along with other readily available resources The supplier does not provide a significant service of integrating the various performance obligations If performance obligations are distinct, the contract price is allocated between them based on the estimated standalone selling price of each performance obligation. Transition and effective date ASC 606 is effective for public entities in annual periods beginning after Dec. 15, 2016, including interim periods therein, and for private entities in annual periods beginning after Dec. 15, 2017. Earlier application is prohibited for public entities. Private entities may adopt the guidance early in years beginning after Dec. 15, 2016. The transition is retrospective, subject to various practical expedients, or modified retrospective, whereby an entity will apply the guidance only to contracts that are not completed at the date of adoption. 2
What this means for the life sciences industry ASC 605-25, Revenue Recognition: Multiple Element Arrangements; ASC 605-28, Revenue Recognition: Milestone Method; and ASC 605-30, Revenue Recognition: Rights to Use, which are commonly used guidance for life science industry revenue recognition, are superseded and replaced by ASC 606. Multiple-element arrangements Contracts that include promises to sell multiple goods and/or services may be complex. For example, a contract for a medical device may include embedded software, replacement parts and other components, installation, training, service and warranty for the device. Historically, these arrangements have required careful consideration of multiple standards under current revenue recognition guidance. ASC 606 replaces all those separate standards and requires an entity to identify distinct performance obligations, which may result in the identification of different performance obligations than those identified using the standalone value criteria in the current multipleelement arrangement guidance. An entity will allocate the transaction price among all performance obligations on a relative standalone selling price basis, which is similar to existing U.S. GAAP. However, the strict hierarchy of vendorspecific objective evidence, third-party evidence and management s best estimate for determining standalone selling price in existing guidance is superseded. Under ASC 606, an entity will first look to the observable selling price of a performance obligation, and if the standalone selling price of a performance obligation can t be observed, an entity must estimate it. A residual approach to estimate a standalone selling price may be applied in limited circumstances. Collaborative research arrangements Collaborative arrangements are common in the life sciences industry and can take many forms. ASC 606 applies to a contract only if the counterparty is a customer. A counterparty to a collaborative arrangement that does not receive goods or services that are an output of the entity s ordinary activities would not be considered a customer. While many collaborative arrangements are excluded from the scope of the new standard, judgment is required in determining whether a transaction, in effect, is with a customer. Collaborative arrangements under the scope of ASC 606 that grant a license, along with a promise for R&D services, should be evaluated to determine whether these activities are separate performance obligations or should be combined into a single performance obligation. Entities with contracts that are outside the scope of ASC 606 should continue to follow other existing guidance, such as for R&D arrangements. 3
Variable consideration Milestone payments: Under ASC 606, variable consideration, such as milestone payments, is included in the transaction price using a probability-weighted or most-likely-amount approach. Estimated amounts are included in the transaction price only to the extent that it is probable that a significant revenue reversal will not occur. In some situations, revenue may be recognized earlier than under current guidance, which requires excluding milestone payments from the consideration until the contingency resulting in the milestone payment is resolved. The new standard may also create more complexity and the need for more judgment, for example, when estimating revenue at contract inception for amounts due from a customer as a product progresses through various development stages, such as milestone payments awarded on an all-or-none basis on successfully passing a research phase. High failure rates for product development projects may make it difficult to evaluate the probability of success for an individual project. Volume discount incentives: An entity should evaluate volume discounts as variable consideration and estimate the amounts in determining the transaction price. Additional purchase options: Contracts that include the right to purchase additional goods or services at a discount, or even at no charge, should be considered a separate performance obligation if the option represents a material right that the customer would not receive without entering into the contract. These purchase options may result in the customer effectively making an advance payment for future goods or services. This portion should be deferred and recognized when the performance obligation for the additional goods or services is satisfied or the option expires. Royalty arrangements: 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: The subsequent sale or usage occurs The performance obligation to which some or all of the sales/usage-based royalty was allocated has been satisfied (or partially satisfied) License rights Right to access versus right of use: Except for certain industry-specific guidance, U.S. GAAP does not include direct guidance on accounting for licenses of intellectual property. ASC 606 provides a single model for recognizing license revenue, which will improve consistency and comparability in accounting for licenses. Under ASC 606, the timing of revenue recognition for a license to a customer assuming the license is a distinct and separate performance obligation depends on whether the customer has a right to access or simply a right to use the entity s intellectual property. If the license provides a right to use the entity s intellectual property as it exists at the time the license is granted, revenue is recognized when the license is transferred and the customer can use the license. This contrasts with the recognition over time for a license right to access the entity s intellectual property as it exists throughout the license period. 4
Right of return Pharmaceutical and medical device companies commonly provide customers (distributors) with a right of return if the product is unsold within a specific period of time or expires. The new standard does not change the requirement that revenue be recognized only for amounts not expected to be returned. However, the right of return makes the amount of consideration variable and subject to the constraint. This might result in a difference in timing of revenue recognized to the extent an entity concludes that the estimated amount differs from the estimate under existing U.S. GAAP. Consistent with existing GAAP, rights of return can be contractual or based on common practice. ASC 606 requires an entity to recognize estimated returns to be accounted for as a refund liability (equivalent to the sales amount of the product estimated to be returned), as well as a corresponding asset (carrying amount of the product estimated to be returned less expected costs to recover) separate from inventory. The return asset is assessed for impairment and not subject to the lower of cost or market testing, as is inventory. For pharmaceutical companies, limited value may be attributed to any asset recorded, because products returned are typically expired and have no value. Under ASC 606, an assessment of the estimated liability and asset amounts should be updated at the end of each reporting period, and any changes are recognized as an increase or decrease in revenue. Disclosures All entities, especially those with contracts longer than one year, will be required to provide more disclosures than currently required. Tax professional standards statement This document supports Grant Thornton LLP s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document, we encourage you to contact us or an independent tax professional to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this document is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Content in this publication is not intended to answer specific questions or suggest suitability of action in a particular case. For additional information about the issues discussed, consult a Grant Thornton LLP client service partner or another qualified professional. Connect with us grantthornton.com @grantthorntonus linkd.in/grantthorntonus Grant Thornton refers to Grant Thornton LLP, the U.S. member firm of Grant Thornton International Ltd (GTIL). GTIL and its member firms are not a worldwide partnership. All member firms are individual legal entities separate from GTIL. Services are delivered by the member firms. GTIL does not provide services to clients. GTIL and its member firms are not agents of, and do not obligate, one another and are not liable for one another s acts or omissions. Please visit grantthornton.com for details. 2014 Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd