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US GAAP: Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 2013 edition Pharmaceuticals and Life Sciences November 2013 Foreword As healthcare reform progresses and regulatory and public scrutiny of the pharmaceuticals and life sciences industry intensifies, the need for accurate and complete accounting under US Generally Accepted Accounting Principles (US GAAP) has never been greater. Transparency in financial accounting will help the industry in its pursuit of delivering greater value to patients and the healthcare system. This publication highlights industry-specific accounting issues under US GAAP. It provides opinions on accounting solutions for many of the most pertinent situations specific to pharmaceuticals and life sciences companies. The solutions provide a general framework for deciding on appropriate answers to accounting questions, which individual companies can apply in specific situations that may give rise to different questions and answers. The publication cannot address every situation that might occur because companies’ accounting issues reflect their particular facts and circumstances, which can differ by company. Creativity in licensing, manufacturing, and research and development arrangements, for example, lead to variations in contracts, corporate structures, and accounting requirements. The contents of this publication are based on guidance effective as of September 30, 2013. Accordingly, certain solutions in the publication may be superseded as new guidance and interpretations emerge. We hope you find this publication useful in understanding the accounting for common transactions you encounter in your business. By stimulating debate on these topics through this publication, we hope we will encourage consistent practices by pharmaceutical and life sciences companies in financial reporting under US GAAP. This consistency will be critical to the continued usefulness and transparency of pharmaceuticals and life sciences companies’ financial statements. PwC Pharmaceutical and Life Sciences Practice We recommend that you reference the website http://www.pwc.com/us/pharma as your primary source for this publication and other thought leadership materials. Portions of various FASB documents included in this work, copyrighted by the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, are reproduced with permission. Table of contents Capitalization and impairment 1 1. Capitalization of internal development costs: timing—Scenario 1 2. Capitalization of internal development costs: timing—Scenario 2 3. Capitalization of internal development costs when regulatory approval has been obtained in a similar market 4. Capitalization of development costs for generics 5. Development expenditure once capitalization criteria are met—Scenario 1 6. Development expenditure once capitalization criteria are met—Scenario 2 7. Development of alternative indications 8. Examples of research and development costs 9. Asset acquisition of a compound 10. Indefinite-life intangible assets 2 3 4 5 6 7 8 9 10 11 11. Indicators of impairment for intangibles 12. Indicators of impairment—Property, plant and equipment 13. Single market impairment accounting 14. Impairment testing and useful life 12 13 14 15 Externally sourced research and development 16 15. Exchange of intangible assets 16. Exchange of intangible assets with continuing involvement 17. Accounting for receipt of listed shares in exchange for a patent 18. Accounting for receipt of unlisted shares in exchange for a patent 19. In-licensing agreements 20. Non-refundable upfront payments to conduct research 21. Payments made to conduct research 22. Fixed-fee contract research arrangements 23. Third-party development of intellectual property 24. External development of intellectual property with buy-back options 17 18 19 20 21 22 23 24 25 26 Research and development related issues 28 25. Payments received to conduct development 26. Upfront payments received to conduct development: Initial recognition 27. Upfront payments received to conduct development: Interim recognition 28. Upfront payments received to conduct development: Completion 29. Donation payment for research 30. Capitalization of interest incurred on loans received to fund research and development 31. Treatment of trial batches in development 32. Accounting for funded research and development arrangements 33. Receipts for out-licensing 29 30 31 32 33 34 35 36 38 Table of contents (continued) Manufacturing 39 34. Treatment of validation batches 35. Treatment and presentation of development supplies 36. Pre-launch inventory—Treatment of ‘in-development’ drugs 37. Recognition of raw materials as inventory 38. Indicators of impairment—Inventory 39. Patent protection costs 40 41 42 44 45 46 Sales and Marketing 47 40. Advertising and promotional expenditure—Scenario 1 41. Advertising and promotional expenditure—Scenario 2 42. Presentation of co-marketing income 43. Presentation of co-marketing expenses 44. Accounting for a sales based milestone payment 45. Accounting for the cost of free samples 48 49 50 52 54 56 Healthcare Reform 57 46. Accounting for the annual pharmaceutical manufacturers fee 47. Accounting for the Medicare coverage gap 58 59 Revenue recognition—Multiple element arrangements 60 48. Multiple element arrangements—Assessing standalone value 49. Multiple element arrangements—Determining best estimate of selling price 50. Multiple element arrangements—Substantive options 51. Accounting for a multiple element arrangement—Scenario 1 52. Accounting for a multiple element arrangement—Scenario 2 61 63 65 66 67 Revenue recognition—Milestone method 69 53. Milestone method of revenue recognition 54. Milestone method of revenue recognition—Sales based milestones 55. Recording a milestone payment due to a counterparty 70 71 72 Revenue recognition—General 73 56. Revenue recognition for a newly launched product 57. Pay-for-performance arrangements 58. Revenue recognition to customers with a history of long delays in payment 74 75 77 Business combination 78 59. Asset acquisition versus business combination 60. Accounting for acquired IPR&D 61. Unit of account—IPR&D 62. Pre-existing relationships in a business combination 63. Useful economic lives of intangibles 79 80 81 82 84 Acknowledgements85 Contacts86 Capitalization and impairment PwC 1 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 1. Capitalization of internal development costs: timing—Scenario 1 Background Relevant guidance Company A is developing a vaccine for HIV that has successfully completed Phases I and II of testing. The drug is now in Phase III of testing. Management still has concerns about securing regulatory approval and has not started manufacturing or marketing the vaccine. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. How should management account for research and development costs incurred related to this project? Solution Costs to perform research and development, including internal development costs, should be expensed as incurred. 2 PwC Capitalization and impairment 2. Capitalization of internal development costs: timing—Scenario 2 Background Relevant guidance A pharmaceutical entity is developing a vaccine for HIV that has successfully completed Phases I and II of testing. The drug is now in the late stages of Phase III testing. It is structurally similar to drugs the entity has successfully developed in the past with very low levels of side effects, and management believes it will be favorably treated by the regulatory authority because it meets a currently unmet clinical need. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Should management start capitalizing the development costs? Solution No. Costs to perform research and development, including internal development costs, should be expensed as incurred, regardless of past history with similar drugs or regulatory approval expectations. Research and development costs should not be capitalized. PwC 3 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 3. Capitalization of internal development costs when regulatory approval has been obtained in a similar market Background Relevant guidance An entity has obtained regulatory approval for a new respiratory drug in Country A. It is now progressing through the additional development procedures necessary to gain approval in Country B. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Management believes that achieving regulatory approval in this secondary market is a formality. Mutual recognition treaties and past experience show that Country B’s authorities rarely refuse approval for a new drug that has been approved in Country A. Should the development costs associated with the additional development procedures necessary to gain approval in Country B be capitalized? Solution No. The development costs should be expensed as incurred, regardless of the probability of success and history. 4 PwC Capitalization and impairment 4. Capitalization of development costs for generics Background Relevant guidance An entity is developing a generic version of a painkiller that has been sold in the market by another company for many years. The technological feasibility of the asset has already been established because it is a generic version of a product that has already been approved, and its chemical equivalence has been demonstrated. The lawyers advising the entity do not anticipate that any significant difficulties will delay the process of obtaining commercial regulatory approval. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Should management capitalize the development costs at this point? Solution No. Research and development costs should be expensed as incurred. PwC 5 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 5. Development expenditure once capitalization criteria are met—Scenario 1 Background Relevant guidance Company A has obtained regulatory approval for a new respiratory drug and is now incurring costs to educate its sales force and perform market research. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations [CON 6, par. 80]. Should Company A capitalize these costs? Solution No. Company A should expense sales and marketing expenditures such as training a sales force or performing market research as incurred. This type of expenditure does not create, produce or prepare the asset for its intended use. 6 PwC Capitalization and impairment 6. Development expenditure once capitalization criteria are met—Scenario 2 Background Relevant guidance Company A has developed a vaccine delivery device and is now continuing expenditure on the device to add new functionality. The additional functionality will require Company A to receive regulatory approval prior to selling the device. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations [CON 6, par. 80]. Should Company A capitalize these development costs? Solution No. Company A should expense as incurred the costs of adding new functionality as these costs are research and development expenditures. PwC 7 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 7. Development of alternative indications Background Relevant guidance Company A markets a drug approved for use as a painkiller. Recent information shows the drug may also be effective in the treatment of cancer. Company A has commenced additional development procedures necessary to gain approval for this indication. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Should Company A capitalize the development costs relating to alternative indications? Solution No. Costs to perform research and development, including internal development costs, should be expensed as incurred, regardless of history with similar drugs or regulatory expectations. 8 PwC Capitalization and impairment 8. Examples of research and development costs Background Relevant guidance Company A is developing a new compound to cure cancer. Company A is analyzing its expenditures to determine which expenditures represent research and development costs. These expenditures include costs incurred to identify a new formulation and a routine update to an existing manufacturing line that will be used to make the clinical trial product. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Activities that typically would be considered research and development are included in ASC 730–10–55–1. Some of the examples in ASC 730–10–55–1 include: • Laboratory research aimed at discovery of new knowledge. • Searching for applications of new research findings or other knowledge. • Conceptual formulation and design of possible product or process alternatives. • Testing in search for or evaluation of product or process alternatives. • Modification of the formulation or design of a product or process. • Design, construction, and operation of a pilot plant that is not of a scale economically feasible to the entity for commercial production. Do the additional expenditures incurred by Company A qualify as research and development costs? • Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture. Solution Research and development costs could include materials, equipment or facility charges, compensation and benefits for personnel, intangible assets purchased from others (if they do not have alternative use or have not achieved technological feasibility), the cost of contract services performed by others and a reasonable allocation of indirect costs. Company A determined that the cost associated with the identification of a new formulation would be expensed as research and development costs, while the cost associated with the routine update to the manufacturing line would be expensed to cost of sales. PwC 9 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 9. Asset acquisition of a compound Background Relevant guidance Company A acquired a compound for $5 million on January 1, 20X2. Assume there is no alternative future use and that the acquired asset does not constitute a business. Company A expects to receive regulatory and marketing approval on March 1, 20X3 and plans to start using the compound in its production process on June 1, 20X3. Intangible assets purchased from others (not in a business combination) for use in research and development activities follow the guidance in ASC 730, Research and Development. Assets that have future alternative use are accounted for in accordance with the guidance in ASC 350, Intangibles—Goodwill and Other. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity [ASC 350–30–35–2]. The method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up [ASC 350–30–35–6]. How should Company A account for the acquisition of the asset? Solution Because the compound was acquired prior to regulatory approval, the payment would be expensed as research and development costs (since there is no alternative future use and the acquired asset does not constitute a business). If the compound had been acquired after regulatory approval, Company A would begin amortizing the intangible asset on the date it is available for its expected use. This would generally be the acquisition date for an approved compound. 10 PwC Capitalization and impairment 10.Indefinite-life intangible assets Background Relevant guidance Management of a pharmaceutical entity has acquired an intangible asset that it believes to have an indefinite useful life. If no legal, regulatory, contractual, competitive, economic or other factors limit the useful life of an intangible asset to the reporting entity, the useful life of the asset shall be considered to be indefinite [ASC 350–30–35–4]. If an intangible asset is determined to have an indefinite useful life, it shall not be amortized until its useful life is determined to be no longer indefinite [ASC 350–30–35–15]. An entity shall evaluate the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether events and circumstances continue to support an indefinite useful life [ASC 350–30–35–16]. What is required to conclude that an asset has an indefinite useful life, and if so, how should management account for it? An intangible asset that is not subject to amortization shall be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired [ASC 350–30–35–18]. Solution Management can regard an asset as having an indefinite life if there are no factors (as cited above) that would limit the asset’s useful life. If an asset has an indefinite life, management is required to test it for impairment by comparing its fair value with its carrying value both annually and more frequently if there is an indication that the intangible asset may be impaired. Pharmaceutical intangible assets that might be regarded as having an indefinite life could include acquired brands (e.g., over the counter products) or generic products. Technological and medical advances will reduce the number of situations where an indefinite life would apply. As a result of limited patent lives, only in exceptional cases would prescription pharmaceutical products have indefinite economic lives. PwC 11 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 11.Indicators of impairment for intangibles Background Relevant guidance Company A has capitalized the cost of acquiring the license rights to a product that has recently received regulatory approval. Company A has plans to begin selling this product in six months, and as such, is not amortizing the asset since it is not available for use. A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable [ASC 360–10–35–21]. An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). That assessment shall be based on the carrying amount of the asset (asset group) at the date it is tested for recoverability… An impairment loss shall be measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value [ASC 360–10–35–17]. What indicators of impairment should management consider? Solution ASC 360–10–35–21 provides several examples of events or changes in circumstances (not all-inclusive) that management should consider when assessing whether an intangible asset should be tested for impairment. Some of the events or changes in circumstances include: a significant decrease in the market price of the long-lived asset, a significant adverse change in the manner in which the asset is used or a significant adverse legal event. Management of pharmaceutical and life sciences entities should also consider other industry-specific indicators, including: • Development of a competing drug; • Changes in the legal framework covering patents, rights, or licenses; • Failure of the drug’s efficacy; • Advances in medicine and/or technology that affect the medical treatments; • A pattern of lower than predicted sales; • Change in the economic lives of similar assets; • Relationship with other intangible or tangible assets; and • Changes or anticipated changes in participation rates or reimbursement policies of insurance companies, Medicare or the government. 12 PwC Capitalization and impairment 12.Indicators of impairment—Property, plant and equipment Background Relevant guidance Company A announced a withdrawal of a marketed product due to unfavorable post approval Phase IV study results. Company A informed healthcare authorities that patients should no longer be treated with that product. Company A has property, plant and equipment that is dedicated specifically to the production of the terminated product and has no future alternative use. A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable [ASC 360–10–35–21]. What impairment indicators should Company A consider? Solution Company A should consider the general indicators given in ASC 360–10–35–21 when assessing whether there is an impairment of property, plant and equipment. In addition, pharmaceutical and life sciences entities should consider industry-specific factors such as the following: • Patent expiry date; • Failure of the machinery to meet regulatory requirements; • Technical obsolescence of the property, plant and equipment (for example, because it cannot accommodate new market preferences); • Changes in medical treatments; • Market entrance of competitive products; • Product recall; and • Changes or anticipated changes in third-party reimbursement policies that will impact the price received for the sale of product manufactured by the property, plant and equipment. As a result of withdrawing the product, Company A determined that the property, plant and equipment was fully impaired as there were no future cash flows associated with the long-lived asset group. PwC 13 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 13.Single market impairment accounting Background Relevant guidance Company A acquired the rights to market a topical fungicide cream in Europe. The acquired rights apply broadly to the entire territory and, as such, Company A determined that it would account for the acquired right as one unit of account. For unknown reasons, patients in Country X prove far more likely to develop blisters from use of the cream, causing Company A to withdraw the product from that country. As fungicide sales in Country X were not expected to be significant, the loss of the territory, taken in isolation, does not cause the overall value from sales of the drug to be less than its carrying value. A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable [ASC 360–10–35–21]. An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a longlived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group) [ASC 360–10–35–17]. For purposes of recognition and measurement of an impairment loss, long-lived asset or assets shall be grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities [ASC 360–10–35–23]. How should Company A account for the withdrawal of a drug from a specific territory? Solution Company A acquired the rights to market the fungicide cream over a broad territory and not specifically in Country X. Therefore, the entire territory would likely represent the lowest level of identifiable cash flows for testing impairment of the marketing rights. Because revenues from product sales in Country X were not significant, the withdrawal of the product from Country X’s market would not be considered a triggering event that would require an impairment analysis to be performed. However, Company A should carefully consider whether the development of blisters in patients in Country X is indicative of potential problems in other territories. If the issue cannot be isolated, a triggering event would be considered to have occurred and a broader impairment analysis should be performed, including the consideration of the potential for more wide-ranging decreases in sales. 14 PwC Capitalization and impairment 14.Impairment testing and useful life Background Relevant guidance Company A has a major production line that produces its blockbuster antidepressant. The production line has no alternative use. A competitor launches a new antidepressant with better efficacy. Company A expects sales of its drug to drop rapidly and significantly. Although positive margins are forecasted to continue, Company A identifies this as an indicator of impairment. As a result of the new competition, Company A may exit the market for this drug earlier than previously contemplated. A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable [ASC 360–10–35–21]. An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group)… An impairment loss shall be measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value [ASC 360–10–35–17]. When a long-lived asset (asset group) is tested for recoverability, it also may be necessary to review depreciation estimates and method… or the amortization period… Any revision to the remaining useful life of a long-lived asset resulting from that review also shall be considered in developing estimates of future cash flows used to test the asset (asset group) for recoverability… [ASC 360–10–35–22]. How should Company A assess the impairment and useful lives of long-lived assets where impairment indicators have been identified? If an impairment loss is recognized, the adjusted carrying amount of a long-lived asset shall be its new cost basis. For a depreciable long-lived asset, the new cost basis shall be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited [ASC 360–10–35–20]. Solution Assuming that the antidepressant asset group represents the lowest level of identifiable cash flows, Company A should evaluate the carrying amount of the antidepressant’s asset group (including the production line) relative to its future undiscounted cash flows. An impairment loss should be recognized if the carrying amount of the antidepressant’s asset group exceeds the future undiscounted cash flows. The resulting impairment would be based on the difference between the carrying amount of the unit and its fair value. In addition, Company A should revise the estimated useful life of the affected assets remaining after the impairment analysis is performed based on the estimated period it expects to obtain economic benefit from the assets. After recognizing the impairment and revising the estimated useful life for the affected assets, Company A would continue to amortize the remainder of the asset over its expected useful life. PwC 15 Externally Research and sourced development research and development 16 PwC Externally sourced research and development 15.Exchange of intangible assets Background Relevant guidance Company A is developing a hepatitis vaccine compound. Company B is developing a measles vaccine compound. Company A and Company B enter into an agreement to swap the two products. Company A and Company B will not have any continuing involvement in the products that they have swapped. The fair value of Company A’s compound has been assessed as $3 million. The carrying value of Company B’s compound was zero, as it was internally developed. The cost of a non-monetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss shall be recognized on the exchange. The fair value of the asset received shall be used to measure the cost if it is more clearly evident than the fair value of the asset surrendered [ASC 845–10–30–1]. A nonmonetary exchange shall be measured based on the recorded amount… of the nonmonetary asset(s) relinquished, and not on the fair values of the exchanged assets, and not on the fair values of the exchanged assets, if any of the following conditions apply: • The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits. • The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange. • The transaction lacks commercial substance [ASC 845–10–30–3]. A non-monetary exchange has commercial substance if the entity’s future cash flows are expected to significantly change as a result of the exchange [ASC 845–10–30–4]. How should Company A account for the swap of vaccine products? Solution Company A should recognize the compound received at the fair value of the compound given up, which is $3 million. Company A should also recognize a gain on the exchange of $3 million ($3 million–zero book value for the compound Company A gave up) because Company A has no continuing involvement or additional obligations with respect to the product given up. PwC 17 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 16.Exchange of intangible assets with continuing involvement Background Relevant guidance Company A is developing a hepatitis vaccine compound. Company B is developing a measles vaccine compound. Company A and Company B enter into an agreement to swap these two compounds. Under the terms of the agreement, Company A will retain the marketing rights to its hepatitis vaccine compound for all Asian countries. The fair value of Company A’s compound has been assessed as $3 million, including $1 million relating to the Asian marketing rights. The cost of a non-monetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss shall be recognized on the exchange. The fair value of the asset received shall be used to measure the cost if it is more clearly evident than the fair value of the asset surrendered [ASC 845–10–30–1]. A nonmonetary exchange shall be measured based on the recorded amount… of the nonmonetary asset(s) relinquished, and not on the fair values of the exchanged assets, if any of the following conditions apply: (a) The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits. (b) The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange. (c) The transaction lacks commercial substance [ASC 845–10–30–3]. How should Company A account for the swap of vaccine compounds, assuming that the transaction has commercial substance? A non-monetary exchange has commercial substance if the entity’s future cash flows are expected to significantly change as a result of the exchange [ASC 845–10–30–4]. Solution Company A should recognize the compound received at the fair value of the compound given up, which is $2 million ($3 million–$1 million). The fair value of $1 million relating to the marketing rights is excluded from the calculation because the rights have not been sold. Company A needed to assess whether it had continuing involvement related to the compound it had exchanged to determine the appropriate accounting for the $2 million. If Company A has determined it had continuing involvement, the gain would be deferred and recognized over the continuing involvement period. The SEC Staff has reiterated that ASC 845, Nonmonetary Transactions, is a measurement standard and does not address the timing of revenue or gain recognition. Company A would need to assess the “earned” and “realized” criteria of CON 5, Recognition and Measurement in Financial Statements of Business Enterprises, and the “performance” and “delivery” criteria of SAB Topic 13.A to determine the appropriate recognition timing. 18 PwC Externally sourced research and development 17.Accounting for receipt of listed shares in exchange for a patent Background Relevant guidance Company A agrees to acquire a patent from Company B in order to develop a drug. Company A will pay for the right it acquires by giving Company B 5% of its shares (which are listed). Company B is in the business of licensing and selling patents in its patent portfolio. The listed shares are considered to be equal in value to the patent. If Company A is successful in developing a drug and bringing it to the market, Company B will receive a 5% royalty on all sales. Company B expects to classify the shares as available-forsale securities. An investment in the stock of an investee… shall be measured initially at cost [ASC 325–20–30–1]. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term [ASC 320–10–25–1a]. Investments in debt securities and equity securities that have readily determinable fair values not classified as trading securities or as held-to-maturity securities shall be classified as availablefor-sale securities [ASC 320–10–25–1b]. The cost of a non-monetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss shall be recognized on the exchange. The fair value of the asset received shall be used to measure the cost if it is more clearly evident than the fair value of the asset surrendered [ASC 845–10–30–1]. How should Company B account for this transaction? Solution Company B should initially recognize the shares received as available-for-sale securities at their fair value. Company B should also derecognize the patent that is transferred to Company A, and recognize any gain arising from the sale of the patent. The fair value of the shares received represents the amount of the consideration received, which would likely be used to measure this transaction as it is more readily determinable (market quoted value) than the value of the patent given up. As Company B is in the business of routinely licensing and selling patents in its patent portfolio, it would be appropriate to recognize a gain on the sale of the patent as revenue. Transaction costs, if any, would be recorded as a reduction of the gain on the sale of the patent. Company B should not yet recognize any asset relating to the future royalty stream from the potential sales of the drug because this stream of royalties is contingent upon the successful development of the drug. The revenue will generally be recognized on an accrual basis in the period that the royalties are earned (e.g., when the related sales on which the royalties are determined occurs), if Company B has an ability to reasonably estimate such royalties. PwC 19 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 18.Accounting for receipt of unlisted shares in exchange for a patent Background Relevant guidance Company A agrees to acquire a patent from Company B in order to develop a drug. Company A will pay for the right it acquires by giving Company B 10% of the shares in an unlisted subsidiary. Company B does not typically sell patents in its patent portfolio. If Company A is successful in developing a drug and bringing it to the market, Company B will receive a 5% royalty on all sales. Company B expects to classify these shares as An investment in the stock of an investee… shall be measured initially at cost [ASC 325–20–30–1]. available-for-sale securities. If a security is acquired with the intent of selling it within hours or days, the security shall be classified as trading. However, at acquisition an entity is not precluded from classifying as trading a security it plans to hold for a longer period. Classification of a security as trading shall not be precluded simply because the entity does not intend to sell it in the near term [ASC 320–10–25–1a]. Investments in debt securities and equity securities that have readily determinable fair values not classified as trading securities or as held-to-maturity securities shall be classified as availablefor-sale securities [ASC 320–10–25–1b]. How should Company B account for this transaction? The cost of a non-monetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it, and a gain or loss shall be recognized on the exchange. The fair value of the asset received shall be used to measure the cost if it is more clearly evident than the fair value of the asset surrendered [ASC 845–10–30–1]. Solution Generally, the fair value of the patent given up will likely be more readily determinable than the fair value of the shares because these shares are of an unlisted subsidiary. ASC 320 states that fair value is only deemed readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the Securities and Exchange Commission or in the over-the-counter market, or similar foreign market. Company B would generally be expected to conclude that the fair value of the shares is the same value as the patent given up. As Company B is not in the business of licensing and selling patents in its portfolio, Company B should recognize the gain arising from the sale of the patent (fair value less carrying value of the patent) as a gain on sale of long-lived assets (separately stated, if material) or as other income. Transaction costs would be recorded as a reduction of the gain. Company B should not yet recognize any asset relating to the future royalty stream from the potential sales of the drug because this stream of royalties is contingent upon the successful development of the drug. The revenue will generally be recognized on an accrual basis in the period that the royalties are earned (i.e., when the related sales on which the royalties are determined occurs), if Company B has an ability to reasonably estimate such royalties. 20 PwC Externally sourced research and development 19.In-licensing agreements Background Relevant guidance Company A and Company B enter into an agreement in which Company A will license Company B’s know-how and technology to manufacture a compound to treat HIV. It cannot use the know-how and technology for any other project. Company A has not yet concluded that economic benefits are likely to flow from this compound or that relevant regulatory approval will be achieved. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. The costs of intangibles that are purchased from others for a particular research and development project and that have no alternative future uses… and therefore no separate economic values are research and development costs at the time the costs are incurred [ASC 730–10–25–2c]. Company A will use Company B’s technology in its facilities for a period of three years. The agreement stipulates that Company A will make a non-refundable payment of $3 million to Company B for access to the technology. Company B will also receive a 20% royalty from all future sales of the compound. How should Company A account for the in-licensing agreement? Solution Company A should expense the $3 million when incurred as research and development costs since the know-how and technology have no alternative future uses. The royalty payments of 20% of sales are generally presented in the income statement within cost of sales. PwC 21 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 20.Non-refundable upfront payments to conduct research Background Relevant guidance Company A engages a contract research organization (CRO) to perform research activities for a period of two years in order to obtain know-how and to discover a cure for HIV. The CRO is well known in the industry for having modern facilities and good practitioners dedicated to investigation. The CRO receives a non-refundable, upfront payment of $3 million in order to carry out the research under the agreement. It will have to present a quarterly report to Company A with the results of its research. Company A has full rights to the research performed, including an ability to control the research undertaken on the potential cure for HIV. The CRO has no rights to use the results of the research for its own purposes. Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Non-refundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executor contractual arrangement shall be deferred and capitalized [ASC 730–20–25–13]. How should Company A account for the upfront payments made to the CRO? Solution Although the payment is non-refundable, Company A will receive a future benefit as the CRO performs the research services over the two-year period. Therefore, the upfront payment should be capitalized and recognized in the income statement (as research and development expense) using the straight-line method, unless another method is more reflective of the CRO’s effort. Company A should continue to evaluate whether it expects the goods to be delivered or services to be rendered each reporting period to assess recoverability of the asset. 22 PwC Externally sourced research and development 21.Payments made to conduct research Background Relevant guidance Company A, a small pharmaceutical company, is engaged by Company B, a large pharmaceutical company, to develop a new medical treatment for migraines over a five-year period. Company A is engaged only to provide research and development services and will periodically have to update Company B with the results of its work. Company B has exclusive rights over the development results. Company B will make 20 equal non-refundable quarterly payments of $0.25 million (totaling $5 million), if Company A can demonstrate compliance with the development program. Payments do not depend upon the achievement of a particular outcome. Research and development… shall be charged to expense when incurred [ASC 730–10–25–1]. How should Company B recognize the payments it makes to Company A? Solution Company B should recognize research and development expense of $0.25 million each quarter for as long as it authorizes Company A to continue performing the research. PwC 23 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 22.Fixed-fee contract research arrangements Background Relevant guidance Company A enters into a contract research arrangement with Company B. Company B will perform research on a library of molecules and will catalogue the research results in a database. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others [on] behalf of the entity, shall be included in research and development costs [ASC 730–10–25–2(d)]. Company A will pay Company B $3 million only upon completion of the contracted work. The payment is based on delivery of the research services. There is no success based contingency. How should Company A account for the contract research arrangement? Solution The costs should be expensed as Company B performs the services and recorded as research expense. Company A should accrue the contract research costs over the expected period of the research. Company A will need some visibility into Company B’s pattern of performance in order to properly expense the contract research costs under the arrangement. The structuring of the payments does not alter the accounting treatment. 24 PwC Externally sourced research and development 23.Third-party development of intellectual property Background Relevant guidance Company A has appointed Company B, an independent third party, to develop an existing compound owned by Company A on its behalf. Company B will act purely as a service provider without taking any risks during the development phase and will have no further involvement after regulatory approval. Company A will retain full ownership of the compound. Company B will not participate in any marketing or production arrangements. Company A agrees to make the following non-refundable payments to Company B: Research and development costs… shall be charged to expense when incurred [ASC 730–10–25–1]. Nonrefundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized [ASC 730–20–25–13]. • $2 million on signing the agreement • $3 million on successful completion of Phase II testing How should Company A account for upfront and subsequent milestone payments in an arrangement in which a third party develops its intellectual property? Solution The initial upfront payment represents a prepayment for future development by a third party and should be capitalized initially and then amortized as Company B performs the research (i.e., generally straight line over the expected period of performance unless another recognition pattern more accurately depicts performance). Company A should expense the milestone payment when it is probable the payment will be made. PwC 25 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 24.External development of intellectual property with buy-back options Background Relevant guidance Company A has out-licensed the development of an existing compound to Company B, an independent third party. There was no upfront consideration paid between the parties. Company A will neither retain any involvement in the development of its compound nor participate in the funding of the development. However, in the case of successful completion of the development as evidenced by regulatory approval in the key markets, Company A has the option to buy-back the rights to its compound. The following terms are agreed: If the entity is obligated to repay any of the funds provided by the other parties regardless of the outcome of the research and development, the entity shall estimate and recognize that liability. This requirement applies whether the entity may settle the liability by paying cash, by issuing securities, or by some other means [ASC 730–20–25–3]. • If the development fails, Company B bears all the costs it incurred without any compensation. • If the development is successful and Company A exercises its buy-back option, Company B receives an agreed buy-back payment (as well as future sales based milestone payments and royalty streams). • If the development is successful and Company A does not exercise the option, Company B can commercialize the compound on its own (paying milestones and royalties to Company A under the license arrangement). To conclude that a liability does not exist, the transfer of the financial risk involved with research and development from the entity to the other parties must be substantive and genuine. To the extent that the entity is committed to repay any of the funds provided by the other parties regardless of the outcome of the research and development, all or part of the risk has not been transferred [ASC 730–20–25–4]. The following are examples of conditions leading to the presumption that an entity will repay the other parties [ASC 730–20–25–6]: • The entity has indicated an intent to repay all or a portion of the funds provided regardless of the outcome of the research and development. • The entity would suffer a severe economic penalty if it failed to repay any of the funds provided to it regardless of the outcome of the research and development. • A significant related party relationship between the entity and the parties funding the research and development exists at the time the entity enters into the arrangement. • The entity has essentially completed the project before entering into the arrangement. 26 PwC Externally sourced research and development 24. External development of intellectual property with buy-back options (continued) Relevant guidance (continued) If the entity’s obligation is to perform research and development for others and the entity subsequently decides to exercise an option to purchase the other parties’ interests in the research and development arrangement or to obtain the exclusive rights to the results of the research and development, the nature of those results and their future use shall determine the accounting for the purchase transaction or business combination… [ASC 730–20–25–9]. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others [on] behalf of the entity, shall be included in research and development costs [ASC 730–10–25–2(d)]. How should Company A account for payments in an arrangement in which a third party develops its intellectual property? Solution Company A effectively removes its exposure to failure of the development of its compound, having transferred all development risks to Company B. In this case, there are no indicators that would lead to a presumption that the buyback will occur and that a liability should be recognized before any decision to reacquire the rights were to occur. Through exercise of the buy-back option, Company A reacquires the commercialization right intangible asset. Since exercise of the buy-back option is triggered upon regulatory approval, the buyback payment would be capitalized when contractually due and then amortized over the useful life of the commercialization right. PwC 27 Research and development related issues 28 PwC Research and development related issues 25.Payments received to conduct development Background Relevant guidance Company A, a small pharmaceutical company, contracts with the much larger Company B to develop a new medical treatment for migraines over a five-year period. Company A is engaged only to provide development services and will periodically have to update Company B with the results of its work. Company B has exclusive rights over the development results. It will make 20 equal non-refundable quarterly payments of $0.25 million (totaling $5 million), if Company A can demonstrate compliance with the development program. Payments do not depend upon the achievement of a particular outcome. Company A estimates the total cost will be $4 million. Service revenue should be recognized on a straight-line basis, unless evidence suggests that the revenue is earned or obligations are fulfilled in a different pattern, over the contractual term of the arrangement or the expected period, during which those specified services will be performed, whichever is longer [SAB Topic 13A]. In the first quarter of year one, Company A incurs costs of $0.4 million, in line with its original estimate. Company A is in compliance with the research agreement, including the provision of updates from the results of its work. How should Company A recognize the payments it receives from Company B to conduct development? Solution If costs incurred are a reasonable representation of the services performed, Company A should recognize the revenue on a proportional performance basis. Otherwise, Company A should recognize the revenue on a straight-line basis over the five-year period. PwC 29 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 26.Upfront payments received to conduct development: Initial recognition Background Relevant guidance Company A has appointed Company B to develop an existing compound on its behalf. Company B will have no further involvement with the compound after regulatory approval. Company A will retain full ownership of the compound (including intellectual property rights), even after regulatory approval is obtained. Company A agrees to make the following non-refundable payments to Company B: Many arrangements require the customer to pay a certain amount of money at the start of the contract. These upfront payments are often characterized as non-refundable and are sometimes earmarked for “past services,” for “access” to some intangible right, or for some general “rights.” Unless the upfront payment is in exchange for a product, service or right and represents the culmination of a separate earnings process, the upfront fee should be deferred over the longer of the contractual life of an arrangement or the customer relationship life. The customer’s perception of value received is paramount in this assessment [SAB Topic 13]. • $3 million on signing of the agreement • $1 million on commencement of Phase III clinical trials • $2 million on securing regulatory approval In addition, Company A will reimburse Company B for any expenditures incurred above $3 million. Company B expects to incur costs totaling $3 million up to the point of securing regulatory approval. Company B cannot reliably estimate whether the compound will obtain regulatory approval. How should Company B recognize the initial payment it has received from Company A? Solution Company B should record the initial payment as deferred income. This deferred income will subsequently be recognized as revenue based on proportional performance or on a straight line basis over the expected development period if development is performed evenly. At no point, however, should the revenue recorded exceed the amount of cash received. When the payment is initially received, the earnings process has not been completed. The future milestone payments are not included in the determination of revenue, as their receipt cannot be reliably estimated and no earnings process has been completed. 30 PwC Research and development related issues 27.Upfront payments received to conduct development: Interim recognition Background Relevant guidance Company B is now in the process of fulfilling the contract with Company A outlined in Scenario 26. It has incurred $2 million in development costs from the inception of the contract on March 1, 20X4 through December 31, 20X4, as projected in the original development plan. Company B estimates that the level of costs incurred approximates the amount of services delivered under the contract. Upfront fees, even if non-refundable, are earned as the products and/or services are delivered and/or performed over the term of the arrangement or the expected period of performance and generally should be deferred and recognized systematically over the periods that the fees are earned. Service revenue should be recognized on a straight-line basis, unless evidence suggests that the revenue is earned or obligations are fulfilled in a different pattern, over the contractual term of the arrangement or the expected period during which those specified services will be performed [SAB Topic 13]. How should Company B recognize deferred income and costs incurred to conduct development for another party? Solution Company B should recognize the revenue on a straight-line basis or proportionally over the contract term based on the level of effort spent each period. Costs incurred may be an appropriate basis for measuring level of effort. Initial set-up costs for materials, equipment or similar items should not be considered as they are generally not related to revenue generating activities. Under a proportional performance method, since Company B has incurred $2 million in development costs to date and expects to incur another $1 million, it should have recognized as revenue a comparable ratio of deferred income (e.g., 66.7% or $2 million as revenue). No consideration should be given to the future milestone payments, as their receipt cannot be reliably estimated and no earnings process has been completed. It is important to note that Company B has no continuing involvement after the development phase in this scenario. If there was continuing involvement (e.g., co-marketing, manufacturing, steering committees), the terms of those deliverables would need to be considered in determining the appropriate period to recognize the upfront payment as revenue. PwC 31 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 28.Upfront payments received to conduct development: Completion Background Relevant guidance Regulatory approval has been received for the compound on which Company B is working (Scenarios 26 and 27). Company A has paid the $1 million and the $2 million milestone payments specified in the development contract in addition to the $3 million it paid on signing the contract. Company B has incurred costs of $3 million to reach this point, in line with original expectations. Upfront fees, even if non-refundable, are earned as the products and/or services are delivered and/or performed over the term of the arrangement or the expected period of performance and generally should be deferred and recognized systematically over the periods that the fees are earned. Service revenue should be recognized on a straight-line basis, unless evidence suggests that the revenue is earned or obligations are fulfilled in a different pattern, over the contractual term of the arrangement or the expected period during which those specified services will be performed [SAB Topic 13]. How should Company B recognize the milestone payments? Solution Company B could recognize the milestone payments received ($1 million due upon commencement of Phase III clinical trials and $2 million for securing regulatory approval) under either the milestone method of revenue recognition, or another proportional performance method. To utilize the milestone method of revenue recognition, the milestones would need to be substantive and represent the achievement of defined goals worthy of the payments. To be substantive, the consideration must (a) be commensurate with either (i) the vendor’s performance to achieve the milestone or (ii) the enhancement of the value of the delivered item or items as a result of a specific outcome resulting from the vendor’s performance to achieve the milestone; (b) relate solely to past performance; and (c) be reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement [ASC 605-28-25-2]. In this example, Company B has no remaining obligations to Company A when it receives the two milestone payments. As a result, regardless of whether Company B utilizes the milestone method of revenue recognition or another proportional performance method to recognize the amounts received, the $3 million received should be recognized since the earnings process relative to these payments have been fully completed. 32 PwC Research and development related issues 29.Donation payment for research Background Relevant guidance Company A has made a non-refundable gift of $3 million to a university. The donation is to be used to fund research activities in the area of infectious diseases over a two-year period. Company A has no right to access the research findings. Contributions made shall be recognized as expenses in the period made and as decreases of assets or increases of liabilities depending on the form of the benefits given… unconditional promises to give cash are recognized as payables and contribution expenses [ASC 720–25–25–1]. How should Company A recognize the donation? Solution Company A should expense the donation when incurred (normally when paid) or at the time an unconditional promise to give is made, whichever is sooner, in the income statement (generally selling, general and administrative expense). PwC 33 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 30.Capitalization of interest incurred on loans received to fund research and development Background Relevant guidance Company A has obtained a loan from Company B, another pharmaceutical company, to finance the late-stage development of a drug to treat cancer. Interest shall be capitalized for the following types of assets (“qualifying assets”) [ASC 835–20–15–5]: • Assets that are constructed or otherwise produced for an entity’s own use, including assets constructed or produced for the entity by others for which deposits or progress payments have been made. • Assets intended for sale or lease that are constructed or otherwise produced as discrete projects… • Investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations provided that the investee’s activities include the use of funds to acquire qualifying assets for its operations. The investor’s investment in the investee, not the individual assets or projects of the investee, is the qualifying asset for purposes of interest capitalization. Can Company A capitalize the interest incurred for borrowings obtained to finance research and development activities? Solution Borrowing costs associated with costs for research and development projects are expensed as incurred as development costs as they do not qualify as assets. 