Understanding the New Accounting for Revenue Recognition: Life Sciences Industry
This is a converged standard with the International Accounting Standards Board (“IASB”), with only minor differences between the two. This far-reaching standard establishes a uniform revenue recognition model for substantially all industries. However, the extent of the industry-by-industry impact will vary dramatically. To assist you in assessing ASU 2014-09, WS+B has prepared the following frequently asked questions and answers for the life sciences industry.
When is ASU 2014-09 effective?
Nonpublic entities are required to apply the new standard for annual reporting periods beginning on or after December 15, 2017, and interim reporting periods within annual reporting periods beginning after December 15, 2018.
Public entities are required to apply these standards in reporting periods beginning after December 15, 2016, and interim and annual reporting periods thereafter.
Stay tuned – the FASB is currently researching delaying implementation and plans to discuss it in Q2, 2015. As of now, the transition dates have not changed.
What are the basic ideas?
ASU 2014-09 establishes the following core principle: recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This replaces the current focus on recognizing revenue when risks and rewards are transferred, with an emphasis on when a change in control occurs.
To apply that core principle, an entity should follow these steps:
| Step 1 | Identify the contract with a customer. |
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- A ‘contract’ does not mean a legal document; it is essentially an agreement between you and your customer that creates enforceable rights and obligations.
| Step 2 | Identify the performance obligations in the contract. |
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- The contract may contain more than one distinct good or service.
| Step 3 | Determine the transaction price. |
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- Variable elements will require up-front estimation and careful consideration.
| Step 4 | Allocate the transaction price to the performance obligations in the contract. |
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- Allocate using the relative ‘standalone selling price’ of each good or service, or an estimate if that is not available.
| Step 5 | Recognize revenue when or as the entity satisfies a performance obligation. |
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- This may occur at a point in time, or over a period of time.
While none of the above sounds radically different from how we account for revenue now, applying the steps in certain industries may be challenging and produce different outcomes than current practices.
All entities will be subject to further disclosure requirements. However, the extent of additional disclosures will vary according to how each industry, and entity, applies ASU 2014-09, and in particular, management’s judgments. Therefore, life science companies will likely see additional disclosures over the new minimum, especially concerning licenses, variable consideration, deferred revenue, and remaining performance obligations.
ASU No. 2014-09 will l replace almost all existing revenue recognition guidance.
How will ASU 2014-09 affect the Life Sciences industry?
Based upon currently available information, we believe the impact on the life science industry could be significant. The following are brief highlights of important, high-level differences that merit consideration. Generally, under ASU 2014-09, life science companies may allocate revenue to more performance obligations, and possibly recognize revenue earlier, than under existing guidance.
Collaborative arrangements
Life science companies frequently enter into collaborative arrangements. These mutually beneficial agreements do not fit the traditional vendor-customer roles. For example, two pharmaceutical companies may contract to collaborate in a defined research and development effort. Present GAAP places collaborative arrangements outside of current revenue guidance, and emphasizes income statement presentation matters. However, do not automatically assume that such arrangements will be similarly scoped out of ASU 2014-09. The principles embedded in ASU 2014-09, particularly regarding vendor-customer relationships, will likely require careful analysis (falling under Step 1). Significant judgment may be required to evaluate whether the collaboration’s terms scope it in, or out, of the new revenue standard. This may be a substantial change for some life science companies. If a collaboration is scoped out of ASU 2014-09, its related income is not considered revenue. The entity will have to determine where to present the collaboration income in its income statement, perhaps as other income or a reduction to related R & D expenses.
Licensing
ASU 2014-09 contains potentially game-changing guidance for licenses of intellectual property (IP), which are often bundled with other goods and services.
An entity should first determine if the IP license is a separate, or ‘distinct’, performance obligation (Step 2). This determination must consider both explicit and implicit promises to deliver other goods or services. ASU 2014-09 provides criteria and discussion around the concept of ‘distinct’, including consideration of whether the customer can benefit from the item on its own. This is another area that will require significant judgment.
‘Distinct’ licenses are analyzed further to determine the timing of revenue recognition: either over the license period, or at the time of grant (Step 5). This analysis is heavily dependent upon whether the full form and functionality of the license is provided at the time of grant to the customer. If so, the license revenue is recognized all at once because the performance obligation is considered to be satisfied. This is referred to as a ‘right to use’ license. Conversely, license revenue arising from a ‘right to access’ the underlying IP is recognized over the license period. Criteria and examples are provided in the ASU.
If the license is deemed to not be distinct from the other goods and services, then the revenue accounting is bundled as a single performance obligation. For example, the license may be integral to the functioning of the item sold, and is worthless without the tangible good.
ASU 2014-09 is a principles-based standard, and the above simplifies many important concepts. Accounting for licensing revenues will require a very careful evaluation of contractual terms. Its concepts do not transfer over as consistently to licensing as they do to other revenue streams. FASB is currently considering implementation issues and suggestions for future improvements in this area. Impacted life science entities should monitor the situation closely.
Variable revenues
Many revenue streams in the life sciences contain variable elements. Common examples are milestone payments, performance bonuses, or incentives. Current GAAP generally disallows revenue recognition if it is contingent upon a future event. The new standard requires variable consideration to be estimated as part of the transaction price (Step 3) as long as it is probable that a significant revenue reversal will not occur (this is referred to as a constraint). ASU 2014-09 provides guidance on how to estimate this. Further, any estimated variable consideration not subject to the constraint will then be evaluated for when to recognize it as revenue (Step 5). Generally, the revenue will be recognized as the related performance obligation is satisfied, subject to the constraint. Given the swing from a risks and rewards approach to an emphasis on change in control, it is possible that life science entities may recognize certain variable revenue streams sooner than they are today.
Accounting for other common areas of variable consideration such as rights of return, chargebacks, rebates and other price concessions, are not expected to be significantly different under ASU 2014-09.
What should we be doing?
Life science companies are concerned about how much internal effort, external help and time they need to address implementation questions. Therefore, we recommend the following:
- Develop a broad understanding of ASU 2014-09
- Perform a deeper dive. Identify and evaluate those aspects of ASU 2014-09 that will be different for your business along department lines: accounting, finance, technology, legal, tax, financial covenants, or internal controls. Specifically, select a few representative customer contracts or arrangements, and plug them into the new revenue recognition model to identify areas for a deeper analysis.
- Monitor industry-specific transition resources.
- Select a transition method, and plan for how you will retrospectively adopt ASU 2014-09
- Establish an implementation plan, including a timeline, educational sessions, and third-party resources needed.
- Educate financial statement users and stakeholders about the changes ASU 2014-09 will bring to your financial statements.
What resources are available to help us?
At Withum, we are experts at assessing the impact of compliance with accounting changes. Look for our future thought leadership on ASU 2014-09. We would be pleased to discuss with you how ASU 2014-09 and other current developments would affect your business and financial reporting.
A broad discussion of ASU 2014-09 can be found at:
A resource for understanding and implementing the new revenue recognition guidance:
AICPA Resource Page: Revenue from Contracts with Customers
The text of the new standard may be accessed as follows:
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The information contained herein is not necessarily all-inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriately qualified professionals.
