When it Comes to New Revenue Recognition Model, ASC 606, It’s Time to Play Ball!
When it Comes to New Revenue Recognition Model, ASC 606, It’s Time to Play Ball!
As winter changes to spring, two things happen: 1) Companies complete and publish their annual financial statements and 2) Major League Baseball teams begin their spring training. As players regroup and plan for their upcoming season, companies start to execute on critical projects and strategies for the current year.
If not already underway, public companies will need to plan for a significant change during 2017: the introduction of a new revenue recognition standard that becomes effective Jan. 1, 2018. While private companies can choose to adopt the new model early, they too must comply by 2019.
The new standard stems from the Accounting Standard Update (ASU) 2014-09, or ASC Topic 606 Revenue from Contracts with Customers, issued by the Financial Accounting Standards Board (FASB) in May 2014. ASC 606 establishes comprehensive accounting guidance for revenue recognition and will substantially replace all existing U.S. GAAP on this topic.
Prior to adopting the new model, the Securities Exchange Commission (SEC) also expects companies to provide SAB 74 disclosures in their annual and quarterly reports. The SAB 74 disclosure is meant to inform stakeholders of the impact the adoption of the new standard will have on companies’ financial statements. For companies that are unsure of what this impact will look like, the SEC recommends that they make a statement to their users to that effect.
Since its release, the FASB has issued several amendments clarifying ASC 606. Perhaps as a result, early adoption of this new standard has been rare: A December 2016 Audit Analytics analysis stated that only six S&P 500 companies are planning to adopt the standard early based on the disclosures from quarterly reports. Unfortunately, many organizations have left this task to the upcoming year.
For companies that have not yet started evaluating how ASC 606 will affect their business, they may encounter moments of uncertainty in applying the new model due to differing assumptions and approaches. Yogi Berra once said, “A nickel ain’t worth a dime anymore,” which, fortunately, is not the expected result of applying the new revenue standard, as the economic value of a transaction will still prevail. However, ASC 606 can change the timing of when certain revenue transactions are recognized, in the way revenue is allocated amongst promises in a contract and the information disclosed in financial statements.
The adoption of ASC 606 will affect multiple departments and business lines, as forecasting, deal structures (e.g. license agreements, milestones, etc.) and the presentation of revenue in 2018 financial statements and footnotes (e.g. grant proceeds are no longer considered revenue from contracts with customers) will all be evaluated through this new model. For life sciences companies, the impact of ASC 606 adoption will ultimately vary based on the nature and stage of each business. Some transactions (e.g. license transactions) will face more significant changes than others, requiring careful planning.
The New Model
The core principles of ASC 606 are built around the contract between a vendor and a customer for the provision of goods and services. ASC 606 utilizes the transfer of control between the parties to determine the pattern of revenue recognition based on the consideration to which the vendor is entitled. To accomplish this objective, the standard requires five basic steps:
- Identify the contract with the customer;
- Identify the performance obligations in the contract;
- Determine the transaction price;
- Allocate the transaction price to the performance obligations in the contract; and
- Recognize revenue when (or as) the entity satisfies a performance obligation.
What Life Sciences Entities Need to Know
For life sciences companies, adopting ASC 606 could be more complicated than other industries due to the nature and structure of various arrangements. Thus, each company should conduct an in-depth analysis of the related agreements.
A sample of such arrangements and some related considerations include:
Research and Development Arrangements
Arrangements are often complex, involving multiple deliverables and various types of consideration and often spanning several years. The analysis of whether a party to an arrangement is a customer (as defined in ASC 606) is important when evaluating whether “reimbursements” or “funded R&D” should be accounted for as revenue from contracts with customers. In answering this question, entities should determine whether the reimbursement relates to goods or services that are an output of the company’s ordinary activities. If the company’s ordinary activities are performing research and development, then it is likely that the relationship between the company and the counterparty is a vendor-customer relationship, and the consideration could be recognized as revenue.
These agreements (including historical agreements) need to be thoroughly re-evaluated as elements of the arrangements could be subject to ASC 606. Additionally, entities will need to consider the applicability of ASC 808, Collaborative Arrangements.
Milestones (a Form of Variable Consideration)
Many arrangements call for milestone payments that are contingent on the achievement of certain development thresholds and/or royalties on future sales of commercialized products.