34 PwC Research and development related issues 31.Treatment of trial batches in development Background Relevant guidance Company A, a commercial laboratory, is manufacturing a stock of 20,000 doses (trial batches) of a newly developed drug, using various raw materials. The doses can only be used in patient trials during Phase III clinical testing, and cannot be used for any other purpose. The raw materials can be used in the production of other approved drugs. The costs of materials (whether from the entity’s normal inventory or acquired specially for research and development activities) and equipment or facilities, that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed… However, the cost of materials, equipment or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred [ASC 730–10–25–2(a)]. How should Company A account for the raw materials and trial batches? Solution Company A should initially recognize the raw materials acquired for the production of trial batches as inventory since the raw materials have alternative future use in the production of other approved drugs. As the trial batches do not have any alternative future use and the technical feasibility of the drug is not proven (the drug is in Phase III), the trial batches (including the cost of raw materials used in production) should be charged to development expense when they are produced. PwC 35 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 32.Accounting for funded research and development arrangements Background Relevant guidance Company A partners with Investor B, an unrelated financial investor, for the development of selected compounds that are in Phase II development. Investor B commits a specified dollar amount to fund the research and development of the selected compounds. In exchange for the funding, Investor B will receive royalties on future sales of product resulting from the compounds being developed. Investor B will not receive any repayment if the compounds are not successfully developed (i.e., the transfer of financial risk for the research and development is substantive). Investor B does not participate in any of the development or commercialization activities. ASC 730–20, Research and Development Arrangements, provides guidance on accounting for research and development arrangements through which a company can obtain the results of the research and development funded partially or entirely by others. This guidance requires a company to determine the nature of the obligation it incurs when it enters into a research and development funding arrangement to ascertain whether the obligation is (i) a liability to repay the funding party or (ii) to perform contractual services. ASC 470–10–25, Debt, provides guidance on the accounting for cash received from an investor when a company agrees to pay the investor, for a defined period, a specified percentage or amount of revenue of a particular product line, business segment, trademark, patent, or contractual right. This guidance discusses whether cash proceeds received from a sale of future revenues should be classified as debt or deferred income. What factors should Company A consider to determine the most appropriate accounting model for the research and development funding? Solution While ASC 730–20 only relates to research and development funding, ASC 470–10–25 does not specifically exclude research and development funding arrangements from its scope. If the research and development risk is substantive, such that it’s not probable the development will be successful, the guidance in ASC 730–20 could be followed. However, if the successful completion of the research and development is probable at the time the funding is received, the guidance in ASC 470–10–25 is most applicable. 36 PwC Research and development related issues 32. Accounting for funded research and development arrangements (continued) Solution (continued) To conclude that a liability does not exist, the transfer of financial risk involved with the research and development from Company A to Investor B must be substantive and genuine. When assessing the substance of the transfer of financial risk, Company A should consider any explicit or implicit obligations to repay any or all of the funding. If surrounding conditions suggest that it is probable that Company A will repay any of the funds regardless of the outcome of the research and development, the funding should be recorded as a liability. Assessing the probability of repayment requires significant judgment and will be based on the facts and circumstances of the transaction. Examples of conditions leading to a presumption that repayment is probable include the following: • Company A has indicated an intent to repay all or a portion of the funds regardless of the outcome of the research and development; • Company A would suffer a severe economic penalty if it failed to repay any of the funds provided to it regardless of the outcome of the research and development; and • A significant related party relationship exists between the parties (in this scenario Company A and Investor B are unrelated). Given the nature of the development and regulatory process, Company A determines that there is significant risk associated with the research and development and that successful development is not probable. Accordingly, Company A will apply the guidance in ASC 730–20 to evaluate the accounting for the research and development funding (i.e., whether it is a liability to repay the funding party or an obligation to perform contractual services). In this example, Company A has no explicit or implicit obligation to repay any of the funds and therefore determines that the arrangement is an obligation to perform contractual services. PwC 37 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 33.Receipts for out-licensing Background Relevant guidance Company A and Company B enter into an agreement in which Company A will license Company B’s know-how and technology to manufacture a compound for HIV. Company A will use Company B’s technology for a period of three years. Company B will have to keep the technology updated and in accordance with Company A’s requirements during this three-year period. Company B obtains a non-refundable upfront payment of $3 million for access to the technology. Company B will also receive a royalty of 20% from sales of the HIV compound if Company A successfully develops a marketable drug. When the elements of an out-licensing arrangement represent a single unit of accounting, the upfront fee should be deferred over the contractual life of the arrangement unless the upfront payment is in exchange for products delivered or services performed that represent the culmination of a separate earnings process [SAB Topic 13]. Revenue should be recognized on a straight-line basis, unless evidence suggests that the revenue is earned or obligations are fulfilled in a different pattern, in which case that pattern should be followed [SAB Topic 13]. How should Company B account for a non-refundable upfront fee received for licensing out its know-how and technology to a third party? Solution Company B should recognize the non-refundable upfront fee received on a straight-line basis over the three-year term of the license. The $3 million upfront fee is a service fee for granting a third party access to its technology and to keep it updated in accordance with its requirements for a period of three years. This is the case even if the technology maintenance requirements are not expected to be significant. Company B should recognize the royalty receipts as revenue when earned. If material, the royalty should be presented as a separate class of revenue in Company B’s income statement. 38 PwC Manufacturing Research and development PwC 39 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 34.Treatment of validation batches Background Relevant guidance A laboratory has just completed the development of a new machine to mix components at a specified temperature to create a new formulation of aspirin. The laboratory produces several batches of the aspirin, using the new machinery to obtain validation (an approval for the use of the machine) from the relevant regulatory authorities. The validation of the machinery is a separate process from the regulatory approval of the new formulation of aspirin. Property, plant, and equipment and most inventories are reported at their historical cost which is the amount of cash, or its equivalent, paid to acquire an asset, commonly adjusted after acquisition for amortization or other allocations [CON 5, par. 67]. This includes directly attributable expenditures incurred in acquiring the equipment and preparing it for use. The historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. If an asset requires a period of time in which to carry out the activities necessary to bring it to that condition and location, the interest cost incurred during that period as a result of expenditures for the asset is a part of the historical cost of acquiring the asset [ASC 835–20–05–1]. Should expenditures to validate machinery be capitalized? Solution The laboratory should capitalize the costs incurred (including materials, labor, applicable overhead) to obtain the necessary validation for the use of the machinery, together with the cost of the machinery. Validation is required to bring the machinery to its working condition. However, management should exclude abnormal validation costs caused by errors or miscalculations during the validation process (such as wasted material, labor or other resources). If the machinery requires revalidation, the costs related to this would be expensed as incurred as the asset had already been prepared for its original intended use. 40 PwC Manufacturing 35.Treatment and presentation of development supplies Background Relevant guidance A laboratory has purchased 10,000 batches of saline solution. These batches are used in trials on patients during various Phase III clinical tests. They can also be used as supplies for other testing purposes, but have no other uses. Management is considering whether the batches should be recorded as an asset. The cost of such materials consumed in research and development activities and the depreciation of such equipment of facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred. [ASC 730–10–25–2]. Should costs associated with supplies used in clinical testing be accounted for as inventory? An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others’ access to it, and (c) the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred [CON 6, par. 26]. Solution The batches do not meet the definition of inventory because they can only be used for development. However, the batches do meet the definition of an asset (other current asset or prepaid asset) since they have alternative future uses in other development projects. They should therefore be recorded at cost and accounted for as supplies used in the development process. When supplies are used, the associated cost forms part of research and development expense. PwC 41 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 36.Pre-launch inventory—Treatment of ‘in-development’ drugs Background Relevant guidance Company A developed a new drug and needs to have sufficient quantities of inventory on-hand in anticipation of commercial launch once regulatory approval to market the product has been obtained. Company A has filed for regulatory approval and is currently awaiting a decision. Company A believes that final regulatory approval is probable. Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events [CON 6, par. 25]. Company A produced 15,000 doses following submission of the filing for regulatory approval. If regulatory approval is not obtained, the inventory has no alternative use. Inventory is defined as the aggregate of those items of tangible personal property that have any of the following characteristics: (a) held for sale in the ordinary course of business, (b) in process of production for such sale, or (c) to be currently consumed in the production of goods or services to be available for sale [ASC 330–10–20]. The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean acquisition and production cost, and its determination involves many considerations [ASC 330–10–30–1]. A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market [ASC 330–10–35–1]. A write-down of inventory to the lower of cost or market at the close of a fiscal period creates a new cost basis that subsequently cannot be marked up based on changes in underlying circumstances [ASC 330–10–S99–2]. 42 PwC Manufacturing 36. Pre-launch inventory—Treatment of ‘in-development’ drugs (continued) How should the costs associated with the production of pre-launch inventory for ‘in-development’ drugs be accounted for? Solution Pre-launch inventory can be capitalized if it has probable future economic benefit. The assessment of whether pre-launch inventory has probable future economic benefits depends on individual facts and circumstances. Factors to consider include whether key safety, efficacy and feasibility issues have been resolved, status of any advisory committee reviews, and understanding of any potential hurdles to regulatory approval or product reimbursement. Company A believes that the filing for regulatory approval indicates that future economic benefit is probable. Accordingly, the pre-launch inventory can be capitalized at the lower of cost or market. Periodic reassessments should be made to determine whether the inventory continues to have a probable future economic benefit (e.g., whether regulatory approval is still probable and whether product will be sold prior to expiration of its useful life). If the value of inventory is written down based on this reassessment, the reduced amount is the new cost basis (i.e., if regulatory approval is ultimately obtained, the inventory is not written back up). If at any time regulatory approval is deemed to not be probable, the inventory should be written down to its net realizable value, which is presumably zero assuming that the product cannot be sold. Companies should consider whether additional financial statement disclosures are necessary related to the capitalization of pre-launch inventory, including the accounting policy and total amount capitalized. Further, if inventory that had previously been written down is ultimately sold, companies should consider disclosing the impact on margins. PwC 43 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 37.Recognition of raw materials as inventory Background Relevant guidance Company A buys bulk materials used for manufacturing a variety of drugs. The materials are used for marketed drugs, samples and drugs in development. The materials are warehoused in a common facility and released to production based upon orders from the manufacturing and development departments. Inventory is defined as the aggregate of those items of tangible personal property that have any of the following characteristics: • Held for sale in the ordinary course of business • In process of production for such sale • To be currently consumed in the production of goods or services to be available for sale [ASC 330–10–20]. How should purchased materials be accounted for when their ultimate use is not known? The costs of materials (whether from the entity’s normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment of facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred [ASC 730–10–25–2]. Solution Company A should account for raw materials that can be used in the production of marketed drugs as inventory. When the material is consumed in the production of sample products, Company A should account for the sample product to be given away as an expense in accordance with its policy, which would generally be either when the product is packaged as sample product or the sample is distributed. When the materials are released to production for use in the manufacturing of drugs in development, the cost of the materials should be accounted for as research and development expense. Alternatively, if the bulk materials were only able to be used for a particular research and development project, and did not have alternative future uses, the costs would be recognized as research and development expense when incurred. 44 PwC Manufacturing 38.Indicators of impairment—Inventory Background Relevant guidance Company A has decided to temporarily suspend all operations at a certain production site due to identified quality issues. Company A initiated a recall of products manufactured at that certain site. Additionally, Company A carries a significant amount of raw material inventory used in the manufacture of the product. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference should be recognized as a loss of the current period [ASC 330–10–35–1]. Is the inventory used to manufacture the product impaired? Solution Company A would need to consider all available evidence to determine if there is an impairment. Suspending production and recalling the product are indicators that the carrying value of raw material inventory used to manufacture the drug may not be recoverable. Other factors that Company A may consider include: the reason for the recall, its history with past recalls, if the quality issue could be fixed, and if the raw materials could be used for other products. PwC 45 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 39.Patent protection costs Background Relevant guidance “Assets are probable future economic benefits obtained or Research and development Company A has a registered patent on a currently marketed drug. Company B copies the drug’s active ingredient and sells the drug during the patent protection period. Company A goes to trial and is likely to win the case, but has to pay costs for its attorneys and other legal charges. controlled by a particular entity as a result of past transactions or events [CON 6, par. 25].” …the legal and other costs of successfully defending a patent from infringement are “deferred legal costs” only in the sense that they are part of the cost of retaining and obtaining the future economic benefit of the patent [CON 6, par. 247].” If defense of the patent lawsuit is successful, costs may be capitalized to the extent of an evident increase in the value of the patent. Legal costs which relate to an unsuccessful outcome should be expensed [AICPA TPA Sec 2260]. Should legal costs relating to the defense of pharmaceutical patents be capitalized? Solution Capitalizing or expensing patent defense costs has evolved into an accounting policy decision. Generally in the pharmaceuticals and life sciences industries, patent defense costs are not viewed as enhancing the value of a patent. In cases where it is believed that the defense of the patent merely maintains rather than increases the expected future economic benefits from the patent, the costs would generally be expensed as incurred. Companies could capitalize external legal costs incurred in the defense of its patents when it is believed that a successful defense is probable and that the value of the patent will be increased by virtue of a successful outcome; in that case, costs may be capitalized to the extent of the increase. Capitalized patent defense costs are amortized over the remaining life of the related patent. 46 PwC Sales and Marketing PwC 47 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 40.Advertising and promotional expenditure—Scenario 1 Background Relevant guidance A pharmaceutical company has developed a new drug that simplifies the long-term treatment of kidney disease. The company’s commercial department has incurred significant costs with a promotional campaign, including television commercials and presentations in conferences and seminars for doctors. The costs of advertising… shall be expensed either as incurred or the first time the advertising takes place. The accounting policy selected from these two alternatives shall be applied consistently to similar kinds of advertising activities. Deferring the costs of advertising until the advertising takes place assumes that the costs have been incurred for advertising that will occur. Such costs shall be expensed immediately if such advertising is not expected to occur [ASC 720–35–25–1]. How should these costs be accounted for and presented in the income statement? Solution The company should not recognize its advertising and promotional costs as an intangible asset, even though the expenditure incurred may provide future economic benefits. Depending on the policy it selected, the company should charge all promotional costs to the income statement as incurred or the first time the advertising takes place. Promotional costs should be included within sales and marketing expenses. 48 PwC Sales and Marketing 41.Advertising and promotional expenditure—Scenario 2 Background Relevant guidance Company A recently completed a major study comparing its Alzheimer drug to competing drugs. The results of the study were highly favorable and Company A has invested in a significant new marketing campaign. The campaign will be launched at the January 20X4 International Alzheimer Conference. Company A has also paid for direct-to-consumer television advertising, which will appear in February 20X4. Related direct-to-consumer internet advertising will also begin in February 20X4, and will be paid based on when viewers “click-through” to its Alzheimer site. The costs of advertising should be expensed either as incurred or the first time the advertising takes place [ASC 340–20–25–3] except for: • Direct-response advertising whose primary purpose is to elicit sales to customers who could be shown to have responded specifically to the advertising and that results in probable future benefits [ASC 340–20–25–4]. How should expenditure on advertising and promotional campaigns be treated in the 20X3 financial statements (i.e., before the campaign is launched)? Solution Advertising and promotional expenditure (i.e., all costs to develop and produce the marketing campaign and related materials, including the television and internet advertisements) should be treated as an expense when incurred or the first time the advertisement takes place, whichever is the Company’s consistently applied policy. Amounts paid to television broadcast providers should be accounted for as a prepayment and expensed when the advertisement airs in 20X4. Costs for hits to Company A’s internet site should be expensed based upon the click-through rate in 20X4. Please note that the above solution assumes the advertising and promotional activities would be deemed to be “Other than Direct Response Advertising” under ASC 340–20. PwC 49 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 42.Presentation of co-marketing income Background Relevant guidance Company A and Company B have entered into a co-marketing agreement for Compound Y. Compound Y was developed solely by Company B and recently received approval from the regulatory authorities to be sold. Under the terms of the agreement, Company A has made an upfront payment to Company B to obtain an exclusive marketing right for Compound Y in Japan. A collaborative arrangement is a contractual arrangement that involves a joint operating activity. These arrangements involve two (or more) parties who are both active participants in the activity and exposed to significant risks and rewards dependent on the commercial success of the activity [FASB Codification Glossary]. Company B will manufacture the product and sell it to Company A. Company A will also pay Company B 20% of its net sales of Compound Y. The promotion and commercialization of drugs are Company A’s main activities, although in this case they are performed jointly with a third party. Participants in a collaborative arrangement shall report costs incurred and revenue generated from transactions with third parties (that is, parties that do not participate in the arrangement) in each entity’s respective income statement pursuant to the guidance in [ASC] 605–45… [ASC 808–10–45–1]. The primary purpose for Company B entering into the co-marketing arrangement with Company A was to allow Company B to utilize Company A’s experienced sales force with extensive knowledge of the Japanese market. Company B does not have a presence in Japan. For costs incurred and revenue generated from third parties, the participant in a collaborative arrangement that is deemed to be the principal participant for a given transaction under [ASC] 605–45 shall record that transaction on a gross basis in its financial statements [ASC 808–10–45–2]. Payments between participants pursuant to a collaborative arrangement that are within the scope of other authoritative accounting literature on income statement classification shall be accounted for using the relevant provisions of that literature. If the payments are not within the scope of other authoritative accounting literature, the income statement classification for the payments shall be based on an analogy to authoritative accounting literature or if there is no appropriate analogy, a reasonable, rational, and consistently applied accounting policy election [ASC 808–10–45–3]. 50 PwC Sales and Marketing 42. Presentation of co-marketing income (continued) How should Company B present the co-marketing income it receives from Company A in its financial statements? Solution Company B first needs to evaluate whether the co-marketing agreement represents a collaborative arrangement between two parties who are both active participants in the activity and exposed to significant risks and rewards dependent on the commercial success of the activity. In this case, Company B concluded that the co-marketing agreement is not a collaborative arrangement since Company A is not an active participant in the arrangement. In particular, Company A was not involved in the research and development of Compound Y; it did not participate on a steering committee or other oversight or governance mechanism, nor does it have a legal right to the underlying intellectual property. Since the co-marketing agreement is not a collaborative arrangement, the agreement represents an arrangement between third parties and Company B’s accounting for its co-marketing income will depend on whether it is the principal or agent in the arrangement based on the factors in ASC 605–45–45–2. In this case, Company B determines that Company A is the principal for sales in the Japanese market. Therefore, Company B should recognize 100% of the sales of Compound Y to Company A as sales revenue and the corresponding costs of production as cost of sales. The co-marketing income, at 20% of Company A’s sales, would typically be presented as royalty income and disclosed separately as a component of revenue, if material. PwC 51 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 43.Presentation of co-marketing expenses Background Relevant guidance Company A and Company B have entered into a co-marketing agreement for Compound Y. Compound Y was developed solely by Company B and recently received approval from the regulatory authorities to be sold. Under the terms of the agreement, Company A has made an upfront payment to Company B to obtain an exclusive marketing right for Compound Y in Japan. A collaborative arrangement is a contractual arrangement that involves a joint operating activity. These arrangements involve two (or more) parties who are both active participants in the activity and exposed to significant risks and rewards dependent on the commercial success of the activity [FASB Codification Glossary]. Company B will manufacture the product and sell it to Company A. Company A will also pay Company B 20% of its net sales of Compound Y. The promotion and commercialization of drugs are Company A’s main activities, although in this case they are performed jointly with a third party. Participants in a collaborative arrangement shall report costs incurred and revenue generated from transactions with third parties (that is, parties that do not participate in the arrangement) in each entity’s respective income statement pursuant to the guidance in [ASC] 605–45… [ASC 808–10–45–1]. The primary purpose for Company B entering into the co-marketing arrangement with Company A was to allow Company B to utilize Company A’s experienced sales force with extensive knowledge of the Japanese market. Company B does not have a presence in Japan. For costs incurred and revenue generated from third parties, the participant in a collaborative arrangement that is deemed to be the principal participant for a given transaction under [ASC] 605–45 shall record that transaction on a gross basis in its financial statements [ASC 808–10–45–2]. Payments between participants pursuant to a collaborative arrangement that are within the scope of other authoritative accounting literature on income statement classification shall be accounted for using the relevant provisions of that literature. If the payments are not within the scope of other authoritative accounting literature, the income statement classification for the payments shall be based on an analogy to authoritative accounting literature or if there is no appropriate analogy, a reasonable, rational, and consistently applied accounting policy election [ASC 808–10–45–3]. 52 PwC Sales and Marketing 43. Presentation of co-marketing expenses (continued) How should Company A present its co-marketing inflows and outflows in its income statement? Solution Company A first needs to evaluate whether the co-marketing agreement represents a collaborative arrangement between two parties who are both active participants in the activity and exposed to significant risks and rewards dependent on the commercial success of the activity. In this case, Company A concluded that the co-marketing agreement was not a collaborative arrangement since it was not an active participant in the arrangement. Company A was not involved in the research and development of Compound Y, there is no participation by Company A on a steering committee or other oversight or governance mechanism, and it has no legal right to the underlying intellectual property. In addition, Company A was not exposed to significant risks and rewards as part of this arrangement since Compound Y was approved for sale by the regulatory authorities prior to the execution of the co-marketing agreement and the rewards that Company A can obtain are limited to the Japanese market. Since the co-marketing agreement is not a collaborative arrangement, the agreement represents an arrangement between third parties and Company A’s accounting for its co-marketing expenditures will depend on whether it is the principal or agent in the arrangement based on the factors in ASC 605–45–45–2. If Company A determines it is the principal for sales in the Japanese market, Company A should present the payments received from customers as sales revenue, and the cost of purchasing Compound Y from Company B as inventory and then cost of goods sold. The co-marketing amounts paid to Company B, 20% of net sales of Compound Y, represent a royalty in return for the product rights in that territory and should be presented as cost of goods sold. If Company A determined it was the agent in the Japanese market, it would recognize revenue calculated as payments due from customers less payments owed to Company B. PwC 53 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 44.Accounting for a sales based milestone payment Background Relevant guidance Company A acquires the intellectual property rights to one of Company B’s completed compounds for an upfront cash payment of $15 million and agrees to make an additional one time sales based milestone payment of $10 million if and when sales for the related product in any one year reach a specified sales target level. In this case, Company A has determined that the transaction does not constitute a business and, therefore, will account for it as an asset acquisition. The sales based milestone payment, if made, does not entitle Company A to additional intellectual property rights beyond those already obtained in the initial asset acquisition. Rather, the payment is in effect a one-time royalty since it is due to Company B for the achievement of a specified sales level. An estimated loss from a contingency shall be accrued by a charge to income if both of the following conditions are met: Company A capitalizes the $15 million payment made to acquire the IP rights since the rights relate to a completed compound and the cost is considered recoverable based on expected future cash flows. The useful life of the intellectual property rights is 15 years and Company A begins amortizing $1 million per year. At the end of the third year, following a significant uptick in sales of the product, it becomes probable that the specified sales level will be met the following year. 54 PwC • 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 [ASC 450–20–25–2]. A lessee shall recognize contingent rental expense . . . before the achievement of the specified target that triggers the contingent rental expense, provided that achievement of that target is considered probable [ASC 840-10-25]. Sales and Marketing 44. Accounting for a sales based milestone payment (continued) How should Company A account for the $10 million sales based milestone payment? Solution Company A follows a practice of accruing the sales based milestone payment when it becomes probable that it will be paid. The obligation to make the milestone payment, while contingent on the company reaching a specified sales level, is considered to be established on the date the agreement to make the payment is entered into. Accordingly, at that date Company A concludes that it has a contractual contingent obligation, based on having received the intellectual property license rights, and accrues the additional amount when payment is no longer contingent. In this case, that occurred when it became probable that the payment will be made. After concluding that the sales based milestone should be accrued, Company A would then consider the economics of the arrangement to determine the expense recognition pattern. Because $25 million is the total consideration paid for the intellectual property rights, it would be appropriate to adjust the carrying value of the intellectual property rights on a cumulative catch-up basis as if the additional amount that is no longer contingent had been accrued from the outset of the arrangement when the obligation for that amount was established. Accordingly, Company A would immediately expense 20% (3 out of 15 years) of the $10 million sales based milestone and capitalize the remainder of the payment. At the end of the third year, Company A would have expensed an aggregate of $5 million, and $20 million remains capitalized on the balance sheet. Alternatively, if the economics of the arrangement were such that the payment appeared to be the equivalent of an additional royalty to be paid annually, it would be appropriate to expense the $10 million payment over the relevant annual period. This might be the case, for example, if there were similar sales based milestone targets in each year of the arrangement. As a general rule, a view to amortize the $10 million payment prospectively over the remaining term (twelve years in this example) would only potentially be supportable if the payment was in exchange for additional intellectual property rights under the arrangement. PwC 55 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 45.Accounting for the cost of free samples Background Relevant guidance Company A is eager to increase knowledge of its new generic pain medication within hospitals. Accordingly, Company A’s sales force distributes free samples of the pain medication during sales calls and at certain hospital conventions. If the consideration consists of a free product or service… or anything other than cash… or equity instruments…, the cost of the consideration should be characterized as an expense (as opposed to a reduction of revenue) when recognized in the vendor’s income statement. That is, the free item is a deliverable in the exchange transaction and not a refund or rebate of a portion of the amount charged to the customer [ASC 605–50–45–3]. How should Company A classify and account for the costs of free product distributed in order to promote sales? Solution The cost of product distributed for free and not associated with any specific sale transaction should be classified as an expense according to the Company’s policy, which would generally be either marketing expense or cost of sales. Company A should account for the sample product to be given away at conventions and during sales calls as an expense in accordance with its policy, which would generally be either when the product is packaged as sample product or upon distribution of the sample. 