How Business Combinations Impact Accounting in Life Sciences

April 2017

By Jeffrey Keene and Liza Prossnitz

The development of medical breakthroughs in the life sciences industry requires an incredible amount of talent and dedication, as well as the capital to fund the necessary studies to achieve regulatory approval.

Over the years, the industry has evolved into a dichotomy dominated by large, well-capitalized companies with blockbuster therapies that enjoy lengthened market exclusivity, as well as start-ups comprised of scientists and researchers working on the next big development.

The well-capitalized companies are always on the search to broaden and deepen their development pipelines, while the start-ups are often searching for the funding necessary to advance their therapies.  These complementary needs often result in a collaboration agreement between the two parties, under which the well-capitalized company (the licensor) agrees to pay funds upfront to receive a license to a compound in development (the licensee). Under this agreement, the licensor agrees to fund milestones based on regulatory successes and royalties upon commercialization to the licensor. Other factors that may be part of these agreements include an acquisition of shares in the licensor, contribution to future development costs and a supply agreement between the two parties.  

Under existing accounting rules, the licensee needs to evaluate if the license represents a business.  A business is the acquisition of a set of activities that represents inputs and processes which are capable of producing outputs (sales or profits) under existing accounting rules. When conducting an evaluation, the licensee should consider what has been acquired, including the Intellectual Property (IP) rights, the medical product or therapy’s stage of development, regulatory applications and filings, and arranged and approved manufacturing facilities. These items are evaluated to determine whether they represent inputs and processes. In addition, the licensee must consider what other inputs and processes were not acquired but are necessary to achieve outputs—and whether they are readily available or whether a market participant (oftentimes the typical acquirer) would have these inputs or processes. A key element typically not included in the arrangement is a sales force, which accounts for why there are many outsourced commercial sales organizations in the industry.

Under these rules, many licenses—especially those for therapies in late-stage trials—are categorized as businesses. This has resulted in challenging accounting consequences. If the collaboration agreement is deemed a business, the licensee then needs to fair value the assets acquired and liabilities assumed. The value attributed to the agreement would be the upfront payment, as well as the fair value of all the additional payments due under the agreement. This can be a challenging task, as the fair value estimate needs to also consider the external factors involved, including the probability of success, potential market size and presence of competitors that could render the therapy obsolete, among others.

In January 2017, the Financial Accounting Standards Board (FASB) released updates to the current accounting standards, the Accounting Standards Update 2017-01: Business Combinations (Topic 805) – Clarifying the Definition of a Business.  Much of this update was fueled by comments and feedback from life sciences companies that claimed that the current definition of a business in “Topic 805, Business Combinations,” is defined too broadly. As a result, many transactions that were more akin to asset acquisitions were being recorded as business acquisitions instead.

In response to this feedback, the update has made the definition of a business more stringent. The accounting update narrows the scope of a business to be a set of acquired assets and activities that includes inputs, processes and outputs.  If the set does not include outputs—for example, a license for a therapy that is not yet approved for commercialization—then it must include inputs and substantive processes to be a business. A substantive process is a process that is critical to developing outputs and requires an assembled workforce to develop. Contracted or outsourced development does not apply. In other words, if there are no outputs and no employees, then the transaction will not be considered a business, as the accounting update does not require the acquirer to consider what a market participant would have or could obtain.

The accounting update requires the consideration transferred in asset acquisitions, which is not a business acquisition, to be allocated to the principal assets acquired. Contingent consideration is not fair valued, but only recorded when probable. In addition, transaction costs are capitalized to the asset acquired—whereas in a business combination, they are expensed as incurred.

The update becomes effective for fiscal years beginning after Dec. 15, 2017 for public business entities and for fiscal years beginning after Dec. 15, 2018 for all other entities. It is applied prospectively to future transactions and can be adopted early for transactions that have not been previously reported in financial statements.

Life sciences companies should familiarize themselves with the updated definitions now. We have seen many life sciences companies adopt the standard early to account for the acquisition of a license as the purchase of an asset.

Jeffrey Keene is an Assurance partner and a regional technical director for BDO’s northeast region. He can be reached at

Liza Prossnitz is a director in BDO’s National Securities and Exchange Commission (SEC) Department. She can be reached at

Read next article, "When it Comes to New Revenue Recognition Model, ASC 606, It’s Time to Play Ball!"

Return to BDO Life Sciences Letter - Spring 2017