The treatment of variable consideration is very different under ASC 606 versus existing GAAP. Current accounting rules typically preclude the recognition of revenue until the contingency or variable consideration becomes fixed or determinable. The “milestone method” currently permitted by ASC 605-28 will no longer be applicable under ASC 606.
In determining the transaction price, ASC 606 requires that companies include an estimate of variable consideration, either using the “expected value” (which is the sum of the probability-weighted potential outcomes), or the “most likely amount” of the consideration. Nevertheless, variable consideration should only be included in the transaction price to the extent that it is “probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty underlying the variable consideration is resolved”—a concept known as the variable consideration “constraint.”
In contrast, estimates of variable consideration are included in the transaction price under ASC 606 (if not constrained) and the fact that an arrangement contains variable consideration does not, in itself, preclude the recognition of revenue.
Royalties are another form of variable consideration. However, ASC 606 contains an exception to the principle requiring an estimate of variable consideration for a sales-based royalty for a license of Intellectual Property (IP). This is because estimating future royalties is quite difficult and would likely result in significant adjustments to the amount of revenue recognized due to changes in circumstances not related to the entity’s performance. Instead, royalties received in exchange for a license of IP are recognized as revenue at the later of when the sale occurs or when the performance obligation to which the royalty relates has been satisfied.
This guidance only applies to royalties received in exchange for a license of IP. Where the arrangement consists of a license and other deliverables, such as research and development services, life sciences companies will need to assess whether the license is the predominant deliverable to which the royalties relate. If so, then the royalty is subject to express guidance discussed in the prior paragraph. If not, then it should be treated like other variable consideration—i.e., estimated and included in the transaction price to the extent not constrained.
Licenses of Intellectual Property
ASC 606 contains special rules in making this determination for licenses. By way of background, the FASB believes that there are two types of licenses:
- Those which provide the customer with a right to access the entity’s Intellectual Property throughout the license period, which are recognized over time, and;
- Those which provide the customer with a right to use the entity’s IP as it exists at a point in time in which the license is granted, which is recognized at a point in time
The determination of whether the license is a right to access IP or a right to use IP depends on its nature. “Functional IP” typically grants a right to use an entity’s IP as it exists at a point in time, and has significant standalone functionality (e.g. a compound, technology or product). “Symbolic IP” provides the customer with a right to access the IP throughout the license period, and its utility is derived from the vendor’s past or ongoing activities (e.g. use of a brand).
In the life sciences industry, no two contracts are alike due to the numerous variables inherent in the development, production and ultimate marketing of compounds or products. This will require significant effort in evaluating contract terms in accordance with ASC 606. In many cases, when a life sciences company enters into a license and development arrangement, the IP (presuming it’s a separate performance obligation) will be considered functional. Revenue for a license to functional IP is typically recognized at a point in time—i.e., at the moment control over the license is transferred to the customer. However, if a license grants a right to use IP as it exists at a point in time, but the functionality of the IP is expected to substantively change during the license period due to activities of the vendor that do not represent a separate performance obligation, and the customer is contractually or practically required to use the updated IP to continue to derive a benefit from it, then the license grants a right to access the entity’s IP and is considered a symbolic license, which is accounted for over time. As such, an appropriate method would be selected to measure the vendor’s progress toward complete satisfaction of its performance obligation to provide access to the IP.
As noted above, evaluating license transactions in accordance with ASC 606 will require significant effort and a thorough understanding of each participant’s rights and obligations pursuant to the contract. Slight differences in structure or terms could result in different accounting results in when revenue is recognized.
The above considerations are based on straightforward contract terms between a vendor and a customer. In practice, each contract is unique and will require its own assessment of the related terms to reach the appropriate conclusion.
The new model will affect all businesses—and even biotech companies with no current revenue should familiarize themselves with the new requirements as future licensing or other revenue-related transactions for themselves or with other entities will be subject to the requirements of ASC 606.
Nevertheless, most companies will need to begin their planning and preparation now and focus on how ASC 606 will impact their financial statements and business. With enough focused effort, consultation and coordination, having a clear, well-documented path towards ASC 606 adoption at the beginning of 2018 is achievable.
How do I get more information?
We encourage you to read our publication BDO Knows FASB: Topic 606 Revenue from Contracts with Customers, which describes the requirements of the new standard in more detail. Additional resources are available at BDO’s Accounting Standards & Reporting Matters Center.