56 PwC Healthcare Reform PwC 57 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 46.Accounting for the annual pharmaceutical manufacturers fee Background Relevant guidance The Patient Protection and Affordable Care Act, which was signed into law in the US in 2010, imposes an annual fee on pharmaceutical companies that manufacture or import branded prescription drugs for each calendar year beginning on or after January 1, 2011. The determination of an entity’s relative portion of the fee is based on the entity’s branded prescription drug sales for the preceding year as a percentage of the industry’s branded prescription drug sales for the same year. Company A, a pharmaceutical manufacturer that sells branded prescription drugs to the US government, calculates its annual fee for the year ending December 31, 20X3 to be $4 million. This Subtopic provides guidance on the annual fee paid by pharmaceutical manufacturers to the U.S. Treasury in accordance with the Patient Protection and Affordable Care Act… [ASC 720-50-05-1]. How should Company A record the $4 million in its financial statements? Solution Company A would record a $4 million liability, and a corresponding deferred cost, once it sells a branded prescription drug to the US government in 20X3, which thereby obligates it to pay the annual fee. The deferred cost would typically be amortized to the income statement as an operating expense over the calendar year that it is payable (e.g., over the course of 20X3 for the 20X3 fee) using a straight-line method. 58 PwC Healthcare Reform 47.Accounting for the Medicare coverage gap Background Relevant guidance The Patient Protection and Affordable Care Act, which was signed into law in the US in 2010, requires pharmaceutical manufacturers to fund 50% of the Medicare coverage gap, starting on January 1, 2011. Pharmaceutical manufacturers are required to provide discounted products to applicable Medicare beneficiaries receiving covered Part D drugs while in the Medicare coverage gap. The existing guidance on contingent sales incentives in ASC 605–50, Customer Payments and Incentives, is the most analogous guidance with respect to the Medicare coverage gap. What accounting models can Company A, a pharmaceutical manufacturer, utilize to account for sales made that are affected by the Medicare coverage gap? Solution There are two models that Company A can utilize to account for the Medicare coverage gap: (i) the spreading model or (ii) the point of sale model. The model chosen by Company A represents an accounting policy election that should be consistently applied. Spreading Model Under the spreading model, the estimated impact of the coverage gap rebate expected to be incurred for the annual period is recognized ratably using an effective rebate percentage for all sales to Medicare patients throughout the year. If Company A elects to use the spreading model, appropriate estimates of both the impact of the Medicare coverage gap rebate and its total expected applicable sales will need to be made as both amounts are needed to compute the effective rebate percentage. Point of Sale Model Under the point of sale model, the revenue reduction is recognized at the time the specific sales of drugs into the channel occur that are expected to ultimately be resold to Medicare patients who are in the coverage gap. If Company A elects to use the point of sale model, it will need to estimate when the specific sales to Medicare patients who are in the coverage gap will occur, and consider both its pharmaceutical products, as well as other pharmaceutical products that its typical end consumer may be acquiring to determine the specific timing of when the end consumer is likely to enter into the coverage gap. PwC 59 Revenue recognition— Multiple element arrangements 60 PwC Revenue recognition—Multiple element arrangements 48.Multiple element arrangements—Assessing standalone value Background Relevant guidance Company A, a biotechnology company, enters into an arrangement with Company B, a pharmaceutical company. Company A provides Company B with a license to its intellectual property. Company B agrees to perform research services and will participate on a joint steering committee. Company B pays Company A an upfront payment at the inception of the arrangement when the license is delivered to Company B. Company A delivered the license to Company B in the first quarter. In an arrangement with multiple deliverables, the delivered item or items shall be considered a separate unit of accounting if both of the following criteria are met: • The delivered item or items have value to the customer on a standalone basis. The item or items have value on a standalone basis if they are sold separately by any vendor or the customer could resell the delivered item(s) on a standalone basis. In the context of a customer’s ability to resell the delivered item(s), this criterion does not require the existence of an observable market for the deliverable(s)… • If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item or items is considered probable and substantially in the control of the vendor [ASC 605–25–25–5]. PwC 61 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 48. Multiple element arrangements—Assessing standalone value (continued) What factors should Company A consider when assessing whether a delivered item has standalone value? Solution Company A should assess the following in determining whether a delivered item has standalone value: • Whether similar deliverables are sold separately by any vendor • Whether a customer could resell the deliverables (e.g., considering legal restrictions that preclude resale) • Whether a hypothetical customer would use the deliverable for its intended or another productive purpose (a deliverable that could only be sold for scrap value would not be considered to have standalone value). When a customer can resell a deliverable or sublicense its rights to the deliverable for a reasonable amount of consideration, the assessment that the delivered item has standalone value is driven by the fact that the customer or a third party could derive economic benefit from the delivered item. When there is not a secondary market, companies will have to use judgment to determine whether it could resell the delivered item for reasonable consideration on a standalone basis. The assessment should consider whether the company could recover a significant portion of its original purchase price in a hypothetical sale (rather than only for salvage or scrap value). If it could resell or sublicense the deliverable for reasonable consideration, it would be appropriate to conclude that there is standalone value for the delivered item. Another factor that impacts if a delivered item has standalone value is whether the research services are required to be performed by the vendor or if they could be performed by a third party. If the vendor must perform the research services because it has proprietary know-how or specialized expertise that another vendor is not able to provide, the delivered item might not have standalone value. If the research services do not require any specialized expertise, and could be performed by a third party, this might indicate that the delivered item has standalone value separate from the research services. Whether a delivered item has standalone value could also be impacted by contractual rights that prohibit a company from transferring the delivered item. Such legal restrictions are common in the pharmaceutical and life sciences industries. Companies need to consider all relevant facts and circumstances when there is a legal restriction before concluding whether a delivered item has standalone value. If a customer could exploit the delivered item through its own use or development, it may be appropriate to conclude the item has standalone value, regardless of whether a transfer restriction exists. In instances where additional services can only be obtained from the vendor in order for the customer to exploit the delivered item, this is an indicator that standalone value may not exist. 62 PwC Revenue recognition—Multiple element arrangements 49.Multiple element arrangements—Determining best estimate of selling price Background Relevant guidance Company A enters into an arrangement that includes a license, research services, and a participatory joint steering committee. Each of these deliverables is a separate unit of account. Vendorspecific objective evidence or third-party evidence of the standalone selling prices of these items does not exist. Arrangement consideration shall be allocated at the inception of the arrangement to all deliverables on the basis of their relative selling price (the relative selling price method)… When applying the relative selling price method, the selling price for each deliverable shall be determined using vendor-specific objective evidence of selling price, if it exists; otherwise, third-party evidence of selling price… If neither vendor-specific objective evidence nor third-party evidence of selling price exists for a deliverable, the vendor shall use its best estimate of the selling price for that deliverable… when applying the relative selling price method [ASC 605-25-30-2]. How would Company A determine its best estimate of selling price for the license, research services, and a participatory joint steering committee? Solution License The appropriate model for estimating the selling price will depend on the nature of and specific rights associated with the license. Historically, models have been used with respect to valuation for tax or business combination purposes that might be useful in making this estimate. For example: Income approach Examples of the income approach include the discounted cash flow method and the transfer pricing or profit split method. Key areas of judgment in this approach may include: cash flow projections, risk adjustment for stage of development, discount rate selection, and level of expected returns. Cost approach In applying a cost approach, companies should consider costs incurred to date in developing the intellectual property and an amount that constitutes a reasonable profit margin or return on investment. Key areas of judgment in this approach may include identifying relevant direct or indirect costs and determining the appropriate return rate. Because the income approach relies heavily on cash flow projections, it may be more relevant in instances where a license is already in use or is expected to be exploited within a relatively short timeframe. Alternatively, the cost approach may be more relevant to licenses in the early stage of their life cycle, where reliable forecasts of revenue or cash flows may not exist. PwC 63 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 49. Multiple element arrangements—Determining best estimate of selling price (continued) Solution (continued) Research services Many companies may consider the amount of effort necessary to perform research services as the most appropriate unit of measurement. This might include cost rates for full time equivalent (FTE) employees and the expected amount of resources to be committed. Key areas of judgment regarding pricing may include: selection of FTE rates for different levels of commitment or experience, inclusion of appropriate levels of profit margin, and comparisons to similar services offered in the marketplace. Key areas of judgment regarding quantity may include: estimated total number of FTE hours, potential contractual requirements and the estimated period over which the development process will occur. Joint steering committee Steering committees, as well as certain upgrade rights, were not historically valued by many companies due to the fair value requirement of the prior accounting guidance, thus, the inclusion of these deliverables in an arrangement often resulted in either full deferral or ratable revenue recognition. Companies may find valuing these items particularly challenging as it may be difficult to determine the expected level of hours to be incurred and rates to be used. Depending on the nature of the services, some companies may determine that steering committee efforts include time related to meeting preparation, attending the steering committee meetings, and working on any follow-up matters that result from the meetings. In addition, examples (not all inclusive) of information that might be considered when establishing rates may include an evaluation of compensation paid to individuals of similar experience or fees paid to consultants on an advisory board. These assessments will need to consider the specific facts and circumstances in each arrangement. 64 PwC Revenue recognition—Multiple element arrangements 50.Multiple element arrangements—Substantive options Background Relevant guidance Company A enters into an arrangement to provide Company B with a license to use its intellectual property for a single indication. Company A also provides Company B with an option during the term of the arrangement to purchase additional indications if the intellectual property is effective for any other indications. The option has not been offered at a significant incremental discount. A vendor shall evaluate all deliverables in an arrangement to determine whether they are separate units of accounting. That evaluation shall be performed at the inception of the arrangement and as each item in the arrangement is delivered [ASC 605-25-25-4]. How should Company A evaluate the option it provided to Company B? Solution Notional options for a customer to purchase additional products or services at agreed-upon prices in the future should be treated as deliverables if the option is not substantive and the customer is essentially obligated to purchase the optional items. When determining whether an option is substantive, a company should evaluate if the exercise of that option represents a separate buying decision. Even when an option is substantive, a company needs to evaluate whether that option has been offered at a significant incremental discount. When it is, the “in-the-money option” would be considered a separate deliverable requiring a portion of the arrangement consideration to be deferred at inception. For example, an option to buy unrelated additional products or services at a price equal to fair value may be a separate buying decision and, if so, would not be a deliverable in the original arrangement. However, if the additional products or services are essential to the functionality of another deliverable in the arrangement, and no other vendor could provide the necessary products or services, the customer would effectively be required to exercise the option and, therefore, it would not be considered a substantive option. In such a case, the products or services to be delivered upon the exercise of that option would be accounted for as a deliverable in the original arrangement. Customer B appears to have sole discretion when, or if, to exercise the option. In addition, the option is not being offered at a “significant incremental discount,” nor is the option essential to the functionality of the current deliverable. The decision to exercise the option is therefore a separate economic purchasing decision by Company B and the option would not be a deliverable in the original arrangement. PwC 65 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 51.Accounting for a multiple element arrangement—Scenario 1 Background Relevant guidance 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 services to Company B to develop the potential drug. The research and development services provided by Company A could be provided by another company. As a result, there are two deliverables in this arrangement: a license and research and development services. Arrangement consideration shall be allocated at the inception of the arrangement to all deliverables on the basis of their relative selling price (the relative selling price method)… [ASC 605-25-25-4]. Company A receives an upfront payment of $20 million at the inception of the arrangement and is eligible to receive milestone payments of $10 million at the commencement of the Phase III clinical trial and $25 million upon regulatory approval. What consideration should be included in the initial relative selling price allocation? Solution In making this assessment, Company A needs to consider which payments are fixed or determinable at the inception of the arrangement. It is common for arrangements in the pharmaceutical and life sciences industries to include contingent consideration such as milestone payments. These and other similar types of additional arrangement consideration need to be carefully assessed before being included in the arrangement consideration at the inception of an arrangement. In this case, Company A concludes that there are two deliverables in the arrangement: a license and research and development services. Further, Company A views all consideration aside from the upfront payment to be contingent at the inception of the arrangement, such that only the upfront fee is fixed or determinable at the inception of the arrangement. Based on the estimated selling price for the two deliverables, the following represents the initial relative selling price allocation (in millions): Estimated Selling Price Relative Selling Price Allocation License $30 $20 x 75% ($30/$40) = $15 Research and development services $10 $20 x 25% ($10/$40) = $5 $40 $20 Company A determined that the license has stand alone value because the research services could be completed by other vendors. As the license has standalone value, Company A recognizes $15 million upon delivery of the license and will recognize revenue for the research and development services as the services are performed. As Company A achieves the subsequent milestones, it would allocate them to both the delivered and nondelivered items within the arrangement given the Company has not made the election to apply the milestone method of revenue recognition. 66 PwC Revenue recognition—Multiple element arrangements 52.Accounting for a multiple element arrangement—Scenario 2 Background Relevant guidance Company A, a biotechnology company, enters into a license arrangement with Company B, a pharmaceutical company, to develop the technology for a possible drug indication for a term of 15 years. In exchange for an upfront, non-refundable payment of $50 million from Company B and future royalty payments if and when the drug is sold, Company A agrees to: Where there are multiple elements within an arrangement, a determination of the units of accounting needs to be made in accordance with ASC 605–25, Revenue Recognition—Multiple Element Arrangements. • Grant a license to Company A’s proprietary intellectual property to Company B, which gives Company B the right to develop the drug indication, manufacture the drug, and market and distribute the drug. The intellectual property cannot be sublicensed by Company B. • Perform research and development services for Company B. • Manufacture the active pharmaceutical ingredient of the drug during the clinical trials for Company B during the term of the arrangement. (Company B is capable of manufacturing the active pharmaceutical ingredient itself.) How should Company A separate the various deliverables into multiple units of account? In an arrangement with multiple deliverables, the delivered item or items shall be considered a separate unit of accounting if both of the following criteria are met: • The delivered item or items have value to the customer on a standalone basis. The item or items have value on a standalone basis if they are sold separately by any vendor or the customer could resell the delivered item(s) on a standalone basis. In the context of a customer’s ability to resell the delivered item(s), this criterion does not require the existence of an observable market for the deliverable(s)… • If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item or items is considered probable and substantially in the control of the vendor [ASC 605-25-25-5]. A vendor shall evaluate all deliverables in an arrangement to determine whether they represent separate units of accounting. This evaluation shall be performed at the inception of the arrangement and as each item in the arrangement is delivered [ASC 605-25-25-4]. Solution The license to Company A’s intellectual property would be the first delivered element. Company A will evaluate whether the license to the intellectual property has standalone value. Typically a license is not sold separately (i.e., without any other elements). Some arrangements allow the customer to sublicense, or resell the rights, which is an indicator that the license has standalone value. However, a careful read of the contract is necessary to determine whether the right to sublicense is substantive and not a limited right. If the customer is prohibited from reselling or sublicensing its right to the license, or if the right to sublicense is limited, it may indicate that the license does not have standalone value. This arrangement also includes ongoing research and development activities. When the customer is contractually required to use the seller for ongoing research and development or other services, a license will have standalone value only if the customer would (hypothetically) be able to reap the benefits from the license without further involvement from the seller. If only the seller has the requisite technical capabilities to perform the services, that would suggest the license does not have standalone value. PwC 67 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 52. Accounting for a multiple element arrangement—Scenario 2 (continued) Solution (continued) In assessing whether the customer could develop the technology without the seller’s involvement, the experience and capabilities of the customer and the stage of development of the technology should be considered. A license to technology can mean many things, and understanding the rights associated with the license is key to the analysis. Is the customer purchasing all rights associated with the technology, including rights to develop, manufacture, and commercialize the license? Or is the customer obtaining only limited rights? Do these rights revert to the vendor under any circumstances? It is important to have an accurate understanding of these factors in order to properly evaluate if the license has standalone value. In this fact pattern, Company A concludes the license to the intellectual property does not have standalone value apart from the research and development services because of its unique know-how with respect to the services and the inability of the counterparty to sublicense the intellectual property. However, the combined license to the intellectual property and research and development services collectively has standalone value from the manufacturing services because Company B has the right to manufacture the drug or outsource it to another manufacturer. The arrangement would be treated as having two separate units of accounting, one being the combined license to the intellectual property and research and development services, and the other being the manufacturing services. The total arrangement consideration would be allocated to each separate unit of accounting using the relative selling price method. The revenue recognition pattern for each unit of accounting would need to reflect the earnings process of all the deliverables in each unit of accounting. 68 PwC Revenue recognition—Milestone method PwC 69 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 53.Milestone method of revenue recognition Background Relevant guidance Company A has entered into an arrangement with Company B whereby Company A has agreed to provide to Company B a license to its intellectual property and perform future research and development. In return, Company B has paid Company A an upfront payment of $10 million and may pay Company A additional amounts in the aggregate of up to $100 million, dependent upon the successful achievement of specified milestones, as follows: The guidance in this Subtopic shall be met in order for a vendor to recognize… consideration that is contingent upon the achievement of a substantive milestone in its entirety [as revenue] in the period in which the milestone is achieved [ASC 605–28–25–1]. • $25 million upon commencement of Phase II clinical trials If the consideration from an individual milestone is not considered to relate solely to past performance, the vendor is not precluded from using the milestone method for other milestones in the arrangement [ASC 605–28–25–3]. • $25 million upon first patient enrollment in Phase III clinical trials • $50 million upon regulatory approval Company A has concluded that the license is not separable from the research and development activities. Company A has made the policy election to apply the milestone method of revenue recognition. How should Company A account for the contingent milestone consideration under the arrangement? Solution The proper timing of revenue recognition depends on whether the milestones in the arrangement are substantive. This determination should be made at the inception of the arrangement. To be substantive, the consideration must (a) be commensurate with either (i) the vendor’s performance to achieve the milestone or (ii) the enhancement of the value of the delivered item or items as a result of a specific outcome resulting from the vendor’s performance to achieve the milestone; (b) relate solely to past performance; and (c) be reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement [ASC 605-28-25-2]. Each milestone must be analyzed separately to determine whether it meets the criteria to be considered substantive. If Company A decides the milestones are substantive, such milestones would be recognized as revenue in full in the period in which the milestones were achieved. If a milestone payment is not substantive, that milestone payment may be treated as additional arrangement consideration. If the multiple element arrangement is treated as a single unit of accounting, the non-substantive milestone will be allocated to the single unit of accounting. If, however, the multiple element arrangement meets the criteria for separating deliverables and deliverables are accounted for as separate units of accounting, the non-substantive milestone will be allocated to all deliverables using the relative selling price method. 70 PwC Revenue recognition—Milestone method 54.Milestone method of revenue recognition—Sales based milestones Background Relevant guidance Company A has made the accounting policy election to apply the milestone method of revenue recognition to any substantive milestones that are achieved. In the current year, Company A entered into an arrangement with Company B whereby Company A has agreed to provide to Company B a license to use its intellectual property. In return, Company B has paid Company A an upfront fee of $10 million and will pay Company A an additional $20 million if Company B’s annual sales exceed $250 million. The guidance in this Subtopic shall be met in order for vendor to recognize… consideration that is contingent upon the achievement of a substantive milestone in its entirety [as revenue] in the period in which the milestone is achieved [ASC 605–28–25–1]. If the consideration from an individual milestone is not considered to relate solely to past performance, a vendor is not precluded from using the milestone method for other milestones in the arrangement [ASC 605–28–25–3]. How should Company A account for the contingent milestone consideration of $20 million? Solution The $20 million milestone represents a sales based milestone that is similar to a royalty. Sales based milestones generally do not fall within the scope of ASC 605–28 since the achievement of the targeted sales levels is not based in whole or in part on the vendor’s performance and is not a research or development deliverable. In most situations, all contingencies associated with sales based milestones have been resolved upon receipt of the sales based milestone and no remaining performance obligations exist relating to the payment. As a result, sales based milestones could be recognized in revenue when earned. However, if the vendor has remaining obligations to the customer at the time the sales based milestone is achieved, the consideration received from the sales based milestone may need to be combined with any other arrangement consideration and allocated to the deliverables in the arrangement. In this example, Company A has no remaining obligations after the initial license is provided to Company B. As a result, when the sales based milestone is achieved, Company A would recognize the full amount of the sales based milestone in revenue. PwC 71 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 55.Recording a milestone payment due to a counterparty Background Relevant guidance Company A entered into an arrangement with Company B. Company A paid Company B an upfront fee upon signing the arrangement and will pay Company B a milestone payment of $2 million upon Food and Drug Administration (“FDA”) approval. An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: Company A follows a practice of accruing contingent payments when they become probable of being paid. Their accounting is supported by the loss contingency guidance and is also consistent with the guidance on contingent rentals. • 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 the loss can be reasonably estimated [ASC 450-20-25]. A lessee shall recognize contingent rental expense… before the achievement of the specified target that triggers the contingent rental expense, provided that achievement of that target is considered probable [ASC 840-10-25]. When should Company A record the milestone payment due to Company B? Solution The milestone payment is due under the contractual terms of the agreement based upon the resolution of a contingency. Under Company A’s practice, it accrues the milestone payment when the achievement of the milestone is probable. Once Company A concludes that the milestone payment due to Company B is probable of occurring, the amount of the payment ($2 million) would be recorded in the financial statements. Due to the uncertainties associated with the FDA approval process, it may be difficult for Company A to conclude that achievement of this particular milestone is probable prior to the occurrence of the event that triggers the milestone (e.g., FDA approval). All facts and circumstances regarding the nature of the milestone should be considered when evaluating when the achievement of a milestone is probable. 72 PwC Revenue recognition—General PwC 73 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 56.Revenue recognition for a newly launched product Background Relevant guidance Company A, a calendar year-end company, received approval from the Food and Drug Administration (“FDA”) for Product X, a treatment for hepatitis C, on October 15, 20X2. Commercial launch of the product occurred on December 1, 20X2. Company A distributes Product X through a wholesale distribution model to pharmacies, healthcare providers, and government agencies, among others. Company A has implemented a general return policy that allows customers to return product purchased directly from Company A during a period of six months prior to and up to 12 months after the product expiration date. If an entity sells its product but gives the buyer the right to return the product, revenue from the sales transaction shall be recognized at time of sale only if all of the following conditions are met: Company A maintains contractual agreements with all customers. The contractual terms of the agreements state that ownership transfers at the point of shipment and that Company A has no future performance obligations following shipment. Company A has analyzed the credit worthiness of its customers and concluded that there are no factors that give rise to uncertainty regarding collection of amounts due. Product X is the first product to be commercialized by Company A and, therefore, Company A has no actual returns history and no historical experience in estimating future returns. • The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. • The seller’s price to the buyer is substantially fixed or determinable at the date of sale. • The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product… • The buyer acquiring the product for resale has economic substance apart from that provided by the seller… • The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. • The amount of future returns can be reasonably estimated… [ASC 605–15–25–1]. Should Company A recognize revenue at the time of shipment? Solution The ability to recognize revenue in this case depends on Company A’s ability to estimate future returns. The lack of historical experience is a key data point in the determination, but it is not the only data point to be considered and therefore does not automatically preclude revenue recognition at the time of sale. Instead, Company A must evaluate all sources of available information, including internal data (e.g., product return policy, product shelf life, and estimates of inventory sold into the distribution channel) as well as external data (e.g., estimated wholesaler inventory levels, estimated market demand, history of returns of comparable products, etc.) to determine whether adequate information exists to develop a reasonable estimate of future returns. If Company A is unable to make a reasonable estimate of returns, it would be precluded from recognizing revenue until (i) the product is sold through to the end customer, (ii) the returns window lapses or (iii) adequate information becomes available. 74 PwC Revenue recognition—General 57.Pay-for-performance arrangements Background Relevant guidance Company A manufactures, markets, and sells Drug B to a hospital. The hospital administers Drug B to its patients. When Drug B is shipped to the hospital, the hospital is obligated to pay Company A under normal 30-day payment terms. However, if after a defined treatment period of three months, patients’ test results do not meet pre-determined objective criteria, the hospital is eligible for a full refund 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 would look to guidance on estimating returns in ASC 605–15–25, Sales of Product when Right of Return Exists, when concluding whether future refunds can be reasonable estimated. This evaluation would include whether there is a sufficient company specific historical basis upon which to estimate the refunds and whether the company believes that such historical experience is indicative of future results. Company A obtained Food and Drug Administration (“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 pre-determined criteria, and it has consistently ranged from 6–7% on a monthly and annual basis. Based on the nature of this drug as well as the relatively consistent patient results over the past two years, Company A expects future refunds to be consistent with historical results. PwC 75 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 57. Pay-for-performance arrangements (continued) Can Company A record revenue at the time of the initial sale, with a reserve for the portion of sales that it expects will not meet the pre-determined criteria, or should it defer all revenue until the end of the refund period (i.e., until five months after the initial treatment)? Solution If Company A can demonstrate it has sufficient historical evidence to support its estimates, it may elect to record revenue at the time of sale along with a reserve for the portion of sales that will be refunded because they are not expected to meet the pre-determined criteria, assuming all other revenue recognition criteria are met. Notwithstanding the above, Company A could continue to defer recognition of the revenue until the contingency has lapsed. This is an accounting policy decision that should be consistently applied and disclosed. It should be noted that slight variations from the facts presented above may cause the model to change and preclude revenue recognition before resolution of the performance contingency. 76 PwC Revenue recognition—General 58.Revenue recognition to customers with a history of long delays in payment Background Relevant guidance Company A, a pharmaceutical company, sells to a governmental entity in a country in Europe. Company A has historically experienced long delays in payment for sales to this entity due to slow economic growth and high debt levels in the country. 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. In order to be able to recognize revenue, a company must conclude that it meets the four revenue recognition criteria in ASC 605, Revenue Recognition: • Persuasive evidence or an arrangement exists • Delivery has occurred or services have been rendered • The seller’s price to the buyer is fixed or determinable • Collectibility is reasonable assured The SEC’s Division of Corporation Finance guidance, issued in January 2012, regarding European sovereign debt holding disclosures. How should Company A account for the outstanding receivables and future sales to the governmental entity in this country in Europe? CF Disclosure Guidance Topic No. 4 provides the Division of Corporation Finance’s views regarding disclosure relating to registrant’s exposures to European countries. It was determined that SEC registrants’ disclosures have been inconsistent, and that investors would benefit from additional disclosure of total exposures to European countries. Solution It may be difficult in the current environment for Company A to determine whether its price to the governmental entity is fixed or determinable or if collectibility is reasonably assured. This is particularly the case when customers have stopped paying for sales on a timely basis or have demanded significant reductions in selling price as a condition to settle past invoices. Slow payment may not necessarily preclude revenue recognition; however, it may impact the amount of revenue that can be recognized because the receivable may need to be discounted at initial recognition. Revenue should not be recognized if collectibility is not reasonably assured, or the amount of discounts and allowances (either due to potential price adjustments or to discounting for the time value of money) cannot be reasonably estimated. If Company A determines that it meets the four revenue recognition criteria, it will then need to evaluate whether it can record revenue for the entire amount of the sale or for a discounted amount. If Company A did not expect to receive payment for a period greater than one year, it would need to discount current sales transactions (i.e., sales are recorded net of the discount) for this specific customer that has an established pattern of not paying amounts owed on a timely basis. The amount of the discount applied, which relates to the time value of money, is based on the estimated collection date and the customer’s borrowing rate. Company A should determine if additional financial statement disclosure is necessary surrounding concentration or risk. This may include: (i) volume of business transacted in a particular market or geographic area; (ii) impact on liquidity; and (iii) discussion of counterparty default risk. Company A should also consider qualitative factors in deciding whether its exposure to Europe sovereign government is material. PwC 77 Business combination 78 PwC Business combination 59.Asset Acquisition versus Business Combination Background Relevant guidance Company A owns the right to several drug compound candidates that are currently in Phase I. Company A’s activities consist of research and development that is being performed on the early stage drug compound candidates. Company A employs management and administrative personnel as well as scientists who are vital to performing the research and development. Company B acquires the rights to the drug compound candidates along with the scientists formerly employed by Company A who are developing the acquired Phase I drug compound candidates. ASC 805–10–20 indicates that a business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…. This definition of a business can result in a broad range of transactions qualifying as business acquisitions. Should Company B account for the transaction as a business combination or an asset acquisition? Businesses consist of assets/resources, and systems, standards, or protocols applied to those assets/resources, that have the ability to create economic benefits. Additionally, as noted in ASC 805–10–55–5, to be considered a business, not all of the inputs and associated processes used by the seller need to be transferred, as long as a market participant is capable of continuing to manage the acquired group to provide a return (e.g., the buyer would be able to integrate the acquired group with its own inputs and processes) or readily obtain those inputs and processes. Solution Company B should consider the stage of development of the drug compound candidates in determining whether a business has been acquired. In most cases, there are likely to be more processes associated with later stage drug compounds than those in earlier stages. However, a transaction involving the acquisition of drug compound candidates in early stage development can still be a business combination. Company B acquired the Phase I drug compounds, along with the scientists who are vital to performing the research and development. The scientists have the necessary skills and experience, and provide the necessary processes (through their skills and experience) that are capable of being applied to inputs to create outputs. While Company B did not acquire a manufacturing facility, testing and development equipment, or a sales force, it determined that the likely market participants are other large pharmaceutical companies that already have these items or could easily replicate them. These factors would likely lead Company B to account for this acquisition as a business combination. PwC 79 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 60.Accounting for acquired IPR&D Background Relevant guidance Company A is in the pharmaceutical industry and owns the rights to several product (drug compound) candidates. Its only activities consist of research and development performed on the product candidates. Company B, also in the pharmaceutical industry, acquires Company A, including the rights to all of Company A’s product candidates, testing and development equipment, and hires all of the scientists formerly employed by Company A, who are integral to developing the acquired product candidates. Company A also had a product candidate that received Food and Drug Administration (“FDA”) approval, but for which it had not yet started production at the time of acquisition by Company B. Company B accounts for this transaction as an acquisition of a business. Under ASC 805, acquired IPR&D continues to be measured at its acquisition date fair value but is accounted for initially as an indefinite-lived intangible asset (i.e., not subject to amortization). Post-acquisition, acquired IPR&D is subject to impairment testing until the completion or abandonment of the associated research and development efforts. If abandoned, the carrying value of the IPR&D asset is written off. Once the associated research and development efforts are completed, the carrying value of the acquired IPR&D is reclassified as a finite-lived asset and is amortized over its useful life. The requirement to recognize acquired IPR&D in an acquisition as an indefinite-lived intangible asset does not apply to incremental costs incurred on the IPR&D project after the acquisition date. These incremental costs continue to be expensed as incurred under ASC 730–10–25. How should Company B account for the acquired IPR&D? Solution Company B will measure the acquired IPR&D at its acquisition date fair value and record it as an indefinite-lived IPR&D intangible asset. Subsequent to the acquisition, the acquired IPR&D would be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. This impairment test would compare the fair value of the IPR&D asset to its carrying value. Incremental research and development costs subsequent to the acquisition would be expensed. With regard to Company A’s product candidate that received FDA approval, any such completed product development (i.e., no longer “in-process”) would be recognized as a finite-lived intangible asset at the date of acquisition, separate from the acquired IPR&D. The testing and developing equipment would be separately recognized as tangible assets, measured at fair value, and depreciated over their estimated useful lives. 80 PwC Business combination 61.Unit of account—IPR&D Background Relevant guidance Company A acquired Company B, which is accounted for as an acquisition of a business under ASC 805. At the acquisition date, Company B was pursuing completion of an IPR&D project that, if successful, would result in a drug for which Company A would seek regulatory approval in the US and Japan. This research and development project is in the latter stages of development but is not yet complete. The nature of the activities and costs necessary to successfully develop the drug and obtain regulatory approval for it in the two jurisdictions are not substantially the same. If approved, the respective patent lives are expected to be different as well. In addition, Company A intends to manage advertising and selling costs separately in both countries. Under ASC 805, because of the requirement to capitalize and test the acquired IPR&D asset for impairment, it is important to determine the appropriate unit of account. Determining the appropriate unit of accounting for valuing and recognizing acquired IPR&D can be complex when an approved drug may ultimately benefit various jurisdictions. One common approach is to record separate jurisdictional assets for a research and development activity that will benefit various jurisdictions, while another approach is to record a single global asset. When making the unit of account determination, companies may consider, among other things, the following factors: • Phase of development of the related IPR&D project(s) • Nature of the activities and costs necessary to further develop the related IPR&D project(s) • Risks associated with the further development of the related IPR&D project(s) • Amount and timing of benefits expected to be derived from the developed asset(s) • Expected economic life of the developed asset(s) • Whether there is an intent to manage advertising and selling costs for the developed asset(s) separately or on a combined basis What is the unit of account for the acquired IPR&D asset? • Once completed, whether the product would be transferred as a single asset or multiple assets Solution The acquired IPR&D project would likely be recorded as two separate “jurisdictional” IPR&D assets. While there may be other factors to consider, Company A’s assessment may lead it to believe that the development risks, the nature of the remaining activity and costs, the risk of not obtaining regulatory approval, and, as noted above, expected patent lives for the acquired IPR&D are not substantially the same in both countries. Finally, Company A intends to manage the drug separately, including separate advertising and selling costs in each country. PwC 81 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 62.Pre-existing relationships in a business combination Background Relevant guidance Company A in-licenses a Phase I compound from Company B in 20X5. With the in-license agreement, Company A acquires the global exclusive rights to develop and commercialize the asset, including rights to manufacture, market, and sell any successful product. The rights granted are for 25 years, the full protected life of the intellectual property. Company B retains the ownership (legal title) of the initial intellectual property. The acquirer and acquiree may have a relationship that existed before they contemplated the business combination, referred to here as a preexisting relationship. A preexisting relationship between the acquirer and acquiree may be contractual or non-contractual… [ASC 805-10-55-20]. The terms of the in-licensing agreement are that Company A pays $300 million upfront and, if commercialized, a 5% royalty on all sales. Company A is responsible for all development of the product and any incremental intellectual property completed by Company A is owned by Company A. The product has successfully moved to pre-Food and Drug Administration (“FDA”) approval (i.e., Phase III). Company A acquires Company B for $2 billion in 20X3, and the acquisition is accounted for as a business combination. There was no stated settlement provision provided for by the in-license agreement. Assume that the market rate to in-license the intellectual property is the same as above: $300 million of payments plus a 5% royalty. However, the market rate to in-license both initial intellectual property and the incremental intellectual property would be a 20% royalty (which is equivalent to the $2 billion in fair value of the company). The higher cost reflects the fact that a Phase III asset is more likely to generate positive cash flows compared to a Phase I asset. 82 PwC If the business combination in effect settles a pre-existing relationship, the acquirer recognizes a gain or loss, measured as follows: • For a pre-existing non-contractual relationship, such as a lawsuit, fair value • For a pre-existing contractual relationship, the lessor of the following: – T he amount by which the contract is favorable or unfavorable from the perspective of the acquirer when compared with pricing for current market transactions for the same or similar items… – T he amount of any stated settlement provision in the contract available to the counterparty to whom the contract is unfavorable… [ASC 805–10–55–21]. Business combination 62. Pre-existing relationships in a business combination (continued) How should the settlement of the in-licensing arrangement be accounted for by Company A upon acquisition of Company B? Solution As the terms at the date of acquisition are assumed to be the same as in the original agreement ($300 million of payments plus a 5% royalty) if Company A were to license the IP retained by Company B, there is no settlement gain or loss to be recognized as a result of the acquisition. This view is consistent with the market value of “the same or similar items” being the market value of the intellectual property retained by Company B. The value of the intellectual property in total has increased due to the successful development efforts and clinical trials conducted by Company A in moving the compound from Phase I to Phase III. These incremental developments, including the efforts expended and funded to move from Phase I and enter into Phase III are already owned by Company A. As such, the gain or loss from settlement of the pre-existing licensing relationship should be based solely on the value of the same or similar intellectual property asset that was originally licensed to Company A by Company B. Determination of the gain or loss should not include the value developed between the date Company A in-licensed the compound and the date Company A acquired Company B because this value is already owned by Company A. In this fact pattern, the 15% increase in royalty rate (20% for the Phase III asset compared to 5% for the Phase I asset) relates to the value attributable to the research and development and regulatory developments undertaken, owned and funded by Company A, and would not be included in the measurement of the settlement gain or loss. If the fair market terms of an in-license for the intellectual property owned by Company B, exclusive of the value of the asset owned by Company A, had changed such that the terms of the original in-license arrangement were favorable or unfavorable at the time of the business combination, the favorable or unfavorable value would be recorded by Company A as a settlement of the pre-existing relationship (gain or loss). PwC 83 US GAAP—Issues and Solutions for the Pharmaceuticals and Life Sciences Industries 63.Useful economic lives of intangibles Background Relevant guidance As part of a business combination, Company A has acquired a license to manufacture and sell a newly approved pharmaceutical drug. As part of the acquisition, Company A will record an intangible asset for the acquired license. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity [ASC 350–30–35–2]. What factors should Company A consider in its assessment of the useful life of the intangible asset? An entity shall evaluate the remaining useful life of an intangible asset that is being amortized each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization. If the estimate of an intangible asset’s remaining useful life is changed, the remaining carrying amount of the intangible asset shall be amortized prospectively over that revised remaining useful life [ASC 350–30–35–9]. Solution When determining the useful life of an intangible asset, Company A should consider the factors included in ASC 350–30–35–3. Some of these factors include: the expected use of the asset, historical experience with similar arrangements, and the expected future cash from the asset. In addition to these factors, pharmaceutical and life sciences companies should consider industry-specific factors, such as the following: • Duration of the patent right or license of the product; • Redundancy of a similar medication/device due to changes in market preferences; • Unfavorable court decisions on claims related to product liability or patent ownership; • Regulatory decisions over patent rights or licenses; • Development of new drugs treating the same disease; • Changes in the environment that make the product ineffective (e.g., a mutation in the virus that is causing a disease, which renders it stronger); • Changes or anticipated changes in participation rates or reimbursement policies of insurance companies; and • Changes in government reimbursement or policies (e.g., Medicare, Medicaid) for drugs and other medical products. 84 PwC Acknowledgements This publication would not be possible without the contribution of the partners and staff of PwC’s Pharmaceutical and Life Sciences industry team, including: • Kevin Burney Partner Boston • Brett Cohen Partner Florham Park • James Connolly Partner Boston • Gerry Flynn Partner Florham Park • John Hayes Partner Florham Park • Jeffrey Hemman Partner Boston • Denis Naughter Partner Florham Park • Mark Barsanti Senior Manager Boston • John Charters Senior Manager Boston • Christopher Kean Senior Manager London • Sonia Luaces Senior Manager Florham Park • Chris Mutter Senior Manager Florham Park • Kristine Pappa Senior Manager Amsterdam • Lindsey Piziali Senior Manager San Jose • Frank Raciti Senior Manager Philadelphia • Lambert Shiu Senior Manager San Jose • Dusty Stallings Partner Florham Park PwC 85 Contacts To have a deeper conversation about how this subject may affect your business, please contact: Karen C. Young Partner, US Pharmaceutical and Life Sciences Assurance Leader Florham Park, NJ 973 236 5648 [email protected] Adrian Beamish Partner, Pharmaceutical and Life Sciences Assurance San Jose, CA 408 817 5085 [email protected] Jim Connolly Partner, Pharmaceutical and Life Sciences Assurance Boston, MA 617 530 6213 [email protected] John Hayes Partner, Pharmaceutical and Life Sciences Assurance Florham Park, NJ 973 236 4452 [email protected] Denis Naughter Partner, Pharmaceutical and Life Sciences Assurance Florham Park, NJ 973 236 5030 [email protected] 86 PwC About PricewaterhouseCoopers PricewaterhouseCoopers’ Pharmaceutical and Life Sciences Industry Group (http://www.pwc.com/us/pharma) is dedicated to delivering effective solutions to complex strategic, operational and financial challenges facing pharmaceutical and life sciences companies. We provide industry-focused assurance, tax, and advisory services to build public trust and enhance value for our clients and their stakeholders. More than 180,000 people in 158 countries across our network of firms share their thinking, experience, and solutions to develop fresh perspectives and practical advice. http://www.pwc.com/us/pharma © 2013 PwC. All rights reserved. “PwC” and “PwC US” refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. NY-14-0286